## Wednesday, November 30, 2016

### Intrusive detail in the rules associated with de-monetisation

by Radhika Pandey and Bhargavi Zaveri.

After the demonetisation exercise announced on 8th November, the Government and RBI have been changing the rules relating to withdrawal, exchange and use of the demonetised currency on an almost daily basis.

• 13th November: The limits for exchange of cash, daily and weekly withdrawal limits were increased
• 14th November: The cash withdrawal limits for current account holders were increased
• 21st November: The withdrawal limits for expenses related to weddings scheduled before 30th December were increased.

The frequent changes in rules have raised several rule of law concerns relating to the manner in which the Central Government and the Reserve Bank of India are implementing the demonetisation measure. The RBI circular of 28th November makes some more changes by relaxing the withdrawal limits. It links the relaxation to the amount of current-legal tender cash that has been deposited in the bank account since 9th November. We argue that the linkage between relaxation of withdrawal limits and deposits of current legal tender money is flawed, the circular is vague, it overburdens banks and depositors and adds to the prevailing uncertainty on withdrawal procedures.

### Linking withdrawal to deposit of current legal tender

The RBI circular of 28th November ostensibly relaxes the withdrawal limits for cash from banks. However, it allows such relaxation only to the extent an equivalent amount was deposited, by the person seeking the withdrawal, in current legal tender. This means that if since 9th November, you have deposited Rs. 10,000 in your bank account in 6 notes of Rs. 1,000 and 80 notes of Rs. 50, you will be entitled to a relaxation of only Rs. 4,000 over and above the existing withdrawal
limits, since notes of 1,000 have been declared illegal tender. This is problematic.

Linking relaxation to deposit of current legal tender is flawed. In a circular issued on 14th November, banks were asked to keep track of depositor-wise information on the amount of deposit made in demonetised notes and the amount of deposits made in current legal tender notes. It is reasonable to presume that people who have had current legal tender (namely, currency notes in denominations other than the demonetised Rs. 500 and Rs. 1000 notes) in the last one month are not likely to have deposited the relatively scarce commodity back in their bank accounts. Hence, it is not clear who are the intended beneficiaries of this relaxation. Second, there is no rationale for linking relaxation to the amount deposited in current legal tender. There can be various principles on the basis of which a framework may be formulated for a staggered relaxation of withdrawal limits. For instance, the relaxation of limits may be need-based or based on the past usage of cash. However, there is no link between the deposit that a person made and the extent to which her withdrawal limit may be relaxed.

The circular is ambiguous on its objective as well as what it asks of banks and persons seeking to withdraw cash. At the outset, it says: "It has been reported that certain depositors are hesitating to deposit their monies into bank accounts in view of the current limits on cash withdrawals from accounts". This appears to convey that the objective of the circular is to encourage people to deposit the cash held by them in their bank accounts. It then says:"As it is impeding active circulation of currency notes (emphasis supplied), it has been decided, on careful consideration, to allow withdrawals of deposits made in current legal tender notes on or after November 29, 2016 beyond the current limits; preferably, available higher denominations bank notes of Rs 2000 and Rs 500 are to be issued for such withdrawals."

This wording raises numerous questions:

• Is the objective of the relaxation to encourage people to deposit their cash freely without an apprehension that they will be restricted from withdrawing it? If yes, it is unclear how limiting the relaxation on withdrawals to the money which has been deposited as current legal tender, will nudge people to deposit more cash. Or, is the objective of the relaxation to allow more legal tender to be circulated in the economy (as indicated in the emphasised language in the second paragraph of the circular)? Or, is it both?
• Does it incentivise people to deposit legal tender
money? Since legal tender is a scarce commodity, it is unclear why people will waste man-hours standing in queues to first deposit money and then stand in queue to withdraw? A related question is does it discourage people from hoarding cash? The answer is debatable. With frequent policy changes, people are uncertain of the next policy move. The uncertainty associated with frequent policy changes induce households to hoard and not spend whatever little cash they have at their disposal. A more predictable policy regime would nudge people to dispense with hoarding and plan their spending in a much more rational manner.
• Will there be no limit on the withdrawal of cash deposits made in legal tender? Banks were instructed on 14th November to keep depositor-wise information of the currency denomination of the notes deposited. Surely, implementation of this measure by the banks would have taken time. In any case, were the banks maintaining such a record from 11th November to 14th November? In short, if there is a dispute between the bank and a depositor on the amount that she deposited in current legal tender, how does a person wishing to withdraw cash in excess of the existing limits, prove that she had deposited an equivalent amount in the current legal tender?
• What if the person proposing to withdraw cash, desires to withdraw cash in a denomination other than Rs. 2000 or Rs. 500? Will her request be denied or will she be persuaded to accept currency notes of Rs. 2000 or Rs. 500?

The relaxation increases the administrative burden of banks and increases the cost of withdrawal for the ultimate consumer. This circular relaxes the withdrawal limits only for those who have deposited money in current legal tender. This requires mapping deposits made by customers since 11th November with withdrawals made by bank customers since then. It would impose a burden on banks who are already reeling under the pressure of increased workload owing to exchange and deposit of old currency notes. Moreover, it would increase the cost and difficulties associated with withdrawals since presumably, the bank customer may require to submit some proof that she had deposited the amount that she seeks to withdraw in the current legal tender.

### The way forward

Newspaper reports indicate that this measure is aimed at discouraging people from hoarding current legal tender money and deposit it in their bank accounts. Hoarding is a symptom of the uncertainty that underlies the frequently changing rules on holding cash. People hoard because they are unsure whether they will be allowed to withdraw their cash once they deposit it in their bank accounts. The key to disincentivising the hoarding of current legal tender, therefore, lies in bringing about greater predictability in the rules for cash withdrawals.

The ideal situation would be that from a given date, say X, the limits on withdrawal are completely relaxed for all economic actors. While this inconveniences people relying on cash until X, it makes it possible to plan one's affairs to account for the scarcity of cash. A gradual relaxation of withdrawal limits is the only way forward.

The process for gradually relaxing withdrawal limits must be such that (a) the rule of law is followed in the relaxation process; and (b) people are able to plan their affairs in advance.

One approach could be to announce a calendar, scheduling the relaxation of withdrawal limits by banks. A tentative schedule of withdrawal relaxations will allow people to plan their affairs in advance, reduce the prevailing chaos and uncertainty resulting from multiple rule changes and conditionalities attached to withdrawals and exchanges of currency. More importantly, it will dispense with ad-hoc relaxations of the kind linked to deposits in current legal tender.

Looking into the future, this episode serves as a reminder to us about the problems of central planning. Once government embarks on intrusive involvement in society, there is a high likelihood of the authorities tying themselves into knots. RBI failures on this subject are reminiscent of RBI failures in other parts of finance where a detailed system of central planning is attempted. The problems of de-monetisation are not so much about the weaknesses of implementation as about the infeasibility of bureaucratic intervention in the working of society.

Radhika Pandey is a researcher at the National Institute for Public Finance and Policy. Bhargavi Zaveri is a researcher at the Indira Gandhi Institute for Development Research.

## Monday, November 28, 2016

How to make digital payments work by Ajay Shah in Business Standard, November 28, 2016.

Post-demonetisation, police have made big cash seizures – without the power to do so under law by Prashant Reddy in Scroll.in, November 28, 2016.

Ten ways to save demonetisation and stop the economy from choking by Gurcharan Das in The Economic Times, November 27, 2016.

SSC Journal Club: Expert Prediction Of Experiments by Scott Alexander in Slate Star Codex, November 27, 2016.

It’'s permanent revolution by Pratap Bhanu Mehta in The Indian Express, November 26, 2016.

Inside a Moneymaking Machine Like No Other by Katherine Burton in Bloomberg Markets, November 25, 2016.

Demonetisation Alone Can'’t Turn Agricultural Markets Cashless by Nidhi Aggrawal and Sudha Narayanan in The Wire, November 25, 2016.

Mammaries of the Socialist Raj by Shekhar Gupta in Business Standard, November 25, 2016.

A Society Can’t Be Served By Intention Alone by Somasekhar Sundaresan in Wordpress, November 24, 2016.

State Of The Economy by Ila Patnaik in Rajya Sabha TV, November 23, 2016.

A flawed policy: The real problem with demonetisation is not just in implementation by Suyash Rai in Scroll.in, November 22, 2016.

CMIE estimation of the direct costs associated with de-monetisation in the 1st 50 days: Banks to bear an estimated cost of Rs.351 billion for demonetisation, Cost of queues to exchange currency is an estimated Rs.150 billion, Demonetisation to cost Rs.168 billion to RBI and Government, Enterprise to pay biggest price for demonetisation Transaction cost of demonetisation estimated at Rs.1.28 trillion, November 21, 2016.

Quit Social Media. Your Career May Depend on It by Cal Newport in The New York Times, November 19, 2016.

Memo from Winston Churchill on brevity: It speaks, Day 19 of 30 days by Narelle Hanratty in Anicca, March 11, 2016.

