Sunk Costs: In War and Peace and Markets

Defenders of Berlin were jolted into motion as a terrible thunder shook everything around on a cold, wet winter morning. At 3 am on 16th April, 1945 the Soviet army had started a barrage of bombardment at Nazi Germany’s final fortifications at Seelow Heights with heavy artillery, in the final assault on Hitler’s Wehrmacht – the German army –  in what came to be known as the battle of Berlin towards the end of World War II. It ended up as one of bloodiest battles in history with more than half a million casualties. It was also a battle where the outcome was largely known beforehand. Even before the battle began, the Wehrmacht, or what was left of it after six years of debilitating war, did not stand any chance in the face of the fierce Soviet war machinery and the red army’s vast superiority in men and resources. Any other conclusion to the WWII would not have seemed plausible that morning to even the staunchest of Nazis.

Then what would have made the Wehrmacht agree to fight a battle that was lost at best, and to take the risk of massive casualties, instead of laying down the arms? More surprisingly why would the German civilians have participated in the defense of Berlin even if it increased the risk of gory retribution at the hands of the red army after the battle?

Fast forward to more recent past. A friend (‘ A’) received a free pass for a play for which another friend (‘ B’) had purchased a ticket for Rs 1,600 for the same show. Unfortunately it turned out to be a rainy day with incessant rains and water logging. ‘ A ‘ decided not to go for the play considering the risks involved in venturing out. However ‘ B ‘ said he would brave the rains and flooded roads, and attempt to drive to the theatre.

Now, what would have led to the difference in behaviors of ‘A’ and ‘B’?

Genesis: Past is present

Both the above instances are examples of sunk cost fallacy. The Germans and ‘B’ – both ignored the economic maxim of sunk costs. As per economic theory, the price paid should not affect our choice since it has already been paid. It cannot be returned and hence is sunk cost. The rational decision for Germany would have been ceasefire- forgetting the lives and resources lost in the war till then, to prevent further destruction of the country and to limit atrocities on civilians that often follow a bloody end to a hard fought battle. For ‘ B’ the rational choice would have been to stay at home – forgetting the money gone towards purchasing the ticket, to avoid any accident or illness that was possible in stepping out on a rainy day.

Such decision points are encountered quite often – continuing to hold a stock with poor prospects, sad marriage, rudderless project at a company, bad job, bleak research project, continuing to wear badly fitting shoes. Sunk cost fallacy hinders rational decision making in such situations and causes unfavorable outcomes. For econs – the rational humans – sunk costs do not matter and they rightly treat sunk costs as irrelevant and hence are able to take better decisions. For normal humans however, sunk costs last longer in mind.

So, why do people think that continuing with a course of action is worth it instead of cutting losses?  Typically when we humans make a purchase at a price that does not produce any transactional utility (i.e. utility of the product, minus what we expect to pay) we do not feel the purchase price as a loss. We have paid some money and are hoping to get the pleasure of acquisition utility ( i.e. utility of the product, minus the opportunity cost) when we consume the product, so that mental account will be cleared. The earlier cost of purchase is wiped out by the later gain in our mental account at the time of consumption.

However what happens when we buy the ticket and skip the event? Paying 1,600 for a ticket for a play that one doesn’t attend feels like losing 1,600. In this case we are forced to “recognize the loss” in the mental books that we are keeping. On the other hand, the more we use something that we have paid for, the better we feel about the transaction.

To put it another way, we tend to view the price paid for a product as an investment (instead of sunk cost) and hence continue to consume it without considering the incremental cost involved. Example – time sharing vacation, membership fee at a club or a shopping chain etc.
In equity markets: Selling the flowers, keeping the thorns?

