## Sunday, January 31, 2016

### Occam's razor of public policy

Occam's razor is the idea that when two rival theories explain a phenomenon, the simpler theory is to be preferred. Aristotle's epicycles fit the data as well as Kepler's ellipses, and a pure empiricist could have been agnostic between the two. Occam's razor guides us in preferring Kepler's ellipses on the grounds that this is a simpler explanation.

In the world of public policy, a useful principle is:

When two alternative tools yield the same outcome, we should prefer the one which uses the least coercion.

### Example: Punishment

When we want to drive the incidence of a certain crime to the desired rate, we want to find out the lowest possible punishment that gets the job done. You can reduce theft to desired levels by promising to cut off the hand of the thief. We would much rather achieve the objective using a reduced use of the coercive power of the State, with mere imprisonment.

The purpose of punishment is deterrence, not vengeance. And, in the class of deterrents, we seek to find the smallest possible use of the coercive power of the State that gets the job done.

Suppose 4 years of imprisonment and 2 years of imprisonment are equally able to get the incidence of a particular crime down to the desired level. Suppose a person says: I am not a liberal; I am not squeamish about using the coercive power of the State; I hate the people who commit such crimes; I don't care whether they get 2 years or 4 years in jail. But an $\alpha$ fraction of all convictions are in error. In these cases, we are inflicting the punishment upon an innocent. The harm is minimised when we have deployed the lowest possible punishment.

### Example: Spending on government programs

All government spending is grounded in taxation, present or future. All taxation is grounded in the coercive power of the State. If there are two different spending programs that get the job done, we should favour the one which spends less.

### Example: Infrastructure bonds

When the market for infrastructure bonds in India does not work, too often, solutions are proposed which use extreme force. Some people propose tax breaks. Some people propose harsh interventions such as forcing every bank to buy infrastructure bonds or forcing every bidder to NHAI to issue infrastructure bonds. As an example, we in India force insurance companies to buy infrastructure bonds.

If, on the other hand, we trace the failures of financial sector policy which have held back the market for infrastructure bonds, this would show how to get the job done while actually reducing State coercion (i.e. getting the State out of inappropiate coercion).

### Example: The journey to cashless

Cash is an abomination and we should have a thousand flowers of electronic payments blossoming. India is one of the most backward places in the world in the domination of cash.

Tax breaks for electronic payments or high taxes for cash transaction or outright bans of cash transactions: these are all ways that get the job done using a lot of force.

If, instead, we understand the failures of financial sector policy which have hobbled the sophistication of payments in India, we will get the job done while actually reducing the use of the coercive power of the State. We would have less cash in India if RBI did not use the coercive power of the State to block the clever Uber cashless transaction.

### Example: Family welfare

A government which runs counselling services on family welfare is using less coercion when compared with forcible sterilisation or a one-child policy.

### How to reduce the use of coercion: go to the root cause of a market failure

Market failures can be addressed in many ways. When we go to the source, with well understood causal claims about the source of the market failure, we will find ways to address the market failure using the smallest use of the coercive power of the State.

If we don't have a deep understanding of the sources of the market failure, we may often endup hitting a symptom rather than the disease. Getting the job done may then require the use of a lot of coercion.

As an example, for some market failures that are rooted in information asymmetry, if an intervention can be found which rearranges the structure of information, this can get the job done using the least coercion.

### Why are big punishments often favoured in India?

A person who thinks of violating a law to obtain an ill gotten gain $G$ faces a probability $p$ of being caught and the fine imposed upon him will be $F$. Standard economic arguments suggest that we must set $F = G(1-p)/p$. In this case, the expected gain from violating the law is 0, and a risk averse person will favour the certainty of compliance over the lottery of breaking the law.

In India, too often, the executive works poorly and $p$ is quite low. This creates a bias in favour of driving up $F$. This is giving us very large penalties. This induces its own problems. We are inflicting terrible harm on the $\alpha$ fraction of innocents who are wrongly convicted. We are giving great power to front-line investigators and judges at a time when institutional capacity is low.

If we are able to build institutional capacity for enforcement, and $p$ goes up, we will then be able to come back to lower punishments that generate adequate deterrence.

### Why does Occam's Razor of Public Policy make sense?

1. It is consistent with the liberal philosophy that desires that humans should be free to pursue their own life with the minimum interference.

2. At best, governments work badly. The information available to policy makers is limited, many wrong decisions are taken, many decisions are poorly implemented. Governments do not know the preferences of citizens. Politicians and officials are self-interested actors and work for themselves. The Lucas critique comes in the way: rational actors change their behaviour when policy changes take place in ways that confound the original policy analysis. Many government actions fail to achieve the desired outcome, but they always have unintended consequences.

It's good to be humble, and swing the smallest stick that would get the job done.

### Limitations

All this, of course, presupposes that all use of coercive power of the State is a purposive activity aimed towards achieving a certain well specified objective. This is not always the case. As an example, the objectives of exchange rate policy or capital controls are hard to decipher. Before we get to discussion of more coercion vs. less coercion, it would be a great step forward if all government intervention were fully articulated in terms of market failure, objective of the intervention, demonstration of the causal impact of the intervention upon the objective, and cost-benefit analysis.

The examples above have featured comparisons where more versus less coercion is easy to identify. Amputation of the hand $>$ imprisonment for 4 years $>$ imprisonment for 2 years. Forcing banks to give out 40% of their loans into priority sector lending is more coercion than information interventions which make the credit market work for poor people. Opening up to private and foreign telecom companies is a way to get phones to everyone with less use of State coercion when compared with forcing banks to open accounts for everyone.

In many situations, however, it is not easy to identify which of two alternative policy pathways involves more coercion. A government program which educated parents that their kids should get immunised seems to involve lower coercion when compared with a forced immunisation program, but this is perhaps not the case when we envision an education program that must generate eradication of polio. A government program to educate young people about saving for old age involves less coercion than forcible participation in the NPS.

### Conclusion

The State has a monopoly on violence and is the only actor who can coerce citizens to do things against their will. All public policy initiatives involve the use of the coercive power of the State. In the field of public policy, we should be humble about our lack of knowledge, respectful of the freedom of others, and use this power as little as possible.

### Acknowledgements

I am grateful to Jeff Hammer, Shubho Roy and Renuka Sane for useful conversations.

### Land market reform is an important enabler of bankruptcy reform

By K.P. Krishnan, Venkatesh Panchapagesan and Madalasa Venkataraman

In India, it seems easy to lend money, but it is difficult to get it back. Just ask our banks. New law, and associated institutional infrastructure, for bankruptcy is in the pipeline, with the draft Insolvency and Bankruptcy Code by the T. K. Vishwanathan Committee. Will it work? What can the impediments be that could limit its effectiveness?

One of the key weapons in a lender's armoury is the collateral (or security) from the borrower. The quality of the collateral - how easy it is to collect, store, value and dispose of - determines the type and extent of credit that a lender is willing to provide. Land and associated real estate constitute a large part of collateral in India. More than 50 percent of corporate loans and 60 percent of retail loans have land and real estate as collateral. It is hence important to understand the complex nature of land markets to determine whether they would facilitate or undermine the effectiveness of these new laws. We examine this issue in a recent paper titled Distortions in Land Markets and Their Implications to Credit Generation in India.

The land market in India is not a homogenous national market but a heterogeneous collection of various State markets with variation in laws and regulations. This is because land related issues fall under the State and Concurrent List under our Constitution. This poses the first big problem: it is not easy to provide credit across state boundaries unless lenders have local presence or partners to count on. Even when land is accepted as collateral, several factors exist that could raise costs and risks for lenders. Let's run through the list of challenges faced by the lender.

### Challenge 1: Does the land belong to the borrower?

It is hard to say because titles are not guaranteed by the State (like the Torrens system used in countries like Australia). Hence, all evidence of title is merely presumptive and can be challenged at any point by a person claiming to have better title to the land.

To mitigate the risk of future challenges to title, lenders spend considerable resources, including legal help, to conduct title searches, to protect themselves. A title search can be a fairly complex and expensive exercise in the Indian setting. This is because:

1. Indian law does not mandate the registration of every single transaction that affects rights in or the enjoyment of, property. Hence, records of some transactions that affect title or enjoyment of property will not be found in any public office.

2. Land records in India are spread across three offices - the Sub-Registrar's office, the revenue offices and the offices of the survey department. Time lags between these offices in updation of land records, often lead to inconsistencies in information obtained from these three offices.

3. Title related disputes in courts require a search process in the courts, as the status of the dispute may not be reflected in the records in the Sub-Registrar's office or the revenue offices.

4. A title search is necessarily a local exercise, as land records are maintained in local offices in local languages. The contents of land records across States are not standardised. Several State laws have restrictions on the transferability of land, depending on the land classification. For instance, in most States, agricultural land cannot be transferred to a non-agriculturist. The localisation of the title investigation process adds to transaction costs.

Lenders do not have recourse to a private title insurance industry in India. Interestingly, even in countries that follow Torrens system of state guaranteed titles, there is an increasing trend for lenders to seek private title insurance (Zasloff, 2011). Hence, lenders in India have to rely on title searches conducted by independent title investigators. This raises transactions costs and particularly hampers small loans.

