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Dirty money: Joining the dots

Which of us does not enjoy pulling down the high and mighty? And the thrill is even sharper if these are people who may have breached laws whilst rising to dizzy heights. And so it was with the recent Panama Papers leak which opens a window into the morbid financial gymnastics of the amoral, global elite. There are five hundred Indians also in the list. But no “A” team players have yet been disclosed. Of course there is considerable overlay between unaccounted money and simply “smart” money which is avoiding not evading tax- the former is illegal but the latter – well it is just good financial management. The Panama data leak does not sift out the latter.

The scale of dirty money

cash

photo credit: gizmodo.com

Global Financial Integrity (GFI) – a United States-based entity, which tracks and campaigns against black money – ranks India fourth out of 149 developing countries, after China, Russia and Mexico, on the basis of the volume of illicit outflows. But this metric is fuzzy. It relates outflows to the size of individual economies and consequently fails to reflect the severity of the problem in each country.

Conflating the GFI data on illicit flows with the World Bank data on GDP at current market prices results in a more useful metric. The average annual illicit outflows as a proportion of GDP for India, according to this metric, was 2.7 per cent over the period 2004 to 2013. Within the BRICS countries cluster, South Africa was at a whopping 23 per cent, followed by Russia at 5.6 per cent. Brazil was the lowest at 0.9 per cent, with China the second lowest at 1.8 per cent.

Out of the other large developing economies, illicit outflows out of Malaysia stood at a worrisome 14.1 per cent of GDP, Thailand at 5 per cent, Mexico at 4.5 per cent, Nigeria at 4.1 per cent and Indonesia at 2.1 per cent. In South Asia, Bangladesh is the leader with illicit outflows at 4.2 per cent of GDP, followed by Nepal at 3.1 per cent and Pakistan at a low 0.1 per cent.

Dirty money links

So, how do illicit outflows, tax evasion, corruption and crime link up? Simply put illicit flows legitimize the proceeds of any of these activities. In the hawala transfer route, an individual or entity, resident in India, desiring to transfer dirty money overseas, makes a payment in cash in India to a hawala agent whilst a designated counter-party overseas gets paid in foreign exchange.

The source of the cash in India could be from income on which tax has not been paid or the proceeds of crime, including corruption. The foreign exchange overseas could be similarly sourced from corruption, crime or from Indians remitting money home (remittance of invisibles, including by overseas Indians of their earnings, was around $223 billion in 2013). Remittances through hawala get a better exchange rate than those via bank transfers. Foreign exchange overseas could also be the proceeds from under-invoicing Indian exports with part payment being made by the foreign importer to an overseas account related to the exporter.

Such illegal caches of foreign exchange overseas can be legitimated by bringing them back to India by over-invoicing Indian exports. Such funds can also be masked as foreign portfolio investments from foreign jurisdictions where obscuring the ownership of funds is a fine art, as in Panama. GFI estimates that under and over invoicing of trade flows accounts for 83 per cent of global illicit outflows. Usually a combination of several illicit transfer mechanisms may be used to obscure and mask the direction and ownership of the net flows.

The drivers of dirty money

Crime, corruption and the ability to avoid tax are all the outcome of poor governance aided by low levels of financial intermediation and digitization in the economy. Identifying the real ownership of bank transactions using biometric tracers, reducing cash transactions, embedded red flags and alerts which identify and monitor irrational transactions and sniff out a mismatch between income and consumption or income and savings, are standard tools for clamping down on the extent of black money. But we have started down this path only very recently.

Till the 1990s, when India had a chronically precarious balance of payments, the loss of foreign exchange through illicit transfers was a major concern. Today with foreign reserves at around one year of imports this is less so. But the loss of potential tax revenue hits us hard. Assume the value of tax lost on illicit outflows of $83 billion at a conservative 30 per cent or $24 billion per year. This equals around one-fourth of the average fiscal deficit during the period 2010 to 2013.

