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Tuesday, September 30, 2014

4 task forces setup by MOF to build institutional capabilities for FSLRC

FSLRC's institutional architecture


The draft Indian Financial Code (IFC) envisages seven financial agencies outside the Ministry of Finance:

  1. Financial Sector Appellate Tribunal (FSAT): An improved version of the existing Securities Appellate Tribunal which will hear appeals all across the financial system.
  2. Public Debt Management Agency (PDMA): The investment banker for the government.
  3. Financial Redress Agency (FRA): The one-stop shop where any individual goes to raise a complaint about a financial service provider, where the difficulty was first raised with the financial service provider but not satisfactorily resolved according to the consumer.
  4. Resolution Corporation (RC): A specialised organisation that will handle distress in certain kinds of financial firms.
  5. Financial Stability and Development Council (FSDC): Systemic risk, coordination, development. This contains a database named Financial Database Management Centre (FDMC), which is the one-stop shop where all financial service providers electronically submit all the data that they have to give to financial agencies.
  6. Unified Financial Authority (UFA): Consumer protection and micro-prudential regulation for all finance other than banking and payments.
  7. Reserve Bank of India (RBI): Monetary policy, and consumer protection and micro-prudential regulation for banking and payments.

Shifting to this financial regulatory architecture will (a) Close the gaps, of the things that are at present not being done; (b) Improve economies of scale and economies of scope for the economy and for these agencies, and (c) Sharpen accountability by clarifying objectives. This reorganisation addresses the problems that derive from the arbitrary choices embedded in the system that we have inherited.

It is one thing to design a clean financial regulatory architecture. The next challenge lies in implementing it. Let's think through what's required for all the 7+1 agencies.

  1. FSAT builds on the best tribunal in India today, SAT, and will become a high quality court.  It has to plan for the much higher case load that will come to FSAT under the IFC when compared with the present arrangements with SAT.
  2. PDMA is a capability which is absent today. Subsets of the work that PDMA has to do are to be found within RBI and MOF but the full task is not being performed in India today.
  3. FRA: at present, there are multiple ombudsman systems running in RBI, SEBI, IRDA, etc. FRA brings these together under one roof, with a high quality IT system.
  4. RC: Is a new capability which does not exist in India today.
  5. FSDC: Is an enlargement of the existing FSDC, which gets shifted out of the Ministry of Finance. FDMC has to be built.
  6. UFA: In terms of the areas covered, it is a merger of SEBI, PFRDA, IRDA, FMC and some things which are presently in RBI. In terms of the work being done, it is different from what these agencies do today.
  7. RBI: In terms of the areas covered, banking and payments and monetary policy are in RBI, but these things are done in different ways under the IFC.
  8. MoF: The IFC has important implications for MoF which has to think and work in new ways. Many people have not noticed the big changes that flow from the IFC for MoF.

The key bottleneck in India: State capacity


Once Parliament enacts a law, this has to be enforced, either by an agency (e.g. RC) or by the main line structures of government qua government (e.g. MoF).  We in India have a long history of under-performance in the enforcement of laws.

This is partly grounded in badly drafted laws, which lack accountability mechanisms, lack clarity of purpose (which reduces accountability) and embed extreme executive power and discretion (which reduces accountability). The underperformance of RBI or SEBI is partly the consequence of drafting problems of the RBI Act and the SEBI Act.

But the underperformance is also grounded in bad public administration. A lot of new work is required in public administration, so as to obtain good quality execution. Alongside bad laws, bad execution is an equally important source of underperformance. This takes us to questions like organisation diagrams, HR policy, process manuals, reporting, internal IT systems, etc.

In developed countries, there is rapid execution in the implementation of new laws. E.g. the UK was extremely impressive in their translation of their new law for resolution of financial firms into State capacity for enforcement. In India, the experience has been that it takes a long time to implement, and particularly to implement well.

It will take some time for the IFC to get enacted. Recognising the bottlenecks of State capacity, we should worry about the delays, and about the quality of the execution, in living by the IFC once it is enacted.

Building institutional machinery ahead of time


Reflecting these concerns, there is a long tradition in India, of building institutional capacity before a law is enacted. Here are a few examples:

  • SEBI was created by executive order in 1988, and the law came in 1992.
  • PFRDA and NPS were constructed 2003-2005, while the PFRDA Act was enacted in 2013. 
  • NSE started building Nifty and the real-time risk management system for derivatives trading at NSCC in 1995, while cash settled derivatives only became enforceable in 1999.
  • Work on building the depository began inside NSE in 1995, before the legal foundations for dematerialised settlement fell into place in 1996.
  • Work on the IT systems for the Goods and Services Tax (GST) began at NSDL in 2011, and the GST has not yet been enacted.

These are just a few examples that I have been around; there are many other episodes of this nature. The general principle is: Once the direction of future legislation is clear, project planning for enforcement of the law commences. Hence, once the budget speech of 2014 has established the legislative direction on the IFC, we should now build the institutional machinery through which the IFC would be enforced.

The MOF announcement today


Today, the Ministry of Finance has announced `Task forces' to build four components of the institutional machinery of the IFC. They are:

  1. Financial Sector Appellate Tribunal (FSAT). Chairman: N. K. Sodhi.
  2. Public Debt Management Authority (PDMA). Chairman: Dhirendra Swarup.
  3. Resolution Corporation (RC). Chairman: M. Damodaran.
  4. Financial Data Management Centre (FDMC). Chairman: Subir Gokarn.

The press releases are : overall, FSAT, PDMA, RC, FDMC.

The task forces are implementation teams which start from the design which is in the text of the IFC, and build the institutions that will implement the IFC. The output of the task forces will be working institutions. Other than the RC, the remaining projects are primarily about building complex IT systems.

With these four in motion, there is only one completely new component of the FSLRC institutional architecture where there is no progress, the Financial Redress Agency (FRA).

Twiddle your thumbs?


SEBI had to twiddle its thumbs from 1988 to 1992 as they had no powers in the absence of the law. NSE built the institutional capability to trade equity derivatives by 1998 and had to twiddle its thumbs till the politics worked out. All situations where institutional infrastructure comes up ahead of time have that tension within, of a race between the legislative process and the State capacity building project. The work of the four task forces that have begun has an array of possibilities, ranging from immediate impact to twiddle-your-thumbs:

  1. FSAT: If SAT voluntarily chose to use the new institutional capabilities built for the FSAT, then those could be valuable right away.
  2. PDMA: The new muscles of the PDMA could be of limited use to the Ministry of Finance in some ways that are compatible with the existing law.
  3. RC: The Resolution Corporation must twiddle its thumbs until the IFC is enacted.
  4. FDMC: Some or all of existing financial agencies could choose to voluntarily utilise the services of the FDMC, which will be a better IT-driven mechanism for submission of data from financial service providers to financial agencies.

The new work on building State capacity could thus start giving gains for the economy even before the IFC is enacted.

