Monday, October 12, 2009

Flawless GST

Address by Dr. Vijay Kelkar, Chairman, Finance Commission
at the FICCI National Executive Committee Meeting on
“Flawless” GST for promoting Growth and Employment


12th October, 2009
Introduction

1. It is indeed a privilege to address the FICCI National Executive Committee and share my thoughts on the issues relating to the design and implementation of Goods and Services Tax (GST).

2. Over the past twenty months, in my capacity as Chairman of the Finance Commission, I have had the privilege of visiting twenty eight States in our country and discussing with the respective State governments their views on our Terms of Reference and how the Commission should go about its work. One important item in our Terms of Reference relates to consideration of “the impact of the proposed implementation of the goods and service tax with effect from 1st April 2010 including its impact on the country’s foreign trade.” A number of State governments have expressed their views on the GST to us while voicing their own concerns. Independently, a number of economists, practitioners and financial journalists have raised issues and suggested options relating to the implementation of GST. I am aware that the GST debate has so far been dominated by the concerns of two of the three major players in this policy triangle – the Central government on the one hand and the different State governments on the other. The third group of stakeholders – trade and industry should proactively seek to influence this debate so that their concerns, needs and aspirations can be incorporated into the GST design as well as the implementation protocols. Policy is best influenced when it is still malleable and I urge not only FICCI but also all the other trade associations to closely study all possible ways in which the GST will impact their membership and put forward their views to the Union Government and the State Governments on the various issues as early as possible.

3. Much has been said on the merits of the GST. It will bring about a qualitative change in the tax system by redistributing the burden of taxation equitably between manufacturing and services. It will lower the tax rate by broadening the tax base and minimizing exemptions. It will reduce distortions by completely switching to the destination principle. It will foster a common market across the country and reduce compliance costs. It can provide a fiscal base for local bodies to enable them to fulfill their obligations. I cannot overemphasize the importance of this given the growing and urgent needs of urbanization. It will facilitate investment decisions being made on purely economic concerns independent of tax considerations. It will promote exports.

4. The Finance Commission had appointed a Task Force on GST as well as commissioned a study by NCAER to assess its impact on growth in GDP and exports. The preliminary results of the NCAER study indicate that the growth in GDP can be between 2-2.5 per cent with the implementation of a well designed GST. This pioneering study explores the impact of GST on growth through direct cost reduction as well as cost reduction of capital inputs. The increase in exports can be between 10-14 percent. If we use 3 per cent as a discount rate, and lower estimate of the GDP increase of 2 per cent accruing year after year, the net present value of the GST reform exceeds half a trillion dollars. You will agree that it is indeed a staggering impact and demands an energetic action to usher in a well designed GST system at an early date. FICCI and their members should be in the forefront in getting this done. Today, I attempt to address some critical questions relating to the design and effective implementation of the GST regime.

Concerns relating to GST

5. Most concerns expressed about the implementation of GST can broadly be divided into three categories -

a. Design issues
b. Operational issues.
c. Infrastructure issues.

I shall take these up one by one.

Design issues:

6. What should be the design of the GST ? The broad framework of GST is now clear. This is on the lines of the model approved by the Empowered Committee of the State Finance Ministers. The GST will be a dual tax with both central and State GST component levied on the same base. Thus, all goods and services barring a few exceptions will be brought into the GST base. Importantly, there will be no distinction between goods and services for the purpose of the tax with a common legislation applicable to both.

7. However a number of issues remain to be resolved. These are presently under the consideration of the Empowered Committee under the Chairmanship of Dr Asim Dasgupta, the distinguished Finance Minister of West Bengal. These issues include :

The rate structure and value

8. The primary concern of all State governments is protection as well as enhancement of existing revenue streams. There are three parameters which need to be balanced here – one is the range of taxes presently being levied which will be subsumed into the GST. This will determine the tax base of the GST. The other two parameters are the number of rates and the numerical value of these rates which will be applied to this base.

9. All indirect taxes on the supply of goods and services would need to be subsumed into the GST. The Empowered Committee in its road map of Dec 2008 has indicated which taxes which will qualify. For the purpose of computing the Revenue Neutral Rate the GST Task Force of the Finance Commission assumed that apart from VAT, stamp duty, vehicle tax, taxes on goods and passengers, taxes and duties on electricity, entertainment tax, entry tax, luxury tax, taxes on lotteries, betting and gambling, purchase tax as well as all State cesses and surcharges will be subsumed into the State GST. Central Sales tax will stand abolished. From the government of India side, Central excise, additional excise duties, service tax, Additional Customs duty (CVD), and all cesses and surcharges (other than educational cess) will be subsumed into the Central GST. This would achieve what I call a “flawless GST” giving maximum possible benefits to Indian economy and particularly to the manufacturing sector.

10. There appears to be agreement that the best option would be a bare minimum number of rates, at best two, preferably one. We assume that a single rate structure will find favour with a very limited set of exemptions available for basic foodgrains as well as basic education and health services. This single rate will ensure low compliance costs, obviate classification disputes, and ensure uniformity of approach amongst all players. But to be attractive, a single rate cannot be too high. At the same time, the rate must be high enough to address the concerns of States regarding revenue neutrality.


11. Using data from about 2 million business entities for the year 2007-08, the GST Task Force of the Finance Commission has generated very interesting data relating to the GST rate which will maintain the same level of income for the centre and States respectively in a minimal exemption regime. Their preliminary calculations suggest that Revenue Neutral Rate will be substantially below the present combined Central and State rates. The report of this Task Force will be published on the Finance Commission’s website shortly and I hope that this will contribute to better awareness and constructive policy dialogue.

Rules of Supply for goods and services

12. While CST will be abolished in the GST regime, the treatment of inter state sales will need to be carefully thought through. It would be necessary to guard against tax arbitrage where local sales which will be taxed could be shown as inter state sales which will not. The CST Act provided for documentation to attest the interstate nature of the sales. A number of models are being examined by the Empowered Committee which will serve as alternatives. Since the final model adopted would have a direct bearing on the ease of inter state trade transactions as well as the compliance cost, I would urge that all trade and industry associations involve themselves in this choice through voluntary submissions of their views to the Empowered Committee.


13. Putting in place the Rules of Supply for the inter state provision of services will be demanding. Services produced and consumed within the same State would not pose a problem as far as the appropriation of taxation proceeds is concerned. However, some services may be supplied from one State, consumed in another and paid for in a third State. A set of rules to determine the taxation jurisdiction and appropriation would need to be worked out. There is adequate international precedent for this but here again, trade and industry associations could take proactive steps to suggest possible options.

The framework for exemptions, thresholds and composition

14. The existing sales turnover thresholds for VAT taxation vary widely across States. Some small States have specified a threshold turnover of Rs 2 lakhs per annum. Larger States have stipulated Rs 40 lakhs per annum. The turnover range for composition eligibility is equally diverse. The list of exempted goods also differs across States. To allow for uniform treatment of inter state transactions nationally, it may be necessary that these variations be bridged so that tax cascading is eliminated. However, the concerns of smaller States need to be kept in mind. For this reason, perhaps such convergence could be targeted over a certain period of time rather than immediately.

Operational Issues

Common Approach

15. For GST to be successful, all States and the Centre should implement it in a similar fashion. Only this will bring about the national common market which is one of its goals. This will be possible when there will be a common law, common exemptions, a common assessment procedure and perhaps even a common return. The Empowered Committee can provide the required leadership to engender this uniformity of approach between all the States amongst themselves and also with the Union government.

Sharing of information

16. Recent experience relating to revenue collections from the Central Sales Tax have raised the issues relating to tax arbitrage. It appears that local sales under the VAT regime are being shown as lower taxed CST sales leading to revenue loss. Some States have expressed concerns and referred to tax evasion in developed countries which have a VAT in place. They have sought reassurance that revenue leakage would be effectively checked in the GST system. Apart from putting in place a comprehensive IT network, sharing of tax related information and coordination amongst all the States will be crucial for this. Perhaps the Empowered Committee could set up a coordination mechanism to address such concerns. Trade and industry bodies also have a strong role to play in curbing such malpractices.