## Friday, November 25, 2016

### Problematic terms in the demonetisation debate

by Anirudh Burman.

The Government's move to demonetise Rs. 500 and Rs. 1000 notes, and place restrictions on withdrawals, exchanges and deposits has attracted both appreciation and criticism. This piece analyses the framework of this discourse and its implications for the economy and society. Terms like "demonetisation", "corruption", "inconvenience and hardship", "implementation" form the basis of this discourse. Interestingly, most of these terms have originated from the Government itself. This piece argues that by confining ourselves to these terms, we fail to grasp the true nature and impact of this measure.

### The economic context

The Indian government's move to withdraw the legal tender status of Rs. 500 and Rs. 1000 notes has had widespread effects on the economy. Holding these beyond a certain notified date will be
illegal. Those left with these notes after December 31 will lose their wealth by a corresponding amount. There are daily reports of the plight of urban daily wage labourers, farmers and those in unbanked areas.

The economic impact of this measure is being contested. A great piece by my colleague Suyash Rai argues that the costs of imposing this measure far outweigh the benefits are likely to affect the poor and under-banked areas disproportionately and may have a modest impact on corruption at best. Others have played down the likely impact on the poor and rural areas. They have supported the demonetisation as a courageous and bold step towards a larger effort at wiping out endemic corruption and black money.

What is already safe to assert is that for better or for worse, there has been large-scale disruption within the economy. Print and electronic media, social media, daily conversations are consumed with conversations around the principle and implementation of demonetisation, and around issues of corruption and black money. Yet, most of this discourse follows a predefined framework, using terms and nomenclatures propagated by the Government. The framework of this discourse is problematic, and this framework itself may have deleterious effects on our society.

### Problematic term: "Demonetisation"

Characterising the government's move as "demonetisation" is the most problematic fallacy of the current discursive framework. In this case, the Central Government has said that the RBI will refuse to honour its promise to provide legal backing to Rs. 500 and Rs. 1000 currency notes. They will effectively refuse to honour the property rights of those holding them. Every time the RBI issues a currency note, it adds a liability to its balance sheet. By refusing to honour these notes as legal tender, the RBI will extinguish its liability towards persons holding them, in effect enriching itself. In addition, substantial restrictions have been placed on exchanging old notes for new, withdrawal and exchange of money. This is a substantial interference in the rights of people from accessing their own money. This is expropriation, not demonetisation.

In its broadest sense, expropriation refers to a taking of certain items or goods by the government by refusing to honour the property rights of those holding such items or goods. Bank nationalisation was an act of expropriation. The Indian government refused to honour the property rights of the owners of banks and transferred the ownership of the banks to itself.

Land acquisition is an act of expropriation.  The government expropriates the property rights of individuals. Land reforms undertaken in the 1940s and 1950s were acts of expropriation where property held by zamindars was transferred to the states by virtue of laws passed by them.

The Vodafone tax demand by the Indian government has been alleged to be an expropriatory action as Vodafone's income is being expropriated by imposing an allegedly unfair tax on it. Expropriation need not be an absolute taking or extinguishment of property rights in all cases.

Even a high degree of restriction or interference with property rights has been held to be expropriatory in many jurisdictions worldwide. Therefore, the Government and RBI's decision to (a) withdraw legal tender status, and (b) impose severe restrictions on withdrawals from one's own account is definitely an act of expropriation.

This act of expropriation is singular, given the nature of the expropriation and the views of the political party in power. Two of its cabinet ministers favoured a debate early last year on whether the word socialist should remain in the Preamble to the Indian Constitution and its ally the Shiv Sena demanded the removal of the word (link here)! This same Government is now justifying this expropriatory act as a moral imperative.

The nature of the expropriation is much more problematic. There are at least three ways in which this expropriation is remarkable:

1. In most cases, property rights of certain defined individuals or classes are expropriated. The owners of banks were identifiable individuals, and so were the zamindars who were expropriated when land reform laws were passed. In this case, it is not so. Property rights across the entire economy are being expropriated without distinction. At the same time, there is no single identifiable person who is being expropriated. This is likely to have societal consequences I will elaborate later.
2. Governments usually expropriate rights, or assets - like wealth, mineral resources, land, intellectual property (through compulsory licensing). In this case, the medium of exchange in society is asset being expropriated. This is an expropriation of cash, not wealth. This is singular in the annals of expropriatory actions by governments worldwide. Many governments have demonetised currencies to combat hyperinflation, but no one has withdrawn legal tender status on currency notes in times of normalcy, and imposed restrictions on an individual's ability to hold cash at the same time. In an economy that is almost completely cash driven, and where most households hold Rs. 500 and Rs. 1000 notes as means of exchange for sustenance, this is bound to have serious repercussions.
Money is not just a medium of exchange and a store of value, it is also, as has been argued, a source of social prestige and psychological security. In a cash-based economy like ours, people primarily derive social capital and psychological security from money in the form of cash. This expropriatory measure has therefore arguably extinguished or imperiled the social prestige and psychological security of those who relied on cash money to provide these for them.
3. Governments usually expropriate the rich to redistribute to the poor (at least ostensibly) or to create benefits for the public good (roads, highways, etc). Bank nationalisation expropriated the rich bank owners so that Indira Gandhi could use banks as agents of poverty reduction. Land reforms were done to expropriate zamindars and redistribute land to the poor. In other countries, governments expropriate owners of oil fields and mineral deposits so that the government can channel the benefits from such resources for the public good. Since this expropriation is economy-wide, everyone's medium of exchange is being confiscated/ restricted regardless of whether they are rich or poor. However, the main brunt of the expropriatory action is on the poor. There are two main ideas being talked about with regard to what the government might do with the windfall in order to redistribute wealth to the poor. To clarify, neither the Government nor the RBI have stated or clarified on what they intend to do, and what legislative changes will need to be made. It is however worthwhile to discuss these as the two broad ideas that are being discussed -
1. The government may improve its fiscal situation and use the fiscal space to provide income tax relief/ loan waivers. The poor are not going to benefit from income tax relief since only 4 percent of India's population pays income tax. The Sixth Economic Census of the CSO (March 2016) finds that only 2.3 percent of non-agricultural establishments received financial assistance from financial institutions. This number is likely to be the same or even lower for agricultural establishments. Loan waivers are therefore going to have minuscule impact, and benefit only those who are well-off enough to access the formal financial system.
2. The government may, through some legislative jugglery, recapitalise banks and kick-start lending. Again, the gains are going to accrue mostly to the rich and the middle class. It is debatable as to how the unbanked and expropriated 40 percent would reap the benefits of any bank-led redistributive measure since 40 percent of the country is unbanked (Census 2011).

This is therefore, a unique expropriatory measure that expropriates from everyone in society to benefit those who suffer the least "inconvenience" from the expropriation (more on this later).
Discussing this step as an expropriatory measure brings to the fore legal protections and requirements that are concomitant with expropriation: what is the legal authority for taking away the
property of individuals? Is compensation due to those who have been expropriated and if yes, in what form? What due process is applicable to expropriatory measures taken by the Government? Coining this expropriation demonetisation is putting lipstick on a pig in its truest sense.

### Problematic term: "Corruption"

Equally problematic is the way this expropriatory action has re-defined the "corrupt" and "corruption". All preceding actions against corruption taken by the Indian State in the past have been against those who have either evaded taxes or earned money by committing illegal acts. The issue was that certain people either evaded taxes or did something they were not supposed to, and such people had to be identified and punished. The voluntary disclosure scheme followed this overarching principle by encouraging people who did not pay taxes to come forward. The same principle is at play in the issue over identifying people who have stashed their illegal money abroad, and in the identification and prosecution of officials violating the Prevention of Corruption Act.

This expropriatory measure has the potential to re-define how people think about the corrupt and corruption. For one, the focus is now on confiscating corrupt wealth and black money. Identifying the corrupt and identifying individual acts of corruption has taken a backstage. Expropriation itself has become a mode of punishment. It is being suggestively implied that society has a chance to start again with a clean slate if black money is wiped out. The complete failure of the state to act against corruption is being used as an excuse to infuse society with a new kind of morality.

Second, corruption has now become a crime without a perpetrator. Multiple people I have talked to situate themselves as victims of corruption. A landlord who has built an illegal flat does
not give his tenant a lease-deed and accepts payments only in cash told me he was proud the Prime Minister had taken this step on behalf of honest people like him. An auto-wallah who confessed to driving without a permit and did not agree to go by meter railed against the corrupt during the duration of my journey. An Uber-driver praised the expropriation repeatedly while he ferried me. Close to the end of the ride he nonchalantly told me he had to drive carefully since the police had impounded his license the previous day. While these anecdotes hardly constitute statistical evidence, they are indicative of the fact that people go to great lengths to justify their actions as moral and honest.