How we got here, and where we go next


The first phase of Indian financial reform ran from the reform of the equity market (1992-2001) and till the setting up of the NPS (2003-2005). Important new institutional infrastructure was created in this period: SEBI, NSE, NSDL, CCIL, IRDA, PFRDA, the NPS. The key features of this first phase were: (a) Responding to immediate difficulties and (b) Thinking one sub-sector at a time. Some parts of Indian finance made enormous progress in this period, such as the equity market and the pension system.

A long period of stagnation followed. This thought process shifted up from one sector at a time to thinking on a financial system scale, looking at the requirements of the economy even without the immediate impetus of a scandal. This started with the Percy Mistry report of 2007, and led up to the IFC in 2013. The IFC is now the centre of Indian financial reform, and is coming about on three tracks: the legislation, the Handbook, and these four task forces.

In many ways, these four projects are more complex than the new institutions of 1992-2005. The institution-building experiences of that period have many lessons, which have been incorporated into the construction and work procedure of the four task forces. E.g. the non-statutory SEBI drafted the SEBI Act, but now we understand that the Agent should not have a say in the contract between Principal and Agent. Similarly, the clarity of the four TORs of the task forces is not to be found in comparable documents from the 1992-2005 period. Institution building that period relied a lot on Level 3 thinking ("the great man theory"), whereas now there is an accent on formal processes that yield predictable outcomes.

All this connects with the core question of bandwidth and State capacity. In the past, one crack team at a time would setup one new institution.  There are concerns about whether there is State capacity to implement the IFC, and there is reason to believe that State capacity in financial economic policy has improved substantially when compared with what was available 1992-2005. At the same time, the four task forces are a daunting challenge: doing four new institutions at the same time has never been done before.

Saturday, September 27, 2014

Hierarchy of thinking about politics and the state

Level 0: Indifference


"Politics: What's that? Gimme my beer."

Level 1: Naivete


"For every problem there is an equal and opposite NGO"

or

"Let's pick monetary policy by referendum"

or

"My favourite government program is the answer".

Level 2: Cynicism


"Politics is hopeless. Gimme my beer."

Level 3: The Great Man Theory


"If only Baba Hazare were the Commissioner of Police, torture by the police would come to an end".

Level 4: Small steps


"Civil servants should come to work on time"

Level 5: Fundamental reform


"Rewrite laws, redesign organisations, establish accountability".

"Don't clean the streets. Fix the institutions that clean the streets".

Friday, September 19, 2014

User rights as a novel instrument for infrastructure financing

by S. Ramann and Manish K. Singh.

An issue on the front burner for the Government today is how to raise financing for the trillion dollars of infrastructure investment required in India. The banking system is facing significant stress, and cannot finance the second wave of investment in infrastructure as it did with the first wave from 2002 to 2012. In this discourse, so far, the main strategy that has been emphasised is the development of the corporate bond market, which includes setting up trading infrastructure, removing capital controls, removing taxation of non-residents, removing barriers against currency derivatives, etc.

We would like to propose one additional element that could help infrastructure financing. We go back to infrastructure financing in the US in late 19th century, where future consumers of train trips became investors in railroad projects. This was done using a form of adebt instrument called User Rights (UR). In a recent paper, User right as a mezzanine capital investment: Innovations in infrastructure debt financing, we analyse this approach to infrastructure financing. In modern terminology, this is crowd-funding for infrastructure from potential consumers. The key insight is to harness users as financiers with a high yield, tradable debt instrument. For a price paid at the time of financing the project, the UR entitles the holder to a rebate on user charges for that project.

As one example, in the paper we analyse a UR that offers a 45\% rebate on fares for one-way journeys on Mumbai Metro Phase I, Line I, for a period of 30 years from the commencement of its operation.

Benefits to UR holders

The UR gives the holder the right to receive a fixed rebate for a fixed period of time when using a well-identified infrastructure facility. What is the fair value of such a right? The price is calculated as the Net Present Value (NPV) of the future stream of rebates. The discount factor would include a risk tolerance parameter based on the probability that the facility will become operational and on the probability distribution of the future price of the facility.

We calculate that it is possible to design a Mumbai Metro UR, priced at Rs.13,978, which gives a saving for the user that starts at Rs.1,381 in the first year, and steadily increases up to Rs.2,825 in the final year. The implied rate of return works out to 10.5 percent, which is higher than the return from investment in tax free PSU bonds at 8.7 percent. The tax free status is not mandated by the government: since no interest is paid to UR holders, there is no tax. The gain is solely from savings on ticket cost.

Since the UR holder is entitled to a rebate, the UR becomes like an insurance contract for the UR holder compared to non-UR holders who use the operational facility. In the paper, we demonstrate other situtations under which the URs can be used strategically to better manage the risk of future increases in the ticket price. The more the final price varies from the scheduled increase in ticket price, the larger is the benefit received by the holder of user rights.

Benefits to issuers

We use a simulation to estimate savings to the project by financing using URs. The simulation is calibrated using the financial information of other metro projects in India. The simulation shows that when the project collects money against sale of user rights at the start of the construction period, the saving in interest payments is high enough to improve project viability. In the Reliance Metro example, substituting a part of debt (which is loans at 11.25 percent) by the issue of user rights, improves the NPV by about 9 percent. The cost of servicing user rights is postponed to the revenue generating phase thereby reducing the required working capital.

Wider economic benefits of URs

Infrastructure financing through URs also has many other economic advantages:

  • Higher standardisation and simplicity - Unlike loans and bonds, URs are standardised and comprehensible, and lend themselves to be traded at exchanges. Easy entry and exit can facilitate wider investor interest, leading to a more heterogeneous participant base which can likely lead to more liquid markets compared to traditional bondsinstruments.

  • Better accountability - As UR-holders, consumers would have higher incentives to monitor infrastructure projects compared to traditional financial intermediaries. Consumers interests are better aligned with better monitoring of the project, which could impose better project governance, compared with banks and asset management companies who suffer from agency problems. Further, users as financiers to infrastructure projects may inject direct pressure on elected governments, and hold them to a higher standard of accountability on such projects.

  • Scalability across projects -- The UR as a financing instrument can span across any infrastructure project -- by the government, under a public-private partnership or even as a purely private initiative -- that produces a service that could be consumed by individuals. Examples include hospital services, community solar power plant or water and sewerage services. The degrees of assurance to the investing public may vary with the type of operator and arguably the degree of confidence in the operator.

  • Augment existing credit sources -- The government is hard pressed to turn to traditional sources of infrastructure financing in India. Commercial banks face high asset-liability mismatch from financing long term infrastructure projects. Bond-based financing is constrained by the lack of resolution when projects fail. Structural constraints of infrastructure projects lead to low ratings by credit rating agencies. This, in turn, poses a barrier for these new projects accessing debt financing from institutions with long term liabilities such as insurance and pension funds. Foreign currency denominated borrowing imposes forces additional mismatch of currency risk. URs avoid all these problems and could hence become one interesting component of infrastructure financing for some projects.