Infrastructural Issues
IT infrastructure

17. A simple system for inter-state verification of dealers and transactions is essential to ensure tax compliance and check avoidance. It will also be essential for enforcing the rules of supply discussed earlier. Given the volume of such transactions, this system necessarily has to be IT based. The present system Tax Information Exchange System ( TINXSYS) does not appear to be fully operational across all States. There are asymmetric benefits to States in putting in place such infrastructure and this appears to be affecting their incentives to do so. We need to put in place a system which will uniformly incentivize all States to participate in and contribute to the verification system. Or alternatively, one central agency could be charged with maintaining this system. Both the alternatives available are challenging, but this needs to be done.

Checkposts

18. Most States have put in place a system of checkposts on its road borders. Apart from other verifications which may take place, these checkposts verify and document inter-state sales of goods carried by the vehicles which cross these borders. These details are then cross verified with the VAT returns of the importing dealers. The need for such an arrangement to continue in the GST regime has been emphasized, especially in view of the abolition of CST and the possibility of tax arbitrage. However, the fact remains that such checkposts by the very nature of their operations, generate enormous delays in road traffic, sometimes upto three hours per checkpost. A freight truck travelling by road between Delhi and Chennai will need to cross five State borders and ten checkposts. Delivery times for goods may be extended significantly because of delays at checkposts. The arrangement also encourages rent seeking behavior.

19. It may be difficult to eliminate checkposts given the valid concerns of State governments which may extend beyond collection of taxes and movement of goods to vehicle fitness examination, prevention of trafficking, collection of local cesses, etc. But what appears to be egregious is that the same vehicle has to pass through two checkposts while crossing one border – the exporting States checkpost and the importing States checkpost. Both these checkposts are often located within a couple of kilometers of each other and a vehicle driver has to spend considerable time in both. Perhaps, it may be possible for both the States to put up a combined checkpost. Officials of both States could sit together and conduct their verifications in one checkpost. Or one State could handle traffic on one direction and the other State in the other direction. But essentially there would be only one check per border for a goods vehicle. Such an arrangement will significantly reduce travel time. The Finance Commission is prepared to support creation of such checkposts if the respective State governments are willing to operate jointly.

Impact on Small Enterprises
20. The impact of GST on small enterprises is often cited a concern. On the State GST component, the position will be exactly the same as under the present VAT regime. There will be three categories of small enterprises in the GST regime. Those below the threshold need not register for the GST. Those between the threshold and composition turnovers will have the option to pay a turnover based tax or opt to join the GST regime. Given the possibilities of input tax credit, not all small enterprise may seek the turnover tax option. The third category of small enterprises above the turnover threshold will need to be within the GST framework. Possible downward changes in the threshold in some States consequent to the introduction of GST may result in obligations being created for some dealers. In such cases suitable provisions could be made to provide direct assistance to the affected small enterprises if considered desirable .

21. In respect of Central GST, the position is slightly more complex. Small scale units manufacturing specified goods are allowed exemption of excise upto a turnover of Rs 1.5 crores. These units, which may be required to register for payment of GST, may see this as an additional cost. In this regard, I would like to invite your attention to the suggestion made to the FRBM Task Force where it was suggested that for these units, the State Government will also collect the central GST on behalf of the central government. This will ensure that the small enterprises will have to only deal with one tax authority and thus ensuring that their transaction costs are not increased. There can be other suggestions. I am sure the authorities will welcome the suggestions from FICCI and how can this be achieved.

A “Flawless” GST


22. Ideally the GST would subsume all the major State Level taxes, use a single rate, allow for only essential exemptions and eliminate all barriers to trade. This flawless GST will feature the following characteristics:


Harmonisation

23. For GST to be effective, there should be identical GST laws across States as well as at the Centre. I propose that not only the law but also the methodology relating to levy, assessment, collection and appropriation of the GST should be similar across States and the centre. Such a unified approach will simplify procedures, eliminate bottlenecks and drastically reduce transaction costs for dealers, enabling them to leverage cost and time gains from the new taxation system. Necessarily, such an approach requires that tax rates for most goods and services be common across the country as should be the list of exemptions and thresholds. These considerations would need to be kept in mind while considering fiscal autonomy of States. Some States have proposed a mechanism which ensures that in future, changes in the essential elements of GST are made only with the concurrence of all States and the center. Such a mechanism will provide stability of the taxation regime and suggestions from trade and industry would be welcome on how to move forward on such a proposal.

Common Procedure- levy, assessment, collection, appropriation


24. For industry to reduce its transaction and compliance costs, it is necessary that apart from a common law, the implementation of the law be also similar across States. All stages of the taxation chain from the levy of the tax to its assessment collection and appropriation should be similar. This would involve similar rules across States dealing not only with assessments, audit, refunds but also more basic issues like registration, filing of returns, treatment of transportation of goods etc. A common dispute resolution mechanism as well as a mechanism for giving advance rulings would further facilitate trade and industry. Here too, associations can play a very useful role by providing advice and suggestions on the modalities to be followed.

Expanding the envelope


25. The broader the tax base, the lower will be the GST rate. I therefore return to an issue raised in the 2003 FRBM Task Force report – the taxation of real estate. The construction sector is a significant contributor to the national economy. Housing expenditure dominates personal consumption expenditure. Further, the present piece meal taxation of this sector encourages perverse incentives. Raw material is charged CENVAT, the works contract is charged VAT and stamp duty is levied on the sale. With no provision of input tax credit in place, there is little incentive to record such transactions either at the construction stage or at the sale stage at their correct value. This leads to substantial loss of tax revenue and fuels the parallel economy. I am aware that the present discussions on the GST configuration do not consider the inclusion of this sector. However, given the potential long term benefits to the economy and to a successful GST, I would urge that the construction and housing sectors be included in the GST tax base, either immediately or during a subsequent phase.

26. Another possible step to expand the GST tax base will be the inclusion of the rail sector. This will be necessary if a level playing field is to be provided to the road and air transportation sectors which will be subject to this tax. This inclusion will also ensure that all inter state transportation of goods can be tracked through the proposed IT network. The railways themselves will benefit from this by availing input tax credit on the significant purchases made by them .

Benefits to State Government


27. A few State governments have recently indicated their opposition to the implementation of GST at the present juncture. While their objections need to be carefully examined, it must also be recognized that while implementation of the GST is aimed at being revenue neutral to the States, it will be budget positive for the government. This is because governments are large purchasers in the market for their own consumption and their cost of procurement will come down significantly with the implementation of GST. Apart from these static benefits, dynamic benefits will be generated in the medium term through more economically efficient production, improved competition and more importantly greater employment.

Role of the Finance Commission


28. It is possible that some States may want assurances that existing revenues will be protected when they implement GST. The Commission is willing to consider providing for compensation in order to advance the implementation of a “flawless” GST.

Next Steps


29. I have shared with you my views on what should be some of the goals of the Goods and Services Tax. The two major players – the Empowered Committee and the Government of India are discussing these issues. As I mentioned earlier, the policy on GST is still malleable and industry and trade associations can play a valuable role in forging it. I would urge that FICCI and all similar promotional bodies study some of the issues highlighted above and present their suggestions to the Empowered Committee and the State governments. In particular, they could work on the appropriate treatment of inter state sales of goods and services; the thresholds, composition and exemption regime which should be adopted; the treatment of small industry; the assessment and audit regime to be adopted; the inclusion of real estate in the tax base and even a draft GST law.


Conclusion


30. During his recent interaction with State Finance Ministers, the Finance Minister has encouraged State Governments to implement GST from 1st April 2010 noting that this was a critical part of the government’s economic reforms program. This is a strong signal. The agenda is vast. All stakeholders need to and must contribute to the present debate. Once GST is introduced, outreach efforts by all agencies will be equally important.


31. The launching of GST will perhaps be the single-most important reform stimulus since the 1991-91 economic reforms launched by the then Prime Minister Narasimha Rao and Finance Minister Dr Manmohan Singh. Flawless GST and the New Direct Taxes Code will put India’s fiscal system at the cutting edge of the world’s market economies. I need not tell you how important this will be for promoting investment – whether domestic or international – and thus give a dynamic boost to our economy.