However, the logic goes, everyone else must be corrupt if corruption is endemic enough to justify this kind of measure. This discourse is elevating the widespread cynicism and hatred against politicians, bureaucrats, the police, big business, small business and the media. Everyone feels like a victim and everyone else is suspect. But no one is a perpetrator or an agent. Everyone wants to sock it to the rich and the corrupt though no one knows who they are. So it is acceptable to take some punches yourself if the corrupt suffer in the process. The Government is at once elevating the pitch for shared sacrifice while also (most probably and hopefully, unintentionally) exacerbating the conditions for social and institutional distrust. Issues of class envy and class conflict are already coming to the fore and may get further magnified in the future.

This, in turn, is likely to create a collective psyche where no individual or institution can be trusted. No one is deserving of empathy since their corruption might be the cause of your suffering. This is happening even though the Government is at pains to explain that this will be one among many previous and future steps against corruption. By re-framing corruption as a crime without an agent through this singular action, the Government has perhaps unwittingly created the conditions in which the nature of discourse regarding solving corruption in society changes permanently.

This is a simple expropriation at its core. The object and effect of this measure are predominantly expropriatory. The confiscation of black money is an incidental benefit by design. The rhetoric of sweeping up black money and the design of the expropriatory measure do not match up to each other.

### Problematic terms: "Inconvenience"

It is inconvenient to have to switch to a mobile wallet and stand in an ATM queue for 2-3 hours once a week. Many people I have spoken to are ready to suffer this inconvenience if it helps achieve the stated objective of finishing off black money in the economy. When individuals who depend on their daily wage to feed themselves and their families are laid off, this cannot be called an inconvenience. The tribulations of agricultural workers and small entrepreneurs cannot be called an inconvenience if their enterprise fails due to the lack of liquid cash. Sectors of the economy that function largely in cash are suffering disproportionately compared to those with access to plastic money and mobile wallets. There is an attempt to normalise and standardise the way the effects of this expropriation are to be thought about by using this one word to describe the depth and diversity of suffering within the economy.

There is a breadth of literature on the impact of income shocks on those who are at the lower end of the poverty line. Income shocks push many just above the poverty line back into poverty. They also push many into debt, since their savings are not sufficient to sustain themselves. Small incidents like an unanticipated illness have an outsized impact on their long-term well-being and potential for growth. The current actions of the Government have administered just such an income shock on the poorest.

The Government should have taken much more aggressive measures to protect the worst affected economic classes in society, but calling this suffering an inconvenience allows it to paper over this failure. Had the Government instead defined the consequences of this measure as a "scarcity" of currency, corresponding actions may have been discussed, and some implemented. Government actions and popular discourse during times of scarcity are motivated by a desire to ensure everyone has adequate rations to sustain themselves.

Scarcity creates its own social dynamics. It creates new intermediaries in the market - when food is rationed, black marketeers emerge to supply food at above-market prices. After this expropriation, intermediaries are delivering white money for black for a commission. The war against corruption is creating new forms of corruption.

Mobile applications with horrifying names like "Book my chotu" are advertising hired help who can go stand in queues for those who can afford it. Most troublingly, scarcity changes relationships in society by creating new power dynamics. Hitherto bankers were service providers. Now they are agents of rationing. They have asymmetric power compared to those standing in the queues before them. It is a credit to them that they are still providing services under conditions of extreme difficulty. On the other hand, like any agent of rationing, they are now exposed to mob fury and mob violence. The customer has now become a beggar. His/her money is locked up in a bank. The psychological security gained from holding money that I alluded to earlier has vanished. Whereas earlier he or she could demand service, now they pray they get to exchange\withdraw money, and can suffer at the hands of a capricious banker.

### Conclusion

Some have argued that even if the Government wanted to take this step, it could have been timed better. But what is a good time for extinguishing property rights? Any time is equally good and equally bad. Others have argued that the step has been implemented badly. But expropriatory actions are judged first and foremost by the validity of the expropriation itself. We have been too quick to assume the validity of this measure and debate its implementation. As long as the terms of the discourse are set by those who introduced the measure, we will also be confined to their predefined moral straitjacket of honesty versus corruption, sacrifice versus timidity and sincerity versus venality. Empathy will be a casualty.

The Government has framed this step against corruption as a moral question. Should we not ask a moral question of the Government: Is it ethical for any State to expropriate the predominant means of exchange from everyone in society, especially in a poor cash-dependent economy?

The author is a researcher at the National Institute for Public Finance and Policy.

### Methods for measurement of delays in the bankruptcy process

by Dhananjay Ghei and Shubho Roy.

When dealing with distress, the single big idea for avoiding value destruction is speed of action. Delays destroy value. When we cope with failing firms (through a bankruptcy code) or failing banks (through a resolution corporation), the measure of institutional quality is the recovery rate, and the key determinant of the recovery rate is speed of action.

#### Methods for measurement of delays

The conventional method for assessing delays is to run a survey of insolvency practitioners (judges, lawyers, accountants). In this article, we offer a new idea for measuring one part of the delay.

There are many parts of the bankruptcy process. Many societies try to avoid the problem of failed firms by putting things off. This leads to a delay between the actual firm failure and the commencement of the formal bankruptcy process. Could this be measured directly? We could start from the date of the end (the date of the official legal action about firm closure), and look back to the date on which extreme credit distress is identified. The gap between the two events will serve as a proxy for delays of the bankruptcy process.

Let's play this idea out with the failure of Kingfisher Airlines.

The decisive end date is 18th November, 2016, when the Karnataka High Court ordered the winding up of Kingfisher Airlines (See here).

Conventional notion of delay: The case was filed by an unsecured (foreign) creditor on 18th September, 2012. It took the legal system four years to come to the conclusion that Kingfisher Airlines is insolvent.

Looking back using interest coverage ratio (ICR) as a measure of credit stress. This is defined as the ratio of the earnings of a company (EBITDA) and the total interest payments due. The logic being that if a company's income is not enough to even pay the interest on its borrowing, there is acute distress. The literature in finance uses ICR in a couple of different ways when assessing firm distress. Here are three examples:

ICR below 1
Distress is where the ICR falls below 1 in any year. Example: Claessens, Djankov, and Lang 1998..
ICR below 0.75
Distress is where the ICR for any financial year falls below 0.75. Example: Love, 2010.
P-ICR
Distress is Persistent-ICR, which is defined as an ICR of less than 1 for three consecutive financial years. Example: Chung and Ratnovski, 2016

We extract the annual financial data for Kingfisher Airlines from CMIE Prowess database. The data is available from March 2001 till March 2013. Figure 1 below shows when Kingfisher Airlines met these criteria. It broke into ICR-below-1 and ICR-below-0.75 in March 2005 (red line) and it achieved P-ICR in March 2007 (orange line). The court finally ordered winding up 3520 days after Kingfisher meeting all the three criteria (gray line). The black line (October 20, 2012) is when DGCA suspended Kingfisher's license.

 Figure 1: Interest cover ratio for Kingfisher Airlines

Looking back using Distance to Default as a measure of credit stress. Distance to Default (DtD) is measured as the difference between the asset value of the firm and the face value of its debt, scaled by the standard deviation of firm's asset value. It measures the distance (in standard deviations) between the expected value of the firm and the "default point" (face value of the debt). Thus, lower values of DtD imply that the firm is more likely to default on its financial obligations. DtD is implemented in R using the ifrogs package developed by IGIDR Finance Research Group.

 Figure 2: Distance to default for Kingfisher Airlines

Figure 2 shows the DtD for Kingfisher Airlines from June 2007 onwards. As the listing took place on 12 June 2006, the DtD calculation only commences on 12 June 2007. The red line shows the date when DtD was below 1 for the first time (August 1, 2008). DtD reached its lowest value of 0.30 on July 6, 2009 (orange line). Thus, at that point the likelihood of default was the highest (19 percent).

#### Conclusions

The approach shown above with Kingfisher is potentially scalable into large datasets and all countries. This could yield large-scale measurement, at the level of individual bankruptcy transactions, about delays. This can yield useful summary statistics.

The new insolvency law should reduce the time between financial insolvency and the legal recognition of the same. This should yield measurable gains when these techniques are applied to the data in the future.

Our approach yields micro data about delays which can be analysed in order to explore cross-sectional and time-series variation. Such analysis is not feasible with the conventional measurement of delays that is based on surveying practitioners.

Dhananjay Ghei and Shubho Roy are researchers at the National Institute for Public Finance and Policy. The authors would like to thank Radhika Pandey, Rajat Kochhar and Mohit Desai for their inputs.

## Thursday, November 24, 2016

### Author: Dhananjay Ghei

Dhananjay Ghei is a researcher at the National Institute for Public Finance and Policy. On this blog:

## Tuesday, November 22, 2016

### Health policy researcher at NIPFP

Founded in 1976, NIPFP undertakes research, policy advocacy and capacity building in areas related to public economics and public policy. NIPFP seeks to recruit two persons in the fields of:

1. Reforming the health care regulatory system, which will include regulation of medical education, health professions and quality of medicines; and
2. Building State capacity for disease surveillance.