Challenges and Concerns

URs are of course not the panacea for all ills associated with infrastructure financing. Large initial investments, long gestation periods, unanticipated construction delays leading to incorrect projections, collection risk of payables and reneging of contracts are major risks in infrastructure projects. These factors also lead to higher uncertainty in assessing the discount rate used in the NPV calculation to price these instruments, and can lead to high price volatility. The advantage that URs have over the traditional credit instruments are that the risks are spread over a much larger audience, and that re-pricing of risk is transparent.

A key concern would be on protecting the rights of the UR holders if the project were to fail, and the facility failed to materialise. One approach could be to invoke an insurance mechanism or debt reserve ratio to repay the principal amount of the investors. Such a mechanism would not come for free and would be incorporated into the cost of the project, which in turn would be borne by the URs holders. This might have marginal price impact if such costs are priced across millions of URs issued. Another alternative that we may visualise is for agencies such IIFCL or LIC to provide a guarantee as part of the UR. This could be financed from an independent source.

Conclusion

In a country that faces multiple challenges in raising capital to support an escalating infrastructure financing requirement, URs can be a useful and innovative debt instrument to tap new funds. URs raise capital based on legitimate expectations of urban residents for consuming infrastructure services. More importantly, it empowers the consumer as a stakeholder which could lead to better governance of long term public goods projects compared to the traditional financial intermediaries as their agents.

Thursday, September 18, 2014

RBI vs. Uber, continued

by Suyash Rai and Ajay Shah.

On 22 August 2014, RBI came out with an order which effectively forces firms such as Uber to either shut down, or switch to cumbersome payments mechanisms.

On 24 August, we wrote an article Shutting down Uber in India was unwise about the economic thinking in payments regulation.

On 15 September, Raghuram Rajan responded to this criticism in a talk, saying:

If there is a rule on the book, we don't allow it to be violated simply because the innovation is cool.

We think that RBI's action does not even constitute proper enforcement of `a rule on the book'. We think that regulators like RBI cannot pass the buck for bad consequences of rules that are fully under their control. We think that if RBI was wise and accountable, it would have behaved differently. Let's work through the steps of this logic.

Does the RBI action constitute sound enforcement of existing law?


Let us first examine what Rajan claims RBI has done - enforcement of current laws and regulations. The RBI's notification states that the routing of payments through offshore payment systems was violating the Payment and Settlement Systems Act, 2007 and the Foreign Exchange Management Act, 1999, and must be immediately stopped. It then allows the firms to make the necessary changes by October 31, 2014. This is unsound enforcement, for the following reasons:

  • The notification just states that the activity is in violation of two Acts, without actually citing the specific provisions or regulations of the Acts, and providing grounds for determining that the activity is violating these laws. For an analogy, this notification is like the police arresting a person saying that he has violated the Indian Penal Code, without citing the specific sections and without providing the reasons for such an assessment.
  • Instead of taking proper enforcement action - starting with a show cause notice and perhaps ending with a penalty - the RBI has simply allowed the firms to "adjust" by the given date. Unlike what Rajan claims, this is not enforcement by any stretch of imagination. An enforcement action by a regulator has to first establish that the enforcement action is necessary, and in a case such as this (assuming the RBI is correct regarding Uber's activities), result in a punishment.
  • The notification, which claims to be a clarification, is vague. It does not describe instances or specific actions that would be deemed to be in violation, so that market participants can understand where they stand. As a result, it has created significant confusion in the market.

RBI cannot be an impassive enforcer of rules that it has drafted


If you were the police, you merely enforce the Indian Penal Code (IPC). When a situation arises in front of you like marital rape, you have to be mindless and say, `Sorry, the IPC is clear that rape in marriage is not a crime, and my hands are tied'. The police does not make the law, it simply enforces it. If the police finds someone violating the IPC, it is its duty to take necessary actions as per the Law.

On the other hand, Rajan's stance - that clamping down on the routing of payment transactions is simply enforcement - is inappropriate. Unlike the police, RBI is not just an enforcement agency. RBI is a regulator. It writes the regulations that it enforces. The regulation for payment security was made by RBI, not Parliament, and therefore can be changed by RBI. Regulators exist because there is value in merging legislative, executive, and quasi-judicial powers within a single organisation.

Once RBI found that some real economy firms with efficient solutions are feeling compelled to find loopholes to give convenience to consumers on services such as taxi rides (which are usually small value transactions), this should have triggered a process of review of relevant regulation. Instead, Rajan simply brushed off the criticism of RBI on this matter, claiming that the critics are calling for suspending enforcement for a "cool" innovation. The critics are calling for no such thing.

Regulations must be enforced, otherwise they are meaningless, but if the regulations are wrong, they must also be reviewed and optimised. What Rajan is dismissing as "cool" is a small but non-trivial improvement in convenience (and productivity) that many consumers were choosing before RBI stepped in. India's future relies on the ability of innovators to come up with myriad small process improvements like this one. So, in addition to enforcing the regulation, it would have been wise of RBI to rectify the problems in regulation that compelled firms to take such a strange and risky route to receive payments.

There are at least four major problems with the regulation that RBI has drafted on two-factor authentication:

  1. It lacks proportionality: it requires the same level of protection for small value transactions as it does for large value ones.
  2. It unreasonably restricts economic freedom of consumers: we do not even have the right to waive the requirement for second factor authentication for small value payments (eg. up to Rs. 1000) on own money, even if we are willing to take that risk.
  3. It focuses too much on prevention and not on enforcement: the approach is to eliminate the possibility of fraud by imposing costs on consumers. You face no risk of a motor accident if you live in the stone age.
  4. It takes initiative away from payment service providers: service providers are supposed to blindly follow RBI's dictum. They do not have the right to relax authentication requirements for some transactions, with the understanding that they would manage risks and make good on losses that occur due to their mistakes.

To ignore these problems, to insist on enforcing a badly drafted regulation, no matter what the consequences are for the economy: this is the hallmark of an unaccountable agency.

If RBI were wise and accountable, what would they have done?


Once RBI noted the route firms were using to get around the two-factor requirement, and that many consumers were willingly using the service with lesser security (signalling a preference for convenience over security for small value transactions), it should have embarked on a comprehensive review. While initiating proper enforcement action against firms allegedly violating the laws, on 22 August 2014, RBI should have issued a statement (perhaps through a press release) saying the following:


  1. "We have a legal framework comprising FEMA about cross-border activities, and two-factor authentication about payments.
  2. "Some companies, such as Uber, are in a grey zone when it comes to FEMA. They are using this mechanism to avoid our rule that requires two-factor authentication.
  3. "We recognise that these are important mechanisms through which the market economy, comprising of service providers and consumers, is choosing to operate. The emergence of these mechanisms raises questions about the soundness of our two-factor authentication rules.
  4. "The tradeoff between security and convenience, and between prevention and enforcement, embedded in our authentication rules is questionable. We need new regulations, which impose some burden of liability upon financial service providers, and empower consumers to make a choice to waive second factor requirement on small value transactions. The default condition may continue to be two factor authentication, unless a consumer opts out for small value transactions, or a service provider takes it upon itself to manage the risk and take liability for failures.
  5. "It is important for regulators to not disrupt organisational capital of firms. Hence, the loopholes which are presently being used will be closed down on October 1 and the new rules will simultaneously kick in. Through this, it would be possible for firms such as Uber to experience no breakdown of operations.
  6. "Enforcement actions will proceed against violators of FEMA who may have to pay fines for the offences. This process will begin with a show cause notice, and may end with a penalty order by an adjudicating officer, if sufficient evidence is found on violation."