32. Flawless GST reforms will remove the historic tax-induced bias against the manufacturing sector and would dramatically increase growth in the manufacturing output, exports and blue collar employment. As you know, even a 2 per cent reduction in the costs increases profits by more than 20 per cent. This will attract investments in the manufacturing sector. What is perhaps most attractive is the very favourable impact of a “flawless” GST on the lagging regions of India. As “tax cascading” disappears, the industry will move to the lagging regions because of the likely lower costs and thus bringing the lagging regions into the growth dynamics. For all these reasons, a flawless GST is a must and FICCI should undertake all possible steps to ensure this happens at an early date.

Thank you.

Saturday, August 22, 2009

Inaugural Rajiv Gandhi Lecture

Rajiv Gandhi Lecture Series

Inaugural Lecture by Dr. Vijay Kelkar, Chairman, Finance Commission at
the Rajiv Gandhi Institute of Petroleum Technology



22nd August, 2009


1. I want to thank the Rajiv Gandhi Institute of Petroleum Technology for inviting me to deliver this inaugural lecture. I feel honored to be associated with this event which is in memory of Rajiv Gandhi who was one of our distinguished Prime Ministers. Although I did not work directly with him, I had the privilege of interacting with him as the Secretary to the Economic Advisory Council to the Prime Minister - which was then chaired by Prof. Sukhomoy Chakravarty - and also as Advisor to Ministry of Petroleum. Rajiv Gandhi was a statesman and a visionary who took a “long view” of our development options as well as development perspectives. He wanted India to occupy her rightful place in the comity of nations and envisaged that a dynamic India will greatly contribute to global welfare and world peace.

2. As I mentioned, at personal level, I got associated with Rajiv Gandhi in connection with two different areas and at both times, I saw his unique ability to think in long term. For instance, it was he who initiated India’s long term fiscal policy and many of the later years’ important fiscal reforms can be attributed to his vision. Similarly, he recognized the importance of natural gas for the coming decades. To recognize this and to impart a new focus, he was the one who changed the name of the Ministry of Petroleum to Ministry of Petroleum & Natural Gas.

3. In today’s lecture, this is the aspect of Rajiv Gandhi’s approach which I wish to emulate by focusing on one of the important long term issues and this issue relates to the natural gas sector. I have therefore titled my lecture “Towards a New Natural Gas Policy”. In preparing this lecture, I was mindful of the fact that there is currently a high octane dispute regarding the KG basin gas between two companies. This dispute has now gone to the Supreme Court. I have therefore made every effort to observe the “Lakshman Rekha”.

4. India, as I argued elsewhere, is on a “Growth Turnpike” . Barring the last 12 months of growth interruption thanks to the global financial crisis, India’s growth rate in recent years had accelerated to 9 per cent per annum while the manufacturing sector attained double digit growth rate. Now that the international crisis seems to be waning, I do think we should be able to go back to our earlier dynamism and resume the accelerated growth path. We can do it for the simple reason that there a number of growth drivers that are available to our economy.

5. Essentially, the growth of any economy depends on the growth in factor inputs and such as labour and capital, the growth in productivity and entrepreneurship which exploits market opportunities. In all these areas, India is indeed very favorably placed today. As far as human capital is concerned, in the coming decades, India will have world’s largest working population and given our emphasis on education, we will have increasingly better skilled human capital. People are calling this phenomenon as “demographic dividend”. As far as supply of capital is concerned, this is also getting more abundant thanks to the increasing savings rate in the economy and growing foreign equity and portfolio capital inflows. We are already investing annually 37 per cent of our GDP and with the present trend, this rate can certainly reach 40-45 per cent in the coming years. When we come to productivity growth, it is getting accelerated thanks to increased competition, network externalities and the technological progress. For instance, now there are new technologies in the areas of telecommunication, information technology, bio-technology, etc. These technologies use less inputs and give better and higher output. These technologies were not available earlier to developing countries. This is one of the few but very important advantages for the latecomers!! There are network externalities due to much larger fixed and mobile phone networking, power transmission network and National Highway network. Further, in recent years, we are seeing blossoming of entrepreneurship in India. All these developments suggest that India is going to be the “next growth miracle” of the global economy and I do see that in the next decade or so, with “better governance and appropriate policies”, India can in fact, become the fastest growing economies in the world. Yes my friends, you must have noticed that I slipped in the words “better governance and appropriate policies”. Inter alia, better governance means greater transparency, fairness and efficient justice system in terms of equitable access and speedy delivery.

6. Now, what are these appropriate policies? These relate to fiscal consolidation, inflation targeting, financial sector liberalisation, reforms of education and health sectors, selling of under-performing assets, vigorous implementation of competition policy covering both private and state enterprises, second generation land reforms to promote land markets, infrastructure reforms including reforms of the energy sector as well as policies to promote environment protection and strengthening of the national innovation system. Fortunately, both the Central and State governments are taking a number of important reform initiatives in many of these areas. Amongst all these policies, reforms of the energy sector will be decisive for accelerating growth as well as for promoting economic security. Within the energy sector, however, I would argue that it is the natural gas which will be of strategic importance to our country and hence the need for a New Natural Gas Policy.

7. In 2006, a High Powered Expert Committee under the chairmanship of Dr.Kirit Parikh, Member of the Planning Commission submitted a report on the Integrated Energy Policy for the country. This thoughtful report looked at country’s energy requirements upto the year 2030 in order to meet the challenge of achieving a growth rate between 8-9 percent as well as meeting the increasingly ambitious environmental standards. This study looks at all the energy sources in an integrated manner. In other words, it covers the respective roles of nuclear power, the non-renewable energy sources like solar and wind as well as traditional sources of energy such as coal and hydrocarbons. Given our resource endowment and the level of development, the Committee projected that to maintain a growth of 8-9 per cent over the next few decades, India’s energy requirement will increase three fold. According to the Committee, by 2030, the per annum total energy requirement will be 1.8 billion tonnes of oil equivalent with natural gas increasing its present share between 6 – 10 per cent which translates to a need of 295 to 430 mmscmd (million metric standard cubic meter per day).

8. As I just mentioned, the Committee projects that the share of natural gas would grow upto 10 per cent. In the advanced countries, the share is now almost 25 per cent. In other words, if the supply of gas is abundant, India’s demand can even grow more, probably exceeding 500 mmscmd. The report has detailed a number of policies for different sectors such as nuclear energy, renewable energy sources such as solar and conventional energy sources such as coal and hydrocarbons. However, when it comes to natural gas, it seems that the policy regime that it has envisaged is more following the present policies which I believe requires a paradigm shift.

9. Natural gas will be the key driver of the global economy for this century. What oil was for the 20th century, natural gas will be for the 21st century. This is due to several compelling reasons.

10. Worldwide reserves of natural gas at the current production rates are of the order of 60 plus years, about 20 years longer than Crude Oil. This does not take into account non-conventional sources of natural gas like shale gas, gas hydrates and potential as a result of technological developments to convert coal into natural gas. Once these become technically viable, reserves could increase exponentially. We must also keep in mind that as far back as early 80s, most oil companies would walk away from gas finds. Only when the world accepted that crude oil will peak in early part of this century, natural gas got its due importance. This would mean that new discoveries of hydrocarbon are more likely to be in the form of natural gas. Present discovery in the KG basin in India is a good example. Similar examples are available worldwide.

11. Compared to the petroleum products, natural gas burns cleanly and efficiently in any fuel application. This is amply borne out by the fact that when Metros started using compressed natural gas (CNG) in lieu of gasoline or diesel in transport vehicles, there was a significant reduction in pollution. In other words, natural gas is a “green” fuel compared to coal or oil.

12. As discussed, control of the CO2 emission to the environment is of utmost importance. As compared to liquid petroleum products, natural gas would emit 25 to 30% less carbon dioxide and roughly half when compared with coal per unit of heat generated. This in itself would be a compelling reason to substitute natural gas in place of petroleum products and or coal in any and every application possible.

13. International price of natural gas on heating value basis, including transportation costs, has always been significantly lower when compared with petroleum products. For the last decade, it has been nearly half. Almost in every application, natural gas can substitute petroleum products. However, success of natural gas substituting petroleum products in transport sector has been somewhat less effective. Some countries with abundance of natural gas like Russia has as much as 50% share of natural gas in commercial energy basket as compared to world average of about 25%.