Lost tax is just one of the problems associated with dirty money. Other downsides are less tangible. Strong political and business interests get entrenched which obstruct enhanced transparency, the reduction of discretionary administrative powers and systematically subvert the formal governance systems and the informal norms which bind society.

Where this happens over a period of time, societal norms shift towards a new normal which actively subverts the rule of law. Prolonged conflict creates a similar loss of cultural and social capital. Government loses credibility as the provider of security and the arbiter of equity and fairness. Citizens look to informal structures like caste, clan or even professional alliances for social support.

Triangulating the evidence

Can we substantiate this link between poor governance and enhanced illicit outflows? The World Bank’s Worldwide Governance Indicators (WGI) provide a ready index which maps six drivers of good governance across multiple data sources. For our purposes we look at two of these – Rule of Law and Control of Corruption. A close and negative correspondence between illicit outflows and the country WGI score can validate both the WGI and the GFI methodologies. High illicit outflows should correspond with a low WGI score.

The WGI ranks Brazil, Malaysia, South Africa and Thailand high on both upholding the rule of law and exercising control of corruption. India edges in only into the Rule of Law category in this ranking. But good performance in the WGI has not helped Malaysia, South Africa and Thailand curb illicit flows which are high, relative to GDP. In comparison, China and India with lower ratings in the WGI have far lower illicit outflows relative to GDP.

Similarly, Pakistan and Indonesia have minimal illicit outflows relative to GDP but score very low in the WGI index. The bottom line is that either the GFI assessments need to be improved or that good governance- at least as it is measured to day needs to be reviewed.

The trend going forward

GFI estimates that the aggregate outflow of illicit money for the set of 149 countries grew at 6.5 per cent per annum during the period 2004-2013 – more than double the rate of economic growth. This is worrisome because it illustrates a looser than desirable link between growth and tax revenues. If economic growth is leaky and does not boost tax revenues in developing countries, achieving social protection and human development targets can be severely compromised. Is India sliding down this slippery slope?

In India, illicit outflows more than doubled overnight from $29 billion in 2009 to $70 billion in 2010. During the period 2010 to 2013 – the latest year for which data is available – it averaged $83 billion per year or around 4 per cent of GDP. This period coincides with the second term of the United Progressive Alliance government, which was marked by serial scams in telecom and coal. But whilst it is tempting to deduce a causal relationship between the two, this is difficult to substantiate.

pipe

Better tools can help

What we do know is that we need better tools to monitor, in real decision time, the origin, magnitude and direction of illicit outflows, which are a vital red flag for poor governance. Achieving this is closely linked to professionalizing the government and rapidly digitizing the economy and government processes. We are doing far more on the latter, than on the former. This could be a costly and careless error. Till advanced robotics and artificial intelligence kick in sometime around 2030, the effectiveness of government servants will continue to matter

Adapted from the authors article in Swarajyamag April 12, 2016  http://swarajyamag.com/economy/joining-the-dots-on-dirty-money-and-how-india-can-become-clean

Packaging Budget 2015

jaitley face

(photo credit: india.com)

The annual ritual of the government’s budget with allocations of money in billions is just gobbledygook for the average citizen. It is the “tone” of the budget which people tune into first and foremost. What must Finance Minister Jaitley do to get the tone right?

First, clothes make a man, as they do a woman. One hopes that the FM will avoid the intricately embroidered shawls he has shown a preference for through winter. He would do well to wear a tailored, dark “bandh gala” (Nehru jacket), now that he has the figure to flaunt one, perhaps with a low- key, accessorized collar. More importantly, the jacket would set the tone of the budget to follow- non-frivolous; cut to a reduced shape to fit the cloth available; modern with a link to the India’s rich past and prescient of India’s glorious future.

A budget theme

Second, he should depart from the tradition of the FM rambling on, in the early part of the speech, about the state of the economy. This is already adequately covered in the Economic Survey released a day or so earlier. Instead, he could usefully spend this time defining a “budget theme” which he must then follow through in the rest of the budget speech by linking specific allocation and taxes to the overall theme.