This would have been a wise and mature approach to financial regulation, one that fully takes into account the mandate of an accountable financial regulator and its responsibilities to the economy.

Rajan's defense of the current system is that two-factor authentication has enhanced peace of mind for people, who were earlier at risk of losing money. But nobody is suggesting unconditionally removing all authentication requirements or consumer protection provisions. The choice should not be posed as existing RBI regulation vs. zero regulation. Instead, the argument is for applying proportionality in security, giving consumers the freedom to waive the second factor for small value transactions, and holding service providers liable for risks they agree to manage.

Overall, the criticism has far more nuance than Rajan has acknowledged.

He also says, as people too often do in India, that innovations from the West do not directly apply in India. This is a particularly harmful argument, because it works as a broad excuse for prohibiting or delaying all kinds of innovations. Rajan should be more precise about what safeguards are required for specific risks that accompany the innovation being discussed, and what his agency will do to address them efficiently. This precision is required, not vague pronouncements on the harm from importing innovations.

Rajan did say that RBI is considering some changes to the system, but it is not clear what these changes will be and when are they likely to be implemented. Till the time he decides to give greater clarity on the issue, affected parties must wait. This sort of waiting, and legal uncertainty surrounding new thinking about business models, is incompatible with high GDP growth. In this process, we have lost sight of the purpose for which a regulatory agency is established, and that it exists for the purpose of serving the people of India.

This is just the tip of the iceberg


Millions of people understand in their bones that forcing a firm like Uber to shut down is a bad idea. In this one case, we have got a careful discussion about RBI regulation in public domain. The real issue runs deeper : an unaccountable agency has written myriad unwise regulations, that are holding India back. Greater humility, and an interest in reform, is the need of the hour.

Monday, September 15, 2014

Technology and institutional machinery that will save Rs.75,000 crore a year

by Viral Shah.

In a recent article, Ajay Shah discussed the potential for Aadhaar to help save Rs.75,000 crore per year, by overhauling the administration of susbidies. The first level gains come from using Aadhaar numbers in the databases of every scheme to elimnate ghosts, fakes and duplicates. The second level gains come from enforcing a one price policy. There is an incentive for arbitrage when and only when a commodity has two different prices in the market. Aadhaar technology helps ensure that all subsidised goods are sold at market prices, and the subsidy is transferred directly to the targeted beneficiary. Finally, there is a need to rationalise the subsidy and social safety net policies - who gets subsidies, how do they get them, how are subsidised goods produced, and how they get distributed.

Let's go closer into these questions, envisioning the concrete actions required on some of these fronts.

LPG subsidy

An implementation plan for the LPG was in the Report of the Task Force for Direct Transfer of Subsidy for LPG, Fertilisers and Kerosene where Nandan Nilekani was the Chairman.

The first step of implementing this plan was the cap on the number of cylinders of LPG that can be purchased by a household. Starting with 6 initially, political considerations led to this limit to be raised to 9 and then 12 subsidised cylinders annually. However, as the report notes, the average consumption of cylinders is less than 9 cylinders annually, and this decision should be reverted to 9 cylinders. While this cap has immediately led to a gain, over time, fake LPG consumer connections will be created as there is ample incentive to do so.

To address this requires implementing the second recommendation: to link every LPG connection with an Aadhaar number and deliver cylinders at market prices. The subsidy amount for the first 12 cylinders is transferred directly to the consumer into their Aadhaar-linked bank account as soon as the cylinder is delivered. While this sounds like science fiction, the Dhande Committee Report finds that this scheme had been rolled out in 291 districts with high levels of Aadhaar registration, and Rs.5400 crore of subsidy was transferred into 28 million Aadhaar-linked bank accounts. This is about 10% of the total subsidy for the year of 2013-14, which was Rs.46,000 crore, with 120 million subscribers in all. The tangible outcomes obtained through this work were: 0.6 million duplicate connections detected, and an 18% reduction in the sale of domestic LPG cylinders.

It took years to align all the stakeholders - the Oil Marketing Companies, Banks, National Payments Corporation of India, UIDAI, Ministry of Petroleum and Natural Gas, the Ministry of Finance, the distributors - to develop the IT systems, processes, exceptions, training materials, etc. Today, this is a scheme that can be rolled out at scale, after one signature on a green sheet by the Petroleum minister. Conservatively, this signature can deliver a saving of Rs.10,000 crore within 2 years.

Today, the private sector cannot enter the domestic LPG business, since the subsidies are funded as under-recovery by the Ministry of Petroleum and Natural Gas, and this is available to the Government owned Oil and Marketing Companies. Once LPG is sold to the customers at market price, it also allows for the entry of the private sector in this business, since the subsidy is directly transferred to consumers. There has been very little innovation in this business due to lack of competition. We will most likely see more investment in LPG import terminals, innovations such as LPG cylinders made from lighter materials, and operational improvements such as in logistics as the sector sees higher competition. Consumers will benefit with lower prices and better service if there with more competition. No signatures are required for this to happen!

Fertiliser subsidy

The same report also outlines a solution for fertiliser subsidy based on the same principles. The size of the fertiliser ecosystem is the same as that of LPG. While 120 million consumers benefit from LPG subsidy, there are about 100 million farmers who benefit from subsidised fertilisers. There are major differences though. LPG is largely sold in dense urban areas, whereas fertilisers have to delivered in sparsely populated rural areas. The distribution of LPG is carried out by Oil and Marketing Companies that have fully computerised operations across the country, and directly appoint their own distributors. In the case of fertilisers, the production and imports is mostly in the private sector, which largely receives the subsidy at source. The Central Government administers the movement of fertilisers up to the district level. Beyond that, the State Government's Department of Agriculture takes over, and different States have different distribution models.

Every aspect of fertiliser manufacturing is controlled and subsidised. Given the importance of food security, even inefficiencies are tolerated to a great extent. Take the case of Urea, which is manufactured from both, natural gas and Naphtha, with natural gas being significantly cheaper. However, natural gas pipelines are not available to factories in the south, which continue to use Naphtha, and the Government covers the additional cost. Not only is the price of Urea controlled, but so is the supply of natural gas (yes, fertiliser manufacturing gets priority when there are disruptions in natural gas imports or production), movement, allocation of railway carriages, freight subsidy, etc. There has been no investment in this sector in over a decade, and no technological improvements due to the cost-plus model of manufacturing.

As a result, we live in a society today, where people camping for iphones overnight are cheered, but farmers camping overnight for fertilisers get hell. Here is an interview with a farmer in Uttar Pradesh that sums up all the problems with fertiliser subsidy.