14. Finally, the availability of natural gas is widespread geographically or less concentrated geographically than crude oil and thus enhancing energy security and market stability. This will become an issue of growing importance for our country.

15. The present policy approach for gas seems to be derived from a mindset that India is relatively “gas short” and this scarcity is attempted to be met through rationing or in other words, allocating available gas through quantitative allocation with its consequent under-pricing. Ironically, this approach only reinforces the shortage phenomenon as this discourages supply and enhances demand as prices are not allowed to play their full role. This policy which creates “rent” in the gas markets gets reinforced through the “political economy” factors as a number of important players share these rents. The other conceptual shortcoming of the present framework is that when people think about gas, it is thought of as something distinct from crude oil while in reality both being hydrocarbons, are close substitutes. The fact that they are close substitutes is vividly reflected by how closely they are tracked in terms of prices in the international markets. For instance, if you look at the international LNG prices or Henry Hub price for domestic gas in USA, both track very closely to the corresponding crude oil prices. Yet another shortcoming in the approach is forgetting Rajiv Gandhi’s insight that we have to think long term and that is of even greater relevance to natural gas. As buyers and sellers usually adopt long term contracts, our own policies need to be stable and the authorities should always honour explicit or implicit commitments as this reduces policy uncertainties and encourages buyers and sellers to enter into long term commitments. I cannot overemphasize the importance of this issue to the development of gas sector. In describing in this manner the present policy framework, I may be criticized for being less than fair to extant policies, but I would submit that I may be closer to the evolving state of affairs in this sector.

16. The current procedure for determination of gas pricing being somewhat non-transparent, there is an element of uncertainty and enormous variance in gas prices in the same markets in India. For instance, both in Gujarat and Andhra Pradesh, amongst consumers, the gas prices vary by almost 200 per cent. Such price variation and non-transparency in price determination ironically discourages anchor customers such as fertilizer and power sector creating further difficulties for making any large investments required for laying the pipeline infrastructure. In other words, the present pricing policy framework is not leading to more rapid development of natural gas sector in India – whether in terms of creating supply or demand. This is unfortunate as with better policies for the gas sector, one can foresee a reduction in total imports of hydrocarbons in our economy and enhancement of the country’s energy security.

17. How do we achieve this paradigm shift? Firstly and most importantly, the policy makers will have to change their perspectives or their mindset by recognizing three important factors. Firstly, both oil and gas being hydrocarbons are close substitutes and these markets move in tandem internationally where the infrastructure for gas is well developed; Secondly, although oil and gas are both hydrocarbons, one is liquid and the other gaseous and therefore requires different logistics in terms of supply infrastructure. Hence, these two energy infrastructures create different market structures which has some regulatory implication. I will come to this point a little later.

18. The third factor is that India is potentially a “gas abundant” country. I am using the word “abundant” compared to availability of oil and compared to the present projections of demand for gas in the next 20 years. Given right incentives for producers, it is possible to foresee India to achieve over a decade or so gas output level of more than 500 mmscmd from current supply level of 120 mmscmd. These supply projections may be somewhat speculative, but I would argue these are not without basis.

19. I have talked to a number of knowledgeable experts and I think it is possible to argue that from the current gas reserves of 30 tcf (trillion cubic feet), we can increase the reserves to more than 120 tcf within the next decade. This is based on likely reserves in the eastern deep waters which is estimated between 70-90 tcf and the CBM (coal bed methane) gas reserves which are estimated to be 10-15 tcf and the west coast gas reserves which are again 10-15 tcf. With these reserves, we can sustain production of even more than 500 mmscmd for 15 years or so. Mind you, I have not added to these reserves either the shale gas reserves or the gas supply possibilities from in situ gasification of the country’s deep coal reserves.

20. The new technology of horizontal drilling makes it possible to access shale gas. For instance, in USA, in a decade or so, the share of shale gas increased by 20 per cent. Our geologists in India also estimate the presence of shale gas in Gujarat and Assam. All these potentially large gas reserves can become a reality only if we allow incentives to the producers. This requires that our exploration contracts should have transparency and complete stability. In recent years, there have been instances of unilateral deviations from the stated policy and practices regarding the Production Sharing Contracts and this needs to be eschewed if we want to make any radical gains in finding new gas which is indeed there to tap. Exploration and production of hydrocarbons is inherently hugely risky and such policy instability makes it even riskier thus discouraging the oil companies. In addition to transparency in the contracts, we should give freedom to producers to market their gas provided the price determination is at arms-length and on a transparent basis which avoids transfer pricing or deliberate under pricing. This would mean, inter alia, long term prices to be linked to international crude oil prices providing transparency like in our LNG contracts. What I am arguing is for further liberalization of gas markets in India. This will require an improved regulatory regime. One possible regulatory model to strengthen gas markets in India is the recent Australian Natural Gas Act, 2008 which has very detailed provisions for pricing, production pipelines, operations including the tariffs and safety etc. We can also learn from the OFGAR (Office of Gas and Electricity Regulator of Australia) about enforcement of competition policies to curb potential abuse arising out of possible monopolistic power. With such incentives and regulatory approach, we will find that a number of oil companies will be forthcoming to invest in our gas sector along with new technologies and improved oil field practices. To achieve such an outcome, I should reemphasize the importance of having an upstream and gas regulatory agency which is fair, transparent and technically at par with the best oil companies of the world.

21. As I mentioned, natural gas is different than oil because of its transportation requirements. Large pipelines are required to transport gas and once such pipelines are created, the market structure can become locally monopolistic. To create competitive national gas market, we require national gas pipeline grid, what I call NATGAS grid. But working of this NATGAS grid will have to be supervised by a regulator for ensuring transparency, competition and safety. This inter-state network has to work as a common carrier and all inter-state pipelines would be built either through public sector or private sector companies where construction, sizing, routing and pricing will be done on open tender basis in consultation with the regulator.

22. One possible way of promoting gas markets could be that even where the cross-country or inter-state pipelines are under the private sector, 25-30 per cent of capacity of such pipelines can be “crown” capacity which can be either on “carried interest” or “participating interest” basis and such capacity will be available to any buyer or supplier of gas with the toll charges which are determined by the regulator. This will enable the development of gas market in India where third party suppliers and buyers can use the common carrier. Given the multiple sources of gas such as ONGC, Reliance, GSPC Cairn or other operators and multiple sources of import like Petronet LNG, Shell, GAIL, or the new ones, under a new policy approach, India’s gas market will become competitive like the one obtained in USA or Europe giving consumers choice as well as supply stability. This way, the gas prices all over India will converge barring inherent transportation costs, the tendency which is already observed in the US gas market which is fully liberalized. This will also vastly improve the bargaining power of our country in organizing large scale gas imports whether in the form of LNG or gas through pipelines.

23. The new gas policy can bring large benefits to our economy due to a number of positive outcomes. Firstly, it will increase energy security by enhancing sharply the supply of natural gas from the home or domestic sources. Secondly, it will reduce imports of crude oil and thus bring in considerable macroeconomic benefits. Thirdly, it will lead to investment in power and fertilizer sectors thus benefiting agriculture as well as Indian industry. Fourthly, by reducing cost of power and fertilizers, it will improve all-round competitiveness of Indian industry and agriculture. Also, gas being more environmental friendly fuel, it will enable us to meet our national goals of sustainable development by reducing pollution. It will also lead to better price discovery and greater choice for consumers. We will see that the long term contractual gas prices will be aligned to international crude oil prices in a transparent manner and one can foresee spot market prices such as our own “Kakinada hub” price emerging and providing transparency to gas prices nation-wide. Such augmented supply of domestic gas can be further supplemented with LNG imports as well as import of gas through international pipelines from Iran or Myanmar. This will increase the system stability as well as give impetus to the growth of the neighborhood region whether Gulf or East Asia. Finally, one of the most important benefits of this policy approach is it will help us to eliminate the humongous levels of subsidies the country is incurring on the nitrogenous fertilizers and LPG. Such an elimination of subsidies will provide fiscal space to the Union government to increase investments in areas such as environmental protection and for the reduction of public debt.