We are looking for curious, motivated and qualified persons for research in public health and health care regulation. These are full-time positions. The persons will be required to support research in law, economics and public policy. The persons will be assisting in writing articles and research papers; and drafting laws. The position will involve working with people from varying backgrounds including economics, law and public policy. It will provide exposure to cutting edge research in the field of health.

NIPFP is a modern workplace with state of the art processes and technologies including Linux, Latex, SVN, R.

A background in economics or law is essential; domain knowledge on health is desirable. A minimum of one year of work experience is required. Ph.D. applicants are particularly welcome, and fresh Ph.D. applicants are welcome.

Desirous candidates may email a resume and a covering letter to consultants@nipfp.org.in where the Subject is "Health policy researcher position".

The positions will remain open until filled.

### Technology policy researcher at NIPFP

Founded in 1976, NIPFP undertakes research, policy advocacy and capacity building in areas related to public economics and public policy. NIPFP seeks to recruit two persons in the fields of:

1. Telecommunications law and policy,
2. Internet governance and broadcasting regulation
3. Net neutrality
4. Quality of mobile and data services
6. Spectrum management
7. Privacy
8. Security in the Internet age
9. Competition policy issues in the new economy
10. Complex IT systems as a tool for achieving State capacity

We are looking for curious, motivated and qualified persons for research in technology policy. These are full-time positions. The persons will be required to support research in law, economics and public policy. The persons will be assisting in writing articles and research papers; and drafting laws. The position will involve working with people from varying backgrounds including economics, law and public policy. It will provide exposure to cutting edge research in the field of technology policy.

NIPFP is a modern workplace with state of the art processes and technologies including Linux, Latex, SVN, R.

A background in technology is essential; knowledge of public economics and law is desirable. A minimum of one year of work experience is required. Ph.D. applicants are particularly welcome, and fresh Ph.D. applicants are welcome.

Desirous candidates may email a resume and a covering letter to consultants@nipfp.org.in where the Subject is "Technology policy researcher position".

The positions will remain open until filled.

### SEBI's proposals on advisors and distributors

by Renuka Sane.

The recent consultation paper by SEBI (SEBI, 2016) that proposed restrictions on the use of the term "advisor", as well as on the ability of people to provide an opinion on public platforms has led to an intense debate on regulatory over-reach (Varottil, 2016). The paper, however, raises a larger question - on how should we think of distribution and advice of retail financial products - the answer to which is not obvious.

How extensively should product sale be regulated for achieving consumer protection ultimately depends on how we think of the following factors:

1. Is the product universally good, or is it good only under specific circumstance?
2. Can the customer be reasonably expected to arrive at a decision about the merits (and harms) of the product?
3. If there exists information asymmetry (i.e. the buyer cannot easily determine the quality of the product), what can drive the seller of the product to behave in the interest of the buyer?
4. What is our ability to enforce any regulation that tries to align the incentives of the seller and the buyer?

### A medicine analogy

Regulations about distribution and advice connected with medicines help us see some of the issues. One could argue that a Crocin is universally useful, and most individuals should be able to decide on whether to take the medicine when feeling unwell. A simple antibiotic may be universally good (i.e. very limited side effects), but the customer may not be able to take the decision by herself. A complicated cancer drug may neither be universally good (i.e. the side effects may vary dramatically depending on the person) nor can it be expected that the customer is equipped to take the decision herself.

We may need intervention in the sale of a simple antibiotic especially if over-use imposes negative externalities by kicking off antibiotic-resistant bacteria, and definitely need intervention in the sale of a complicated cancer drug. The intervention is in the form of a prescription by someone who knows better. The doctor is expected to behave in the interest of the customer - both because she wants to retain the customer, and because there exist regulations that require a certain professional standard.

A requirement on the prohibition of sale of complex medicines without prescription is successful to the extent that the regulator can enforce it. For example, this requires knowledge of what doctors are doing, and whether they are prescribing medicines after due care. It also requires knowledge of what chemists are doing, and whether they are selling medicines only on prescription.

How should we regulate distribution of financial products? Can we find products that are generally good for everyone? The answer to this depends on how large is the investment in the product relative to the overall portfolio of the customer. If it is a small part, then perhaps, no product is too dangerous. If it is a large part, then perhaps, any product is dangerous. If the regulator doesn't know the investors portfolio, and it is not possible or desirable for the regulator to keep a tab on this, then it becomes difficult to think of simple and complex products.

If there are no simple products, and every product is treated as a drug requiring prescription, then there is no purchase at a chemist without prescription either. This implies that sales can only happen after going through a financial advisor. What are the costs of assuming all products are complex products, and require advice? This is the same problem in making people get prescriptions for a crocin. In an economy where most saving continues to be in gold and physical assets, distributors may play an important role in taking the message of financial products to customers. Advisors may only be viable if they are also able to distribute the product. It is unclear which business model will be the most effective.

Why have we been so uncomfortable about distributors? The evidence has pointed to distributors being influenced by high commissions paid by product providers, and not caring for the customer (Anagol and Kim 2012; Halan, Sane and Thomas, 2014). As a result, regulators, especially SEBI, have taken several steps in reducing the influence of high commissions on distributor behaviour.
However, commissions are just one lever to align incentives, as this can never be achieved through a single instrument. It can be done through the following:

1. Product regulation: This involves ensuring that the products available for sale are not toxic in their design. This is not to give regulators unbridled powers to prohibit new products, or ban existing products, but to expect regulators to ensure that products follow basic hygiene principles on costs, investment of customer contributions and disclosures.
2. Disclosures: This involves maintaining easy to understand disclosures about the product for the customer - what the product costs, what return it promises (if guaranteed), what is its past performance (over multiple horizons if the product is market linked), and what are the rules surrounding exists.
3. Fee structure: This involves setting up a fee schedule which has low upfront fees relative to a trail if paid by the product manufacturer. Higher fees may be possible when the customer is directly remunerating the seller.
4. Code of conduct: This involves providing guidelines on what is expected of the seller of a product. This ranges from requiring sellers to undertake a risk profiling of the customer, to acting in a fiduciary capacity.
5. A redress system: Rules on disclosures, fees and code of conduct have meaning only if there is enforcement. This can be brought about only if regulators are able to carry out proactive inspections (through mystery shopping exercises for example), listen to customer complaints through an efficient redress system, and respond both by punitive action and policy action.
6. Uniformity across products: Finally, all the rules that govern seller behaviour and the redress system have to be uniform across all providers, such that there is no regulatory arbitrage. In fact, the idea of solving the regulatory arbitrage issue was one of the central recommendations of the Bose Committee Report (2015).

### The SEBI proposal

The SEBI proposal addresses one component of the framework required for solving the mis-selling problem. The objective of the proposal is to specify uniform standards across all intermediaries engaged in providing investment advisory services. The distributor can continue to sell products, and obtain a trail commission, but not use the title of an independent financial advisor.

In principle, and keeping aside the specific issue of regulatory over-reach related to people putting up opinions on public platforms (Shah and Zaveri, 2016), this seems to be a reasonable requirement. Customers should be easily able to distinguish "advisors" from "distributors", and then make up their minds about what works in their interest. Where the proposal becomes problematic is in requiring that distributors do not provide incidental or basic investment advice in respect of mutual fund products. If they wish to provide such advice, then they have to register with SEBI as an Investment Advisor and follow the SEBI (Investment Advisers) Regulations, 2013. This is difficult for two reasons.

First, distributors may be providing a valuable service in explaining what a mutual fund is to people who have never invested in a mutual fund. Or when a customer asks a distributor questions about the product she is buying, it may difficult to answer customer queries, without providing advice to the customer. For this the proposal says that the distributor may describe the product specification without recommending any particular product. However, one can think of several situations with descriptions of the product can be construed as product recommendation.

Second, the SEBI proposal is silent on how it will enforce this requirement. The proposal provides no clarity on what recourse a customer has if advice was given by the distributor other than a cursory mention of SCORES (the SEBI redress system), and what recourse the distributor has to justify why the information provided was not advice. We have seen from experience that distributors often get customers to sign disclosure forms, and then use these against the customer when things go wrong. The SEBI proposals do not provide any tools to ensure that such instances will not happen with these new proposals.

If SEBI is serious about segregating distribution from advice, then it needs to do a lot more work in designing guidelines on how it would distinguish between the two, and how it would enforce this distinction. SEBI also needs to put out evidence, gathered through inspections, mystery shopping exercises or analysis of customer complaints, on why advice given by distributors is not working in the interest of the customer, and what should be different about this advice. It should provide examples of what it expects distributors to do in different situations, so this could guide distributors on what exactly the regulator expects of them. It would not be very useful to proceed in the direction proposed by SEBI without such an underlying clarity, and establishment of processes to deal with such ambiguities that will certainly arise over time.

### Way forward

As discussed earlier, aligning commissions, establishing advisors, enforcing the distinction between advisors and distributors are some of the requirements for getting closer to consumer protection in retail finance. However, until we enact the draft Indian Financial Code (IFC), we will continue to have sectoral regulators, and continue to grapple with the problem of regulatory arbitrage.