### Challenge 2: Has the land been already pledged with other lenders?

There is no single point of information on all the processes and transactions that can encumber land. Again, some transactions which create encumbrances on land (such as the mortgage by deposit of title deeds) are not required to be registered. Consequently, the records of such mortgages cannot be found in any public office.

The Central Registry of Securitisation Asset Reconstruction and Security Interest of India, or CERSAI, was set up to consolidate information about mortgages against property. However, its scope is limited: it does not include reconstruction loans outside the purview of the SARFAESI Act or loans given out by entities other than banks. Nor does it have information about all loans issued prior to 2011 when CERSAI was set up. Further, since the registry requires identification of land clearly, the importance of accurately mapping land boundaries becomes critical for its success. Accurate mapping of land boundaries has its own set of problems as described next.

### Challenge 3: Is the land properly identifiable in classified records?

Land parcel identification is a challenge since cadastral maps are outdated and rarely reflect the reality on the ground. As mentioned above, record-keeping of various related aspects of land - titles and registrations, encumbrances, geographic information sources, revenue and taxation - is done in silos by various departments, often leading to conflicting information on the same land parcel. The problem is more acute in rural areas, where use of technology is still limited. The use of different units (acres, hectares etc.), terms (like Khata in Karnataka and Patta in Tamil Nadu) and bookkeeping standards across states present their own set of difficulties in identifying land across States, thus hampering the economies of scale of running a nationwide lending business.

### Challenge 4: Do the constructions/settlements on the land adhere to local laws, and have all dues been properly paid?

Important attributes such as flood plain, seismic zone, lake encroachments, easements and rights of way etc. also cannot be conclusively established given the siloed nature of record keeping. If not properly accounted for through pricing, these attributes could pose significant risk to lenders. The recent announcement in Bengaluru that several lake beds have been encroached by entities including the Bangalore Development Authority - the agency obligated to protect lake beds - shows the extent of risk to lenders who have financed development activity on such land.

The problem is exacerbated where the collateral is built-up property. In the case of built-up collateral, the lender is also required to verify whether the building complies with city-level zoning regulations and has the requisite building permissions. This is to avoid the possibility of the future demolition of the collateralised property which is not compliant with the local laws. The value of the collateral may also change depending on issues such as the area on the land, if any, earmarked for municipal road widening, changes in town planning norms, etc. This requires searches in the local municipal offices.

### Challenge 5: Is the value of land sufficient enough to cover the loan in case of distress?

Land valuation is done by lenders at the time of loan origination, and after the borrower has exhibited distress. Empanelled valuers use a combination of recent transactions and government estimates (called guidance values or circle rates) to derive land values that are used by lenders. Given the significant presence of black money in land transactions, getting true market values is more an art than science. Issues such as defective land title and illegal developments, mentioned above, impede land values but are hard to account for at the time of origination of the loan.

### Challenge 6: If there is default, can the land be sold to recover dues owed easily?

The battle to recover the collateral really begins after default. The SARFAESI Act has shortened the recovery process for banks and financial institutions. However, it leaves out creditors who are not banks and financial institutions such as creditors of firms which have borrowed through secured bond issuances. For such creditors, a mortgage foreclosure suit will, under current law, have to go through the delays associated with civil courts. Moreover, the implementation and interpretation of the SARFAESI Act has not been free of problems. For instance, proceedings under the SARFAESI Act are often delayed through writ petitions or simultaneous proceedings which are pending in other fora (Ravi, 2015). Similarly, the SARFAESI Act does not resolve the problems of already encumbered collateral or collateral with no marketable title. For example, a bank or a financial institution cannot evict tenants of collateralised property under SARFAESI. This proposition was recently upheld by the Supreme Court in Vishal Kalsaria v. Bank of India and Others, January 2016.

### Conclusion

Bankruptcy reform is important and valuable in and of itself. Land market reform is important and valuable in and of itself. Given the prominence of land as collateral in the working of the Indian credit market, improved working of the land market is an important enabler of a better functioning credit market and improved working of the bankruptcy code. Parallel and simultaneous progress on both fronts will yield a magnified impact upon the economy.

While the Bankruptcy Code is expected to improve recovery proceedings, it will not help where the title to the collateral itself is challenged at the time of recovery. Unlike movable collateral, the ability of a creditor to monetise immovable collateral quickly is fettered. Indian lenders have, so far, rationally responded to these issues by protecting themselves through credit rationing and through solutions like personal guarantees. Also, due to the difficult process of establishing title and related encumbrances, urban lands - where recovery time and cost are high - are subject to higher loan to value ratios.

One part of the reforms agenda is structural, and involves significant fiscal outlays, for cleaning up land titles, improving the quality of land registry through digitisation, overhauling the land litigation system and creating efficient stamp duty and registration processes. In addition, in the paper, we propose many modest, feasible and less expensive reforms. To begin with, we must standardise land-related data capture across states and create a repository of valuers' data that can be shared across lenders. Similarly, States need to focus their energies on building capacity in land record offices to enable smooth and efficient updation of land records. While creating conclusive titles with state guarantees is a laudable and ultimate goal, there are numerous opportunities for front-loading gains by streamlining existing land records using modern technology, and facilitating private title insurance to mitigate risk from lending against land.

Most of the challenges described above relate to the structure of information. Modern technology -- computers, telecom networks, GPS, Aadhaar, ubiquitous digital cameras -- has created a new opportunity to build improved institutional infrastructure for creating, storing and disseminating information that would transform the land market.

### References

Aparna Ravi, The Indian insolvency regime in practice -- an analysis of insolvency and debt recovery proceedings, Economic and Political Weekly, 2015.

J. Zasloff, India's Land Title Crisis: The Unanswered Questions, Jindal Global Law Review, 2011.

K. P. Krishnan is at the Department of Land Resources, Government of India. Venkatesh Panchapagesan and Madalasa Venkataraman are researchers at the Indian Institute of Management, Bangalore.

## Saturday, January 30, 2016

### Draft IRDAI regulations on insurance commissions: Going back to the beginning

by Ashish Aggarwal and Renuka Sane

On 13 January 2016, the Insurance Regulatory and Development Authority of India (IRDAI) released the draft (Payment of commission or remuneration to insurance agents and insurance intermediaries) Regulations, 2016 and invited public comments. The regulations propose a substantial increase in commissions for life insurance distributors starting April 2016.

In their present form, the proposals will be detrimental to consumer interest, increase the regulatory arbitrage in favour of products regulated by the IRDAI and undermine the recent attempts by the government towards curbing mis-selling and rationalisation of incentives for financial product distribution.

The regulations are intended to govern payments by an insurance company to individual agents or intermediaries (which include corporate agents, insurance brokers, web aggregators, insurance marketing firms, and any other entity as may be recognised by the IRDAI) for soliciting and procuring an insurance policy. Payments may be in the form of a commission (paid to agents), remuneration (paid to intermediaries) or a reward (any direct or indirect benefit over and above the commission). The Bill proposes that the Board of every insurance company will approve the commissions and reward policy. The draft Regulations propose two big changes.

### Big change 1: Raise the overall commission rates

For bundled products, such as ULIPs and traditional plans, with a tenure of twelve years or more, an insurance company would be able to pay intermediaries 49% of the first year premium as commission and reward. This cap is proposed at 42% for insurance agents (See Table). The commissions for subsequent years has been increased to 7.5% of premium for year 2 to 6. Earlier, the cap from year 4 onwards was 5%. The 5% cap is now applicable from year 6 onwards.

Pure risk cover, or term plans, will have a maximum first year commission rate of 50% for policies of tenure 12 years or more. For those between 5 and 11 years, commission will be capped at 40%. Subsequent year commissions will be capped at 10%. The addition of rewards to these implies that the maximum cost cap for term policies of duration 5 to 11 years will become 48% for agents and 56% for intermediaries. For policies more than 12 years, the caps will be 60% for agents and 70% for intermediaries.

First Year Life Insurance Commissions and Rewards
Category Proposed Existing
of 5-11 year:
ULIP/ Traditional - 42% for intermediary and 36% for agent

Term - 56% for intermediary and 48% for agent [Note 1]
15% to 33% based on premium
paying tenure of the policy [Note
2]
Policies with premium paying term of 12 years and
more:
ULIP/ Traditional - 49% for intermediary and 42% for agent
Term - 70% for intermediary and 60% for agent [Note 3]
35%
Note 1: Commission:- 30% of premium (ULIP/Traditional), 40% of premium (Term), Reward - 20% of Commission for agent and 40% for intermediary.
Note 2: Tenure and Commission:- 5 year - 15%, 6 years - 18%, 7 years - 21%, 8 years - 24%, 9 years - 27%, 10 years - 30% and 11 years 33%.
Note 3: Commission:- 35% of premium (ULIP/Traditional), 50% of premium (Term), Reward - (20% of Commission for agent and 40% for intermediary).

### Big change 2: Bring in hereditary commissions

These are being reintroduced. Section 54 of the The Insurance Laws (Amendment Act), 2015 had removed section 44, according to which, if an insurance agent had served for more than 5 years, the commissions had to be paid to the heirs of the agent, even if the agent was no longer servicing the policy.