This afflicts equity investors in a related way – the disposition affect, a form of sunk cost. When there is need of cash, the investor has to decide on which stock’s holding should be trimmed. The untrained human mind often forces a decision on the basis of stocks’ trailing performance. As a result stocks that have performed well so far are the ones that tend to be sold. This helps in closing our mental account in the positive zone. It adds to our sense of self esteem, and of our expertise as an investor. Obviously this process is flawed. The stock to be sold should be decided on the basis of relative prospects -as visible at that point in time.

How to avoid: Look ahead in life

To avoid sunk cost fallacy an active, engaged and disciplined mind is required in the situation. One needs to consider the counter-factual possibilities to think like an econ. Would Germany have fought such a one sided battle with such high risks to civilian areas in the beginning of the war in 1939 – when the WWII had begun, instead of in 1945? Would  ‘ B ‘ have braved rains if he had received the tickets free of cost? Would a CEO have continued to invest in a mining project facing insurmountable environmental hurdles if he had not pumped in Rs 100 crore in it till the decision point? The key is to close mental account when the cost is incurred, and to look at future prospects instead of keeping the past alive.

The Plight of the Forecasters

Yet again the Indian Meteorological Department (IMD) has confessed– that its forecast (6% above LPA – Long Period Average) of above average monsoon in India may not be met. Understandably this will again fuel a debate on the utility of weather forecasts given the frequency with which IMD and other agencies are unable to call important weather developments like cyclone, rainfall pattern, intensity and duration of heatwave/coldwave etc.

Now, we all make forecasts – in selecting a career path, deciding on a life partner, buying a house, making an investment, relocating to some other city etc. We take these decisions based on our expectations, i.e forecasts, regarding the future.

On the other hand there are bigger developments, relevant for the society on the whole, like capital market movements, elections, diplomatic events, outbreak of a disease, weather patterns etc where experts seem better placed to give advance notice so that the general population is better prepared for that development.

Forecast and folly

Not surprisingly we come across experts who dish out forecasts on every topic under the Sun via various media channels on a daily basis. However if one thinks of forecasts – on weather, stock markets, elections, war etc- one realizes that most experts are woefully short of expectations. Not surprisingly, in his research on this topic over a twenty year period the Wharton professor Philip Tetlock found that an average expert did little better than blind guesses on many political and economic forecasts.

Poor quality of forecasting is to some extent caused by low demand – by consumers of forecasts- for evidence of precision. When there is no measurement metric to test the accuracy of forecasts in stock prices or in election results the forecaster does not have enough incentive to revise his forecast after further focused work. Interestingly, consumers of forecasts are often attracted just by the conviction of the forecaster and the attractiveness of the story. Unfortunately, compelling story and conviction are poor indicators of forecast quality. Apart from this, forecasts are also marred by overconfidence, single directional approach, excess optimism etc.

Ten Commandments for aspiring superforecasters

Ability to forecast is an art (and science) that can be developed by deep, deliberative practice. So what should forecasters do to develop this ability? Philip Tetlock, in his book ” Superforecasting: The Art and Science of Prediction ” has laid this out succinctly.