Even if we are able to enact the IFC, and set up the Financial Redress Agency (FRA) to deal with customer complaints, we would have made only established the institutional infrastructure. Sane and Shah (2014) suggest three other elements that are required. The first is a more detailed Consumer Protection Handbook that translates principles-based IFC into a shared contemporary practical understanding. The second is the design of the actual regulations that flow from the IFC. The third is setting up effective enforcement.

As suggested by the authors, Consumer protection would come about when individuals inside financial agencies, and those inside financial firms, have a shared understanding of all four steps: of the law, the regulations, of the kinds of enforcement actions that get taken, and the stance of the judiciary on the standards of proof that are required and on contemporary interpretation of timeless principles from the IFC. To achieve true consumer protection, we need to move towards this direction.

### References

Anagol, S. and H. Kim (2012), The Impact of Shrouded Fees: Evidence from a Natural Experiment in the Indian Mutual Funds Market, The American Economic Review, 102(1).

Bose Committee Report (2015), Report of the Committee to recommend measures for curbing mis-selling and rationalising distribution incentives in financial products, Ministry of Finance, Government of India.

Halan, M., R. Sane and S. Thomas (2014), The case of the missing billions: Estimating losses to customers due to mis-sold life insurance policies, Journal of Economic Policy Reform, October 2014.

Sane, R., and A. Shah (2014). Consumer protection in Indian finance: Going from ideas to action, Ajay Shah's blog, August, 27, 2014.

SEBI (2016). Consultation Paper on Amendments/Clarifications to the SEBI (Investment Advisers) Regulations, 2013.

Shah, A., and B. Zaveri (2016). SEBI's proposal to regulate social media: Where did we go wrong?, Ajay Shah's blog, October, 15, 2016.

Varottil, U (2016), SEBI's Proposals on Stock Advice through Social Media, IndiaCorpLaw blog, November, 4, 2016.

The author is an academic at the Indian Statistical Institute, Delhi Centre. I think Monika Halan and Bhargavi Zaveri for useful discussions.

## Monday, November 21, 2016

Six battlegrounds for the war on corruption by Vijay Kelkar and Ajay Shah in The Mint, 21 November.

China's Great Leap Backward by James Fallows in The Atlantic, December 2016 Issue. And:
Crackdown in China: Worse and Worse by Orville Schell in The New York Review of Books, 21 April. From the Fallows article: “Their political model has absolutely no appeal, not even to their own people,” Chas Freeman told me... “This is a sui generis system that no one is copying.”. Sadly, there are people in India who aspire to the China model'.

Ushering in insolvency professionals by Rajeswari Sengupta and Anirudh Burman in The Business Standard, 20 November.

Wedge-tailed eagles do battle with mining giant's drones, knocking nine out of sky by Jarrod Lucas in The ABC News, 18 November.

GDP conundrum: Some areas of concern around growth overestimation in Indian manufacturing by Amey Sapre, 18 November. GDP conundrum: Is India booming? by Rajeswari Sengupta, 16 November and  GDP conundrum: What makes the changes in the new series so radical by J. Dennis Rajakumar and S.L. Shetty, 16 November. All  in Ideas For India.

At Delhi's Azadpur Mandi, Lack of Money is Slowly Choking Business and Also Workers by Anuj Srivas and Ajoy Ashirwad Mahaprashasta in The Wire, 18 November.

P.E.I. farmer assists in near-eradication of methane from cow farts by Shane Ross in The CBC News, 18 November.

Gone in 9 days The Mumbai Mirror, India Times, 18 November.

You have been warned by Pratap Bhanu Mehta in The Indian Express, 17 November.

We in India are quite inured to politics as a family business; compare and contrast with The Bitter Feud Behind the Law That Could Keep Jared Kushner Out of the White House by Josh Zeitz in The Politico Magazine , 17 November.

Helping consumers win the telecom wars by Smriti Parsheera in The Mint, 16 November.

According to Snopes, Fake News Is Not the Problem by Jessi Hempel in The Backchannel, 16 November.

## Friday, November 18, 2016

### Drafting hall of shame #2: Mistakes in the Insolvency and Bankruptcy Code

by Shefali Malhotra and Rajeswari Sengupta.

The Insolvency and Bankruptcy Code 2016 establishes the Insolvency and Bankruptcy Board of India. One of the primary functions of the Board is regulation of insolvency professionals and insolvency professional agencies. Section 240 of the Code empowers the Board to make regulations to carry out its functions. Some provisions under section 240 are peppered with drafting errors.

### Confusing cross-reference

Section 240(2)(zzg) deals with setting up and management of governing boards of insolvency professional agencies. It should cross-reference the provision granting power to the Board to make appropriate regulations. Section 240(2)(zzg) states:

the setting up of a governing board for its internal governance and management under clause (e)...of section 196

It is not clear whether the above reference relates to clause (e) of sub-section (1) or sub-section (2) of section 196. Section 196(1)(e) deals with minimum curriculum for the examination of insolvency professionals, and has nothing to do with the governing of boards. It reads:

lay down by regulations the minimum curriculum for the examination of insolvency professionals for their enrolment as members of the insolvency professional agencies;

Section 196(2)(e) is the correct cross-reference. It reads:

setting up of a governing board for internal governance and management of insolvency professional agency in accordance with the regulations specified by the Board

Section 240(2)(zzg) also deals with the conduct of examination for insolvency professionals. Section 240(2)(zzg) reads:

...the manner of conducting examination under clause (m), of section 196

In this case also it is not clear whether the above reference relates to clause (m) of sub-section (1) or sub-section (2) of section 196.

### Incorrect cross-reference

This part of section 240(2)(zzg) talks about setting up of curriculum for examination of insolvency professionals. It reads:

...the curriculum under clause (l)...of section 196

In this case, neither clause (l) of sub-section (1) nor of sub-section (2) of section 196 apply. Section 196(1)(l) deals with constitution of committees of the board, and section 196(2)(l) deals with procedure for enrollment of insolvency professionals.

The correct cross-reference should have been clause (e) of sub-section (1) of section 196. Section 196(1)(e) reads:

lay down by regulations the minimum curriculum for the examination of insolvency professionals for their enrolment as members of the insolvency professional agencies

### Non-existent cross-reference

Section 240(2)(zzj) deals with the functioning of insolvency professionals. It reads:

the manner and the conditions subject to which insolvency professional shall perform his function under clause (f) of sub-section (2) of section 208

However, sub-section (2) of section 208 does not even have a clause (f)! The correct cross reference should have been clause (e) of sub-section (2) of section 208. Section 208(2)(e) reads:

to perform his functions in such manner and subject to such conditions as may be specified.

### Conclusion

The Government setup the Bankruptcy Law Reforms Committee (BLRC), on 22nd August 2014, to design the legal framework for corporate insolvency in India. The BLRC submitted its report on 4th November 2015. That is a total of 440 days. The Insolvency and Bankruptcy Code 2016 is based on the report of the Committee. The Code was introduced for the first time in the Lok Sabha on 21st December 2015, was cleared by both the Houses on 11th May 2016 and received the assent of the President on 28th May 2016. During its passage, the Code was also referred to a joint committee.
That is a total of 160 days in the Parliament.

The quality of drafting does not appear commensurate with this effort. The drafting errors pointed out in the Code leads to unnecessary confusion and opens up gateways to litigation, which could have been easily avoided. The presence of such basic errors raises the possibility that more serious errors are also present. We should analyse the steps that led up to the IBC, evaluate them against the ideal mechanism, and do better in future projects.

Shefali Malhotra is a researcher at the National Institute for Public Finance and Policy. Rajeswari Sengupta is a researcher at the Indira Gandhi Institute for Development Research. They thank Shubho Roy and Anirudh Burman for useful discussions.

### Author: Shefali Malhotra

Shefali Malhotra is a researcher at the National Institute for Public Finance and Policy. On this blog:

### Legal questions about demonetisation: What happens to the assets that back extinguished rupee notes

by Radhika Pandey and Bhargavi Zaveri.

There are three important questions of law associated with demonetisation. This article seeks to shed some light on the third question. The demonetisation of Rs. 500 and Rs. 1000 has led to speculation about the amount of currency that will not be deposited or exchanged at all, because of fear of scrutiny by tax authorities. Some suggest that from and out of the notes in circulation, close to 20 per cent may not be exchanged or deposited at all with RBI (see here, here and here). (Others believe this will not happen). The numerical values involved are very large; 20 per cent works out to INR 3 trillion disappearing from circulation.

The law governing the withdrawal of legal tender in India allows the Central Government to declare that currency notes of a certain denomination will not be legal tender, except at the specified offices of RBI until such date as may be specified by the Central Government in a gazetted notification. In his speech, the Prime Minister specified March 31, 2017 as the date up to which RBI will accept the demonetised currency. However, in our knowledge, this date has not appeared in a gazetted notification (See here). Let's assume that RBI will cease to be liable to accept the un-returned demonetised notes after a certain date, which for the time being, appears to be March 31, 2017.