### Problems with the draft regulations

Ignores all evidence on the perverse impact of high commissions
Research has shown that the incentive structure of agents has played a large part in the mis-sale of financial products. When agents get remunerated by the product provider, the incentive comes not from higher sales driven by customer satisfaction, but from commissions paid by the product provider. The product that pays the higher commission is the product that gets sold. This is not always in the interest of the customer. The world over, the response of regulators has been to ban conflicted remuneration structures, and/or impose requirements on ensuring the suitability of the product to the customer. Against such a background, the IRDAIs proposal to increase commissions, and also not impose any suitability requirements seems misplaced. This is particularly relevant as metrics of performance such as persistency and lapsation of policies have been steadily worsening.
Increases regulatory arbitrage
The same insurance distributor is likely to be selling other products like mutual funds and New Pension System which at their core are long term investment products. The commission structure for mutual funds is based on asset based trail fee. This results in relatively much lower commissions in initial years which could grow into substantial sums after say, 10-15 years, provided the customer stays into the scheme and invests regularly. The commission structure for NPS distributor provides for a nominal flat transaction fee and a 0.25% fee on amounts invested. A distributor is naturally incentivised to push insurance plans irrespective of suitability for the consumer. A consumer would be more likely sold a traditional insurance plan than a basket of NPS, mutual fund and term insurance. This makes selling difficult for the mutual funds and NPS. The proposed regulations are likely to further skew the markets.
Does not realign the pure term and bundled insurance products
It would be misleading to assume that the regulations incentivise sale of term insurance products by providing for higher commission rate as compared to ULIPs and traditional investment oriented plans. A term plan of Rs.1 crore for a 35 year old would cost Rs.13,000. At 70% of premium, Rs.9,100 should be a very attractive first year commission given that these products are apparently more difficult to sell as compared to investments. However, even if the initial commission rates on ULIPs and traditional plans were much lower, say 10%, these could still be more attractive for distributors to sell than term plans. For example, premium for ULIP/ traditional plan with a similar insurance cover would be about Rs 100,000 and even a 10% commission would fetch Rs.10,000. Of course, these are basically investment products with only a small portion of the premium going into insurance component. The raising of commissions on pure term along with that of bundled products does not alter the skew against the sale of pure term products.
Poor process
The draft regulations provide an approach which has gone into the formulation of the regulations. They do not, however, provide a rationale. How would these regulations benefit the consumers? In less than one year of the Insurance Laws (Amendment) Act omitting hereditary commissions, it is not evident why these are now proposed to be brought back through regulations? Regulators such as RBI, SEBI, have shown a poor track record in following regulation making processes. Regulations on fund management, and regulations on aggregators of the NPS, by the PFRDA have also raised similar concerns. The IRDAI draft regulations are yet another example of the failure of the attempts by the Government to encourage regulators to frame regulations as laid down in the Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code.

### Another recent committee's recommendations on commissions

It would be useful to look at the recommendations on similar issues of another recent committee setup by the Government of India and headed by Sumit Bose, Former Union Finance Secretary. The report has recommended doing away with the practice of front loaded commissions. It noted that these created perverse incentives for distributors to push products with higher upfront/ first year commissions, increased regulatory arbitrage and proved expensive for the consumers. The committee's recommendations provided that:

1. There should be no up-fronts for the investment part of the premium. The investment part should attract only AUM based trail commissions. The trail commission treatment should be decided with consultations with the lead regulator in the market-linked investment space. These should be level or declining.

2. Upfront commissions should be allowed only on the mortality part of the premium.

3. Distributors should not be paid advance commissions by dipping into future expenses, their own profit or capital.

4. The illegal practice of rebating should be punished harshly by the regulator as it distorts the market.

In its present form, the IRDAI draft regulations ignore all the recommendations of the Bose Committee report.

### Way forward

The disjointed approach as apparent in the draft IRDAI commission regulations is not in consumer interest. A useful approach would be to:
1. Fix the commission structure for the distributors based on the  recommendations of the Bose Committee.

2. Improve the regulation making process. Inviting public comments on draft regulations is a great step but mere existence of a public consultation process does not mean that the public will spend time and resources to comment and participate in the exercise. When the final regulations get released, the IRDAI should take care that these are accompanied with a proper explanation of (i) what exactly is being changed; (ii) evidence that has been relied upon to propose the changes and (iii) expected impact of the regulations on key stakeholders like consumers and sellers.

Ashish Aggarwal is a researcher at the National Institute for Public Finance. Renuka Sane is a researcher at the Indian Statistical Institute.

## Thursday, January 28, 2016

### Concerns about compliance with IRDAI regulations by insurance companies

by Sumant Prashant and Renuka Sane

Before choosing to buy any product, we want to know what the product is actually offering for the price, and how it suits our requirement and taste. For this comparison to work, we need information that a) describes truthfully all the features, or at least the material features, of the product and b) allows us to compare similar features across competing products. As the Bose Committee Report pointed out, when a financial, and especially an insurance product advertises its product features, it is not clear that the advertisement correctly represents the product. Sometimes advertisements are blatantly misleading. Sometimes, they are just hard to decipher. This environment of opaque disclosures has contributed to episodes of mis-selling, and losses to customers.

The Master Circular divides advertisements into two categories based on their intended purpose:

• Institutional Advertisements are meant to promote the brand image of the insurer company.

• Insurance Advertisements are meant to solicit insurance business and therefore provide more details about the product, such as name and benefits of the product and financial performance of the insurer company. Insurance Advertisements are further divided as

• Invitation to Inquire advertisements, which only provide basic information about the product and advise the customer to refer to a more detailed brochure.

• Invitation to contract advertisements, which contain detailed information about insurance products and induces prospective or existing consumers to purchase them.

Of these, Insurance Advertisements are critical in influencing the purchase decision of a customer. They also have the potential of being misused by insurance companies through projection of exaggerated benefits or non-disclosure of important terms and conditions of a product. The Master Circular, therefore, provides detailed do's and dont's for Insurance Advertisements. Some of the requirements for an advertisement are:

1. The product should be identifiable as an insurance product, disclose risks, limitations and exclusions of the product.

2. The benefits of a guarantee, when advertised, should also mention the cost and charges of the guarantee. If conditions of guarantee are elaborate, the advertisement should be accompanied by conditions applicable to the guarantee in specific font size.

3. If promise, projection or past performance are mentioned, this should be accompanied by assumptions, sources of information and the statement that past performance is not an indication of future performance.

4. If tax benefits are mentioned, this should be accompanied by statement that tax laws are subject to change.

5. If a ranking or award is advertised, this should have been awarded by an agency independent of the insurance company which is advertising.

6. Viewers of Internet advertisements should be able to view all the key features of the product.

7. Insurer's website should flash a cautionary notice about spurious calls and fictitious offers.

8. In case of ULIPs, the asset mix of various underlying funds, approved asset composition and pattern should be placed on website on half yearly basis.

9. In promoting product combinations, all particulars of each product should be disclosed with an advice to refer to the sales brochure.

### Evaluating Compliance

1. Some of the requirements which seem easy to implement, like mentioning the registration and UIN number have not been satisfied.

2. Some advertisements did not mention that the product is an insurance product.

4. Some of advertisements did not follow the font and appearance requirement provided in the Master Circular.

5. Some advertisements did not include the disclaimer mandatorily required by regulations.

1
2
3
4
Registration
number
NoNoNoNoYes
Product identified as insurance
product
YesYesNoYesYes
Unique Identifiable reference
number
YesNoNoNoYes
Mandatory
disclaimer
NoNoNoNoYes
FontN.A.N.A.N.A.NoYes

N.A. means "Not Applicable"

### Conclusion

Many insurance companies appear to be violating the IRDAI Master Circular on Advertisements.

## Monday, January 18, 2016

### Assessing RBI's medium-term debt management strategy

by Radhika Pandey and Smriti Parsheera.

The international community has long highlighted the importance of a sound and transparent public debt management (DeM) strategy. Its objective being to set out the plan for achieving an optimal debt portfolio that minimises costs while accounting for associated risk factors. The Reserve Bank of India (RBI) has made a welcome move in this direction by publicly articulating the medium term debt management strategy for the three year period from 2015-18. Some key features of the strategy include adherence to a transparent debt issuance calender, elongating the maturity of the debt portfolio, undertaking buybacks and switches for effective liability management and taking steps to improve the liquidity of the government securities market.

The World Bank's Debt Management Performance Assessment Tool (DeMPA), which consists of a comprehensive set of indicators used to assess the strengths and weaknesses in government DeM practises, is a useful starting point in thinking about this issue. The DeMPA identifies the DeM strategy document as being an important component of the assessment toolkit and advocates that it should meet the following requirements:

1. Description of the market risks being managed (currency, interest rate, and refinancing or rollover risks) and historical context for the debt portfolio;

2. Description of the future environment for DeM, including fiscal and debt projections; assumptions about interest and exchange rates; and constraints on portfolio choice, including those relating to market development and the implementation of monetary policy;

3. Description of the analysis undertaken to support the recommended DeM strategy, clarifying the assumptions used and limitations of the analysis;

4. Recommended strategy and its rationale.

The RBI's strategy document also tries to base itself on these parameters. For instance, it begins with an assessment of the current debt profile of the government and then sets out the future strategy adopting the three broad pillars of low cost, risk mitigation and market development. The document however falls short of achieving a level of analysis that would meet the highest quality standards contemplated in the DeMPA. For this, the DeMPA requires that the strategy should ensure that the target ranges for the risk indicators are based on a comprehensive analysis of costs and risks - identifying the vulnerability of the debt portfolio to shocks in market rates - and these analyses are clearly described, clarifying the assumptions used and limitations of the analyses.