The subsidy on fertilisers has cost us close to Rs.100,000 crore in 2013-14. India has the largest subsidy in place worldwide, which leads to overuse of urea that decreases soil quality, and far too much control in the manufacturing and distribution that leads to perennial shortages and rampant black marketing. (See page 42 of Chapter 2 of the 2014 Economic Survey from the Ministry of Finance).

The savings in the problem of fertiliser subsidy can be conservatively estimated at Rs.20,000 crore per year. However, the implementation is a lot more challenging than the LPG case, due to involvement of the Central and State Governments, a less technologically skilled ecosystem, and the geographical spread of the solution, the grip of co-operatives in many states, etc. At the same time, just because it is difficult, this does not mean it cannot be done.

If Urea is fully decontrolled, we can expect entry of the private sector. Selling at market prices will get rid of the black marketing, and higher customer service levels will emerge from multiple producers competing for customers.

One possible way to deal with fertiliser subsidy is to eliminate it altogether, and instead adjust the higher input costs as part of the Government procurement of foodgrains. In the same way, many other input subsidies such as electricity and water subsidies offered by the state governments can be eliminated altogether and adjusted in procurement.

Reforming the PDS and Kerosene Subsidy

Many of the ideas above can also be implemented in the PDS, where the food subsidy is on the order of Rs.60,000 crore. The Report of the Task Force on an IT strategy for PDS also chaired by Nandan Nilekani provides a comprehensive set of steps to reform the PDS.

The kerosene subsidy is also administered by the State Governments, who receive subsidised kerosene from the Centre. Both, food and kerosene subsidy require better administration.

Again, by Aadhaar-linking and administering these subsidies directly into the bank accounts of the beneficiaries, there are significant gains possible. The beneficiaries can then procure foodgrains from any retail shop or grocer in the country, which has its back-end tied into the subsidy administration platform as outlined in the above report.

The expected savings from these initiatives can be on the order of Rs.20,000 crore.

Payments

An electronic payment architecture for administering Aadhaar-linked subsidies and payments is the backbone of the entire idea. This has already been put in place for purposes of LPG subsidy, and the same architecture can be leveraged for all other subsidies and entitlements.

The ideas behind linking Aadhaar and payments are detailed in the Report on Aadhaar-enabled payment infrastructure. Translating these into implementation gave the following institutional infrastructure:

  • Aadhaar Payments Bridge, operated by National Payments Corporation of India. This is a back-end payments platform through which payments can be sent to bank accounts simply on the basis of the Aadhaar number. This system worked, on scale, for the LPG subsidy transfer.
  • The MicroATM device design and interoperable network through which any shop owner with a mobile phone and biometric reader can become a Business Correspondent. The specifications were designed by an RBI appointed committee and have full stakeholder acceptance, that includes the Indian Banks Association, all banks, IDRBT, and UIDAI. Without issuing any token such as debit cards or mobile phone linkage, anyone in the country can access their accounts simply with their Aadhaar number and biometric authentication. This is working, on scale, in Andhra Pradesh for MGNREGS payments by India Post. A national rollout can be carried out in a matter of months with a decision from the Department of Financial Services as part of the Jan Dhan scheme.
  • The Aadhaar e-KYC service provides electronic KYC for opening of bank accounts and satisfying KYC requirements in any domain.

Every government scheme -- from the MGNREGS, every form of social security pension, Janani Suraksha Yojana, scholarships, and payments to para-workers such as Aanganwadi workers and Asha workers -- can be routed through these payment. These form of payments add up to roughly Rs.100,000 crore. We may guess that Rs.25,000 crore will be saved through computerisation and elimination of fakes and ghosts.

Conclusion

These calculations suggest that it is feasible to save Rs.75,000 crore per year, by fully utilising these ideas and institutional infrastructure. Achieving important change in India is about this two part process: (a) going after big ideas that can move the needle and then (b) building State capacity for the institutional machinery which will make these ideas happen. We fail when we stick to small ideas and we fail when we fail to back big ideas with execution.

The work described above took place over a period of three years at UIDAI, under the leadership of Nandan Nilekani. I was part of the secretariat. The behind-the-scenes stories, and more, are going to be in a book Rebooting Government, that is presently being written by Nandan Nilekani and me.

Call for papers for the 13th Research Meeting of the NIPFP-DEA Research Program

On behalf of National Institute for Public Finance and Policy, New Delhi, and the Department of Economic Affairs of the Ministry of Finance, New Delhi,  the organisers invite papers for the 13th Research Meeting of the NIPFP-DEA Research Program. This builds on the preceding 12 such meetings (http://macrofinance.nipfp.org.in/meetings.html). The meetings have a blend of academic scholars, senior policy makers and finance practitioners.

THEME: 

Macroeconomics and Finance, with an accent on capital controls, capital flows, international finance including firm internationalisation, the exchange rate regime and monetary policy.  Papers that illuminate these issues in emerging markets are of particular interest.

DETAILS: 

Date: 6 to 8 March 2015
Check in: 5 March 2015 (14:00)
Check out: 8 March 2015 (12:00)
Venue: Neemrana Fort Palace, Rajasthan, India

PAPER SUBMISSION PROCEDURE: 

Extended abstracts or papers (completed papers preferred) should be sent to the e-mail address
anurodh54@gmail.com  on or before 5 December 2014.


SUPPORT: The organisers will provide local hospitality and partial air fare for academic presenters.

Sunday, September 14, 2014

A dramatic cost reduction for KYC using the e-KYC API of UIDAI

by Suyash Rai, Smriti Sharma, Sanhita Sapatnekar.

The problem


On 2001-09-11, Mohammad Atta hijacked American Airlines Flight 11 and flew it into the North Tower of the World Trade Centre. Tracing flows of money led to the observation that a high ranking official within Pakistan's Inter-Services Intelligence (ISI) had allegedly ensured more than USD 100,000 was wired to Mohammad Atta, before the attack took place. Law enforcement authorities became quite keen to observe and block the `financing of terror'.

The Financial Action Task Force (FATF) develops and promotes policies that hinder money laundering, financing terrorism and financing weapons of mass destruction. One element of this requires financial institutions of member countries to implement `Customer Due Diligence' (CDD) for a variety of financial activities and circumstances. India is a member of FATF and Indian regulators are obliged to apply CDD. Regulators in India have applied CDD through excessive forms of `Know Your Customer' (KYC) requirements, which go well beyond the principles-based risk-sensitive requirements of CDD. As a result, financial firms in India face increased costs.

When an Indian financial service provider deals with a low value customer, the cost of performing the KYC that's required is often a substantial one when compared with the lifetime NPV of the customer. This has hampered financial inclusion by reducing the profitability of small value customers in the eyes of financial firms.

In 1999, Project OASIS (Old Age Social & Income Security) was established by the Ministry of Social Justice and Empowerment to make recommendations on how to develop old age income security. One of the key insights of Project OASIS was the importance of modern computer technology for the objective of serving small value customers. Paper- and human-intensive processes can even be viable for the rich, but when dealing with poor people, the only way to make ends meet is to push to the frontiers of technology.