This writer suggests the theme of “open economy, markets and poverty reduction”. All three fit nicely with the “growth” expectations unleashed by PM Modi. Also these are the three legs for equitable growth.

Open Economy stance

An “Open Economy” policy stance has been consistently followed since 1991 in external trade. It is just that, India has not benefited as much as our neighbours in East Asia. The fault is clearly ours.

Our governments have not seized opportunities overseas which could be dovetailed with domestic comparative advantage, to make the economy part of global value chains. This becomes vital now if jobs are to be added in India.

The real issue is what must we do next to “open” the economy to competition- domestic and international? Four steps suggest themselves.

First, linking markets physically by a first rate “infrastructure grid”-ports, roads, rail and electricity is key to create a seamless national market.

Second, a digitized “tax grid” linking national, state and local level tax systems can enhance revenues; prune evasion and reduce the aggregate tax burden by avoiding “the pancaking of multiple autarchic taxes”. The ongoing Goods and Services Tax (GST) initiative barely scratches the surface.

Third, aggressively privatizing state owned enterprises, including in arms and ammunition, can provide the required business momentum for competitiveness; assist in reaching fiscal deficit targets and benefit consumers.

Fourth, why not open, hitherto closed, domestic markets in land, legal and media services to foreign investment except where considerations of national security exist.

The FM could signal the second wave of liberalization and reform to follow up on the 1991 wave- external trade reform and industrial delicensing, by (A) tweaking competition thwarting domestic regulations and (B) supporting Indian business to reap the benefits of an open economy internationally.

Living by market logic

The BJP has always enjoyed the trust of business. But their commitment to expand markets and competition is not deeply etched enough. There is a lingering fondness for using and growing, the already vast powers of the State to bypass markets and “fast-track” development in a top- down “Developmental State” mode.

Examples include the loss of focus on privatization of state owned enterprises- partially attempted by the Vajpayee government (2000-04); a growing tendency to use the already iffy balance sheets of public sector companies and banks as leverage for funding “impossible public dreams”. Examples are a larger than feasible or necessary target for horrendously expensive and as yet commercially unviable, renewable energy systems and the development of a hundred SMART cities with even the concept remaining undefined nine months down the road.

Neither of these “public dreams” can be funded by market based finance. Both require huge subsidies, either direct budgetary allocations or indirect like “directed” loans from public sector banks. Bad loans which are artificially rolled over in government banks are, as a proportion of total assets, more than double the proportion in Indian private banks. Government owned businesses and banks need to be made autonomous if they are to survive. RBI should censure banks, which make irresponsible “dream” commitments and SEBI should do the same for listed government companies to protect minority shareholders.

The FM must set the record straight on both fronts. The fiscal constraints on public finance are unlikely to permit massive direct allocations for renewable energy or urbanization. He must further clarify that whilst both goals are laudable they should be achieved through projects, which are technically sound and financeable through market instruments.

Commercial finance for renewable energy and urban development

The FM must point out that renewable energy development, whilst a flag ship project, is hampered by the disincentive of subsidized conventional energy supply. Allowing market prices to prevail for retail energy supply is the first step to making renewable energy financeable.

The World Bank initiated a new program of Green Bonds which tap “specific institutional and retail investors with a yen for green development” internationally. Of the US$37 billion Green Bonds issued in 2014 nearly one half were corporate Bonds. Such debt instruments could also be developed for the US$ 1 Trillion Indian domestic Bond market, 25% of which is corporate debt.

Similarly, realism on urbanization agendas is urgently needed. For orderly urbanization the funds must be found within urban areas by rationalizing property and land tax and raising revenue by leasing government land banks for development to private developers. China successfully unleashed Municipal entrepreneurial energy to finance local development. Using national tax resources for urbanization is a poor use of scarce resources. Cities, which on average are 50% richer than rural India, must finance themselves through user charges, local taxes and monetization of local government resources. There can be no free lunch for a city.