  1. Triage – Don’t waste time on too easy or impenetrable questions. Here two basic errors could be either the failure to predict the predictable, or time wastage in trying to predict the unpredictable.
  2. Break seemingly intractable problems into tractable sub-problems – Remarkably good probability estimates often arise from remarkably crude assumptions and guesstimates.
  3. Strike the right balance between inside and outside views – Superforecasters know that there is nothing new under the Sun. Nothing is 100% unique. They use this fact to pose outside view questions – how often do things of this sort happen in situations of this sort? Inside view evidence, which is more detailed and direct, has to be super imposed after this.
  4. Strike the right balance in under and over reacting to evidence – Savvy forecasters learn to ferret out telltale views before others. They snoop for non obvious lead indicators and tend to be incremental belief updaters. At the same time Super forecasters also know how to move their probability estimates fast in response to diagnostic signals. Thus a good forecaster must be good at making small, measured revisions but has to be prepared to make large or even directional changes to his forecasts if new evidence requires so.
  5. Look for the clashing casual forces at work in each problem – For every good argument there is typically a counter argument that is at least worth acknowledging. Synthesis of various viewpoints is important.
  6. Strive to distinguish as many degrees of doubt as the problem permits – The more degrees of uncertainty one can distinguish the better forecaster one is likely to be. Translating vague hunches into numeric probabilities can be developed as a habit with patience and practice.
  7. Strike the right balance between over and under confidence, between prudence and decisiveness – Good forecasters routinely manage trade-offs between the need to take decisive stands and the need to qualify their stands. Long term accuracy requires getting good scores on both calibrations as well as resolution – which requires moving beyond blame game. Good forecasters have to find creating ways to tame down both types of forecasting errors – misses, as well as false alarms.
  8. Look for the errors behind your mistakes but beware of hindsight bias – Don’t justify or look for excuses for your failures. Own them. Conduct post mortems – even for successes. Don’t learn too little or too much from your mistakes. Not all successes imply that the reasoning was right. It’s important to get the process right.
  9. Bring out the best in others and let others bring out the best in you
  10. Master the error – Just like one can’t learn riding a bicycle by reading a physics book one can’t become a good forecaster by reading training manuals.
  11. Don’t treat commandments as commandments – Two cases are never exactly the same. So be prepared to modify ground rules as per the situation.

On the monsoon forecasts 2016

Weather is one of the more difficult things to forecast. Especially, as we go farther out into future forecast quality deteriorates. Interestingly, weathermen are amongst the most humble forecasters – more so versus stock market experts or political analysts, perhaps due to the ease of measurability of their forecasts. They are quick to admit mistakes and perhaps that explains the meaningful improvement in quality of weather forecasts over last 3-4 decades. Finally, in this instance even if monsoon turns out to be 4-5% lower than LPA it won’t harm the prospects  of Indian economy much since a) 80% area in India is receiving normal rainfall and , b) Kharif sowing has already been done satisfactorily.

Paul Pogba, BHEL and Stock Markets

One of the most promising midfielders in contemporary world football Paul Pogba was recently signed by English power house Manchester United from Juventus for a world record fee of GBP 94m. Considering Pogba’s age, ( still 22 years – and he has been playing top level football for last four years) and achievements in Italy’s Serie A it would not have been difficult to ignore his underwhelming performance for France in the recently held UEFA European Cup. Not surprisingly two other top clubs – Real Madrid and Barcelona too were said to be in pursuit. Except for some raised eye brows not many pointers have come up regarding the transfer price of this fine young player.

However even amid the jubilations in Manchester there are some facts that should raise a red flag – outgo on Pogba is almost 25% of ManU’s annual revenues, Pogba is an amazing player but he is still a work- in- progress even if he is to become the next Zidane or Scholes, despite his high work rate he can’t lead the midfield that one would expect from a player who costs 93 m GBP. Most importantly he is not in the league of Messi or Ronaldo (or even, Neymar). Given his style and position preference he will also never be a Xavi, Pirlo or Iniesta. Since he won’t score too many goals – not being a forward- he won’t even get the occasionally exalted status provided to Bale.

Thus, the biggest problem in this transaction is that ManU system – that has been of late starved of the laurels that it was so used to in the Ferguson era – will have little patience with such an expensive player if their trophy drought continues for another year. Already, the ManU hierarchy will be cognizant of the dichotomy between their fans’ – big exponents of open and attacking football- expectations, and the dour style of their new manager Jose Mourinho. Eight ten-twelve weeks of sub- par performance in the English Premier League – and knives will be out at ManU.

It’s not just Paul Pogba

What would have gone on in the minds of ManU decision makers when they agreed to pay such a hefty fee? Indeed similar situations often occur in stock markets too. How does one justify the 4x appreciation in BHEL stock in 2006 and 2007 (followed by a decline of almost 70% in the ensuing four years)?

