India's potential likely to materialise, says former RBI Governor YV Reddy

Below is excerpt from the interview.

Q: We have got this upgrade from Moody's and yet, we are, at the moment, only in gross domestic product (GDP) terms, lower than what we were last year. So what exactly is Moody's telling us? Are you in agreement with them on the upgrade?

Reddy: Basically, many of the reforms undertaken in the recent past have two implications. One, some sort of disruption in the short-term and potential for very good things in the medium-term. So Moody's is, in a way, trying to say that though there is some disruption now, it is going to result in good things and perhaps, in a way, strengthening the forces in favour of good things. But I think, it is really a potential which they interpret is likely to materialise.

Q: How would you interpret it? Do you think the steps undertaken, and if you can even tell me which steps?

Reddy: Basically, definitely the goods and services tax (GST) issue. But more importantly is the ecosystem like insolvency code. The fundamental institutional underpinnings that should strengthen the ecosystem of finance are in place. At least they attempted to do that in a big way which was pending for a long time. Even GST, it has been in the making for 17 years. Obviously, there are a lot of difficulties otherwise why should we wait for 17 years. There are difficulties but they are prepared to face it. So in that sense, Moody's rating represents a hope which is backed by reasonable expectations.

Q: Can I say that these reasonable expectations would be a higher tax to GDP ratio, both because of GST and also because they have linked PAN to bank accounts?

Reddy: But that is only one element. This is an important step in what I may call two steps. One is formalisation of informal sector and second is constitutional objective of having one market, one country which was originally like that and they are not supposed to have any barriers. It took such a long time to remove.

Q: So you think both these?

Reddy: No, it is a fundamental reform. All over, it would have been difficulty in any case and they require certain amount of determination and boldness. And if there is a trip-up, a trip-up is inevitable when you want to do something important.

Q: So your expectation is that not only will there be more people in the formal system and therefore, more taxes, but also more efficient economy?

Reddy: Not only more taxes. Once you come into the formal sector, there are many things which fall into place. So, the income tax, the contract obligations, you got contract system. Earlier it was informal sector, faith in each other, trust in each other. This will not work at some level. Let me put it this way. These are institutional mechanisms which will take you to a middle income country. You can always grow from low income to middle income, but to stay there and continue and move on, you require a difference, otherwise it is also called a middle income trap. Many in the world, there is a concept called middle income trap. So if you want to get out of the middle income trap, these are required.

Q: This is extremely hopeful, the way you have interpreted it.

Reddy: Hopeful means, we have to make sure. Sometimes, our problem is very often we trip-up in implementation and dilute. That should not happen.

Q: Standard and Poor (S&P) has not done that just yet and in the hierarchy of rating agencies it is very well-regarded. Would you say that S&P is behind the curve?

Reddy: My recollection is, I am not very sure. But I think S&P gives a little more way to political considerations. If you see the rating methodology, S&P gives a little more weight. So that may explain the difference.

Q: But the political part, I thought is the strongest for India. We are in a state where the legislature is functioning, something we did not have earlier.

Reddy: I would say that they are not strictly comparison. Its rating depends on certain other factors. For instance one of them gives lot more way to fisc and less weight to others. I do not know which one. S&P and Moody's I do not remember which one is which. But interesting to take the rating criteria available on the website and then you will be able to see. What I am saying is it is not necessary that they assume differently, but the weights may be different.

Q: What about the problem of growth itself? The expectation is that on November 30, when we get the second quarter growth, we would have troughed out at that 5.6-5.7 and gone on to 6-point-something. But does it still worry you that the informal sector has been rather badly battered?

Reddy: Any important changes cannot but be disruptive. How disruptive and how long is the issue. The shorter term, as I said, shorter term numbers are exaggerated. Apart from that, there is another reason also, the numbers themselves are undependable in the normal course. When especially short-term GDP, etc. if you know how it is cooked, they have some correlations. If this happens, or last ten years this happened. They break down. What I am saying is demonetisation and GST or such a thing that the methodology on which the GDP calculation is based itself and that itself makes the dependability of that reliable data suspect. So I would not even proceed on any assumption except look for more anecdotal data.