Ending poverty by creating jobs

For starters, the FM could usefully adopt the international metric for defining the very poor as those who earn less than $1.25 per day and the poor as those who earn up to $2 per day. But what is much more important is to share a time bound vision for ending poverty.

The World Bank has set 2030 as the year by when world poverty (per capita income >$1.25 per day) is expected to be reduced to a residual economic and social challenge. India could simply align with this challenging target.

Today, 25% of the 1.2 billion poor people are Indian. Setting 2030 as the target for graduating them out of extreme poverty is aggressive. Even with an 8% annual growth, India could only be where China is today. China took 30 years to end extreme poverty (1985 to 2014). India would do well to achieve the same in 50 years (1980 to 2030)

The international consensus on poverty reduction is that strategies which allocate more resources for human development, livelihoods and private sector employment work best. India has lagged in enhancing budgetary allocations to education and health (including water and sanitation), as compared to any other growth oriented economy. One hopes the FM shall redress the skewed allocation since it affects the poor the most.

Small is still beautiful

If this logic is followed, the small and medium scale manufacturing sector, rather than mega projects, should be the focus for jobs and poverty reduction. This is where manufacturing is the least capital intensive; can use existing infrastructure with some rejigging; is most easily related to agriculture and could more easily grow incrementally as business expands.

We must avoid the trap of subverting the “growth” agenda into glitzy but lazy action points. To grow jobs for the poor it is the small things that count, like removing municipal and police harassment of street vendors; simplifying tax assessment processes and “problem solving” by getting local and state governments in growth mission mode.

The FM must pledge to blur the dualism in “well-being”, between 10% of the workforce in the “large, formal” sector and the 90% in the informal sector. The lot of employees in the informal sector can only be improved by “facilitating” employers to grow their businesses. This will happen only if labour regulations are light handed; permit flexible and fair employment practices and adopt a sequenced, incremental strategy for improvement in labour welfare supported by adequate public fiscal support for social protection.

Poverty and jobs filter for budget allocations

Applying a “poverty and jobs filter” to the budget allocations could be an innovative way to present the inter-se allocations across sectors and relate them to the budget theme. This would also discipline government departments to relate their work to the objective of private sector jobs and poverty reduction.

There are many ways of packaging a budget speech which very few actually read though more may hear it through. It should therefore be written for this audience and not the specialist, who will anyway delve between the lines. Best to outline the inflection points in Indian public finance history the budget seeks to create and leave the rest to the TV channels.

1558 words

Skills Development: putting the cart before the horse?

Jobs

(photo credit: the hindu.com)

It is curious that we learn nothing from experience. The World Bank, sundry bilateral and multilateral donors spent 10% of their funds during the 1990’s on developing generalized skills (also known loosely as capacity development) in developing countries before junking the program, because results were difficult to attribute to inputs and “value for money” difficult to assess.

The lessons drawn from international experience are: First, that skills development is best integrated into the system of education and not treated as an end-of-pipe intervention. Second, end-of-the-pipe skills development has to be linked to the jobs available and, from a “value for money” perspective, is best done on-the-job.

The UPA government, in its typically muddled manner, whilst looking for ways to explain away poor growth, picked on “skills deficit” in India as a key constraint for growth. Industry immediately applauded the initiative, sensing that public resources were likely to be spent on a task, they should rightly be doing themselves.

Putting skills before jobs is a strange priority for a country which exports skills, across the value chain and which could export more, if only there were no visa constraints imposed by developed markets, where these skills are in demand.

Why would skilled Indians seek to work overseas if there were sufficient opportunities at home? The fact is that there are none. Today you can hire a skilled carpenter or a plumber for Rs 800 (US$ 13) per day in any of the Indian Metros. You can get a computer literate, office assistant for as little as Rs 10,000 (US$ 160) per month. Graduates, without permanent jobs, subsist on temporary employment at Rs 7000 per month. The entry level monthly salary for engineers is Rs 20,000 (US$320).

