RBIs balance sheet expansion driven by growth in foreign currency assets
RBIs balance sheet increased by ~10% in the year ending June 30, 2014. This was mainly due to expansion in the foreign currency assets, which increased by ~15% (in rupee terms). The balance sheet of the issue department (in charge of notes in circulation) increased ~12% while the balance sheet of the banking department increased ~7.5%. Exhibits 1-5 detail RBIs balance sheet along with explanation on some of the components.
Record transfer to government due to zero transfer to contingency reserves
RBIs total gross income fell 13.1% to Rs646.2 bn in 2013-14 (see Exhibit 6). Earnings from foreign sources decreased due to lower interest rates in the global market. Earnings from domestic sources decreased due to higher depreciation (as yields were higher in 2013-14 compared to last year) even as profit on sale of securities was higher (see Exhibit 7). With expenditure falling 4.9%, RBI generated surplus of Rs526.8 bn with zero transfer to both contingency reserve (CR) and asset development reserve (ADR). The Technical Committee II (chaired by YH Malegam) recommended that since balances in CR and ADR are in excess of the required buffers, no further transfer was needed. Hence, the entire surplus of Rs526.8 bn was transferred to the central government, the largest-ever surplus transfer by RBI.
A few measures to reduce food inflation through supply-side management
RBI highlighted a few measures that could help reduce high food prices:
} Agriculture price policy. Given that long-term elasticity of market prices to MSP is close to unity, the model of fixing MSP (which is based on cost-plus approach) should be relooked at.
Equating wage growth to productivity growth. Wage cost increase has been a major factor behind higher agriculture production costs. Wage increases in excess of productivity growth lead to a wage-price spiral and make food inflation a self-perpetuating cycle. Wage increases should be in line with labor productivity for rural employment programs to be non-inflationary.
Storage, warehousing and more competitive markets. Short-term supply disturbances (such as weather-related ones) could lead to significant volatility, which can be reduced through increasing storage and warehousing facilities, as also cold storage facilities for perishable food, besides more competitive marketing structures. The Union Budget highlighted the need for a national market to introduce competition and integration across markets. State governments need to be encouraged to develop farmers markets in towns, which would require suitable modifications of APMC Acts.
Effective use of international trade. The export window should be shut only in extremis so as to give farmers gains from international trade and a fair chance of higher realization in an open economy. Imports should also be used liberally in anticipation of scarcity, and should not be delayed until scarcity (when it is too late to import). This will also improve consumer welfare.
Some of the other key medium-term challenges
Fiscal adjustment through revenue augmentation
To improve tax collection, it is important to improve tax efficiency and tax buoyancy. Tax efficiency can be improved through minimization of distortions by broadening the tax base, targeting negative externalities and strengthening tax compliance.
Low returns on government investments in public sector undertakings, insufficient returns on use of natural resources and inadequate disinvestment receipts also contribute to low revenue mobilization. These should be addressed to put Indias public finances on a firm footing.
Engagement of professional merchant bankers with proven track records and measurable performance yardsticks with market-related fees and incentives is needed to ensure quicker decisions and professional management of disinvestments. These merchant bankers could quickly handle the process of road shows and putting together the prospectus so as to complete the entire process of budgeted disinvestment as quickly as possible.
The government also needs to give a thought to privatizing some PSEs, which are not yielding due returns. This is typically the case where the PSEs suffer from capital misallocations and corporate governance issues.
Strengthening infrastructure by improving contractual arrangements for private sector
The nature of contracts with the government determines the risk allocation to the private sector in infrastructure. The broad principle is to allocate such risks as can be controlled or managed by the private sector to them, but many current contracts do not fully reflect this principle.
Based on learning from existing projects, revamped contract arrangements that limit risk transfer to project costs and controllable revenue items and use of innovations like Least Present Value of Revenue (LPVR) bids, e.g. for electronically tolled roads, may be examined.
Revamped infrastructure contracts also need to factor in the possibility of renegotiation and include mechanisms that clearly lay out the process to be followed in such an event. This will reduce the advantages of those who bid unreasonably in the expectation of being able to renegotiate better terms subsequently. Also, a more level-playing field will help to attract foreign direct investment (FDI) into the sector.
Removing obstacles and improving access to finance
A number of studies have shown that financing is a greater obstacle for small and medium enterprises (SMEs) than it is for large firms, particularly in the developing world, and that access to finance adversely affects the growth of the SME sector more than that of large companies.
In the Indian case, there is overdependence of SMEs on trade credit. Lowering information asymmetry through improved credit reporting, and greater competition and productivity enhancements in banks to lower intermediation costs, are necessary to improve credit flow to SMEs.
Harness technology to lower transaction costs and thus facilitating inclusion. Competition will also help, not just through more bank licensing but also by encouraging NBFCs and other businesses with the necessary capabilities and reach.
Managing the NPA cycle to ensure a sound banking system
There is need for countercyclical capital buffers and dynamic provisioning to deal with cyclical economic movements.
There is need to focus more closely on restructuring of standard loans.
While encouraging the process of recovery of distressed assets through asset reconstruction firms (ARCs), RBI is taking steps to ensure that distressed asset sales to ARCs genuinely transfer risks from the banks.
By Kotak Institutional Equities