24. There is a final point and this relates to the possibility of the new gas policy increasing fiscal space to the State governments also. As our increased gas resources are going to come from off-shore, it is going to create literally tens of thousands of crores of “resource rent” in the form of profit gas and royalty. This resource rent from off-shore hydrocarbon resources while belonging to the Union of India could be shared with all the States of the Union. Already, the Union government shares the profit petroleum or profit gas and royalty from the on-shore fields under the NELP with a State where oil or gas is being produced. By sharing the off-shore profit gas and royalty, considerable amount of resources will become available to all the States of the Union for increasing the supplies of critically short public goods in the important fields such as health, education, water and urban infrastructure.

25. Friends, in conclusion, what I am saying is that with these second generation reforms of the hydrocarbon sector, we can change the energy base of our economy and this will give all-round benefits to the economy. Given our human capital, natural resources endowment and the new technologies, it is possible to achieve this with a new approach or with what I call “Towards A New Natural Gas Policy”. I am mindful that I have only outlined an approach and many improvements may be necessary for the implementation of these proposals. I leave that to you all who are experts and keen students of this fascinating field.

26. I thank you all for your kind attention.

Wednesday, February 11, 2009

Swaminomics

Kelkar's $500-billion, writes Swaminathan S Anklesaria Aiyar in Economic Times

We are on the verge of a revolution worth half a trillion dollars. After almost a decade of effort, India is about to move to a unified goods and services tax (GST) to replace the current plethora of central and state indirect taxes. The Empowered Committee of State Finance Ministers is giving finishing touches to the GST, which is due to be implemented by April 1, 2010. You might ask, why should ordinary folk worry about arcane tax issues? The answer comes from Vijay Kelkar, head of the
Finance Commission and former finance secretary. He estimates that the value of the GST reform to India will be $500 billion, or almost half the GDP of India. Hence, he calls the GST reform the biggest reform in India since industrial delicensing in 1991. Only time will tell whether his estimates are accurate. But if he proves even half right, he will be justified claiming that this is a silent revolution. Kelkar came out with these estimates in his convocation address at the Indira Gandhi Institute of Development Research on February 6. He observed that in Canada, which is widely recognised as having a very good GST, Professor Hamilton used a computable general equilibrium model to estimate the impact of a well-functioning GST on the economy. He came up with an estimated benefit of 1.4% of GDP for Canada. Assuming the same level of benefit for India — an additional 1.4% of GDP — Kelkar says the positive gain will be $15 billion. Using a modest 3% discount rate, he then estimates the net present value of the reform to be worth $500 billion. Moreover, says Kelkar, this incremental GDP would increase employment by 4-5 million. That represents a massive financial and human rate of return on a reform that is about to be achieved without any of the political economy storms and upheavals that usually make radical reform difficult. Why will the GST improve the efficiency of the economy so much? Because it will restore rationality and ease of administration to an existing system riddled with multiple authorities, corruption, evasion and distortions because of a plethora of rates and exemptions levied by different states and the Centre. Manufacturing in India is hit badly by cascading taxes, to the point where India truly stands out in global comparisons. Capital goods bear an especially high rate of cascading tax, a serious distortion that holds back our growth. Services in India were long untaxed, and today are still undertaxed, while some services escape taxation altogether. Services now constitute 55% of GDP, while manufacturing contributes around 24%. Service tax has plugged the tax gap to some extent. But clearly India needs a unified tax system covering both services and manufacturing, taxing only the value added at each stage. The tax needs to be levied at the destination point for maximum economic efficiency, compliance and ease of administration. And to the extent possible the GST rates should be uniform. Exports will be zero-rated and hence escape indirect tax totally, in accordance with the international norm. Currently, exporters are unable to get full refunds of sundry indirect taxes, handicapping them in the global market.
Kelkar lists four major channels through which GDP will improve after the introduction of a GST. First, the current system fails to tax all goods and services. This failure leads to distortions and a misallocation of resources from maximum-efficiency areas to undertaxed areas. GST will maximise coverage of goods and services, and thus reduce distortions and improve output. Second, the current unrefunded taxation of capital goods is a real curse on capital accumulation, hitting savings and investment. Kelkar believes that by ending such overtaxation, GST will make a huge long-term difference to outcomes. Third, indirect taxes need to be levied at the destination point to be comprehensive and non-distorting. At any given price level and exchange rate, says Kelkar, violation of the destination principle puts local producers at an unwarranted disadvantage with outside producers. A destination-based GST will end the anomalies of the current system. Fourth, differences in the tax bases of different states and the central government greatly increase the cost of doing business, and impose dead-weight losses on the economy. “This is a league table in which we have constantly languished at the bottom,” says Kelkar. GST will go a long way towards reducing the current system’s red tape, delay, hassles, corruption, leakages and waste. We can all agree with Kelkar that the potential gains from reform are high. It remains to be seen whether the full potential is realised. The immediate problems ahead relate to the finalisation of GST details by the Empowered Committee of State Finance Ministers. They will be tempted to have a large number of tax rates, and to have a large number of exceptions and exemptions. That, after all, is what enables politicians to develop patronage systems and collect kickbacks through changes in tax regime. We can only hope, along with Kelkar, that the Empowered Committee will minimise the number of different tax rates, exemptions and exceptions to the GST. If the number becomes large, that could erode the functioning, effectiveness and economic gains of GST reform. We must also hope that the state finance ministers will subsume other levies — octroi, entry tax, stamp duty — within GST. If such taxes are levied over and above GST, they will violate not only the simplicity of a comprehensive GST, they will also sabotage the aim of converting India into a true common market. Cynics will say that nothing works well in India, so don’t expect GST to work very well either. The gains may be far less than Kelkar’s estimates. I share some of this cynicism. But let me add that precisely because India is so messy, the potential gains from GST must be much higher than in Canada. So perhaps we can reap a $500 billion bonanza after all.

Sunday, January 13, 2008

On Financial Inclusion - NP Sen Memorial Lecture

FINANCIAL INCLUSION FOR “INCLUSIVE GROWTH” - ASCI, Hyderabad


1. I want to thank the NP Sen Memorial Trust and the
Administrative Staff College of India for giving me this opportunity to pay my tribute to Shri N.P. Sen, the distinguished Principal of the Administrative Staff College of India.

2. I seek your indulgence and allow me to begin on a personal note. I met Shri N.P.Sen in 1969, almost 40 years ago in Berkeley, where he was visiting USA for faculty recruitment. What I distinctly remember about the meeting is his passion for India. Naturally, for me on my return from the United States, Hyderabad was the first place to visit. I was interviewed by a Search Committee which was chaired by Shri C.D. Deshmukh, the Chairman of the Committee of Governors and I joined the College in 1970 as a senior faculty.

3. Potlada, as Shri N.P.Sen was fondly called, was not only the Principal of the College but also my mentor. Potlada and Nanditadi were full of great affection for me and the young bride Lata who came to Hyderabad in 1971 when we got married. Lata was promptly adopted by the Sen family and this further elevated my status with the entire family! I learned a lot from Potlada. He was not only a distinguished manager but an exceptional human being. He nurtured the younger colleagues and encouraged them. He was a true liberal in thought and in action and was committed to promote our country’s pursuit towards building a better and equitable society. At the micro-level or on an enterprise level, he would not accept any inefficiency but on the macro-level, he felt that efficiency without equity is not sustainable and equity without efficiency is not possible. Hence, I have chosen for today’s lecture the topic ‘Financial Inclusion’ for inclusive growth. The expression inclusive growth has now become fashionable but the promotion of equity has always been a part and parcel of India’s policy goals.

4. The second reason for choosing the topic ‘Financial Inclusion’ is that after my leaving the Government three years ago, I moved from Delhi to Mumbai, the financial capital of India. In Mumbai, I have had a ring side view of the financial markets and it gave me an opportunity to reflect on the role of markets and particularly on the role that financial markets can play in advancement of growth and equity.