Q: Point is taken. I think they extrapolate on service tax collections and now, there is no comparison because we have a new tax regime.

Reddy: There is a paradigm shift.

Q: But that problem hits more in the third quarter.

Reddy: It will be there in different ways. It depends on the government.

Q: But your anecdotal feeling is that we are still trapped and we are not able to come out into a higher growth trajectory, we are not even in potential?

Reddy: No, but my limited point is, in the last few years, we have come down in the potential output from 8 to 7 partly because of domestic economic management. It is not entirely explicable by the global crisis. The foreseeable financial savings have come down. The investment and fiscal deficit has continued to be high. That is where the productivity growth is not divided capital formation is not divided. So what I am saying is instead of pushing the potential output up, it has gone down and all of it cannot be explained by global crisis. So you have to catch up with something that you lost.

Q: So where do you think the bottleneck is? Is it in power, where power plants are up and not getting consumed? Is it sectoral?

Reddy: I think part of it is the bottlenecking. Part of it is the incomplete projects. So all the incomplete projects are added to the situation where the lower investment output is even lower. So all these things, once there is a slowdown, they get exaggerated, even non-performing assets (NPA), when the credit growth is low.

Q: In the LitFest, when you spoke about credit growth, there were people making the point that the bond market has stepped in where the banks have stepped out. You said that is a worry.

Reddy: It could be because you have see if the banks owe money that means their balance is under stress. But they have to carry on the activities. If the balance sheets are under stress, in order to carry on, somebody else financed, whether that case has been recognised by the bond, has been priced by the bonds market.

Q: So you will hope regulators look for bubbles in the bond market or misadventures?

Reddy: No, that should not be taken as a sign of growth. The impression given in the discussion was you think growth is stalled, but actually stock markets are doing well, bond markets are doing. Stock markets can partly refresh on the global developments. It is also speculative capital. All over the world it is happening. Second is, as far as the bond market development is concerned, yes, but it may only be replacing a situation where you are assuming the risk also. So do not be sure. I am not saying it is a problem, but do not be sure.

Q: The other point was about NPAs. Now of course, the big news from the government is that they have announced Rs 2.1 lakh crore of capital. Do you think that addresses the problem or do you think it should be preceded or at least accompanied by some reforms?

Reddy: In the actual scheme of things, though you can make an attempt, structurally and historically that cannot happen. Basically, what we are doing is for the sins of the past we ensure that normal activity goes on, you have to put in capital. So unless you decide in advance to sell, the moment you have decided to put in capital, you are putting in capital, whatever conditions you put, you cannot put conditions for the capital, you are only telling the management to do it and you have to hope for the best. You cannot withdraw the capital, so there is no recourse

Q: But what would you have, at least post facto the government about PSU banks?

Reddy: I would definitely say that immediately you have to put the capital so that the activity goes on, they should not choke. But if you want things to improve, you should take a view and that view, as I explained in the meeting, I will send you the final version, means that you have to take a view about the presence of public sector banks. It is obvious not that every time the government is putting in money in the banking sector where the share is coming down, then why are you doing it?

Q: Most important event that has happened apparently is, Moody’s upgrading India. Do you think that this is something which is overdue and that there is good reason for them to upgrade India?

Chidambaram: I don’t think it is the most important event. It is a happy occasion but I don’t think we should get carried away.

Only a few months ago the government of India officially wrote to Moody’s saying, your methodology is all wrong, your conclusions are wrong and please therefore revise your methodology and today they are basking in the upgrade.

Upgrades don’t happen depending upon what happened in the last three weeks or three months. Upgrades happen over what happened over a long period of time.

So, we can be happy but there is no reason to be boastful because the very upgrade document cautions that if our debt burden increases and if the bank NPA problem is not resolved, there is a potential downgrade. Therefore while I am happy, I don’t wish to join the chorus and boast about it.

Q: The first paragraph of reasons for the upgrade pointed out to the fact that there is a bankruptcy code, that the GST will eventually hopefully bring more people into the formal system and the tax system. You don’t see these as positives which will create higher tax to GDP ratio and a banking system that will work, that will be able to cease bad assets?

Chidambaram: These are, provided there are implemented properly. GST is a positive, it could have been a very strong positive if it had been implemented properly. However you messed up the GST implementation.

