#211 Of Motives and Presumptions

India Policy Watch #1: Silly Season Is Upon Us

Insights on issues relevant to India

— RSJ

Late on Friday this week, the RBI issued a circular withdrawing the circulation of ₹2000 denomination banknotes. The RBI clarified that these notes would continue to serve as legal tender, so this isn’t another demonetisation. Here’s the Indian Express reporting:

THE RESERVE Bank of India (RBI) Friday announced the withdrawal of its highest value currency note, Rs 2,000, from circulation, adding that the notes will continue to be legal tender. It said the existing Rs 2,000 notes can be deposited or exchanged in banks until September 30, but set a limit of “Rs 20,000 at a time”.

“In order to ensure operational convenience and to avoid disruption of regular activities of bank branches, exchange of Rs 2,000 banknotes can be made up to a limit of Rs 20,000 at a time, at any bank starting from May 23,” it said.

“To complete the exercise in a time-bound manner and to provide adequate time to the members of the public, all banks shall provide deposit and/ or exchange facility for Rs 2,000 banknotes until September 30, 2023,” the RBI said.

The RBI circular and the press note also attempt to make a convincing, logical case for this decision. There appear to be three reasons for doing this.

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One, the ₹2000 denomination notes seem to have served their useful purpose. They were introduced in November 2016 when the legal tender status of existing ₹500 and ₹1000 banknotes in circulation were withdrawn. Looking back, it appears these were introduced to help re-monetise the economy really quickly, which was under the stress of not having adequate new legal tender banknotes. According to the RBI, after this task of re-monetising was completed, the printing of new ₹2000 banknotes was stopped in 2018-19. Therefore, after 5 years of not printing any new notes, this looks like the right time to take them out of circulation completely.

Two, since most of the ₹2000 denomination notes were issued prior to 2017, they have apparently completed the typical lifespan of a banknote which is between 4-5 years. In an ideal system, most of these old notes should have come back to the RBI by now. Further, these notes are not seen to be used for transactions anymore. They seem to be just sitting somewhere out there. So, in pursuance of the ‘clean note policy’, the best course of action is to withdraw them from circulation. 

Lastly, there was also an allusion to the ₹2000 notes being often found by various investigative agencies in their haul of black money or frauds. So, somewhere there is a view that withdrawing these notes would smoke these fraudsters out, who are sitting on piles of this unaccounted-for cash.

Now, as students of public policy, we must assess this measure based on its intended objectives, the likely costs of doing it and the unintended consequences that are likely to arise. The first reason—that the ₹2000 banknotes have served their purpose, so it is time we take them out—can be scrutinised further.

I don’t think it was made clear when they were introduced back in November 2016 that the only reason for doing it was to re-monetise the economy quickly. There’s a bit of retrofitting of logic here. Also, the decision to stop printing new ₹2000 notes in 2018-19 has meant the total circulation of these notes has been on a decline. In the last four years, the total value of the ₹2000 notes in circulation has gone down from ₹6.5 trillion (over 30 per cent of notes in circulation by value) to about ₹3.6 trillion (about 10 per cent of total circulation by value). I guess, left to itself, we might have had this number slide to a smaller number, say below, ₹1 trillion in the next 3 years. The same point is relevant for the ‘clean note policy’ since these notes would have eventually come back if they were not being used for transactions and were already at the end of their lifetime. So, the question is, did we need to accelerate something that would have followed a natural path to the policy objective that’s desired? Would another three years of these notes in circulation have been detrimental to some policy objective? It is not clear. What’s clear is there will be another season of ordinary citizens queuing up in front of bank branches that will begin on Monday.

It might be argued that there won’t be any panic because the regulator has made it clear that these notes will continue to be legal tender. But who will receive these notes for any transactions starting today? These notes are as good as useless, and for anyone who uses them for transactions or has stored them for any legal purpose, the only way is to get them exchanged for those notes that are both legal and usable. There’s always a sense of schadenfreude among the middle class that it is the rich who will suffer. As was seen during the demonetisation exercise, the poor suffer equally, if not more. The cost of the logistics of sending all ₹2000 notes back from ATMs and branches to the RBI, replacing them with notes of other denominations, the extra hours spent by people exchanging their notes in batches of ₹20,000 and the additional measures to be taken to check for the provenance of the money that will come into the banking system and the risk of frauds during this process are all additional costs to the system. There should be a more compelling upside to these costs except to argue that these notes have served their purpose.