These are (although to be fair, Pogba’s case is yet to be settled depending on his performance in the coming years) cases of economic misbehavior – deviation from a rational approach.

Decision making with a rational approach

A stock that keeps going up like crazy, or a very high bid in an auction scenario are often explained by behavioral scientists along the following lines. These also happen to be the emotional pitfalls that we need to be aware of, and avert, to prevent bad decisions.

  • Overconfidence in our ability – Generally we tend to overestimate our ability to discriminate between potential of two players or stocks. Here it is important to challenge our inclination with a barrage of counter arguments.
  • Tendency to make extreme forecasts – Decision makers very often are prone to this fallacy especially once they have made up their mind. Isn’t it common to come across statements like “this guy will be the next Messi” or ” this stock is a five bagger”? Just looking at history can provide a nice base level – how many players of Messi’s caliber have emerged in recent times, or how many five baggers have come up in last ten years?
  • False consensus – If we like some stock we start thinking that the stock is being chased by others too. This prompts us to quickly make the purchase to prevent others from bypassing us in the queue. This is especially pertinent for private equity transactions. Here the key is to evade the urge to act early. Also, taking into account all the existing information and analyzing them properly can aid an independent stance that may not need the consensus’ seal of approval.
  • Winner’s curse – When many bidders compete for the same object (or player, or stock) the winner of the auction is often the person who most overvalues the object. In many cases the object will be quite good but not as good as the person winning it thinks. Taking a deep breath and softening one’s ego is perhaps the only way to avoid wining in an aggressive auction.

Coming back to Pogba – one really hopes that he succeeds at one of the most demanding clubs in the world. With solid technical abilities, imposing physical presence and tremendous work ethics he is one of the next big hopes of global football especially for the post -Messi and Ronaldo era although the high hopes of Manchester United may not be easy to meet.

Divestment: Don’t quibble over quarters and eighths

In last ten years India’s governments in their urge to time the stake sale in PSU companies missed opportunities and ended up with abysmal receipts from divestment. Stock market returns on BSE PSU index over last 10 years( till June’16) have been a paltry 4% per annum versus 11% p.a. for the Sensex suggesting that attempts to maximize stake sale proceeds haven’t yielded desired effect over long term. Had the government sold off its stakes in these public sector companies in 2006 and invested the proceeds passively in the BSE Sensex it would have been better off by a massive Rs 750,000 crore in 2016. Of course, it is not just the implementation process but the focus and intent too that have been lacking. However if divestment is pursued with vigor in next two years it can still throw up the much required capital that the government will need for banks’ recapitalization and for improvement in education, health and infrastructure facilities.

Government’s business to run businesses?

It is remarkable that even twenty five years after liberalization India’s government is so circumspect in getting out of the business of running businesses ranging from mining, power and shipping, to airline and telecom. In fact this is one area where the current government has not even attempted to break from the past and hence this largely seems like a continuum from earlier regimes.

Question of positioning

To a large extent, poor record on divestment is rooted in both – formulation as well as implementation. Firstly, governments in the past have failed to build political consensus- perhaps due to lack of focus- on need and potential benefits of divestment. Secondly, divestment has largely been seen just as a way to bridge the country’s fiscal deficit whereas common sense and basic economic principles suggest it should be positioned as rebalancing of government resources which can be used for better applications, or as a way to improve long term sustainability of some of these PSU companies and thus as a way to save jobs. In fact as various sectors were thrown open for private sector participation as a part of liberalization programs over last twenty five years, the governments should have followed a calibrated approach to completely exit those sectors except some sectors that require government participation. PSUs like Heavy Engineering Corporation, Hindustan Steelworks Construction Limited, Hindustan Machine Tools, Indian Tourism Development Corporation etc never stood a chance once private sector had been allowed in their respective sectors. Eventually these companies devoured tax payers’ money and caused acute problems for their employees and their families.