A new attack upon the KYC problem


The Unique Identification Authority of India (UIDAI) has developed a novel technology that cuts the cost of opening an account by approximately 80%. The steps of this process are as follows:

  1. First, the customer has to have already enrolled in Aadhaar once. This involves supplying the name, identification, address details, and biometric data including the photograph. As there are many Aadhaar applications springing up in India, many individuals have ample incentive to undertake this cost of enrollment, once. Recent data shows that 670 million people in India have enrolled.
  2. Now let's focus on the account-opening process at a financial firm. The customer shows up with his Aadhaar number.
  3. The staff-person at the financial firm engages with the customer and takes the Aadhaar account number and captures fingerprints using a device.
  4. Aadhaar has provided an applications programming interface (API) through which the software at the financial firm now reaches into the Aadhaar database, presents (encrypted) credentials of a Aadhaar number and matching fingerprints, and requests a packet of information.
  5. This information is used to populate the form for the account-opening process. E.g. the photograph is brought from the Aadhaar database and placed into the account opening form. The entire process -- from fingerprint to completed form -- takes roughly 15 seconds.

e-KYC eliminates human effort in account opening, and allows residents to present their KYC information electronically and instantaneously, without needing any physical form of identity or address proof. e-KYC eliminates the movement and storage of verification papers, and therefore costs of document management. Error-free data is obtained from the Aadhaar database, at a much lower cost when compared with the costs of typing in and removing the errors in human-created data. e-KYC is a game changer when it comes to opening accounts for poor people.

An example


Invest India Micro Pension Services (IIMPS) enables low income informal sector workers to accumulate micro-savings for their old age. It has faced KYC challenges in the past, and is an early adopter of e-KYC. IIMPS's target population, i.e. the informal sector poor, cannot gain access to formal financial products as they have insufficient identity documentation (due to factors such as migration), or a complete lack thereof. As a result of this, and due to differences in KYC compliance across regulators, a host of interested low income workers are unable to join the integrated micro-pension program. This is only the first half of the problem. Lengthy KYC application and verification procedures cause significant cost and time overhead expenses for IIMPS while processing each micro-pension application. e-KYC has resolved both of these issues.

Watch a demo



Making it a reality


In the past, there has been doubts regarding the future of UIDAI's Aadhaar project. However, the BJP government has recently reaffirmed its interest in continuing with it. e-KYC is a valid document for all financial services, under the Prevention of Money Laundering Act Rules. e-KYC has also been accepted as valid proof of identification and address by five regulators in the financial sector, namely the Reserve Bank of India (RBI) ; the Securities and Exchange Board of India (SEBI) ; the Pension Fund Regulatory and Development Authority (PFRDA) ; the Insurance Regulatory and Development Authority (IRDA) ; and the Forward Markets Commission . It is also compliant with the Information Technology Act, 2000. This means the encryption and digital signatures ensure both end-points of the data transfer are secure, making e-KYC legally equivalent to KYC paper documents. e-KYC is up and running. However, most financial firms do not (at present) utilise it. They need to modify their software systems in order to utilise the API. As only 670 million people are enrolled in Aadhaar, financial firms have to have the ability to do the old-style KYC also. In the future, there could be situations where the entire process capability for conventional KYC is removed, which would further reduce costs.

Wednesday, September 10, 2014

What role is played by the commodity futures in India?

by Nidhi Aggarwal and Susan Thomas.

Commodity derivatives markets are the unsung song of the Indian reforms that started in the 1990s. The National Agriculture Policy, announced by the government in 2000, advocated the development of futures markets so that consumers and producers of commodities could use these contracts to procure commodities at a more rational price than at the Minimum Support Price (MSP) set by the government, which came with a large cost to the exchequer. This set in place a drive of reforms in these markets, following the reform model that had lead to the development of the Indian equity markets previously.

In 2003, commodity futures contracts started trading on electronic exchanges with a nation-wide reach. Counterparty credit risk, that was a serious problem in the older exchanges, was eliminated using netting by novation at clearing houses similar to their more visible equity derivatives cousins. Total traded volumes of commodities derivatives increased by more than 100 times between 2003 and 2013, with agricultural commodity derivatives increasing by nearly 15 times.

These markets have been subject to a great level of mistrust and criticism, and a slew of negative interventions from policy makers, politicians and other financial sector regulators. From outright banning of contracts to restrictions by RBI, SEBI, IRDA and PFRDA on participation by their respective constituencies in this market, the mistrust from policy makers about the commodity derivatives markets is pervasive. Most of these interventions do not identify a clear market failure that they are attempting to address. The consistent and stated reason for these bans is to reduce high commodity price volatility. This is despite evidence, including some government reports, to the contrary.

In a recent IGIDR working paper, which was created as a part of DEA's D. S. Kolamkar Committee, we examine the commodity markets in India in the two required roles: price discovery and hedging. In this analysis, we use daily futures and spot prices for eight commodity futures markets (six agricultural and two non-agricultural) between 2004-2014. We have two main findings.

Q1: Does the futures market matter in price discovery?


We measure price discovery using the Information Share (IS) of futures prices. The IS can be between 0 (no price discovery) and 100 (sole price discovery) percent. An IS of 50 percent or above implies that futures prices dominate price discovery. We find that the IS of the Indian commodities futures prices is greater than 50 percent. This is evidence that futures help price discovery for all these commodities, both agricultural and non-agricultural. The futures market is the venue of more than half the information production of the market process.

It is often claimed, in India, that futures price movements are driven by market manipulation, because prices of these leveraged products can be manipulated with greater ease than spot market prices. If this were the case, futures prices would have a low relation to the actual demand and supply of the underlying commodity. In a persistently manipulated futures market, we would expect that futures prices would be persistently de-linked from the spot and there would be no price discovery in the observed futures prices. Our analysis provides evidence contrary to this outcome.

Q2: Is the futures market an effective tool for hedging?


Another role of a well-functioning derivatives markets is that the derivatives are useful as hedges -- financial contracts that provide protection against price volatility (Sahadevan, 2012). For the same eight commodities under study, we measure hedging effectiveness by comparing price risk faced by two types of individuals who have a financial exposure to the commodity: one who does not have a futures position (unhedged), and the other has a futures position (hedged). We find that there is some reduction in the risk faced by the hedged individuals, but that the amount of risk reduction varies widely the different commodities. For example, a rubber farmer can use futures to reduce 61 percent of price risk of selling rubber in the future. But the sugar farmer can only reduce 8 percent of price risk. The amount of risk reduction is observed to be even lower for the non-agricultural commodities.

With this evidence, the glass is half full on the role of the futures market for price discovery (the futures market is an important venue for information production). But the glass is half empty in that in many cases, the futures contracts are not too useful for hedging.

What are the bottlenecks?