Lastly, on high denomination notes abetting corruption and fraud, there’s some data from experiences in other countries that suggest this. However, experience in India has shown after the initial ‘disruption’, the system finds a new equilibrium, and things continue as usual. The idea that demonetisation would aid the digital economy and will bring down cash in circulation was compelling at that time. But as seen, over time, cash in the economy continued to rise despite a significant ramp-up in digital transactions, which might have happened anyway because of UPI. There are more fundamental reasons for corruption that need to be addressed than making a case for smaller denomination notes. Anyway, the corruption argument never gets old in India, where everyone assumes that, barring them, everyone else around is corrupt. So, the usual arguments have started surfacing on social media that this will impact a small minority of people, and they anyway need to answer why they were hoarding these high denomination notes. And, there’s the political masterstroke argument which suggests this will derail the fundraising ability of the opposition in this election year. I’m not sure if that’s supported by data because we had the unusual scenario of almost 100 per cent of the invalidated denomination notes during demonetisation eventually returning to the RBI. Nobody was wiser when that happened. The only upside at the end of this exercise will possibly be with banks that will have a temporary increase in their deposits. The scramble for deposits that was on because of shrinking liquidity will abate for some time. That will possibly help them support loan growth that was dependent on deposit mobilisation. That might not be a bad outcome, but it is a torturous way to get there. But then we like convolutions.

In parallel, there was another interesting piece of policy-making going on. The TCS (tax collected at source) on international credit card spending outside of India. Earlier during the week, reports emerged that all such spends will now attract a TCS of 20 per cent which can then be recovered by individuals at the time of filing their annual return. The Indian Express on Tuesday reported:

THE CENTRAL Government, in consultation with the Reserve Bank of India, in a late night notification Tuesday amended rules under the Foreign Exchange Management Act, bringing in international credit card spends outside India under the Liberalised Remittance Scheme (LRS). As a consequence, the spending by international credit cards will also attract a higher rate of Tax Collected at Source (TCS) at 20 per cent effective July 1.

The notification brings transactions through credit cards outside India under the ambit of the LRS with immediate effect, which enables the higher levy of TCS, as announced in the Budget for 2022-23, from July 1. This is expected to help track high-value overseas transactions and will not apply on the payments for purchase of foreign goods/services from India.

Prior to this, the usage of an international credit card to make payments towards meeting expenses during a trip abroad was not covered under the LRS. The spendings through international credit cards were excluded from LRS by way of Rule 7 of the Foreign Exchange Management (Current Account Transaction) Rules, 2000. With the latest notification, Rule 7 has now been omitted, paving way for the inclusion of such spendings under LRS.

Now, what could be the reason for this? The Chief Economic Advisor in a column in the Indian Express gave an insight into the thinking:

It is a fact that remittances under LRS have increased multi-fold in the last few years, and as per data published by the Reserve Bank of India (RBI), LRS remittances which were Rs 0.9 trillion in FY2019, crossed Rs 2 trillion in FY2023. During FY2023, an interesting trend was noticed in the remittances for deposits, purchase of immovable property, investment in equity/debt, gifts/donations and travel. Remittances under these heads constituted almost 70 per cent of the total, representing a year-on-year growth of 74 per cent. Foreign travel alone was almost Rs 1.1 trillion in FY2023, a three-fold increase from the pre-Covid period. In all of these, payments made through credit cards are not reflected as such payments were not subject to the LRS limit. This is an anomaly that needed to be fixed anyway.

We are back to the old Indian argument. There are people who are spending money on their credit cards abroad that’s not captured in the LRS limit. We need to know who these people are and what is the amount they are spending. That’s fair. It is an information problem that needs to be solved. Find out who are the people spending this and add it back to their LRS eligibility. Better still, increase the LRS limit so that people can spend more freely. We aren’t in the 70s that we need to conserve foreign exchange through means that make the lives of ordinary citizens difficult. Why should a tax be applied to an information problem? And it is conceptually fine to say that this tax amount is only deposited with the government during the transaction and can be recovered at the time of filing the annual return. But there are way too many complications at an operational level, including upfront working capital costs.

