(Photo: Mint)
(Photo: Mint)

Opinion | What investors want from Modi season 2

The rules that worked when the economy was at $500 billion are under stress

Now that the election is done and dusted, all eyes are on the Budget and the reforms that the government needs to front load. The way a market is structured reveals a lot about the stage of development of the country. Indian regulations for markets and money have evolved piecemeal, solving problems as they came along. But the rules that worked when the economy was at $500 billion are already under stress as India rises to hit $3 trillion. The journey to $5 trillion and then double of that will need new rules of the game. Here are three areas that are crying for change.

One, as India moves from a financially repressed economy, the rules around forced investment into government bonds will need to change. Financial repression is when the government uses its dominant position to put in rules of the game such that it appropriates a bulk of the savings of the nation. It also means that the government, through the central bank, uses its power to set interest rates that are below the inflation rate. In the first case, household money finds its way to government bonds through banks and insurance firms. In the second, the government is able to inflate away its debt. Look at the rules for Indian banks and insurance companies and you see a text book case of financial repression. Banks are currently forced to keep 19% of their deposits in government securities as part of the statutory liquidity ratio (SLR) requirement and another 4% currently as the cash reserve ratio (CRR) requirement with the RBI. So of every 100 of deposits that a bank collects, it cannot put 23 to use (for lending). Insurance rules are similar. A bulk of the 32 trillion assets under management of Indian insurance firms buy government bonds. Notice how tough basic reforms have been in both banking and insurance in India, while stock market reform has been much easier. But this was the paradigm of a low-income, low-tax-paying and low-growth economy. A faster growth with more people paying taxes that result in a higher tax-GDP ratio will give the government the elbow room to relax these regressive rules that punish household savings. The Narendra Modi government should rethink these rules specially since an inflation-targeting central bank will keep inflation under the lid and the Fiscal Responsibility and Budget Management (FRBM) will keep deficits under control—the need for forced household savings will reduce. A rethink in investment rules in insurance, in particular, will open the door for change that stops the huge mis-selling that is in turn driven by high commissions. To read this piece click here

Two, remove the tax arbitrage between various asset classes. India today has the absurd classification of long-term that differs across products with no logic. Equity goes long-term at one year, real estate at two years and debt products at three years. Since short-term tax rates are higher than long-term rates, the holding period is the nudge to hold the product for longer tenures. Equity and real estate long-term should be at least five years and debt no more than one year. If the government wants financialisation of household savings, then it should allow for zero long-term capital gain on equity after a holding period of five or seven years. Equally absurd are the tax rules around switching of investments. A real estate switch within two years goes tax-free, as it does in life insurance products, but not in mutual funds. This tax arbitrage needs to go.

Three, bring back the Financial Resolution and Deposit Insurance (FRDI) Bill that was killed due to the Left mafia colluding to drum up mass hysteria, scaring people that their bank deposits would be appropriated by a rapacious government. The Bill was actually putting in place an early warning system that flags distress in financial firms. Much as the bankruptcy law allows firms to fail in an orderly manner, so also the FRDI Bill wanted to put in place a protocol to allow financial firms to fail without pulling the entire system down. The fear of contagion is much higher when a bank fails than when a biscuit maker fails. All the FRDI Bill aimed to do was to put this system in place.

This government has come with a popular mandate. It has learnt how to negotiate Lutyens’ Delhi and the well-organised loud voices of the extreme Left. It will take the old incumbents time to regroup, and this time should be used to front load hard reform quickly.

Monika Halan is consulting editor at Mint and writes on household finance, policy and regulation