Price discovery across markets is measured by which price moves first in response to new information and which follows Hasbrouck, 1995. Hedging effectiveness, on the other hand, is the extent of price convergence between the two markets over longer horizons, and depends on how tightly the two markets are tied by arbitrage (Garbade and Silber, 1983). Arbitrageurs ensure that futures market prices are linked to spot market prices through the cost of carrying forward the delivery. The cost of carry, which is also known as the futures basis, typically includes storage costs and capital costs (interest cost for deferred payment on maturity of the futures contract). If hedgers are to get insurance through buying and selling futures, the basis needs to be predictable. Garbade and Silber (1983) say: To the extent that the lower storage and transactions costs and greater homogeneity of the underlying cash commodity encourage arbitrage activities, the linkages between the two markets will be enhanced, thereby improving the risk transfer functions of the futures market. To improve the hedging effectiveness of the futures contracts, we need to make the world safer for arbitrageurs.

In India, several of these factors cited as important for healthy arbitrage activity are missing. These are the bottlenecks that disrupt the ability of arbitrageurs to ensure that the futures and spot market relationship holds over longer horizons. Addressing these bottlenecks will, in turn,   improve hedging effectiveness. These bottlenecks fall into three main categories: those relating to the legal and regulatory uncertainty in the market, those relating to settlement of contracts and those related to availability of products.
  1. Legal and regulatory uncertainty: Among all financial contracts, commodity derivatives have been especially vulnerable to micro-management by the government. These include price and quantity interventions in the underlying spot market, banning of futures contracts and regulatory restrictions on participation. There is interference from the central government (through the Essential Commodities Act and MSP on the underlying commodities), state governments (because agriculture is on the state list) and the other financial sector regulators (who restrict wide participation of institutions and foreign participants and create barriers to development and innovation). These increase the uncertainty about the spot price, derivatives price and the cost of carry in commodities markets.
    Since such interventions affect both the quality of prices in the spot and derivatives markets, and the availability of the spot commodity, they hurt both the price discovery function and the hedging effectiveness of the futures. For example, in our analysis, the IS of sugar futures dropped to 10 percent in the 2010-2014 period, aligned with the ban on sugar futures between May 2009 and September 2010. Similarly, after the restrictions on gold imports imposed by the RBI in mid-2013 we see a drop in the information share of gold futures.
    When a market is vulnerable to hostile actions by the government, such as arbitrary increases in margin requirements or arbitrary reductions in position limits or arbitrary contract bans, this deters the development of organisational capability in financial firms. Arbitrage requires building systems, processes, and sources of capital. Financial firms are unwilling to invest in building a serious organisational capability in commodities arbitrage as the regulatory risk -- of getting shut down by the government -- is high.
  2. Settlement problems: Derivatives markets work better when there is certainty of settlement of the underlying, irrespective of whether it is cash settled (Indian equity derivatives) or physically settled (Indian commodity derivatives). Uncertainty of settlement in the form of quantity and quality of commodities delivered at exchange-registered warehouses or about the warehouse receipts issued, create uncertainty in the link between the futures and spot price.
    Regulation and governance of warehouses is in the ambit of the Warehousing (Development and Regulation) Act, 2007. The Warehousing Development and Regulation Authority, which this Act established as an independent regulator of warehouses, became operational only in the end of 2010, It is yet to develop a clear regulatory role. Once it starts functioning effectively, delivery related problems in the functioning of commodity derivatives, may get mitigated.
  3. Problems of product structure: Commodity derivatives today are very similar to their older and more successful equity market cousins in contract terms and form. However, commodities have different characteristics. Unlike equities, commodities have seasonal cycles in prices, are non-standardised with significant regional differences across the country, with varying supply in different years. In order to improve the efficiency of commodity futures for price discovery and risk management, deep insights into the spot market have to find their way into contract design.
    For example, contract maturity ought to mimic the seasonality of the underlying crops for agricultural commodity derivatives. Commodities with wide variation in available grades ought to have contracts on multiple categories rather than just a fixed grade each year. Once that is in place, index contracts ought to be constructed that proxy the risk of the single commodity (this is hampered today by the FC(R)A which prohibits index contracts). There may be a case to consider a wider range of number and location of delivery centers depending upon the commodity. Such features require focussed knowledge development about the specifics of each commodity and what will increase the utility of the futures for traders with positions in the underlying spot.

Moving forward


Now that FMC is part of the Department of Economic Affairs, and now that major changes have taken place in the ownership and governance of commodity futures exchanges, the process of building trust in FMC and in commodity futures exchanges can commence. For a series of commodities, particularly agricultural commodities, India is potentially a global player in the field of commodity futures. The emergence of a well regulated commodity futures ecosystem will make possible a new phase in Indian finance in terms of exporting financial services.

This requires a work program at FMC comprising eight elements:
  1. Foundations of public administration. The foundations are laid by public administration reforms as envisaged in the FSLRC Handbook that is being implemented at all financial regulators. This will reshape the internal working of FMC and its interactions with the economy. There should be a design of a report card about how well FMC is faring, including the concept of the annual report from FSLRC. A quarterly report card can also be constructed of the working of commodity futures market around measurement of liquidity, market efficiency, the information share of commodity future and the hedging effectiveness.
  2. Improvements in information. FMC should lead the work of improving the statistical system on all issues connected with commodity futures trading. This includes better measurement of spot prices e.g. through polling. FMC should construct, and release, high quality data about the field, which will foster better thinking by financial firms and better analysis of policies.
  3. Improvements in research. In order to do regulation, a clear scientific understanding is required about the market failures in the field, and the minimum interventions through which those market failures can be addressed. This requires constructing a body of literature on these questions. At present, there is a negligible flow of academic research papers on commodity futures in India. Initiatives need to be undertaken through which there are (say) 12 high quality papers which are produced per year by the research community.
  4. Market failure 1: Consumer protection. FMC needs to measure and understand the ways in which consumers are being mistreated when they become customers of commodity futures exchanges. This should lead to drafting and enforcing regulations that prevent this.
  5. Market failure 2: Micro-prudential regulation. FMC needs to establish a scientific foundation for margin rules and position limits through which the failure probability of clearing members goes down.
  6. Market failure 3: Systemic risk. FMC needs to establish a scientific foundation for margin rules so as to drive down the failure probability of a clearinghouse to near-zero levels. FMC must get away from the methods used for manipulating margins in the past based on opinions of the government on the level of the price or of price volatility.
  7. Market failure 4: Market abuse. FMC needs systems to detect and enforce against market abuse. There is much value in utilising the notions of market abuse as defined in the draft Indian Financial Code.
  8. Problems of coordination. FMC needs to work with other financial regulators to remove the barriers which have been placed, that hamper participation in commodity futures exchanges by a broad array of financial firms. This will require trust in FMC and in the commodity futures ecosystem. FMC must also coordinate work on strengthening WDRA, as warehousing is a critical industry that enables the working of commodity futures markets in general and commodity arbitrage in particular. FMC must coordinate work with all agencies in the government that have the power to ban commodity futures trading, and put an end to such practices.