The challenge of tracking international spending, separating corporate and individual purchases and optimising for the overall LRS limit, especially if people have kids studying abroad, will burden individuals. For card companies, it will mean helping customers track this, figuring out all sorts of exception scenarios when a customer cancels a foreign transaction on which a TCS has already been paid or where they default on payment but the card company has already deposited the TCS with the government. Instead of simplifying the tax structure and remittances, the attempt is to complicate things to catch hold of a few exceptions. And those who claim this impacts only 7 per cent of people who have a passport, I can only say why inconvenience even 1 per cent of citizens if there’s no compelling motive. 

Thankfully, some sense seems to have prevailed, and we had a clarification from the finance ministry on Friday. The ministry clarified:

Concerns have been raised about the applicability of Tax Collection at Source (TCS) to small transactions under the Liberalized Remittance Scheme (LRS) from July 1, 2023. To avoid any procedural ambiguity, it has been decided that any payments by an individual using their international Debit or Credit cards up to Rs 7 lakh per financial year will be excluded from the LRS limits and hence, will not attract any TCS.

Small mercies. But it still doesn’t fully do away with an unnecessary measure. 

India Policy Watch #2: Technological Learning is a Marathon, Not a Sprint

Insights on issues relevant to India

— Pranay Kotasthane

Electronics manufacturing is a hot topic nowadays, as it is being seen as a lead indicator of India’s improving manufacturing prowess. Not a week goes by without reports on this topic, ranging from the mobile exports clocked every quarter and the difficulties encountered by companies in localising production to the uptake of the Production-linked Incentives (PLI) scheme to encourage production.

Broadly speaking, the analyses can be classified into two simple categories: detractive (“hum se naa ho paayega” type) and presumptuous (“Hum jahan khade ho jaate hain line wahi se shuru hoti hain” type). I contend that both kinds of analyses make a common mistake: they don’t appreciate a concept of called technological learning. This leads them to reach similar conclusions, albeit through different perspectives.

Dodgson, a scholar of innovation, defines technological learning as “the ways firms build and supplement their knowledge-bases about technologies, products and processes, and develop and improve the use of the broad skills of their workforces”. The assumption is that firms build additional capabilities over time as and when they keep getting better at doing relatively simpler tasks, projects, and processes.

The detractors of India’s nascent electronics manufacturing are quick to point out that Indian manufacturers’ high failure rates are a clear indication that India cannot do large-scale manufacturing. For instance, the news report that iPhone casings produced at Tata’s Hosur plant had a 50 per cent failure rate, has become an oft-cited datapoint to downplay India’s manufacturing capabilities. While such critiques should not be dismissed lightly, it’s also important not to overreact. Electronics manufacturing in China faced pretty much the same challenges; in fact, Chinese manufacturers had far lower yields in the initial phases. Technological learning and upgradation happen over time; it is unrealistic to expect immediate success in this field.

On the other hand, fervent supporters believe that the Indian government can boost manufacturing output and export competitiveness merely by implementing industrial policies and import substitution measures. In this model, PLI schemes, higher import tariffs, and infant industry protection are necessary and sufficient conditions for building India’s electronics manufacturing sector. This line of thinking also ignores technological learning. Indian firms will have to begin with the assembly of imported components necessarily. In fact, we should be willing to digest a decrease in the domestic value added per unit of demand over the next few years, as was the case in China and Viet Nam. As Indian manufacturing achieves global scale, local content addition will increase by default, as firms seek to optimise costs, and employees go on to become local entrepreneurs. The hurry to localise domestic value addition runs at odds with exporting competitiveness, a point that the self-assured are ignoring.

And so, both viewpoints are misguided due to their disregard for the role of technological learning in manufacturing development. It is crucial to acknowledge that gaining proficiency in manufacturing takes time.

Naushad Forbes Business Standard article explains this process of learning took place in East Asia:

Firms like Samsung, Hyundai, LG, TSMC and Acer did not start as global brands. They began with outsourcing, as original equipment manufacturers or OEMs, building manufacturing operations of global scale. They used their demanding buyers as a source of technology that made them world-competitive. But they did not stop there. They invested in R&D, as process innovation, to make manufacturing more efficient. They then offered their buyers products with new and improved design, moving up the scale to own design and manufacture or ODM, claiming a piece of the innovation rents that came from better products.  This required them to invest in substantial product design capabilities, which over time completely outclassed and replaced the design capabilities of their buyers. And, finally, with world-competitive manufacturing and leading-edge product design in place, they made the shift to own brand manufacture or OBM, launching their own brands, going beyond their home market, spreading step by step into the world. This is the story of Samsung in microwaves and semiconductors, LG in TV sets, Hyundai in cars and excavators, TSMC in microprocessors, and Acer in laptops. This OEM to ODM to OBM story is one of continuous learning.