Then, there is one steam of thought that considers PSUs as family jewels and hence is inimical to selling them even partially. The truth is that many of these so called jewels run the risk of dramatic erosion in their value in near future. In fact this euphemism itself looks too far from reality. Except in sectors where private sector is not allowed or has been allowed only recently, most PSUs lag behind their private sector peers on parameters of efficiencies, execution, financials, scale and long term prospects. Sadly, by not selling them in a timely fashion we are effectively waiting for these jewels’ worth to deplete further.

Close the door before the horses bolt

On the political front this process of consensus building should not be as difficult as it has been made out to be so far. Essentially, in the name of social good the extremely poor classes have been deprived of government resources that are deployed less productively in public sector undertakings. At the same time, middle class– which, employees of these companies typically belong to – who ostensibly are the ones gaining from continued government support to PSUs, can be the biggest losers in the end owing to risks of job losses if these companies are not reinforced to compete in the market place. For this, non-government ownership is often what the doctor ordered for. It is no secret that operational inefficiencies, slow decision making, and interference from government give PSUs a massive disadvantage.  Many PSUs have turned defunct and many more are on the path to oblivion. On the other hand there are some examples where impressive improvement in performance has been seen after privatization without much job losses.

There is no reason to expect a trend reversal in next ten years especially given that competition in all sectors has aggravated. This is the primary reason why it makes financial sense for the government to monetize its equity in PSUs on a mission mode.

The government can start the process on a clean slate by drawing up i) a proper policy delineating the need, motives and potential benefits from divestment in various sectors, ii) a roadmap for divestment – list of companies in which stakes will be reduced to 51%, 26% and nil – over 1 year, 2 years, and 3 years, and iii) a clear plan regarding the proposed usage of receipts from this divestment.

The stakes are big – literally: 4% of GDP can be raised

Regarding the utilization of divestment proceeds, while education and health are two important focus areas which need enhanced budgetary support, in current circumstances the proceeds may also be used to recapitalize the PSU banks. Even though it can be argued that this will practically keep government involved in some form of business, it is not illogical for the government to have at least some presence in banking via some PSU banks so that it can perform its duties of a welfare state in banking sector. Also, it would be naive to deny that PSU banks need to be revived urgently for pick up in broader economy.

The stakes are big for India- literally. Total market value of government’s stake in the fifty seven companies in PSU index is about Rs 950,000 crore. If the government brings down its stakes to 26% in these companies ( except for SBI, and the three large oil marketing companies where one assumes that the government holding is kept at 51%) it can raise about Rs 475,000 crore, equivalent to about 4% of India’s GDP in F2015. This sum can be sufficient to run 2x the current budget on primary education and healthcare- for next five year, after recapitalizing the PSU banking system.

The Chasm between Theory and Practice of Contrarian Investment

Contrarian investing is simple to appreciate and can lead to meaningful wealth creation. However, even as it seems simple as a concept it takes extreme discipline and will power to practice. It is difficult to follow due to the way we human beings are wired – to always think that we are different from consensus and that we are right, our inability to predict how we shall behave in future, and our reluctance to play even favourably biased games when in an extreme situation.

Bias blind spot: The irony of herd behavior
Devastation due to bubbles in financial markets – or on the other extreme, our inability to benefit from sharp slump in asset prices – are mostly driven by lemming behaviour. Ironically even while blindly following the herd – often to disaster, most of us tend to think that we are different from consensus, and that consensus is wrong (or rather, we are right).
This behaviour, known as bias blind spot in behavioural finance terminology, is a cognitive bias due to which one is unable to spot the impact of biases on one’s own judgment even though one feels that one recognizes the impact of bias on others’ judgment. This hinders the ability to analyse if the path being followed is right.
So how does someone who is late to a stock market rally (which may be peaking) justify one’s fresh buying? Simply, by concluding that consensus is too pessimistic and is unable to see the blue sky scenario that one “knows will happen”.