Indian Economy - Growth Experience in recent years

5. The Indian economy, in the post-liberalisation period has witnessed considerable growth acceleration and the economy has been growing at an annual rate of 9 per cent or so in the last 4 years. Our country has now the potential to become the fastest economy in the world in the coming decades. The major drivers of the growth acceleration are demographic dividend, greater domestic and international competition, sharp increase in total factor of productivity, blossoming of entrepreneurship and India’s acceptance of globalisation. I should also mention that India’s vibrant democracy is also a fundamental determinant of rapid growth. This growth acceleration is accompanied by reduction in the percentage of the people below poverty line. With the current growth momentum, almost one million of our citizens are moved above the poverty line month after month. Although these achievements are indeed impressive, little reflection immediately tells us this is not the full story. This growth process is also accompanied by growing inter-regional, intra-regional and inter-personal inequalities in wealth and income. We are still a home for world’s largest number of poor and what is even more disturbing is that India has now world’s largest number of under-nourished children. The urban-rural difference is getting wider and according to a recent report of Arjun Sengupta, almost 370 million people are facing some form of deprivation. In particular, rural and tribal areas are becoming acute victims of deprivation. So, we should not be surprised by the growth of naxalism in these areas. What is clear is that present economic growth process is not inclusive enough and the political economy suggests that this is not sustainable for maintaining growth or stability or unity of the country. Clearly we need to do something urgently.

6. It is heartening that 11th Five Year Plan approved recently is aimed at promoting greater inclusive growth.

7. To achieve this goal, State led intervention as well as market based instruments are required. What my 3 years of stay in Mumbai has taught me is that much greater emphasis may have to be on market based instruments. Unlike state-driven measures, markets are gender, caste, region and religion-blind or neutral. In other words, as policy instruments, markets are better in promoting inclusive pattern of outcomes as they do not differentiate among citizens. Ironically, it is a State action which is more differentiating in nature and, therefore, can be non-inclusive. I am mindful that while markets may be caste, colour, religion, gender-blind, they are not income or wealth neutral and there is a need for regulation to ensure that markets are transparent and competitive. Therefore, Government’s role as an umpire is of vital importance towards ensuring the desired outcomes while deploying market instruments. But I sincerely believe the balance may now have to be shifted towards deploying much larger measure of market-based instruments for promoting inclusive growth and to paraphrase - Saddam Hussain financial market is a mother of all markets. Hence if we can make financial markets also more wealth or income neutral this will enormously empower the poor. This is the role of financial inclusion. This takes me to the definition of “financial inclusion”.

What is Financial Inclusion?
8. By financial inclusion, we mean delivery of financial services, including banking services and credit at an affordable cost to the vast sections of disadvantaged and low-income groups. The various financial services would include access to savings, loans, insurance, payments and remittance facilities by the formal financial system to those who tend to be excluded. One of the key financial services that is of great relevance here is that of “risk management” or “risk mitigation” services vis-à-vis economic shocks which may be an income shock via loss of income due to adverse weather conditions or natural disasters or an expenditure shock due to health emergencies or accidents leading to a high level of unexpected expenditure. This aspect of financial inclusion is of vital importance in providing economic security to individuals and families.

Financial Inclusion as a Quasi-Public Good

9. It is well recognized in the literature that finance performs the important functions of mobilizing savings, allocating capital and transforming risk by pooling and repackaging it. There is a growing evidence that a well-functioning financial system fosters faster and more equitable growth. Access to financial services allows the poor to save money outside the house safely, prevents concentration of economic power with a few individuals and helps in mitigating the risks that poor face as a result of economic shocks. Providing access to financial services is increasingly becoming an area of concern for the policymakers for the obvious reason that it has far reaching economic and social implications.

10. Increasingly, in developing countries access to finance is positioned as a public good, which is as important and basic as access to safe water or primary education. The pertinent question to ask here is whether ‘Financial Inclusion’ can be construed a public good? A good is considered a ‘public good’ if it meets the conditions of non-rivalness in consumption and non- excludability. The degree of ‘publicness’ in ‘financial inclusion’ maybe different from the stand point of a typical public good like say ‘defense’, but there is little doubt that financial inclusion meets the above two criteria to a large measure and to that extent is a “quasi public good”. There are a number of positive externalities of financial inclusion. One of the important effects is one is able to reap the advantages of network externality of financial inclusion as the value of the entire national financial system increases. Yet another reason why Financial inclusion is a quasi-public good is that the consequent fuller participation by all in the financial system makes monetary policy more effective and thus enhances the prospects of non-inflationary growth.

11. Hence once it is agreed that financial inclusion is a ‘quasi public good’ we are now in the realm of public policy and hence it is incumbent upon the government to provide it in partnership with other agencies (including private agencies).

12. What is the present state of financial inclusion in India? A recent National Sample Survey reveals that out of 89 million farm households in our country,more than 40 million households have no access to finance whether formal or informal. Out of the remaining 45 million households who have outstanding debt, more than 40% of these outstanding debt comes from non-formal institutions such as moneylenders, etc. Consequently, in 2006-07 more than 1.5 lakh crores have been borrowed from the traditional moneylenders and not from formal financial sector. We do not have similar detailed data in urban areas but some estimates show that only 60% of the households in urban population have bank accounts. Which means rest of the urban population do not have access to financial services such as savings, credit, payment system and in case of migrants, the situation is even worse. NSSO survey also shows that in recent years, the share of traditional system of credit such as moneylenders may be increasing in rural areas and possibly in urban areas also. This is a challenge to the financial system. Financial system needs to be reformed to ensure that everyone can access financial goods and services. The promotion of financial inclusion can be possibly done in two major ways. Firstly, by expanding the role of formal financial system including banking and secondly, through the growth of micro-finance institutions in rural and urban areas. It is these two instruments which I would now proceed to discuss.

Routes to Financial Inclusion

13. In all fairness, our policy makers have been cognizant of the role of financial system in promoting growth as well as equity. In the early 1990s, banking sector reforms was spear-headed by the venerable Dr. Narasimham, the Chairman of the Court of Convenors of the Administrative Staff College. Through his reports, the Government had initiated a silent revolution in the Banking Sector but we now need a second wind to these reform efforts to promote financial inclusion.

14. I will take a quick look at the past efforts to promote the financial inclusion in India.

Past efforts at financial inclusion in India
15. The institutionalisation of the systems for financial inclusion in India started with the establishment of the credit cooperatives following the enactment of the Cooperative Societies Act in 1904. After Independence, these efforts were intensified following the recommendations of the All India Rural Credit Survey Committee of 1954. Nationalisation of Commercial Banks in 1969 gave a fillip to increasing the breadth of financial services in rural areas and was a major step that facilitated rapid expansion of the banking system to hitherto unbanked areas, bestowing on them the special responsibility of stepping up advances for all the areas identified as ‘priority sector’.
16. Realising that the rural population, which forms round 75% of our total population, needs simple, flexible and small-sized financial products in very large numbers, the Govt. set up the Regional Rural Banks (RRBs) in the mid-seventies, which were visualised as hybrid banks incorporating the technical competency and professionalism of the Commercial Banks and the local feel and low cost structure of the cooperative credit system. Further, NABARD was established in 1982, as an apex level institution to deal with all issues related to agriculture and rural development. Thus, a multi-agency approach to address the needs of the poor was adopted through the wide network of Commercial Banks, Regional Rural Banks and the Cooperative credit institutions. The impact of all these efforts resulted in extending the coverage of rural banking – there are over 32,000 rural bank branches of public and private sector banks and RRBs, more than 14,000 branches of rural cooperative banks which in turn has around 98,000 retail outlets of Primary Agricultural Credit Societies (PACS).
Financial Inclusion – RBI initiatives
17. The Reserve Bank of India has recognized financial inclusion as thrust area and initiated a series of policy measures in recent years. The Bank’s Annual Policy Statement for 2005-06, while recognising the concerns in regard to the banking practices that tend to exclude, rather than attract, vast sections of the population, urged banks to review their existing practices to align them with the objective of financial inclusion. With a view to achieving greater financial inclusion, RBI has asked banks to make available a basic banking “No Frills” Account with either Nil or very minimum balances or charges that would make such accounts accessible to vast sections of the population. This has been an important step.
18. Similarly, banks are encouraged to provide a General purpose Credit Card (GCC) facility, at their rural and semi-urban branches. The facility is aimed at providing revolving credit to the cardholder to meet his financial requirements, upto Rs. 25,000. In 2007-08, two Funds, i.e., Financial Inclusion Fund (FIF) for promotional interventions and Financial Inclusion Technology Fund (FITF) for meeting cost of technology adoption were also established with NABARD.
19. Incidentally, although a number of initiatives have been taken by the financial systems to promote financial inclusion, more needs to be done. I think our policy has not adequately encouraged private sector banks whether domestic or foreign in opening new branches at rural areas. Such an encouragement will bring new financial products and financial services to serve un-served sections of the society. It would be also worth-while to consider to bring strategic investors in the regional rural banks (RRBs). This will bring new capital and innovations and thus promote more efficient and innovative financial services for the farmers, artisans and the rural households. Similarly, the removal of interest rate ceiling by the RBI will encourage our banking sector to supply credit to new borrowers with or without collateral and thus enormously improve access to financial services.