Analysed against this background we find that the strategy document in its current form suffers from certain flaws.

Scope limited to internal debt: The strategy is incomplete in that it has been prepared only for the country's internal debt and within that for the marketable debt of the Central Government. It is missing on two key components that are a part of the government's overall liability position: external debt and liabilities in the public account (i.e. National Small Saving Fund). The strategy also does not take into account contingent liabilities. There are close inter-connections between contingent liabilities and debt management. The government may guarantee a loan, but it will only be liable to make the payment if the recipient of the loan defaults. In such situations the government will have to assume the responsibility of paying the outstanding debt. Invoking of guarantees can therefore have an important bearing on the risk assessment of the debt portfolio of the government. This problem is, in turn, related to the lack of a unified Public Debt Management Agency, which would be able to take a full view of India's debt management problem.

Weak on forward looking analysis: A public debt management strategy must be set in a forward looking framework. The strategy document makes a point that external debt is being ignored on the ground that it forms a very small proportion of the total debt portfolio. This is a fallacious argument because if no analysis is made of the cost-risk trade-offs between external and domestic debt for the medium-long term then how can it be determined that the external debt will continue to remain "small". Similarly it has been stated that keeping currency risk low is a policy decision but the basis for this decision is not clear. It would have been desirable for such statements to be supported by an analysis of global interest rates versus domestic.

Inadequate description of underlying risks: The strategy falters in veering towards an over optimistic assessment of expected outcomes. For the baseline scenario it assumes that the "economy will record moderate to reasonable growth, a moderation in inflation as per the path projected by Reserve Bank and financial stability". It takes into account two alternate scenarios - a positive scenario in which the economy would grow at a higher pace than projected in the baseline and an adverse scenario where the reverse happens. However, the conclusion once again is that the stress tests "indicate a very low level of stress" and "the debt is stable, sustainable over medium to long run. Further, there are no short-term risks to the debt structure."

It assumes that the Government will follow its fiscal consolidation path i.e. a fiscal deficit of 3.9% by 2015-16, 3.5% by 2016-17 and 3.0% from 2017-18 onwards. It also assumes that the CPI inflation will follow the inflation targeting path adopted by the RBI. In the alternate scenario of fiscal slippage and high inflation it comes up with a higher debt-GDP and interest-GDP ratio. However, a clear analysis of the sources of fiscal and inflation shocks and the implication of deviation from the baseline scenario on the debt profile has not been demonstrated.

The strategy is weak in that it does not show a thorough analysis of the assumptions underlying its projections. For example: It says that the net market borrowing as a proportion of GDP is expected to fall from 33 per cent in 2014-15 to 31 per cent in 2017-18 reflecting fiscal consolidation. It does not explain how this will be impacted if there are deviations from the fiscal consolidation roadmap. The confidence of this statement also appears to be at odds with the Mid Year Economic Analysis which proposes a case for fiscal expansion to steer the economy on a higher growth path.

Mix of indicators for debt-sustainability and debt management: The strategy mixes debt sustainability and debt management indicators (See Table A3 of the strategy document). In a broader macroeconomic context there is merit in distinguishing between these two sets of indicators. The IMF's Guidelines for Public Debt Management emphasize that Governments should seek to ensure that both the level and rate of growth in their public debt is fundamentally sustainable, and can be serviced under a wide range of circumstances while meeting cost and risk objectives. Examples of debt sustainability indicators include debt service to revenue, debt service to exports, debt service to tax revenue in addition to what RBI has already calculated on debt to GDP and interest to GDP. In that same section the analysis of ATM (average time to maturity) is more of a debt management indicator, arising from the composition of the debt portfolio, and not of debt sustainability.

Time lag between the application of the strategy and its publication: The present strategy covers the period from 2015 to 2018 with a requirement of annual revisions. However, the RBI chose to publicly notify this strategy only on 31, December 2015, i.e. three quarters after its commencement. Going forward, if the objectives of transparency are to be met, it is essential that any revisions in the strategy for the coming period should be notified prior to its commencement.

The articulation of a medium term DeM strategy is a welcome step. The notified strategy has positive features like listing out measures to develop the domestic debt market and trying to conform with international best practices. However, it needs to be strengthened on its analytical foundations. In its present form the strategy is at best a description of the actions required to achieve a desired debt profile. Improving the analytical foundations will go a long way in improving the quality of the document to enable it to become a guidepost for achieving an optimal debt portfolio.

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

### Understanding heterogeneity in tax compliance

On 14 January 2016, we had a talk by Raymond Duch of the Nuffield Centre for Experimental Social Sciences (CESS). The title was Why we Cheat: Experimental Evidence on Tax Compliance [paper, video]. In an experimental setting, they find that high performance ("rich") experimental subjects are more likely to cheat on tax payments.

#### Understanding the results

I felt a key problem of the setup was the absence of coercion and punishment. Paying taxes is, at heart, about the coercive power of the State. Nobody wants to pay taxes; it is only the fear of punishment which makes you pay taxes.

I would interpret his results as saying: In a cooperative, high performance people are more likely to not pay in a fraction of their output to the common pool. The paper is about the behaviour of people in voluntary arrangements, and not tax compliance.

It perhaps suggests that a poll tax comes more naturally to humans as compared with a tax which is a fraction of the income. Imagine that you were in a cooperative: it's easier to think of everyone in the cooperative putting up Rs.X, rather than of everyone putting in x% of their income.

#### Heterogeneity in tax compliance

Turning to tax compliance, let's think of a simple setup where there is income $y_i$, a flat tax rate $\tau$, actual tax payment $T_i$, a $p$ probability of getting caught and a punishment $\lambda$ times larger than the tax shortfall $\tau y_i - T_i$. In this setup, the key parameter which will shape compliance is risk aversion. People who are more risk averse will comply more.

In countries where $p$ is high, the outcome will have high compliance. As $p$ becomes higher, the distribution of compliance will collapse into a point mass. When $p$ is low, and for certain kinds of distributions of risk aversion, we will get economically significant heterogeneity in tax compliance.

Low risk aversion is likely to be correlated with high performance. So we may endup with a simple correlation where high performance people are more likely to cheat on taxes. This is perhaps less spicy than meets the eye.

#### Tax compliance by firms in India

Consider the Indian operations of a multinational corporation versus an Indian family business. There is evidence that tax compliance by multinationals is superior. In my understanding, two things are going on.

The first is that $\lambda$ is not a constant; it is lower for Indian firms, as they are better able to manage the non-rule-of-law environment in the tax administration.

The second issue is risk aversion. MNCs tend to be very risk averse and look for safe interpretations of law. This may be related to multiple layers of bureaucracy and the principal-agent problems between the shareholder and the manager. Global compliance teams have a cover-your-ass attitude and force the local operations to play very safe. In contrast, Indian business houses tend to be take more aggressive interpretations of the law. They know this is risky and they walk into it with their eyes open.

There isn't much of a low-compliance-correlates-with-performance story here, as some of the best run companies in India (the MNCs) have the highest tax compliance. The empirical regularity actually runs in the reverse direction.

## Sunday, January 17, 2016

### Participatory governance in regulation making: How to make it work?

by Bhargavi Zaveri.

In December 2015, SEBI issued five discussion papers. Decisions on three of the five discussion papers were taken at the board meeting of SEBI held on January 11, 2016. As of today, SEBI has not published the responses received from the public or its responses to the public consultation process.1 This problem is present more broadly in the regulation-making process in Indian finance (Pattanaik and Sharma, 2015).

In recent years, there has been a great emphasis on strengthening the regulation-making process used by regulators in India. One element of this is a formal public consultation process. Effective public consultation processes are a powerful tool for reducing mistakes in the regulation-making process, and in reducing the dislocation caused by the sudden introduction of new law. However, the mere existence of a public consultation process does not, in and of itself, mean that the public will spend time and resources to comment and participate in the consultation exercise. A full ecosystem has to develop involving sophisticated private parties, who commit resources into the consultation process, and sophisticated persons in government, who utilise this effectively.

The extent and quality of public participation in a consultation process depends on four conditions.

### Condition 1: Effective notice of the proposed regulation

The public cannot comment on a proposed regulation if they do not know about it. Barriers to information access can be blatant or subtle. Not making information available in an open format is an example of a blatant barrier. Examples of subtle barriers include cases where outdated information is not archived or the information is organised in a manner which makes it difficult for a user to access that information.

For example, an Indian regulator can initiate a public consultation process by publishing the proposed regulations in the official gazette. While the Indian official gazette has been recently digitalised and is therefore relatively more accessible, the chances that the public (or even stakeholders) will browse through the official gazette to respond to it, range from slim to none. On the other hand, if there is a concerted process whereby all financial regulators consistently put out notices on the gazette, and gave the gazette the role for which it was intended, then the public will make it a practice to look regularly at the gazette. This will be assisted by technological improvements such as RSS feeds and open APIs by the Gazette of India.