The central bank of any country must, for every note that it issues, back itself with corresponding assets. The liability incurred on notes issued and the assets backing such liability, are reflected in the balance sheet of the central bank. Typically, these assets are government securities, bullion and foreign securities. Now, in a one-time event like demonetisation, the liabilities of the central bank may significantly plummet, as the central bank will no longer require to honour the commitment to pay on the notes that are not returned to it. This would lead to a mismatch in the balance sheet of the central bank.

In the past, we have seen such gains being made in other countries that have substituted currency. For instance, the Bank of Israel recorded a gain of about USD 62 million for the notes that had passed the legal date for exchange and were no longer in use. There is considerable public discourse on what will happen to the windfall made by RBI, if the above mentioned estimates were to translate into reality.

In this article, we argue that unlike several other countries with precise laws governing their central banks, there is legal uncertainty on what happens to the surplus reserves or income accruing to RBI, whether as a result of a one-time demonetisation event or due to its regular operations. There is a need to re-visit the legal framework governing surplus distribution by RBI.

### Lack of clarity in distribution policy

Ordinarily, when a mismatch occurs on the balance sheet of a corporation due to a sudden change in the liabilities, the resulting surplus assets are either (a) distributed as dividend to the shareholders; or (b) credited to reserves. This takes place under the rubric of a dividend distribution policy', which is generally voted upon by the board. The circumstances in which shareholders should or should not expect dividend, and the manner in which the retained earnings will be utilised, are generally codified in the dividend distribution policy. The policy is disclosed to the shareholders, so as to enhance predictability, and governs their relationship with the corporation.

Likewise, where a central bank has surplus reserves or profits in any given financial year (whether due to a one-time event like demonetisation or otherwise in the course of its regular operations), the shareholders of the central bank (in a majority of the cases, the government) must have clarity on the distribution policy. This must be clearly spelt out to the Central Government in the law governing its relationship with RBI or in an agreement between them that is available in public domain. This is critical to ensure both (a) the independence of RBI as it pre-empts any possiblity of political pressure for distribution of surplus profits or reserves; and (b) accountability of both the RBI and the Central Government with regard to the distribution of surplus profits to the Consolidated Fund of India.

Currently, this clarity is missing. As a result, the distribution of surplus assets by RBI to the Central Government has fluctuated year-on-year, except for the last three financial years, as shown in the graph below:

 Transfer to Government of India, by RBI (Percent to profits)

The graph shows that the proportion of profits transferred to the Central Government has fluctuated across the years. However, for the last three financial years, the distribution has remained constant at 99.9% due to the recommendations of the Report of the Technical Committee to review the level and adequacy of internal reserves and surplus distribution policy. See here (hereafter, the Malegam Committee Report, which is discussed in greater detail later in this article).

### What does the law say?

In India, the relationship between the RBI and its sole shareholder, ie. the Central Government, is governed by the Reserve Bank of India Act, 1934 (RBI Act). As currently drafted, the provision governing allocation of surplus profits lacks details on the reserves that RBI must maintain and the proportion of surplus that RBI must distribute to the Central Government. The RBI Act contains one provision on allocation of surplus profits. Section 47 of the RBI Act says:

After making provision for bad and doubtful debts, depreciation in assets, contributions to staff and superannuation funds and for all other matters for which provision is to be made by or under this Act or which are usually provided for by bankers, the balance of the profits shall be paid to the Central Government.

The provision implies two things (a) surplus is only the amount which is left after RBI has made adequate provision for all other matters for which provision is to be made (i) under the RBI Act or (ii) for matters which are usually provided for by bankers; and (b) the entire residual surplus shall be paid to the Central Government. There is no clarity in the RBI Act on:

1. The proportion of profits which may be allocated to reserve funds or the purpose of the reserve funds;
2. the cap, if any, on reserves;
3. the proportion of profits which must be distributed to the Central Government;
4. the timing of distribution of profits;
5. the manner in which these decisions must be made.

The current legal framework is, therefore, inadequate as it offers no transparency with regard to these matters.

### What do central banks around the world do with their profits and surplus assets?

Laws governing several central banks around the world have a numerical value, which offers clarity on the distribution policy. Several legal frameworks governing central banks across the world, precisely state the proportion of surplus assets that must be credited to the reserves, the proportion that must be distributed to the exchequer, the timing of distribution, etc. Some examples are listed below:

1. Specifying the percentage of profit which must be distributed - Some laws governing central banks mandate the specific percentage of net profits which must be distributed by the central bank. For instance, the Bank of England Act, 1946 requires the Bank of England (BOE) to pay to the Exchequer, on every 5th April and 5th October, a sum equal to 25% of BOE's net profits for its previous financial year, or such other sum as the Treasury and BOE may agree.
2. Specifying the proportion of profit which may be credited to the reserves - For instance, the Bank of Korea Act, 1997 has adopted an alternative approach by specifying the proportion of profits that Bank of Korea (BOK) may retain. It allows BOK to accumulate 30% of the profits, after providing for depreciating assets, every year. It allows the balance profits, remaining after such accumulation, to be credited to special purpose reserves, with the explicit approval of the Government. It mandates that the balance, if any, remaining after creation of such reserves must be paid out to the Government of Korea.
3. Specifying the kinds of reserves that the central bank may accumulate - The Bank of Thailand Act, 1942 specifically sets out the percentage of reserves that the Bank of Thailand (BOT) must accumulate. It requires the BOT to constitute the following reserves, namely, (a) ordinary reserves intended to cover possible loss; (b) reserves derived from the revaluation of assets and liabilities; and (c) other reserves for particular purposes as may be established by the BOT Board upon the approval of the Minister. The net annual profits of the BOT, after deduction of accumulated loss, if any, shall be provided in the following order for: (1) ordinary reserve amounting to 25 per cent; (2) other reserves for particular purposes, as specified by the BOT Board, upon the approval of the Minister. Any remaining net profits shall be paid in as state revenues.
4. Capping the accumulation of reserves - The United States follows a de-centralised system of central banking where there is no single federal reserve bank, but 12 Federal reserve banks. The Federal Reserve Act, 1913, which governs the Federal Reserve System, mandates the Federal reserve banks to first pay out dividend to the stock holders (which are essentially member banks) in proportion to their holding in the Federal reserve bank. It then allows the surplus to be accumulated as a surplus fund of the Federal Bank, but specifically caps the surplus. It mandates that the surplus, if any, remaining with the Federal reserve bank, after providing for expenses, payment of dividend and allocation to surplus, shall be distributed to the Treasury.

The takeaway from the list of laws illustrated above is that there is a quantitative indicator that imparts clarity to the treatment of surplus assets by the central bank. The indicator may be indicative of what needs to be distributed, what needs to be credited to reserves or the cap on reserves. The RBI Act lacks this clarity, thereby leading to speculation.

### Reserves maintained by RBI

RBI maintains the following major funds: (a) Currency and gold re-valuation account (CGRA); (b) Investment Re-valuation account (IRA); (c) Exchange Equalisation Account; (d) Asset Development Reserve (ADR); and (e) Contingency Reserve (CR). Out of these, the first three are funds to which unrealised gains and losses on existing assets of RBI, are credited and debited. The ADR was created out of profits to meet RBI's internal capital expenditure and invest in subsidiaries and associated institutions. The CR consists of the amounts added on a year-to-year basis for meeting all other unexpected and unforeseen contingencies (Malegam Committee Report (2013)). Therefore, technically, in the absence of any specific provision in the law, which restricts the internal capital expenditure that RBI may make or the contingencies that RBI can provide for, it is perfectly legitimate for RBI to credit the windfall to its CR or ADR.

In the absence of legal clarity, the Malegam Committee was set up by RBI to review the level and adequacy of internal reserves and surplus distribution policy of the RBI. It suggested that (a) since the balances in the CR and ADR were in excess of the buffers needed, there was no need to make any more transfers to these funds; (b) the entire surplus should be transferred to the Central Government. Hence, for the three years immediately following the report of the Malegam Committee, i.e. 2013-14, 2014-15 and 2015-16, the entire surplus was transferred to the Government. This brought some consistency in the distribution of surplus. But, no steps have been taken to reform the law to ensure such consistency in future.

### Conclusion

The present legal framework is unclear on the adequacy of reserves of RBI. While this has led to widespread speculation on what will happen to any windfall that may be realised from the demonetization event, the issue of distribution of surplus by RBI is not a one time problem. This problem will continue to crop up every time RBI has surplus profits. To ensure transparency in the distribution of surplus from the central bank to the CFI and to ensure the independence of the central bank in making such decisions, revisiting the legal framework governing reserves and the surplus distribution policy, is imperative. This legal framework should offer precise guidance on i) the purpose for which the RBI can maintain reserves, ii) a cap on such reserves, and iii) the dividend distribution framework.