It’s crucial to bring technological learning back in conversations on India’s manufacturing.

P.S.: Earlier this week, the government announced another PLI scheme for "laptops, tablets, all-in-one PCs, servers etc.", with a budgetary outlay of ₹17000 crores over six years. If the government appreciated technological learning, it would accompany this PLI with a reduction in customs duties. Competitive exports need competitive imports of intermediate components and equipment.

Matsyanyaaya: Launch India-US Trade into Another Orbit

Big fish eating small fish = Foreign Policy in action

— Pranay Kotasthane

Ahead of the Indian PM’s visit to the US next month, some of us at Takshashila propose an ambitious agenda on the trade front in this document—increase bilateral trade to $500 billion by 2030 and $1 Trillion by 2040.

Here’re the pathways to achieve this goal:

* Expand the existing US-India 2+28 ministerial dialogue: This dialogue currently comprises the Foreign and Defence ministers from both countries. However, to comprehensively address the intricacies of global trade relations, it would be beneficial to transition to a 3+3 format to include both nations' trade and commerce representatives.

* Capitalize on the role of states: The economic landscape in India is witnessing a shift towards the states. Various factors that significantly influence business operations, such as land acquisition and law and order, predominantly lie under the jurisdiction of individual states. Owing to India's vast size and diverse nature, different states have fostered their unique strengths and advantages. The trade relations between the two nations can be further enhanced through a partnership where groups of states engage in reciprocal visits each year, bolstering trade ties and fostering mutual growth.

* The Trade Policy Forum (TPF) must be held every year. It is the right cadence to ensure disciplined action and follow-through on ambitious goals. The institutional memory of the TPF will work to create continuity. The old adage "we overestimate what can be done in one year and underestimate what can be done in 5 or 10 years" is particularly applicable here.

* The organic growth in trade between companies on either side needs only the occasional enablement. Trade in technology services, pharmaceuticals, SaaS, industrial goods and many other sectors can continue. It will benefit from forums like the US-India Business Council (USIBC) that seek to remove frictions in the ordinary conduct of business and shine a light on some sticky areas.

* Create plurilateral trade partnerships. Until now, the US and India do not together find themselves in any regional trade partnership. The revived QUAD, with a heavy security focus, will be one such partnership with significant trade implications. The Indo-Pacific Economic Framework (IPEF) proposed this summer is a promising way to advance on a partnership, but the partnership details must be worked out. For the greater good, India and the US will have to work out sticking points in the data & privacy sections of the agreement. There appears to be significant mutual concurrence on tax, anti-corruption and clean energy, the other three pillars of the IPEF agreement.

* Trade in high-technology sectors would get a fillip from the two governments setting up specific framework agreements. The new US-India initiative on Critical and Emerging Technologies (iCET) is an example of a framework agreement that could kickstart interaction between government, industry and academia in areas such as artificial intelligence (AI), semiconductors, 5G/6G telecommunications, quantum computing, biotech, deep ocean and space technologies.

* In commercial and societal terms, the exchange of people will be the biggest binding factor between the two countries. In the short term, reciprocal visa access and availability should be addressed on a priority basis. In the longer term, both sides should work on Indians being separated from the general pool of "H1" applicants and in a category of their own. Additionally, the thresholds for each country employing citizens of the other should be brought down gradually.

[From Narayan Ramachandran et al., “Time to Launch the US-India Trade Relationship into Another Orbit,” Takshashila Policy Advisory 2023-02]

HomeWork

Reading and listening recommendations on public policy matters

* [Article] Anupam Manur on the ₹2,000 note withdrawal in Moneycontrol — “Like a nightmare resulting from a traumatic experience for a person suffering from PTSD, demonetisation came back to haunt the collective consciousness of this country when the Reserve Bank of India (RBI) decided to recall the 2000 rupee note.”

* [Podcast] In the next Puliyabaazi, Devashish Dhar talks about cities, urbanisation, working in government, etc. Strongly recommend it to people considering public policy as a career option.

* [Articles 1, 2, & 3] Naushad Forbes’ series on private R&D and national innovation in Business Standard is a must-read for those interested in technology geopolitics and tech policy.

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