20. Equally, in my view, the time has come for revisiting our policy on “priority sector” lending requirements imposed on banks. One option that would allow the most competitive lender to emerge in rural areas is by making the priority lending obligation tradeable. This would be beneficial both to the banks and to the rural poor by making available financial services from the most efficient and competitive institutions. Similarly, as the transaction costs of the banks’ correspondents, such as NGOs, MFIs, cooperatives or carefully chosen individuals are much lower than the banking sector, the banks should be encouraged to utilize the services of banking correspondents more extensively. This would improve access to a vast section of our society.

MFI (Micro-Finance institutions) Route

Now let me turn to the new Micro-Finance route which is promoting financial inclusion.
21. Post 1991, many policy changes were carried out, a few of them being deregulation of interest rates, although interest rates on loans under 2 lakhs are still subject to cap and the service area approach and 1:4 branch license rules have been done away with. The post liberalization period saw banks shying away from lending to rural areas as it was based on a belief that small and poor borrowers are not bankable and lending to such a target group were not in the interest of banks especially in a competitive environment. Although, it is ironic that this became the starting point for the MFI which held a contrary view and saw the poor as bankable and having a business potential. It is only now that the banks have started coming around to the same view.
22. Followed by the success of Self Help Group(SHG)-Bank Linkage programme as also Bangladesh Gramin Model, many of the NGOs engaged in social intervention have taken to financial intermediation for providing financial services to their target clients adopting innovative delivery approaches. Though initially only a handful of NGOs were into financial intermediation using a variety of delivery methods, their numbers have increased considerably today. While there is no published data on private MFIs operating in the country, the number of MFIs is estimated to be around 800. A large majority of MFIs operate on much smaller scales with clients ranging between 500 to 1,500 per MFI. However, a few big NBFC MFIs have an outreach of over 100,000 clients.

Self Help Group (SHG)-Bank Linkage Programme

23. One of the most important programme for promoting financial inclusion through micro-finance is the SHG-Bank Linkage programme which aims at improving access of the weaker and other sections of the society from formal financial institutions. The ability of people to pool their micro-savings, provide collective social collateral for banks to lend against and add to the SHGs’ funds and the collective allocation of Funds to meet emergent credit needs of the SHG members, charge rates which reflect risks and management cost of funds, are the unique feature of this movement which has enabled banks to assist in meeting the credit needs of very poor people without sacrificing their funds and has helped rural women especially to empower themselves both economically and financially.
24. Over the last 15 years, the Micro-Finance initiative of NABARD has assumed the shape of a micro finance movement in the country by linking around 30 lakh SHGs with the formal banking system by March 2007. Further, the programme has enabled an estimated 394 lakh poor households to gain access to funds from the formal banking system. Studies conducted by various experts show that the programme has indeed helped in the social and economic empowerment of rural folk, especially women, causing significant up-scaling of social capital while at the same time delivering crucial financial services. In this emerging micro finance movement, ICICI is providing a new momentum with their “No White Spaces(NWS)” initiative which will cover 450 of 640 districts which make up rural India so that no individual will be more than 5 kms away from the ICICI touchpoint. With the initiative of the NABARD and of the banks like the ICICI, India’s micro-finance program has now become largest in the world in terms of the outreach.
Joint Liability Groups (JLGs)

25. Like self help group the Joint Liability Group (JLG) is yet another interesting institutional invention that is being introduced in India. Absence of ability to provide adequate collateral security works as a major hurdle for landless/tenant farmers in securing loans. The inability of this section of farmers to provide collateral often excludes them from the purview of formal credit cover. Keeping this in view, a pilot project on financing Joint Liability Groups (JLG) was initiated for developing effective credit products for such clients, which reduce risk and transaction costs for the banks and also introduce a greater degree of flexibility for the credit user to determine their credit needs and priorities. Joint Liability Groups (JLG), established under the project, comprise a group of 5-10 member clients who are together informally recognised by the bank as a group. The group members offer an undertaking to the bank that enables them to jointly receive such amounts as deemed eligible by the bank for pursuing any activity, individually or jointly, as found suitable by the group. This is of great promise.

Rythu Mitra Groups

26. The State of Andhra Pradesh has been a pioneer in the field of MFI initiatives. In Andhra Pradesh more than 8 million women have been mobilized in the last 15 years by NGOs like SEWA, the DHAN Foundation, SEWA Mandir and Pradan in the micro-finance movement. With the initiative of the State Government, the programme called Rythu Mitra Groups is being implemented, which envisages bringing about holistic development in the lives of small/marginal/land less farmers through collective action. RMGs are expected to serve as a conduit for technology transfer, facilitate access to market information and markets, assist in carrying out activities like soil testing, training, health camps, assess input requirements, etc., for its members. During the last year alone, 4437 RMGs were financed by 18 commercial banks, 9 RRBs and 9 DCCBs involving ground level credit flow of Rs. 28.11 crore. About 62,000 farmers have been assisted under the project.

27. I have a somewhat innovative proposal for promoting financial inclusion as well as improving the delivery of a number of Government subsidies. Today, a number of subsidies are given via multiple channels such as food subsidies by fair price shops, fertiliser subsidies, kerosene subsidy, power subsidies, etc. Given the reach of information technology, it is now possible to deliver subsidies more efficiently and effectively to the target groups. One can now think of unifying all these subsidies into a single subsidy or an entitlement and could be given to a targeted individual or family through a smart card. This will be equivalent to an annual negative income tax that can be given to a targeted family. Such a procedure will have several advantages. Firstly, it will reduce transaction cost, including administrative costs, and it will also enormously reduce leakages as the present subsidy system essentially leads to “dual pricing” of products such as foodgrains, LPG, kerosene, fertilisers, etc. Dual pricing i.e. two prices for a same product is open to an arbitrage possibility and hence the massive leakages. Consequently, dual pricing corrodes administration due to corruption, leads to fiscal loss and misallocates resources as “dual” product prices do not lead to an efficient use of resources. President Lula of Brazil has successfully implemented a version of such an entitlement system. Given our IT prowess, it would be even easier and less expensive to implement such a policy in India. This approach will also give much greater consumer choice to an individual family in choosing the goods and services which it prefers at any given time. Such a government entitlement via negative income tax has an additional advantage. It can be securitised through the banking sector by a family and they can have access to larger capital. Quick calculations suggest that the annual amount of such negative income tax or an entitlement could be as much as Rs.20,000 per family. This means that such a family can raise as much as Rs.1 lakh of capital from the financial system by securitising even a part of their entitlement. An access to such capital can help poorer families to increase their income, employment and also offer them access to a pool of capital in case there are health related emergencies. In other words, such a fiscal reform measure will go q long way in promoting financial inclusion of large section of the society and improve the efficiency of the subsidy delivery system. I am mindful of the potential difficulties of such an approach. What can be done is what in China they call a ‘policy experiment’ which is implemented first on a pilot basis and then expand it on a large scale.