The last couple of years have witnessed some headway in reforming the decision making processes at RBI. In 2016, the RBI Act was amended to provide clarity on the manner in which it may exercise its monetary policy functions. The current government must focus its effort on such deep institutional reforms. It is a good time to resume this process by focusing on the decision making process for allocation of surplus assets by the central bank.

Radhika Pandey is a researcher at the National Institute for Public Finance and Policy. Bhargavi Zaveri is a researcher at the Indira Gandhi Institute for Development Research.

### Questions of law in demonetisation

by Pratik Datta, Radhika Pandey, Suyash Rai, Shubho Roy, Ajay Shah.

In the demonetisation problem, there is an economics dimension [example], and there is a public administration dimension [example]. These two dimensions have, thus far, dominated the discourse. In addition, we feel there are three important questions of law which deserve attention:

1. Restrictions were imposed on withdrawing money in bank accounts. What is the legal validity of such restrictions?
2. The notes cease to be legal tender, i.e. valid for exchange between counterparties to a transaction. However, what happens to the signed promise of the Governor of the RBI to honour the notes? Answer by Pratik Datta and Rajeswari Sengupta, 1 December 2016.
3. What happens to the assets (on the RBI balance sheet) which back the notes that are not exchanged? Answer by Radhika Pandey and Bhargavi Zaveri, 18 November 2016.

The authors are researchers at the National Institute for Public Finance and Policy.

### Long journey to sound capital controls on foreign currency borrowing

by Pratik Datta and Radhika Pandey.

Policy reform happens in three stages:
Setting course
Choosing the strategy for reforms.
New law
Enacting new Parliamentary or subordinate law.
Implementation
Building State capacity to enforce the new law.
In India, the expert committee process is an important element of the first stage; we are learning how to draft better laws; and we have early insights on how to build state capacity for the third.

A major bottleneck in the implementation phase arises out of lack of coordination in these three elements. Often, expert committees recommend vital policy changes after extensive deliberations. But then implementation suffers at the end of the government and regulators. New regulations are issued after considerable delay and in a piecemeal manner. Law is too important to be left to the lawyers;  when the law is drafted by people who lack the relevant domain knowledge, this gives faulty drafting.

The recent changes in the framework governing dollar denominated borrowing (referred to as external commercial borrowing (ECB) in India) is one such example of delayed and piecemeal implementation. On November 7, 2016 RBI issued a Circular No. 15 clarifying its regulation on hedging in relation to short-term ECB by infrastructure firms. RBI clarified that wherever hedging has been mandated by the RBI, the ECB borrower will be required to cover principal as well as coupon through financial hedges. Effectively, this clarifies RBI's earlier March 30, 2016 circular which, for the first time, mandated 100% hedging for infrastructure firms engaging in short-term ECBs. This marks an important shift in RBI's stance towards hedging.

### Why are regulations on hedging required?

ECBs expose borrowers to exchange rate risk. If left unhedged, this may expose the financial system to systemic risk. There is an extensive literature in international finance (see here, and here) on the adverse implications of unhedged currency exposure in the event of exchange rate fluctuations.  The international policy discourse, and recent experiences of peer economies such as Indonesia and SouthAfrica, shows that addressing these concerns is helped by regulations that constrain borrowers to hedge their exchange rate exposure.

Ideally, exchange rate flexibility should give private persons ample incentive to hedge. From 2007 to 2013, India was doing well on this, but from late 2013, India has gone into a soft exchange rate peg to the USD. Under these circumstances, private persons have an incentive to borrow in USD and leave it unhedged, hoping to free ride on the peg. Unhedged foreign currency borrowing is thus particularly problematic now.

### RBI missed this point

One of the most effective arguments in favour of capital controls is this issue, of  hedging requirements for foreign currency borrowing. However, for many years, while RBI had an elaborate system of capital controls on ECB, there were no hedging requirement.

In the beginning of 2014, RBI took a small step towards addressing this. Around the same time, in order to discourage banks from providing credit facilities to companies that refrain from adequate hedging against currency risk, RBI prescribed guidelines on incremental capital and provisioning requirements for banks with exposures to entities with Unhedged Foreign Currency Exposure (UFCE).

These changes did not succeed in nudging firms to hedge their exposure. In a speech, the then RBI Deputy Governor raised an alarm about the reduced propensity of firms to hedge foreign currency exposure. He noted that the hedge ratio for ECBs/FCCBs declined sharply from about 34 per cent in FY 2013-14 to 24 per cent during April-August, 2014 with very low ratio of about 15 per cent in July-August 2014.

The IMF Article IV Report in March 2015 on India highlighted concerns of rising unhedged corporate exposure and underscored the need to strengthen regulatory oversight. The report recommended strengthened monitoring of corporate vulnerabilities in the wake of increased unhedged foreign currency exposure of banks. A year later, in March 2016 another IMF report raised concerns about unhedged foreign currency exposure. But the RBI abstained from imposing a direct obligation on firms to hedge their foreign currency exposure.

### Sahoo Committee recommended hedging

In Februrary 2015, the Sahoo Committee for the first time recommended hedging to address the underlying systemic risk emanating from ECBs. The Sahoo Committee report recommended that the regulatory framework should require mandatory hedging by Indian firms which borrow in foreign currency. It recommended a complete dismantling of the extant regime of complicated controls on ECBs, as this merely introduced bureaucratic overhead and did not address any market failure; it recommended focusing the capital control on ECB on this one issue: hedging. The report recommended that the required hedge ratio should be decided by the MOF-RBI Committee keeping in view the financing needs of the firms and of the economy, the development of onshore currency derivatives markets and any other systemic concern such as volatility in global risk tolerance.

### Partial and delayed implementation by RBI

While the Sahoo Committee submitted its report in February, 2015, the RBI did not prescribe mandatory hedging till March 30, 2016. Even then, RBI mandated hedging only for infrastructure firms that borrow for less than 5 years. While this is a good step as most infrastructure firms do not have a natural hedge against the currency risk, this is only an incremental move towards the optimal framework of mandating a hedge ratio across all sectors and across all durations of borrowing. As recommended by the Sahoo report, hedging should be mandated for all kinds of ECBs unless there is a natural hedge.

### Conclusion

This episode illustrates how economic policy failures arise from communication gaps between expert committees, which figure out what is to be done, and the different arms of the State which implement it. Often the latter are either not fully aware of the committee's thinking, or have misaligned incentives. When the drafting of legal instruments is tightly linked to sound domain knowledge, the results are better.

The authors are researchers at the National Institute for Public Finance and Policy.

## Wednesday, November 16, 2016

### Runs on real estate companies?

by Shubho Roy.

#### A new threat

Many households in India like to invest in real estate, even though this has not worked out as a great asset class. The Indian real estate business has been facing considerable difficulties in the present business cycle downturn. The recent `de-monetisation' is expected to adversely affect this sector, as there is considerable use of unaccounted cash. There is a natural analogy with the crisis of 2008, where real estate companies were one of the first places where stress became visible.

There is an additional looming problem that has not been as widely noticed. The Supreme Court has started passing orders asking real-estate companies to refund buyers of apartments in projects which have been significantly delayed:

• Unitech was asked to refund Rs.20 Crores to 30 buyers on 19th October, (See here).
• Parsvnath Builders was ordered to refund Rs.22 crore to 70 buyers on 18th October (See here).
• Supertech was ordered to return deposits of 17 buyers on 6th September, 2016 (See here).

In this article, I worry that this could set the stage for runs on real estate companies. Thinking about this problem also helps us better understand the inter-relationships between corporate finance, consumer protection and bankruptcy process.

#### Corporate finance of Indian real estate companies

Delays by real-estate developers are not new in India. People book apartments, putting down large deposits, then wait as the developer fails to meet deadline after deadline. Many buyers have dragged developers to court, trying to pressurise them to finish the buildings. What is new is that some of these buyers do not want the apartments; they just want their deposits back. This has adverse implications for the developers, the buyers who do not want their deposits back, the real estate industry as a whole, and all other creditors of such real estate companies. When a customer asks for the refund of deposits, there are two possibilities:

1. The buyer thinks that the real-estate developer will never be able to deliver the promised buildings; or
2. The buyer thinks that these buildings are not the worth the money they have committed to pay for.

In a normal market, such exit by a few buyers should not matter. However, the structure of the real estate market in India is an unusual one. Most real estate firms lack formal financing. Real-estate companies usually launch a project and collect advances from the buyer. These advances are often used as fungible working capital by the company; they are pressed into service to meet the most urgent need for cash.

While this seems to be an efficient way to employ capital while the going is good; it fails when the going gets bad. This system works as long as the real estate company is able to launch new projects and get advances from them. If new project launches do not generate advances, previous incomplete projects are also in jeopardy. The business model of the companies presumes an ever increasing demand for new projects at ever increasing prices with ever increasing number of buyers willing to make advance payments.