Empathy gap: On a sunny day do I know, how will I behave on a cold rainy day
Empathy gap- which occurs when human understanding is state dependent i.e when someone underestimates the influence of visceral states on one’s choices – is another behavioural bias that prevents investors to defy the crowds even if there is strong evidence. It is like finding it difficult to imagine being happy at a point when one is angry. Another example can be the situation where after a heavy meal one can’t even think of eating something in future.
In real life situation, we all are perennially waiting for the equity markets to tank by Say, 25% so that we can load up on stocks paving the way to a wealthy retired life. Unfortunately empathy bias often sets in, in the event of a 25% slump in markets. When experts are discussing doomsday scenario on business TV channels, when newspapers are full of stories of mayhem on the ground, and when companies are sounding extremely pessimistic we as general investors are unable to even try to think otherwise. In such a situation if at all we try to apply our mind it is mainly to justify why the current gloomy situation will sustain for foreseeable future.
These are the occasions which investors wait for, where well thought contrarian moves can drive solid wealth creation and where our inner biases prevent us. However even for the most disciplined investors it is not easy to defy this empathy bias.

Terminal paralysis: Fear of pulling the lever
Let’s assume we manage to overcome bias blind spot and empathy bias. However there is one more troll for a contrarian investor. The environmental bias in extreme circumstances (a roaring bull market or a limping bear market) are so strong that even if we push ourselves to do some proper analysis, or even if someone else highlights some obvious stock opportunity with solid arguments then too we won’t act. Terminal paralysis prevents us from acting even on favourably loaded games if environment is adverse.

So how to avoid these behavioural mine fields?
To be able to think and act in an extreme environment we need to be aware of these biases first. Conscious thinking and will power can help us overcome bias blind spot and empathy gap- at least partially. However every such occasion will need a fresh stock of will power.
On the action part a good way to defy terminal bias is effectively to tie oneself to the proverbial pole on the ship – like Odysseus, to avoid falling for siren songs. If we are ready with names of stocks that can offer good entry opportunity at certain price point then it is easier to take action when those price points are achieved – irrespective of market environment.
Legendary investor John Templeton, sensing this human weakness, used to do his research in normal environment in a cold, rational state when nothing much was happening in the markets– not in extreme market conditions. Thus before the onset of bear markets he was ready with his picks with rough price ranges where he would buy them. Once he got his prices he would go ahead and buy the stocks. Thus advance research and pre-commitment to follow one’s analysis are the keys.

Bad loans of Indian banks: Questions galore

Acceleration of the process of classification of bad loans as NPA(Non Performing Asset), by India’s PSU banks has opened the proverbial Pandora’s box as a result of which many convoluted questions are looming large. Unless some consensus is built around a rational road map from here, the solutions to the bad loans issue can be extremely painful for many stakeholders with lasting negative impact on the broader economy.