Some Indian regulators have made considerable progress on giving easy access to information about proposed initiatives. For instance, the website of Airport Economic Regulatory Authority (AERA) has a Consultations segment displaying all the active consultation papers in one place. The archives page of AERA's website too has a consultations segment which displays:

1. All the consultation papers ever issued by AERA together with the dates on which the consultation opened and closed for each paper;
2. Responses recieved and minutes of stakeholder consultation meetings, if any; and
3. Orders issued pursuant to each consultation exercise.

Similarly, the website of Telecom Regulatory Authority of India (TRAI) has a dedicated section on Consultations, which organises all the consultation papers ever issued by TRAI subjectwise, shows the status of the consultation paper (whether it is ongoing or closed) and displays the responses received.

### Condition 2: Institutional mechanisms outside the State

While information dissemination exercises are the responsibility of the regulatory agencies seeking public participation, they need not be limited to initiatives of the State alone. For instance, researchers at a US university have developed a platform called Regulation Room. The program collaborates with certain federal agencies whose rules are put up on the platform for discussion, aggregates comments and submits a detailed summary of the comments recieved to the regulators it has tied up with.

What is remarkable is not just that the program was concieved and is running, but that Federal agencies in the US actively encourage and collaborate with it, in addition to spreading information about proposed rules through other methods for dissemination of information mandated by law. We wonder how financial agencies in India might respond if an academic institution initiated such a platform.

### Condition 3: Stakeholder resourcing

Easy access to information does not automatically translate to effective public comment:

1. Effective public comment requires reasoned arguments supporting it. Depending on the field of regulation, comments may require to be supported by research, collection and analysis of data and legal arguments. This requires the public to expend time and resources toward understanding the subject or if they are experts, putting together their research and experience in a coherent form for processing by the regulator.
2. The kind and volume of stakeholders who are likely to respond also entirely depends on the field of regulation. Therefore, while a discussion paper on net neutrality has elicited close to 2.4 million comments, a discussion paper on the proposed regulatory framework for convertible securities will likely not attract as much attention. In other words, the breadth and technical nature of the proposed regulation will influence the extent of participation.
3. Some elements of stakeholders' responsiveness are a direct function of what the regulator does. For instance, the time given for responding to proposed regulations, the quality of the information published in the public domain, the readability of the discussion paper, etc. will influence the decision to participate or otherwise. If the regulator displays sound intellectual capabilities, it is more likely to elicit responses from the best people, as has happened with the TRAI document on net neutrality.

### Condition 4: Responsiveness of regulatory agencies

The last stage of participatory governance - that of the regulator publishing comments recieved from the public and responding to them - is perhaps the most crucial. It is important that the regulator completes the loop on public consultations because:

1. It enhances the transparency of the consultation process. It is important that people know what motivated changes from the draft that was published for their comments.
2. If the regulator persistently rejects public comments without assigning reasons, it leads to a breakdown in conversation between the regulator, the regulated and the beneficiaries of the regulation. There is no incentive left for responding to documents put out by the regulator.
3. The exercise of responding to public comments brings clarity on the objective of the proposed regulation and the reason for preferring a selected policy tool over others. This helps the regulator and also answers future challenges to a selected policy tool.

While several empirical and qualitative analyses have been done on the the extent of influence of public comments on draft regulations (West 2005, Kerwin 2003 and Golden 1998), the methodologies have been open to criticism because it is nearly impossible to identify what prompted a change in a regulation. However, where, over a period of time, the outcome of a series of discussion papers or draft regulations have been identical or largely similar to the draft proposed by the regulator, it is safe to infer that public comments have not influenced regulation-making at all.

### Some examples of good State responsiveness

Regulators in developed countries spend considerable time and resources in bothering to respond to public comments on proposed rules.

For instance, recently, the SEC issued a regulation which seeks to strengthen the technology infrastructure of participants in the US securities markets and enhance SEC oversight of such infrastructure. The text of the regulation is 11 pages. However, the press release containing the text of the regulation runs into 200 pages. The first 189 pages of the press release are dedicated to the comments received from the public on the proposal which was put up for public comments and SEC's response to those proposals. This is standard practice with all rules made by the SEC.

Similarly, the Australian Prudential Regulatory Authority generally issues a separate document dedicated to its response to comments received from the public on consultation papers that it puts up for discussions. For instance, see here.

As discussed above, TRAI and AERA also have dedicated sections reflecting the public comments received in the course of the consultation exercise.

While AERA reflects its response to the public comments in its orders, none of the other Indian regulatory agencies have transitioned to a rulemaking framework where the regulator responds to public comments. However, the examples of AERA and TRAI show that some Indian regulators are ahead of financial agencies on issues of participatory governance.

### Some examples of bad State responsiveness

Recent research on the regulations and circulars issued by SEBI from June 2014 to July 2015 (Sharma and Pattanaik, 2015) found:

1. An analysis of 27 regulations issued by SEBI showed
1. It conducted a public consultation on 12 of them; and
2. It did not publish the public comments recieved in any of the 12 public consultation processes.
2. An analysis of 23 circulars issued by SEBI showed:
1. It conducted a public consultation on four of them; and
2. It did not publish the public comments recieved in any of the four public consultation processes.
3. There was no case where there was a change in the final regulations in response to public comments.

While the above study is silent on whether SEBI published its response to the responses recieved from the public, the website indicates that no response was published.

The trend seems to be continuing even after July 2015. For instance, we, at NIPFP, responded to two of the five discussion papers published by SEBI in December 2015 [link, link]. We resourced this work with two teams of four people each, which spent an effective working time of three full days, researching on the subject, looking up international precedents and consulting with external experts, so that we could collate our responses and submit them within the indicated timelines. The cost to make these responses was 24 man-days each.

While it is the absolute prerogative of the State to accept or reject comments received from the public,  the people who spend time and resources on preparing a response expect that their comments are considered. Today, we have no way of verifying whether our comments were considered and whether we should similarly galvanise resources the next time a regulator initiates a consultation process. This is precisely the kind of break-down that lack of State-responsiveness can lead to.

### An ecosystem for participatory governance

A takeaway from this discussion is that the extent of public participation in a State-initiated consultation process is a function of various elements. While some of these elements (such as the technical nature of the regulation) are not within the control of the State, most of them are. This begs the question of how does one go about fostering an ecosystem which enhances public participation in consultation exercises.

Many countries have taken the approach of fostering this eco-system through the primary law. For instance, the Administrative Procedure Act, 1946, a US federal statute, requires Federal agencies to subject delegated legislation to a public notice and comment process. Delegated legislation which does not go through the entire notice and comment process has been struck down by US courts by applying an 'arbitrary and capricious' standard.

Subsequent agency-specific legislation and executive orders have led US Federal agencies to disseminate information in a user-friendly manner. For instance, the Open Government Directive2 issued by the President's Office requires Federal agencies, amongst other things, to:

1. Publish information online in an open format that can be retrieved, downloaded, indexed, and searched by commonly used web search applications;
2. Create an Open Government Webpage which enables people to give feedback on and assessment of the quality of published information.

### Indian examples

A couple of recent Indian legislations have an in-built overarching legislative mandate of transparency. For example , the Airports Economic Regulatory Act, 2008 mandates the airports regulator to ensure transparency in exercising its powers and discharging its functions' by holding consultations with stakeholders, allowing them to make submissions to the authority and documenting and explaining all decisions taken by it. Perhaps, the existence of this principle in the primary law has led to AERA being a relatively far more responsive regulator. Similarly, the Electricity Act, 2003 requires that all delegated legislation under the act be subject to previous publication'.

The absence of similar principles in the Indian financial legislative framework is glaring. A first attempt of this kind can be found in the Indian Financial Code (IFC) which was the outcome of the recommendations of the Financial Sector Legislative Reforms Commission led by Justice B.N. Srikrishna. IFC1.1 (which is a refined version of IFC) codifies a comprehensive process to be followed by financial regulators when making delegated legislation. This process entails the (a) publication of a proposed regulation with a statement of objectives, (b) a cost-benefit analysis of the proposed regulation, (c) a notice and comment process, (d) publishing the responses received and a general account of the regulator's counter-responses to the feedback recieved in the consultation exercise, and (e) approval of the regulation at the highest level within the regulator.

In December 2013, the Finance Ministry released a Handbook which serves as a guide towards the improving the regulatory governance of financial sector regulators.3  The Handbook requires the financial sector regulators to:

1. Consider all comments while framing the final regulations;
3. Publish a general account of the response to the representations along with the final regulations.

Thus, while attempts to foster an eco-system for participatory governance have been taken by the Indian Government, RBI and SEBI have not implemented this. Owing to this, Ministry of Finance regulators now lag the practices found in AERA, TRAI, and WDRA.

### References

West, William (2005), "Administrative Rulemaking: An Old and Emerging Literature", Public Administration Review, Vol.65, No.6.

Kerwin, Cornelius M. (2003), "Rulemaking: How Government Agencies Write Law and Make Policy.", Washington, DC: Congressional Quarterly Press.

Golden, Marissa Martino (1998), "Interest Groups in the Rule- Making Process:Who Participates? Who Gets Heard?", Journal of Public Administration Research and Theory, Vol. 8(2).