Likewise the IBC is a good law, we all joined in passing it in parliament but if you mess it up as I think they are, it is not a positive.

So, bank recap is a positive idea but I still don’t know where they are going to find the money and how they are going to do it. As I pointed out in a column, bank recap has to be accompanied by a whole host of reforms. Therefore while these are positives, I want to underline that Moody’s itself has pointed out that they will watch out for how it is being implemented.

Q: I am worried, you are saying that IBC is messed up, I thought that was one piece that was maybe working.

Chidambaram: There were a couple of cases of real estate builders which went to the IBC but they have got stalled in court.

The court has pointed out that the home buyer’s credit to the builder was much larger than the banks credit, yet the home buyers have no representation in the creditors committee and in the waterfall they come last.

Therefore in the implementation of the IBC, they have to be extremely careful, lest each one of the IBC cases gets stalled in some court or other.

Q: About the GST itself you will have to admit that there have been course corrections and the deficit – the states themselves – the J&K finance minister was on our channel saying that the deficit from what they estimated is coming down. So, probably things will pick up.

Chidambaram: What are they doing now? They are unscrambling a scrambled egg. Why did you scramble the egg in the first place? We had cautioned you in parliament don’t keep any rate above 18 percent except for the couple of so called sin goods but they were adamant. They were adamant and put something like 280 items in 28 percent when we had cautioned them.

CEA’s report cautioned them saying the revenue neutral rate (RNR) is 15-15.5 percent and you should only have an RNR minus and RNR plus. It is not as though good advice was not available. Good advice was available, you brushed aside the good advice, broke the egg, tried to make scrambled eggs and now you are trying to unscramble the scrambled egg. Who is paying the price for that?

Q: At least do you feel confident that 5.6-5.7 percent is a troughing out and now things are definitely on the mend?

Chidambaram: I don’t know. I hope that 5.7 percent is the bottom of the slide. The figures for July-August-September will come on November 30, it is possible that 5.7 percent will now be replaced by or succeeded by 6.1 or 6.2 percent, I will be very happy if India grows but the decline in the growth rate in six quarters should have sent alarm bells in the government. However government did not wake up.

We tried to wake up the government but they refused to wake up. Therefore let us wait for the seventh quarter. I hope the seventh quarter is better. If the seventh quarter is better, then the government must remain alert to ensure that there is no further slipup.

Q: The final point you pointed out was bank recap and looks like there the government has woken up. They have at least proposed this recapitalisation plan. Now the cry everywhere is that the tax payer’s money goes but the banks again get back into the hole. So, as a person who has been there done that, what would you suggest would be a way that will seminally reform public sector banks?

Chidambaram: It is for government to tell us where you are going to find the money. From what I gather, banks are plush with money, government will issue bonds, banks will invest in the bonds and then that money will be given back to the banks as equity.

Q: It is like your 1994 scheme.

Chidambaram: That was on a very modest scale - Rs 5000 crore. We are now talking about over Rs 200000 crore. So, I think the scale makes a big difference. If you make a mistake in Rs 5000 crore, it is a small mistake but if you make a mistake with over Rs 200000 crore, it is a huge mistake.

I think it has been pointed out that for the government it will be fiscally negative because the cost of servicing the bonds is in all likelihood will be higher than the return on equity plus the capital appreciation which is likely to be nil anyway. So, it would be fiscally negative for the government. So, do they have a better plan? I don’t know.  Can they raise money from other sources? I don’t know.

So, as I wrote in a column, it is robbing Peter to pay Peter. You are taking money from Peter and putting it back in Peter. You are converting debt into equity. I wish it works but it is fiscally negative.

Q: If they were to propose that some banks could be privatised, would the UPA, would you as an intellectual support it?

Chidambaram: Personally yes but I don’t know my parties position on that nor do I think that the mood of the country is that all public sector banks should be privatised. You heard YV Reddy say that we must still have some public sector banks. So, I don’t think the government would propose privatising all public sector banks.

Q: They haven’t even said one, but I am just asking?

Chidambaram: If a few public sector banks will be privatised even while the government will keep a few of the bigger better performing public sector banks, I would welcome it, that is part of the reform process.