Below are some of these questions –
•Is recognition of loan as an NPA, tantamount to write-off of the loan?
No. Conversion of a loan into an NPA is just the cognizance, as per set norms, that the loan has ceased to generate interest for the bank and risk of default has risen. However this does not absolve the debtor of her liability to service the debt.
• Do rising NPAs for Indian PSU banks imply a sharp dip in their financial health?
Mounting NPAs are delayed symptoms – at best- of banks’ ailment. Any attempt to establish causality between NPA recognition, and the state of balance sheet would be erroneous. Similarly, seeing NPA recognition even as a symptom of deteriorating balance sheets is incorrect. That PSU banks’ balance sheets have been worsening has been written on the walls for quite a while now. Performance and trends in income statements, balance sheets and cash flows of some large borrowers in critical sectors like power, metals and infrastructure over last 6-8 quarters have been giving clear and loud signals in this regard. Thus it is not the rising NPA recognition that is implying a sharp dip in PSU banks’ health. Instead it is the ebbing prospects of large borrowers of these banks that have been signifying this deterioration – for almost two years.
• What if the banks do not clean up their books quickly?
Firstly, continued defiance of norms to postpone classification of bad loans as NPA does not change the ground realities of weakness in the banks’ loan books. More importantly, faulty classification of loans sustained over a long time can deny banks the much needed support from the government, RBI and shareholders which can aggravate the matters further. Also hidden bad loans in the banking system – if not acted upon expeditiously- can keep on deflating the credit cycle thus hurting the country’s economic progress on the whole.
• How to think of large bad loans to corporates by public sector banks – aren’t they effectively, subsidy provided to the rich by the government? For the sake of fairness shouldn’t the banks be asked to write off loans of rural debtors in acute distress?
Banks have not been instructed by the government to write off loans to the corporate sector as per some policy and so it is not correct to treat any write off as subsidy to the rich. In fact loans had been driven by business considerations – though with the benefit of hindsight at least, it can be said that in many instances due diligence was not up to the mark. Of course instances of wrong doing in loan sanction and disbursal should be identified and punished. Rising quantum of bad debts on the corporate loan books in itself cannot justify large scale write off of rural debts by PSU banks. However on an unrelated note, the government does need to help the revival of rural economy and to ease the anguish due to two failed monsoons on Indians in rural areas. For this it may need to don its welfare state hat and think of ways for direct transfer of subsidy in geographies facing extreme economic duress.

How should the burden arising from bad loans be distributed among various stakeholders? To what extent personal liability of promoters be fixed in case of write off of entire chunks of principal?
Collateral should be used for recovery of debt and for this purpose takeover of assets should be quick and as per set norms. The proposed bankruptcy code can go a long way in achieving this once it is approved by the parliament. In addition debtors should be asked to pay up to the extent of personal guarantees even by liquidating their personal assets. However stretching this beyond a limit – crossing the principles of limited liability- may be counterproductive for the economy over the long term. In addition, it will be important to differentiate between malfeasance, and poor management of business. Similarly, bad credit decisions by bank officials should be treated as incompetence and not as misconduct – unless there is proof to indicate otherwise. Finally, the role of regulatory issues and a slump in commodity prices too needs to be assessed in analyzing the drivers of bad loans, and possible sharing of the concomitant burden. Under-recovery after this exercise will need to be borne by the banks’ shareholders – government, and others.
• How much, and why, should the tax payers share the burden – of dubious credit decisions by the banks, or poor performance of companies that raised loans?
To the extent of its ownership of these banks the government as a shareholder (and thus, the tax payers) will need to bear the impact of under recovery. This development reemphasizes the need for the government to withdraw from the business of running businesses including banks, and to take the direct transfer route for subsidy distribution as per requirement.

As we come closer to the annual ritual of India's central budget the biggest dilemma facing the finance minister would be how to strike a balance between continuing on the aggressive fiscal deficit contraction program as per plan -  3.9% in F16, 3.5% by F17 and 3% by F18- and, taking an audacious approach in an attempt to recharge the economy which is badly in need of pump priming from investments.
Make no mistake, F16 deficit target can comfortably be achieved with prudent policies followed by the government on distribution of gains from crude oil price drop. However deficit figures for F17, and possibly for F18 seem to be under pressure.

 The pinch points….

Ironically, low inflation, which is distorting nominal GDP estimates (pulling the nominal GDP lower than the estimated figure due to diminished inflation applied to calculate nominal GDP) is emerging as a threat to India’s fiscal deficit currently by denting the denominator for fiscal deficit. For every 300 bps decline in inflation the fiscal deficit can be higher by about 10 bps.
Pay commission impact on wages will cause a hit of about Rs 1000 b for the government in F17. Add the impact of OROP and one can estimate about 60 bps upward impact on the fiscal deficit.
Thus these two factors – which may not be easy to mitigate- may inflate the fiscal deficit by 60- 70 bps in F17.

and the vents

Although the government is set to miss out on its divestment target by a massive Rs 400b the fiscal deficit target for F16 does not seem too daunting due to large gains owing to oil price reduction.
Even in F17 oil price is the most obvious pressure vent here as it may average about US$8-10/bbl lower in F17 than in F16 which will mean a gain of about Rs 650b ( about 0.45% of GDP) for the government.
On the other hand proceeds from divestment in F17 seem set to be subdued given the near term market prospects.