Pattanaik, Arpita and Sharma, Anjali, Regulatory governance problems in the legislative functions at RBI and SEBI, Ajay Shah's blog, 23 September 2015.

### Footnotes

1. Disclosure: NIPFP has responded to two of the discussion papers published by SEBI in 2015. Back
2. Memorandum on the Open Government Directive dated December 8, 2009 issued by the President's Office to the heads of executive departments and agencies. Back
3. The Handbook was issued as a follow-up document to a resolution passed by the Financial Stability and Development Council in October 2013, which requires financial sector regulators to adopt the recommendations of the Financial Sector Legislative Reforms Commission, which do not require legislative changes. Back

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

## Saturday, January 16, 2016

### Seasonal adjustment with Indian data: how big are the gains and how to do it

by Rudrani Bhattacharya, Radhika Pandey, Ila Patnaik, Ajay Shah.

In India, we usually focus on year on year growth rates of macroeconomic series to monitor the economy. Structural change in the economy, and the rise of modern business cycle fluctuations (Shah, 2008; Ghate et. al. 2013), have given a surge of interest in monitoring macroeconomic data on the part of both economic agents and policy makers.

The analysis of macroeconomic data using year-on-year growth rate suffers from serious problems. Each value for the year-on-year growth of a monthly series is the sum of twelve previous month-on-month changes. When we compare June 2015 to June 2014, we are looking back at the entire year and not at June 2015 or May 2015. To know what is happening in May 2015 or June 2015, we need to look at month-on-month changes. However, most of the time, these are obscured by seasonality.

Seasonal adjustment removes the seasonality, permits the computation of point-on-point growth rates, and thus allows us to know what is going on in the economy in the latest data. As an example, Bhattacharya et. al., 2008, show how our understanding of inflation in India is improved by using seasonally adjusted data, and how this could have improved the conduct of monetary policy.

In most advanced countries, the statistical system publishes seasonally adjusted data series, in addition to the raw "non-seasonally adjusted" data. In India, the growing need for seasonally adjusted data has not yet been met by the Statistical System. Some statistical software packages (e.g. Eviews) are available which permit a certain black box usage, and have started getting used in this fashion, mostly by economists in financial firms.

In a recent paper (Bhattacharya et. al, 2016) we show the complete steps of the seasonal adjustment process for four monthly time-series: the Index of Industrial Production, Exports, the Consumer Price Index and the Wholesale Price Index. This involves calendar adjustment, correction for outliers, model selection and conducting diagnostic tests.

Further, it involves testing for festival effects and other features that may occur in certain months of a year. We find that Diwali has a significant effect on the IIP. In the jargon of seasonal adjustment, Diwali is referred to as a moving holiday'' since in some years it falls in the month of October and in some years in November. The Diwali month is a month of festivities with fewer working days but enhanced purchases prior to Diwali. The paper finds a significant negative impact of Diwali on IIP.

We examine the importance of the choice of direct' versus indirect' seasonal adjustment for some composite series. If a time series is a sum of component series, each component series can be seasonally adjusted and summed to get an indirect adjustment' for the aggregate series. On the other hand, we can apply the seasonal adjustment procedure directly to the aggregate series to obtain direct seasonal adjustment'. We compare the direct and indirect adjustment of IIP (following the use-based classification) and find that direct adjustment removes noise better compared to indirect adjustment.

A key question in India, given the rapid pace of structural change, is the wise choice of data span. There is a trade-off between the need for a longer time series in order to get a better estimate of the time-series model, and the necessity to avoid modeling a time series containing a structural break. A very long series will have data which will not relate to the pattern of the current series. On the other extreme, a short series may be highly unstable and be subject to frequent revisions. The length of the series may be shortened owing to changes in methodologies, definitions, moving to new statistical classifications, the use of new sources of information. This issue is particularly relevant for India as recently a number of series have undergone revisions due to changes in statistical methodology. We show that seasonal adjustment of a short series is unreliable. A ten year time span is appropriate to arrive at stable model parameters and reliable diagnostics as well as to retain the current pattern of the series.

How do we know that a seasonal adjustment procedure is adding value? We propose the following metric: The standard deviation of the month-on-month change. The standard deviation of the month-on-month change of the raw data is likely to be artificially elevated owing to the presence of seasonality. A good seasonal adjustment procedure should do well at reducing this standard deviation. E.g. a seasonal adjustment procedure that does not understand that Diwali is an India-specific holiday will suffer from a strong whiplash across the month containing Diwali, which will yield an elevated value for the standard deviation of the month-on-month change.

 IIP Raw series 73.26 SA using Eviews 26.79 SA with our approach (optimal span, outlier adjustment, trading day effect) 25.73 SA after adjusting for diwali effect 23.23 SA with full capabilities 23.12 Exports Raw series 132.53 SA using Eviews 89.40 SA with our approach (optimal span, outlier adjustment, trading day effect) 78.01 CPI Raw series 9.22 SA using Eviews Fails SA with our approach (optimal span, outlier adjustment, trading day effect) 7.28

The Table above shows the improvements obtained for three series: the IIP, Exports and CPI.

For the IIP, the raw series has a standard deviation of the point-on-point change of 73.26%. If Eviews is used as a black box, a sharp gain is obtained, and the volatility drops to 25.73. Our procedures add value, getting the standard deviation down to 23.12.

For the exports series, the raw data has a standard deviation of the point-on-point change of 132.53%. This drops to 89.4% using Eviews as a black box, and improves further to 78.01% using the steps described in the paper.

In the case of the CPI, the raw series has a standard deviation of point-on-point changes of 9.22%. Eviews as a black box is unable to process this series. Our best procedures get the standard deviation down to 7.28%.

The main finding of this paper is that the use of black box seasonal adjustment, e.g. by Eviews, yields a substantial reduction in the standard deviation of the point-on-point series. When a blackbox can do seasonal adjustment, it is better to do this when compared with using the year-on-year changes. However, careful analysis of seasonality is a superior approach: it works reliably for all series and it yields improved reductions in the variance of the point-on-point series.

### References

Rudrani Bhattacharya, Radhika Pandey, Ila Patnaik and Ajay Shah. Seasonal adjustment of Indian macroeconomic time-series. NIPFP Working Paper, January 2016.

Rudrani Bhattacharya, Ila Patnaik, Ajay Shah. Early warnings of inflation in India, Economic and Political Weekly, November 2008.

Chetan Ghate, Radhika Pandey and Ila Patnaik. Has India Emerged? Business Cycle Facts from a Transitioning Economy. Structural Change and Economic Dynamics, Volume 24, Page 157-172, March 2013.

Ajay Shah. New issues in macroeconomic policy Chapter 2, page 26--54 in Business Standard India edited by T. N. Ninan, Business Standard Books, 2008.

## Wednesday, January 13, 2016

### How bad is IIP growth after controlling for Diwali effects?

by Radhika Pandey and Pramod Sinha

Yesterday's data release showed a sharp contraction in industrial production in November. Some say that this contraction is an aberration as it was largely driven by seasonal fluctuations including the placement of Diwali and the number of working days in November.

A previous post on this blog How bad was industrial production in October? has highlighted the merits of using month-on-month seasonally adjusted numbers to provide timely and accurate information about the state of the economy. We apply our work on seasonal adjustment to analyse the true extent of contraction in the November IIP numbers. In the jargon of seasonal adjustment, Diwali is a moving holiday': one that shows up in different months in different years.  A Diwali effect' is found to be statistically significant for IIP and IIP (Manufacturing).

The figure above superposes the two time-series of seasonally adjusted annualised rates (SAARs). It has the SAAR IIP (without adjusting for Diwali) and SAAR IIP (with adjustment for Diwali). In most months, the two series are identical. But in some months, the interpretation of the IIP data strongly requires adjustment of Diwali as a moving holiday. The numbers for the month of November 2015 are worth noting. Without adjusting for Diwali effect, the month-on-month growth shows a sharp contraction of -71%, after adjusting for Diwali effect the month-on-month numbers modestly improve to -39%.

The figure above shows the same analysis for IIP (Manufacturing). If we look at the manufacturing sector, the seasonally adjusted month-on-month growth yields a negative growth of -44%. Adjusting for diwali effect results in modest improvement to -33%.

To conclude: After adjusting for the Diwali effect, IIP dropped by an annualised 39%, and IIP manufacturing dropped by an annualised 33%.

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

## Tuesday, January 12, 2016

### Does the role of the Rajya Sabha in the legislative process require reform?

by Suyash Rai.

Orders of men, watching and balancing each other, are the only security;
power must be opposed to power,
and interest to interest.

- John Adams, Thoughts on Government

The BJP won a majority in Lok Sabha (the House of the People). However, for about 20 months, the Government has seen its legislative agenda slowed down by the Rajya Sabha (the House of the States). Is this a healthy outcome, in line with a sound logic of the Constitution, or does this gridlock expose errors in the Constitution?

The Government, and some who sympathise with it on this matter, are unhappy about the legislative role of the Rajya Sabha. Some are even calling for sweeping reforms. There are early signs that Government may try to find ways to work around the Rajya Sabha. On December 21st, it reportedly tried to introduce the Bankruptcy and Insolvency Bill in the Lok Sabha as a Money Bill - a surprising move given that the Bill has very few provisions that relate to matters a Money Bill is supposed to be exclusively for, as defined in Article 110 of the Constitution.