The new real estate law [Real Estate (Regulation and Development) Act, 2016] recognises this problem and tries to partially address it. Section 4.(2).(l)(A) of the law mandates requires:

...that seventy per cent. of the amounts realised for the real estate project from the allottees, from time to time, shall be deposited in a separate account to be maintained in a scheduled bank to cover the cost of construction and the land cost and shall be used only for that purpose

However, this law applies to deposits after 2017, and not the ones already made. There is no clarity where existing deposits of buyers have been used.

#### A bit like banks

Under these conditions, real estate firms in India are a bit like banks.

When you deposit money in a bank, the money enters the fungible pool of deposits of the bank. When someone else withdraws money from their account, this is withdrawn from the fungible pool. Banks do not match individual deposits to individual loans. They ensure that that the overall income from all loans is higher than the bank's liability to depositors (on the whole). This works fine as long as the depositing public is confident that the bank is making more money out of its loans than it has to pay the depositors. Banks do not keep the total deposits in liquid cash waiting to be withdrawn at any moment. If they did so, they would have no money to lend. Instead, banks keep a historical average of withdrawals (net of fresh deposits) in branches to meet the requirements. This is commonly known as fractional reserve banking.

When many people lose faith in the ability of a bank to repay its depositors, we get a run on the bank. A run is when depositors try to quickly get their deposits out before everyone else. Depositors know that if they can withdraw money, before the liquid cash kept by banks runs out, they are safe. Late comers are left in the lurch, as the bank runs out of cash.

Bank-runs are sometimes a self-fulfilling prophecy. Depositors worry that the bank is out of cash and start withdrawing their deposits at the same time. Since the loans made by the bank cannot be recalled quickly, the bank fails to refund some deposits. On the other hand, if the depositors do not panic, banks may be able to recover their loans and pay out depositors in due course.

To address this problem of bank runs, multiple layered safety measures have been developed in law and in financial markets. First, banks are heavily regulated by the banking regulator which is supposed to keep a close eye on the loans they make and mandate banks to keep some of their deposits in liquid cash. Moreover, when one bank faces some unusually large withdrawals, it can borrow from other banks for a short time, at low interest rates -- commonly known as the inter-bank market. Finally, the central bank of the nation acts as the lender of last resort, if a bank is unable to borrow in the inter-bank market. This is the institutional machinery required to forestall runs on banks.

#### Runs on real estate companies

There is no such safety system for the Indian real estate business.

Capital expenditure by real estate companies is now in the decline. They cannot rely on the old model of launching new projects to obtain working capital which is used to complete older projects.

Real estate companies can go to banks to borrow money when faced with the problem of refunding customers. Banks have cause for concern when buyers of the apartments do not want those apartments but want their money back. The fact that some buyers are approaching courts rather than finding another person to buy-out their claim means no one is willing to buy these unfinished apartments. Therefore, most of these apartments will be finished at a loss. This makes it commercially unwise for a bank to extend more loans to an entity which will not make profits.

Apartments are not fungible in the way money is fungible. When a real estate company has multiple projects, it cannot shift buyers from one project to another. Buyers have been promised a specific apartment in a specific housing project. Real-estate companies cannot move these buyers to another project. The flexibility of real estate companies when faced with withdrawals is lower than that of a bank.

The orders of the Supreme Court can possibly give a run on real estate companies. Before the Supreme Court orders, delays in delivery was a way for the real-estate companies to ride out the problem. They could wait for real-estate markets to turn around and then complete projects. Now the Court has taken away this choice.

On one hand, the order of the Supreme Court is just enforcing the law of the land:

Promises in a contract must be kept

The more such orders the Supreme Court makes, the more money will be taken out of the real estate companies. We do not know where the builder will find the money to pay for the Court order. It could be that this money comes from someone else's deposits. As more money is taken out, this could increase the balance sheet stress in real estate companies, and make it harder for them to complete their projects. This imposes externalities: it has adverse implications for people who have not filed cases against their builders to recover their deposits (including people who have filed cases to force the builder to finish their apartments). Such people may end up being the last guys in the line in a real-estate run. Every person who gets his/her deposit back reduces the chance of the project getting completed. People who wait may neither get an apartment, nor their deposits back.

The long term prospects of the real estate sector might be better. New projects under the new law will get better protection. However, the projects presently underway, and delayed, are a large block of capital, and a large block of bank loans. Many real estate firms may not survive this storm. The new law provides them no protection. In fact, the new law prevents real-estate developers from using new projects to fund older projects, thereby harming the chances of the older projects being completed.

The orders thus have adverse consequences for the real estate sector. The Court is blindly asking the real-estate companies to return the deposits (with interest) without asking from where the money will come from. The advance/deposit money collected from individual buyers is not lying in some separate account which is clearly identifiable. It has been mixed with the general assets and resources of the company. Worse, it could have been spend in some other project. When you ask a company to return the money to these buyers: what is the guarantee that the company will not take money out of another project to pay these buyers?

#### Fair treatment requires the Bankruptcy Code

Buyers are on sound ground when they demand a refund. When this refund does not materialise, the solution is not specific performance but bankruptcy. If a court jumps this step, and orders companies to repay large sums of money, the court may end up unfairly prejudicing other creditors of the company.

To avoid this problem, whenever courts in the US impose a large fine on a company, it asks for a financial analysis to determine whether the company will remain solvent after paying the fine. If this analysis (by accountants) returns a negative answer; then the courts force the company into insolvency with the fine/court being the last creditor.

The Supreme Court, by ordering real-estate companies to pay large sums of money to a select set of buyers, may be doing injustice to all other parties in the case. Fair treatment of all stakeholders requires the Insolvency Resolution Process under the Insolvency and Bankruptcy Code.

The advance payed by these buyers has most likely been used up within the firm. That money no longer exists in liquid form. The financially and legally sound solution to these requests to return advances is to place these incomplete projects under liquidation and sell them at an auction to the highest bidder. The surplus from the auction should be equally distributed amongst the buyers, whether they have asked for their deposits back or not. Buyers will probably not get back their entire deposits, but at least some buyers will not unfairly prejudice others. If the new real-estate company in the auction decides to continue building, the last buyers may deposit their pay-outs to such company.

Under the environment created by the Supreme Court, there is an incentive for each buyer to run. If, in contrast, failing or delayed projects led to a bankruptcy process, there would be no incentive for each buyer to run.

#### Where did we go wrong?

Why did our legal and administrative system come up with the wrong answer? The root cause of this situation lies in two elements:

1. An unforeseen use of the Consumer Protection Act, 1986.
2. The Supreme Court trying to solve individual problems in the interim, rather than laying down an appropriate legal principle.

The Consumer Protection Act, was envisaged as a quick and lightweight judicial system for small consumer disputes. While the law does not state it, debates about the law in Parliament indicate that the law was designed to solve minor disputes about consumer goods like blenders or phones. These are small value disputes, compared with the total capital of the companies which manufacture them. If a consumer goods company is asked to replace a blender, this will (most probably) not drive the company into insolvency.

However, the law was not clearly drafted: there is no financial limit to the jurisdiction of consumer courts. Such limits are usually a feature in similar laws in other countries. This enables people to use this law to file cases involving large sums of money.

When the dispute involves millions of rupees, the economics behind fines and compensation changes. Now a single dispute can bankrupt a company. Such disputes require more disciplined thinking about contract law, company law, bankruptcy law and laws of specific performance and monetary compensation. Disputes about real estate should not be decided by consumer courts. However, the vague drafting and the definitely pro-consumer slant of the law (low court fees, lax procedure, etc.) attracts litigants to file under this law.

All the three orders of the Supreme Court are interim orders. These orders are done without finally deciding the case on merits. They seem to be minor/incidental orders where the Court has not really thought about the implications. The court is not clear about the financial implication of imposing such large financial burden on the companies. Courts have come to see bankruptcy law as inoperable. As reported in the news it seems that the bench remarked:

"We are not concerned whether you sink or die. You will have to pay back the money to homebuyers. We are least bothered about your financial status"

Such a statement seems to indicate that the Court thinks that the effect of the fine will fall only one the management/owners/promoters of the company. But a company is a much more complicated being. The financial status of the company affects not only the management, but all creditors of the company, which include other buyers who have paid deposits/advances, banks which have lent money (in turn the public which put money in the banks and the taxpayers who will re-capitalise the banks), bond-holders of the company, employees, suppliers, etc. By making the company pay these buyers (out of turn) the Court orders may end up ensuring that all these creditors (who are not at fault) are left in the lurch and unfairly lose their rights to recover their dues from the company. It is very probable that some (if not most ) of these dues are superior (or at least of the same priority) as the rights of the buyers (who want their advances back). The Court is effectively paying some customers at the expense of others, and encouraging runs on real estate companies.

The Court seems to equate the company with the promoters/management of the company, who at this point may have very little invested in the company. The company has no incentive to openly admit that these fines will affect the solvency of the company. If it does so, it is at risk of being put under administration. This would remove the current management and equity owners (who control the company's representations before the court).

The author is a researcher at the National Institute for Public Finance and Policy. He acknowledges the help of Dhananjay Ghei and Manya Nayar in this work.