The problem is not a skills deficit. The problem is the lack of jobs. We generate only 10% of the 10 million jobs we should create incrementally every year in addition to employment at 163 million in the informal and 32 million in the formal sector. The Union Government should concentrate on enhancing growth with jobs. The downstream activity of skills development should be integrated into our education system and is best left to the private sector for short-term end of the pipe solutions. It is a task the private sector has managed very well thus far.

The IT sector explosion of the 1990s did not happen because there was already a large pool of jobless IT specialists sitting around in India, waiting for jobs. It happened because savvy IT entrepreneurs spotted a business opportunity to provide back-end services. They leveraged the low wage expectations in India to grow an export oriented service industry. Licensing liberalization for satellite links helped create the necessary telecommunication channels. The IT industry initially employed scores of specialists who incubated raw skills and trained them on-the-job.

When Suzuki (Maruti) started operations in India, in the 1990s, it did exactly the same, to create the technical skills needed to change over from the 1940s automobile technology peddled till then by the Birlas (Ambassador) and the Walchand group (Premier Padmini). Licensing liberalization in automobile manufacture created competition for the two incumbents from SUZUKI-MARUTI, which in turn upgraded and re-skilled Indian technicians to meet the needs of a modern automobile plant. The rest is history.

Only industry and business know the skills they need and how best to shape them to enhance value-on-the-job. Government intervention to finance such initiatives or (horror of horrors) plan for where, what and when training is to happen, can only be an unmitigated disaster and a complete waste of money.

Industry will argue that skill development is a public good; that individual companies have no incentive to train employees because they can get poached by others. This is nothing but griping. Skill development is what industry association like CII, FICCI, ASSOCHAM and their regional offshoots should be doing using pooled industry resources. This is their natural role just as much as lobbying for industry.

The gold standard in skill development is the apprenticeship system in Germany. Next time the PM transits through Frankfurt, he should take time out, after meeting Ms., Merkel, to review the difference between what we are planning to do and what Germany does. It is not for nothing that German engineering skills are the best.

We don’t need a separate Union Ministry for Skills Development or for Entrepreneurship. The Ministry of Human Resource Development or even the Ministry of Labour and Employment, are the natural homes for this function.

The Peter Principle operates strongly in public institutions. Work expands to fit the resources available. Often, the result is unnecessary, heavy handed, inefficient, intrusive regulation, of the kind the University Grants Commission demonstrated recently, with respect to the Delhi University and the IITs.  More ministries means more problems.

What we need to fix, is the system of education. Skills come in an extended value chain ranging from basic life skills, needed by everyone to be a productive part of society, to the highly specialized skills needed to land on Mars. Skills need to be integrated seamlessly into our system of education. Skills must not be developed piece meal. Doing so is expensive and has a very high failure rate.

We need to do away with the “paper chase” for degrees which has resulted in a proliferation of tertiary education institutions run more like “businesses” than schools. We need to focus far less on academic knowledge and significantly more on experience and practical learning.

Most “educated” Indians do not keep a set of home tools. The reason is they do not know how to use them. The average “educated” Indian cannot fix a broken chair; repair a blown fuse; darn underwear; knit a cap; polish shoes; iron clothes or clean the toilet to leave it sparkling. The only skills we value are the ones which involve sitting on an office table and barking orders at inferiors.

Our education system assumes that every child who joins primary school is going to be a top flight scientist. This leaves learning room only for the obviously brilliant students and immediately sidelines those who are late starters and even those who have limited ambitions in academics. This is the least inclusive and the least effective way to teach kids to explore and develop their individual comparative advantage. It also does very little for encouraging “innovation” which is the key to growth.

Public resources are scarce. They should be used to leverage private resources for creating jobs and enhancing growth. Focusing on skills, well before we have a strategy for creating productive, skilled jobs is putting the cart before the horse.

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