We usually hear calls for reforming institutions in times of distress or disharmony. However, in such turbulent times, we are likely to err in diagnosis and treatments. In such times, we tend to be swayed by immediate and temporary facts about what those institutions are doing, and those facts, especially if we don't like them, blind us to the structural nature of the institutions. We have often changed laws because some specific situation riled us. The amendment to the Juvenile Justice Act is only the most recent example of a lasting change inspired by momentary passions. We have changed time-tested systems for far smaller reasons. We abolished the jury system because of one case in which the system may have failed us.

Winning elections determines who leads the Government, but this is not unlimited power. The formal design of the Republic is put down in the Constitution. Among other things, this design divides and limits power among various arms of the State, and mandates procedures and protections that are non-negotiable. Even the wisest policy must be implemented only within the limits imposed by the Constitution. Even if the elections for the Lok Sabha deliver a very strong mandate' (as the mass media likes to say this), this does not confer absolute power to reshape the working of government. The analysis of present criticisms of the legislative process must be located within a full normative design. We must have a reasoned point of view on the question: what is a good design for the legislative branch of the Republic of India? All conceivable designs are problematic in certain times; we have to judge alternative designs in terms of their overall performance in the context of the remainder of the Constitution.

We the citizens have the ultimate constituent powers, and can therefore debate the Constitution. However, a certain veneration for the Constitution and its basic institutions is necessary for the Republic to thrive. This veneration should not be blind but based on reason. It should come from respect for the intellectual aspects of it -- the political science and political philosophy underpinning it -- and the act of founding that gives it legitimacy. Veneration implies that only an overwhelming force of reason and evidence may necessitate amending the basic institutions of the Constitutional system. If we consider the arguments and find that we agree with the calls for reforms, when imbued in a certain veneration, we would be more likely to be doing so in the long-term good of the Republic.

### Rajya Sabha in the Constituent Assembly Debates

The Republic of India is to political science what the Large Hadron Collidor is to physics. Our Republic is a grand experiment in political organisation of human affairs, made more ambitious by the scale and complexity of our society. Rajya Sabha, the House of the States, is a part of the Constitutional construct. Although the concept grew out of history and institutions of the time, the Constituent Assembly debated and altered it. A second chamber in the Parliament was envisaged for the first time under the Montague-Chelmsford Reforms. The Government of India Act, 1919 provided for the Council of State. Under the Government of India Act, 1935, a different design was proposed, but that never materialised. As a result, the Second Chamber set up under the Government of India Act, 1919 continued to function till 1947.

The Constituent Assembly debated the merits and demerits of the upper house and chose a design based on an understanding of the ideal legislative process. Naziruddin Ahmad said:

A popular house is known for its vitality and vigour and that House will have the exclusive power in regard to money. But a second chamber introduces an element of sobriety and second thought.

Gopalaswami Ayyangar, who later became Leader of Rajya Sabha, also pointed at the need for the second chamber:

... to delay legislation which might be the outcome of passions of the moment until the passions have subsided and calm consideration could be bestowed on the measures which will be before the Legislature.

He considered the Rajya Sabha as "an instrument by which we delay action which might be hastily conceived" and a place to "give opportunity to seasoned people who may not be in the thickest of the political fray..."

Highlighting the need for the states to participate in lawmaking at the centre, Naziruddin Ahmad said:

"Without a second chamber it would be difficult to fit in the representatives of the States in the scheme of things."

Some members opposed the idea of an upper house. Mohd. Tahir made an impassioned appeal against the idea of an upper house by, among other arguments, invoking the irony of a single-house Constituent Assembly proposing a Parliament with two houses. Prof. Shibban Lal Saksena, opposing the upper house, said:

"...experience in the last so many years has been that the Upper House acts as a clog in the wheel of progress. In no country an Upper House has helped progress. It has always acted as a sort of hindrance to quick progress."

One can almost hear an echo of the sentiments being expressed at present.

The debate may have been spirited, but the sense of the Assembly was that a bicameral Parliament with a Council of States was required, as the benefits of a stable legislative process with States having a say in lawmaking outweighed the costs of such a system.

The overall design of the Rajya Sabha has remained largely stable. About 95 percent members are indirectly elected by the state or territorial assemblies through single transferable votes, and the remaining members are nominated by the President of India. Being indirectly elected is not the same as being unelected. Rajya Sabha members are supposed to represent the States and Territories that sent them, and also play a moderating role in the legislative process, as most of them did not come out high energy contestations of general electoral politics.

### Bringing stability and states into lawmaking

The Constituent Assembly debates thus show two key rationales for giving an indirectly elected Rajya Sabha substantial legislative powers: to ensure states' views are considered, and to bring stability in the process.

In a federal setup, states derive their powers directly from the Constitution, unlike a unitary system wherein sub-national units get only those powers that the all-powerful central government delegates. States ought to have the opportunity to have a say in central laws as many of those laws affect all the states, which may have varied interests. An upper house elected through the state assemblies is more likely to represent the states than a lower house wherein the national party politics gains more importance than state-level issues.

The other rationale for the Rajya Sabha is to bring stability into lawmaking. As the American founding father James Madison wrote in Federalist 37, Republics need to harness two conflicting modes of institutional being: energy/agility and stability. It is easy to understand the case for energy/agility. The Republic must respond to the necessities of the day. In a border conflict, the need to protect the Republic necessitates quick marshalling of its arms. This calls for adequate powers for the executive to act when faced with a border conflict. Such necessities can be found in areas such as public health (epidemics), foreign relations, disaster response, law and order, etc.

The case for agility has, however, been taken beyond the necessities. What Alexis de Tocqueville called the idea of human perfectibility', coupled with the democratisation of politics, has created fertile ground for projects aimed at solving big social and economic problems by political means. Even those with somewhat modest expectations from politics believe in good consequences of laws and policies, albeit for them such consequences fall short of a revolution in human nature. In these views, opposition to any Government action aimed at progress is bad. It is easy to argue, but not necessarily true, that if a problem can be solved, it must be solved sooner rather than later. Progress cannot come too soon, and those slowing it down are acting against the grain of society.

The best among us subscribe to such views. If we like a policy, we get impatient with the process of implementing it. Process is a public good, and has the paradoxical characteristic of being everybody's business while being nobody's business. This preference for agility is greatly advantageous for the Government, irrespective of who is in power. It can continue promising a glorious future to the people, and usurping more powers to do bigger things at a faster pace. Even though Governments have seldom delivered on promises, hope springs eternal, and the persons making tall promises can always harness a positive aura as a consequence.

Thus, while agility can defend itself in the name of necessity or even progress, stability (or slowness) requires a more complicated defense to be put up.

The starting premise for stability is that powers of the Government must be limited and checked to guard against certain risks - of tyrannical overreach by the Government; of speed coming at the cost of prudence and diligence; and of majoritarian passions leading to bad decisions. These risks are real and democracy does not suffice to protect against them. Therefore, in the words of philosopher Pierre Manent: "to love democracy well, one must love it moderately." While we must love democracy, we also need to see its limitations and excesses.

Therefore, a democratic Republic has to be more than just democratic. Consider the risks emerging from majoritarian passions. In a democracy, passions of the majority can become so powerful that only rare statesmanship by an elected Government can stand up against them. Some of those passions may be harmful. In the absence of a Constitutional alibi, Governments will feel pressured to respond to majority's demands. Constitution can help the Government protect itself from its own constituents. It can create statesmanship even among those lacking the spirit of statesmanship. So, we must see that all slowness is not bad, because all change is not progress, all progress is not good, and everything that is popular is not in the long-term public interest.

What seems good today may appear less appealing in a few days, as knowledge and understanding are limited. However, there is a temporal mismatch between political power and its consequences. Legislation is approved by people who are in power for short periods of time, but it affects us in the long run. Consider just three of the legislations enacted in the year 2013: Companies Act; National Food Security Act; Right to Fair Compensation and Transparency in Land Acquisition, Rehabilitation and Resettlement Act. A certain buyer's remorse has started creeping in about the drafting of some of these. Many of those who voted for these legislations are no longer members of the Parliament. And yet, what they did will affect us for decades.

Infusing stability in the legislative process is a way of saying: we don't know what is good, so we better go slow. So, decisions must be taken only after following due process, even if this sometimes leads to the popular will not getting implemented. In a representative democracy (as opposed to a referendum democracy), legislation should not be just a simple expression of the popular will, but should result from an intermediated and deliberative process encoded in the Constitution. Rapid action was required when Lehman Brothers filed for bankruptcy in September 2008, but years of deliberation is required when designing the financial regulatory architecture as was done through the Financial Sector Legislative Reforms Commission. These deeper changes in the working of government should be thought through, and debated adequately. It should be harder to enact the Indian Financial Code when compared with enacting a Finance Bill.

An empowered upper house expands room for politics in the inter-election period. It can prevent Government from becoming arrogant and arrogating to itself powers that do not rightly belong to it. All political acts, including those that are oppositional, aim for some notion of the "good", even though partisan instincts don't let us see that. The "common good" is discovered through (a certain kind of) politics. Processes and politics slow things down. "Slow" has the opportunity to be "deliberate", and "deliberate" can be "reasonable". Fast is rarely reasonable, even with the best intentions.