After a better policy regime is put into place, it will take many years for financial firms to come to trust FMC and the commodity futures ecosystem, and then commit resources to develop organisational capabilities in the field. Hence, there is urgency in implementing these changes.

Monday, September 08, 2014

The fiscal correction that India requires is feasible: Aadhaar and subsidy reform holds the key

The size of the task


Last year (i.e. 2013-14 RE), the fiscal deficit was 4.6% of GDP. The fiscal deficit budgeted for 2014-15 is 4.1% of GDP. The budget speech has said that the target for 2015-16 is 3.6% and then the target for 2016-17 is 3% of GDP. For India to achieve macroeconomic stability, this fiscal contraction is extremely important.

How are we going to get this overall gain of 1.6 percentage points of GDP from 2013-14 till 2016-17? The international experience suggests that sustained fiscal corrections are dominated by reduced expenditure; attempts at increased tax revenues tend to peter out as the economy changes its behaviour in response to short-termist tax measures. Hence, we have to focus upon expenditure reductions.

How might we get an expenditure reduction of 1.6 percentage points? Will it be done by doing a little bit here and a little bit there? The trouble is: 1.6 percentage points of GDP is a full Rs.2,06,026 crore (i.e. Rs.2.06 trillion or $33 billion). Minor initiatives will not move the needle. Any one initiative which yields an impact of below Rs.10,000 crore is not a big element of this task. What this requires is the pursuit of qualitative change.

Aadhaar offers a stab at the task


In November 2012, we at the Macro/Finance Group of NIPFP had done a cost-benefit analysis of UIDAI. At the time, the key focus was on the question: Is the construction of UIDAI an NPV-positive project? The answer of this calculation was in the affirmative. The extremely conservative estimates made in that calculation are revealing about the far-reaching consequences of Aadhaar for improvements in numerous expenditure programs. A big area for focus is on better engineering, and reforming, subsidy programs. We should think about it in three parts:

  1. Superficial change: just add biometric authentication. The first and easy area for progress is the removal of duplicates (i.e. payment to the same person twice) and ghosts (i.e. payment to a non-existent person). This is low hanging fruit and only requires systems engineering of existing programs using UIDAI. At this stage, nothing changes on the working of the existing program. People continue to buy subsidised LPG through the existing subsidy program; there’s just a biometric check which establishes that the same person is not buying many cylinders. NREGA continues to operate; we just use Aadhaar to eliminate ghosts and duplicate payments.

  2. Deeper change: Commodity-specific subsidies continue, but transfers are in cash. The second stage is deeper changes in the design of the program. As an example, consider the LPG subsidy. Progress had begun with direct benefit transfer for LPG (“DBTL”). In 289 districts, consumers got cash of Rs.435 a month into their bank accounts when they purchased LPG at the market rate. This program was working; Rs.5,400 crore was transferred into 28 million accounts. Unfortunately, the UPA government lost nerve and on 30 January 2014, this initiative was shut down.

  3. Eliminating commodity linked and other subsidies, and doing income support. Once enough people are plugged into Aadhaar-enabled payments, it becomes possible to replace commodity-linked subsidies by a cash subsidy. This is more efficient as the government would not distort commodity markets or intrude on the preferences of households. Government would empower poor people with money and not get into decisions about whether consuming LPG is a good thing. The construction of such a cash-based subsidy involves its own design choices. This design work can start now, and one year from now, Aadhaar adoption will be on a scale large enough to support implementation.
All this was quite novel a few years ago, but by now these ideas are ripe for implementation. The policy analysis and workplan documents are ready on the fertiliser and fuel subsidy, use of Aadhaar for large-scale payments infrastructure, and restarting DBT for LPG.

 The low hanging fruit from Aadhaar adoption in the implementation of subsidies works out to around Rs.75,000 crore a year. While this does not take us all the way to the required Rs.2,06,026 crore, this is big enough to move the needle in a way that tinkering at the margins is not. Re-engineering subsidy programs using Aadhaar also sets the stage, and changes the political possibilities, for deeper subsidy reform (e.g. capping the number of cylinders per household, or kilograms of subsidised fertiliser per farmer) through which the remainder of the required reduction in expenditure can be obtained.

The early initiatives which can be easily rolled out are reviving the DBTL (that was done for LPG) and using the same framework for Kerosene, Fertiliser and Food. Alongside this, state governments can also use DBT for water and electricity subsidies, which will help free up fiscal resources at the state level. As with DBT for LPG: when the household pays a water or electricity bill, the subsidy would show up in the household’s bank account.

DBT can help in all government to person payments including : MNREGA, scholarships, salaries, pensions. It can help in delivering stipends and incentives to the 1-2 million contract workers associated with the government: SSA school teachers, anganwadi workers, ASHA workers etc. The WTO may require India to put an end to procurement from farmers; we can shift to delivering cash to farmers using DBT.

 It is important to remember that every time we shift from a price-based subsidy to an income support, this simultaneously yields an impact of GDP growth, as the distortions associated with price-based subsidies are removed. Hence, such an approach to reform simultaneously hits the numerator (fiscal deficit measured in rupees) and the denominator (GDP), and thus gives a bigger bang for the buck.

A few minor things or grand schemes?


To summarise, Aadhaar is the big idea around which we can take a stab at the required 1.6 percentage points of GDP of a reduction in expenditure by 2016-17. This generates cost savings right away, and sets the stage for deeper subsidy reform which will generate the remainder of the required fiscal correction. Aadhaar has been constructed and is ready to go. The BJP government has reaffirmed its interest in continuing with this program. What a difference a few years makes: Aadhaar was viewed as a complex, risky, new system, but now it’s a big working system:

  • 670 million Aadhaar numbers have been issued, and the system is at its point of inflection into near-complete coverage of the poor people who would be beneficiaries of subsidies.
  • A few thousand crore have been transferred through Aadhaar DBT.
  • Over 60 million bank accounts are linked to Aadhaar.
  • Several million authentications have been done so this is also a proven capability.
  • Jan Dhan Yojana will use Aadhaar e-KYC, which is a statement of the maturity of this capability.
  • Jan Dhan Yojana, as presently envisaged, has many problems: it is a continuation of 60 years of failed RBI thinking on financial inclusion. But this work could be channelled into a big push for getting a Aaadhar-linked mobile-based payments mechanism to every citizen of India, which would be a pretty good thing.

As with all important progress in India, what matters is obtaining execution on grand schemes, and not tinkering at the margin. Our present ways in public administration are broken: we need to think big, and implement new systems. The centrepiece of our journey is implementing five big transformational projects: Aadhaar, the Goods and Services Tax, the Indian Financial Code, the Direct Taxes Code, and the Delhi-Mumbai Industrial Corridor. These are the five initiatives where the analysis and thinking is complete, and we’re ripe for execution. They are big enough to move the needle for the Republic.

For many bureaucrats, it is far more comfortable living around little initiatives, and being fashionably cynical about grand schemes. The little stuff is, however, a bad use of top management time, and becomes irrelevant in a few years. A more intellectual perspective shows us, by looking back into 20 years, that it was only the grand schemes that mattered.