28. Let me now draw your attention to some of the issues, which are hindering financial inclusion and which are in the domain of the real sector. One is aware that finance (and credit) can be effective and shall have the desired effect if only it is properly used and the environment where it is sown is conducive for its growth. Credit can become counterproductive if capacity does not exist to absorb it and this aspect has implications for the health of the financial system itself. I am now discussing the demand side factors that affect financial inclusion. For example, Rural Roads are a powerful instrument by itself of financial inclusion. Physical access to growth centres for the people living in rural areas unleashes the productive capacity and generates positive externalities. Some studies have even shown that rural roads have larger impact than irrigation in reducing poverty and inequalities in rural areas. Similar multiplier effects are possible by improving the working of land and water markets in rural India.

Access to land
29. For the marginal farmers, access to land also determines access to other resources. In the past, ceiling legislations were enacted with the objective of sequestering land from large holdings and distributing the same to landless labourers or marginal farmers. But this policy met with very limited success. There is a need to have in place a market friendly land reforms policy wherein (a) small farmers should be encouraged, and enabled to expand their holding by purchasing or by leasing – in land, (b) Large farmers should be encouraged to sell or lease out land and be offered opportunities to take up / start non-farm rural enterprises. As Dr Bandhopadhyay mentioned yesterday, in many states, this is not permitted and consequently the poor tenants cannot access credit and other inputs for the financing system.
30. The large farmers as a group have resources, access to institutional support and a better risk bearing capacity. Hence, it is advisable that as a group they be encouraged to take up non-farm activities like agro-processing and rural industries involving higher ticket loans and banks would be more than willing to finance these as it reduces their transaction cost. Alongside if steps are taken to create a well functioning and vibrant lease markets it shall enable small farms to increase their operational areas. For achieving the objective of ‘free lease markets’ urgent efforts are required for having proper record of rights, Clear enunciation of the rights and obligations of the landowner and the tenant, effective IT enabled machinery for monitoring and adjudication at the ground level and computerisation of land records
31. On their own, small farmers may find it difficult to negotiate land purchase deals. Is it possible for some state agency to undertake this role by purchasing land at market prices from the large farmers and selling it to the small farmers? Similarly, government can prepare a “market” leasing contract to ensure that the tenants receive a fair deal. Credit agencies can be made partners in this arrangement by offering financial support to small farmers to expand their holdings.
Water Markets
32. What is true about improving land markets is also true in the case of other scarce resources, namely water resources. Water User’s Associations (WUAs) were created (in many states) as the primary organisational units of irrigation water users with the primary objective of maintaining the physical infrastructure and resolving conflicts over water distribution etc. The initial cost of setting up the WUAs by holding elections and training is usually borne by the government thereby reducing thee transaction cost for the new institution (in this case WUAs) to operate effectively. What are the implications for Financial Inclusion? These WUAs were the new institutions created with the assistance of the state governments with the hope that they would in due course of time become an economic agent (entity) and shall be able to deal, interact and transact business with other economic agents (entities) in the area (say banks) which shall be beneficial for both. The functioning of WUAs is crucial for creation and penetration of a viable water markets in rural areas- credit through the banking system then only shall flow in.
Urban Poor- Financial Inclusion
33. The urban poor population of the country is estimated to be around 8 crore (one-third of the urban population is poor) and only 50% of them live in slums. Most of the urban poor work in the unorganised sector having limited sustainable livelihood options. Some estimates have put that 40% of the adult urban population in India do not have access to a bank account thus depriving them of the whole set of financial services starting from savings, credit, remittance etc. The poor in urban areas too have the same basic financial service needs such as secured savings; credit and additionally mechanism to transfer remittances back home like their counterparts in rural areas. However, identification for the urban poor is becoming a significant barrier to access and more generally this is an issue for the successful operation of the credit bureau. Some banks have already started on the issuance of electronic cards, which are biometric. If now the Government can absorb the cost of the PAN card (or more simply give an option to the client not to ask for one) one big problem would be behind us. Secondly, the issue of residence proof for migrants is a real challenge and currently the requirement is that only a government issued identification process would work for the urban poor. Potentially in collaboration with the Election Commission and Banks, this problem could be comprehensively addressed.

34. It is only very recently that some MFI or micro-finance institutions have started functioning in addressing the issue, but banks need to get into the sector more aggressively and see the segment as a business opportunity, which exists just under their nose. Naturally, the strategy of the banks while dealing with the urban poor has to be devised differently compared to other clients in urban areas.

Risk Management Measures in Agriculture
35. We are all aware that farmers in general are exposed to risks arising from various sources eg, credit uncertainty, rainfall variability, market price fluctuations, and that those arising from adoption of new technology. The diversities in the sources of risks require a variety of instruments for protecting the farmers. In India, these include crop insurance, rainfall insurance, farm income insurance and a calamity relief fund. Except for crop insurance, the others are in the experimental stage.
36. To address the issue head-on, a system should be placed in place whereby the small farmers can access the commodity markets and benefit directly from it. Presently this is not possible. Further, the RBI should allow Banks to take positions in the commodity markets and hedge on behalf of the farmers or farmers organisations.
37. Post-liberalization, after the introduction of the international capital adequacy and prudential norms, the perceptions of the bankers towards agriculture suddenly underwent a change. The public sector bankers started perceiving agriculture as a ‘high risk’ business – much of this was due to the high NPA levels. This perception was reflected in bankers shying away from lending to agriculture. Such a policy stance has done more harm to the banking system/bankers because in a developing economy like India, it should be the medium term objective of monetary and credit policies to seek to change the risk profile of the agricultural sector itself; and credit policies should become an important ingredient of the macroeconomic management package designed to eventually change the risk profile of agriculture. Credit - both short term and long term - should be viewed as both growth-enhancing and risk-reducing instrument. A typical example is investment in irrigation.
38. Considering the proportion of our population that still remain ‘excluded’, what has been achieved so far pales into insignificance in comparison to what remains to be done. The formal financial system has to recognise the huge business potential coming from the unmet demand for financial services from those who normally tend to be excluded.
39. The focus on financial inclusion comes from the recognition that financial inclusion has several externalities, which can be exploited to the mutual advantage of those excluded, the banking system and the society at large. Banks need to understand the market and develop products suited to the clientele. They need to develop data sets to evolve risk assessment models for proper rating and pricing. Financial inclusion has to be viewed as a business strategy for growth and banks need to position themselves, accordingly.

Impact of greater financial inclusion
40. To sum up, I have no doubt in my mind that the enhanced financial inclusion will have significant impact on our economy. I have already argued that because of the economy and community-wide, positive spillover effects of financial inclusion, it is a quasi-public good.

41. First and foremost, enhanced financial inclusion will drastically reduce the farmers indebtedness which has been one of the main cause for farmers suicides. The second important benefit is it will lead to more rapid modernization of Indian agriculture. The new agriculture, by nature, needs more working capital and is capital intensive as it depends on improved seeds, fertilizers and other modern inputs and equipments. As the enhanced financial inclusion means better risk management tools for the farmers, they will be encouraged to adopt new technologies at a faster rate. Yet another benefit would be increased growth, as well as more equitable growth both in rural and urban areas as it will mobilize what Prof Prahlad calls the bottom of the Pyramid. By providing greater access to educational loans to all sections of the society, improved financial inclusion will also mean India becoming more equal opportunity nation, a pre-condition for promoting inclusive growth

42. Finally, one of the most important positive impact of promoting financial inclusion would be to promote grass root innovations and entrepreneurship. I am involved with National Innovation Foundation which was set up in the year 2000 to promote grass root innovations. The spirit behind the Foundation is Prof. Anil Gupta of Indian Institute of Management, Ahmedabad. The Foundation encourages, by recognizing and supporting the grass root innovations from farmers, artisans, housewives and students. The Foundation has mapped more than 25,000 grassroot innovations and has so far helped our farmers/innovators to secure growing number of patents including four US patents. One major constraint is in diffusing their technologies i.e. commercialization is the absence of micro-venture capital fund. Here, greater financial inclusion will promote micro venture capital funds and thus reward and mobilize creativity from segments of our society which remain completely untapped.

43. Given the vital importance of the issue, I am confident that in the coming years we are going to see many strides in the reforms of the financial system to make the system more efficient and much more inclusive.

I thank you all for your attention.
[*] I would like to thank Dr. Nachiket Mor of ICICI and Dr. Rajendra Kulkarni of NABARD and his colleagues for their assistance in preparing the lecture.