We may interpret the design of the Constitution as envisioning three components of stability: the Rajya Sabha, the judiciary and the civil service. Rajya Sabha can slow down and alter legislations. The judiciary serves as a custodian of the Constitution, and can even nullify a legislation if it is found inconsistent with the Constitution. The civil service can bring continuity and stability into the governance system, and since it is protected, it can also play a moderating role vis-a-vis the governments. The idea is not to find absolute good in stability or agility, but to see that a balance between them is necessary for the good of the Republic. Stability can degenerate into obstructionism, which can lead to dysfunction. We must guard against excesses of stability, just as we must be wary of imprudent agility.

### Legislation and the Government

Our Constitution has empowered the Government substantially in the Executive domain. Government also enjoys significant advantages in the legislative process. The Money Bill, which concerns regular raising and deploying of resources by the Government, only requires the Lok Sabha's assent (Article 110 of the Constitution). The Government's budget, is approved and funds are appropriated using this instrument. The Government also has the power to promulgate Ordinances, which have the force of law, and may eventually become laws, once they are passed by the Parliament. These powers have often been used by the Government to go beyond their original purpose. Mrs. Indira Gandhi issued 43 Ordinances between 1973 and 1975, many of them with far-reaching consequences.

The Government also has a role in setting the legislative agenda. Most of the time, the Government gets a substantial part of its legislative agenda implemented. In spite of its numerical disadvantage in the upper house, the current Government has got 45 bills passed in the Rajya Sabha. In the budget session, the Government was able to get Bills passed on 5 out of its 6 Ordinances. If a Bill is rejected by any house of the Parliament, after six months, a joint session can be called for passing the Bill. The Bill only needs a simple majority in a joint session. Since the Lok Sabha is 70 percent of the house, if a coalition has 60 percent seats in Lok Sabha, it only needs support of about a quarter of Rajya Sabha members to pass a Bill in a joint session.

The Lok Sabha almost by definition is not likely to disagree with the Government, especially when the Government enjoys a comfortable majority. Rajya Sabha is a house that can disagree with the Lok Sabha and with the Government. Rajya Sabha can even stand up to the popular will. It can slow things down. When it does that, Rajya Sabha can be an antidote to the passions that may have been stirred up momentarily.

Since one of its tasks is to slow down the legislative process and make it more deliberate and reasonable, the more substantive empirical question is: has the Rajya Sabha made legislations more reasonable? Since this is a subjective assessment, only the most egregious examples would do. Also, pending a comprehensive study of this question, some examples from recent experience would have to do.

Rajya Sabha had an important role in stopping the Prevention of Torture Bill, 2010, which sought to dilute the existing legal protections against torture. Another example is the GST Constitutional Amendment presently under consideration. In the last session, the Bill passed by the Lok Sabha was being presented by the Government as the best and the only possible version of the comprehensive tax reform. That Amendment would have gone through had the Rajya Sabha not stood in the way. Due to the slowed down process in the Rajya Sabha, two changes have reportedly been accepted in the Bill - removal of the 1 percent additional tax, and an independent dispute resolution mechanism. These changes are widely supported by independent experts as well as some advisors of the Government.

In the Indian experience, there have been limits within which Rajya Sabha has slowed down or altogether stalled the Government's legislative proposals. Compromises are eventually found on all but the most egregiously unacceptable legislations. Of the over 3000 laws that have been passed by the Parliament till date, only 3 were passed in joint sessions of the Parliament. The Government of the day either finds a political coalition or lets the Bill lapse.

The stalling of the house, and other disruptive tactics that impede the agenda of the Government, are aesthetically unappealing. But we should look beyond form to function. Democratic politics is always an ugly spectacle, but liberal democracy has delivered the most successful States in world history. It is difficult to make a definitive comment on this, but it is possible that the Rajya Sabha may be delivering on its objectives as envisioned in the Constitution.

### Rise of competitive and regional politics

The Constitution envisions the Rajya Sabha as an intermediary between the states and the centre. All important parties play two roles: at the level of the state and at the level of the centre. Sometimes, competition in one sphere hampers cooperation in the other. A fractured polity can exist at the national level because of state politics, and that is not necessarily a bad thing as the interests of states must not be considered inherently subservient to the agenda of a national Government.

The rise of competitive politics since the 1970s has made Parliament more representative and it is now more capable of checking the Executive. There are now many more questions asked in the Parliament, and more Bills are referred to committees. To add to the vibrancy of our politics, regional politics has become much more important for the national agenda.

Regional parties went from 51 Lok Sabha seats in 1991 to 158 seats in 1998. They have held more than 150 Lok Sabha seats in every General Election since then. The BJP has been the largest or second largest party since 1991. Regional parties get more representation in the Rajya Sabha, because they tend to perform better in state assembly elections than in the general elections for the corresponding regions. If we consider the last 25 years, we find that the combined share of the Congress Party and BJP in Lok Sabha has ranged between 60 percent and 77 percent, while their combined share in Rajya Sabha has almost never been 50 percent.

It is possible that regional parties may coalesce around one of the two big parties to slow down the other big party's legislative agenda. However, this is not necessarily the case. It just so happens that at the moment, for some regional parties, there is little apparent incentive to coalesce around the BJP, but more to support the Congress. Those incentives could change over time. A short-term view of politics should not be taken while discussing long-term Constitutional reform.

### Proposals for reform

In a recent column, Baijayant Panda, Member of Lok Sabha belonging to Biju Janata Dal, a regional party, has suggested curtailing the powers of Rajya Sabha or changing its nature. He proposes two alternative reforms: make Rajya Sabha directly elected (like the US Senate), or limit the time period for which it can stall a legislation (like the forthcoming change in the Italian Parliament).

These proposals are problematic. If Rajya Sabha's powers are curtailed to limit its ability to stop a legislation to a period of, say, 1 year, the government will get everything it wants, with just a bit of delay. This will let the Government run amok, which is exactly what we have seen in the instrument of legislation that does not require Rajya Sabha's assent - the money bill. In taxation and expenditure, the Government has made drastic changes without due consideration, at one point taking the tax rate to 97.5 percent, and at another time rapidly scaling up subsidies.

Italy's example must be understood in its context. Italy is a unitary parliamentary republic. The Government of Italy is the only government that has real powers, and other bodies derive their powers from it. India is a federal republic with states having elected legislatures, and the interests of the states must be protected by giving them a say in the legislation.

Direct election to the upper house may lead to an even greater national party centered politics, just like we see in the Lok Sabha members. While giving the US example, we must also understand the extent to which the poweres of the US Congress are curtailed by the Presidential veto. The US has much clearer separation of powers than India. The President, who heads the Government, is directly elected, and so are members of branches of the Congress (Senate and House of Representatives). Once a legislation makes its way through the two houses, and has therefore tided over the myriad rules that allow a legislation to be stalled, the President can veto it and you are back to square one.

Interestingly, in the US, it rarely happens that the President and both the houses of the Congress are controlled by the same party. In the last 35 years, this has been the case for only 8.5 years. For the remaining 26.5 years, at least one of the houses had a majority of the opposing party. This does not mean that things did not get done. For all his 8 years as President of United States, Ronald Reagan had a hostile or a divided Congress. Many people say he got a lot done. How was this done? By politics.

### Reforms are needed, but elsewhere

There are significant weaknesses in our legislative system that need to be addressed. As a house of the people, the Lok Sabha is supposed to take measures that are in the interest of those who elected its members, with elections holding them accountable for doing that. For Rajya Sabha, elections are indirect, and the members are expected to act in the interests of the states that sent them. Both houses are expected to uphold the overall interest of the Republic. Rajya Sabha can realise its potential as a source of constructive stability if the considerations that affect its decisions are somewhat different from those that bear on the Lok Sabha. However, by giving disproportionate weight to the electoral interests of political parties, the Anti-defection law has reduced the effect of other considerations in both the houses. This limits the effectiveness of both Rajya Sabha and Lok Sabha, as it alters their essential nature. Repeal of the Anti-defection law would make the Lok Sabha more democratic and enhance the heterogeneity of considerations that weigh upon the Rajya Sabha. This would enhance the effectiveness of the Parliament.

We also need reforms in the way the Parliament functions. Stricter management of the floor, more transparency in the committee process, better research support to legislators to help them stand up to the Government, and other ideas are worth considering.

### Conclusion

There is a simplistic view of democracy that is often heard in India, where the distinctions between direct democracy and representative democracy are not understood. The Constitution of India has set in motion a complex system with many moving parts. There is method in much of its madness. All successful democracies have comparably complex systems of checks and balance. Winning elections does not give untrammelled power.

Proposals to curtail the powers of Rajya Sabha need to be analysed with great care. In our view, the case for fundamental change has not yet been persuasively made. Reducing Rajya Sabha's powers with the purpose of empowering the popularly elected Government is a simplistic view of democracy, one that is not consistent with the sophisticated political thinking that underpins the Constitution. Under the Constitution, winning an election gives the ruling parties an opportunity to lead the debate on change: but executing change requires persuading politicians of all shades, and building coalitions for change.

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