The need for sticking to the fiscal roadmap ….. 

Apart from the risk of sovereign rating downgrade any further slippage versus the fiscal deficit road map also presents the possibility of loss of credibility for the government since the latter had already postponed this roadmap once earlier.
More importantly reckless increase in fiscal deficit will open up the spectre of inflation which will create its own demons. In that sense, some industry leaders that have been calling aggressively for loosening of fiscal deficit targets to initiate a massive stimulus in the shape of government spending, will do well to remember that the concomitant inflation may force the RBI to reverse the rate cycle.

….And the case for augmentation of investments 

Amid low capital expenditure, poor industrial growth and depressed job creation India’s economy seems to be missing the zing that is expected in the fastest growing developing economy in the world. As exports remain muted investments need to be magnified to reinvigorate the economy. Now, private sector is unlikely to take the initiative in investments given the low capacity utilization in the economy which leaves government investments as the only way to pump prime the economy. Indeed there is a risk that contagion - in the shape of shrinking exports- of global slowdown may start pulling down the economic growth if domestic bolsters are not put in place quickly.

Is the balance so difficult?

In the gloomy global macroeconomic environment prevalent currently the merits of disciplined approach to fiscal management cannot be overstated. Sticking to the plan will bring kudos from international rating agencies, multilateral lending institutions, and general observers.
However if GDP growth slumps then fiscal deficit will have at least some tendency to expand. Hence the government cannot afford to lose sight of the GDP growth imperative too – even if controlling the fiscal deficit is taken as the primary objective.
Private sector investments are at least 6-8 quarters away and in this scenario if the government spending does not pick up the growth may nosedive by end of F17. This is even more relevant now due to two consecutive years of poor monsoon which has pressurized the rural economy.
Some areas where the government needs to work on urgently from the deficit perspective are –
  1. Curb revenue expenditure aggressively – While the pay commission related expense is unavoidable due to political compulsions there are some areas where revenue expenditure can be cut by 25-30 bps (of GDP). Especially, assistance and grants to states can be curbed now that share of states’ in tax collection has been enhanced from 32% to 42%. Even on pay commission related impact at least some pressure can be postponed to F18.
  2. Rework the subsidies – Even as there is an urgent need to upgrade the budget for MNREGA and other rural schemes like pension yojana, gram jyoti, surakhsa bima, and Jeevan jyoti yojana - the government needs to eliminate the kerosene and cooking gas subsidies altogether and work on shifting at least some part of fertilizer subsidy to direct transfers. Overall subsidies may not shrink in F17 from the budgeted 1.7% of GDP in F16 due to continued need of food subsidy. However if repackaged to make it more focussed the subsidy program may actually aid GDP growth thus bolstering the fiscal deficit figure at least to some extent. In addition, for F18 actually subsidy bill should be brought down even in absolute terms.
  3. Give a massive push to road construction, railways, urban development and defence (capital spending) – Spending on these areas will not only buttress industrial activity and create urgently required jobs, but also improve the basic infrastructure for citizens. It may be prudent to allocate 30-40% more Y-o-Y on the above heads – even if it causes upward pressure of 65-70 bps on fiscal deficit.
  4. Front load recapitalization activity of banks – As the RBI continues with its efforts to clean up banks’ balance sheet the government may have to aggressively recapitalize some of these banks so that credit growth starts reviving by F18. The Rs 700b that the government has set aside to recapitalize PSU banks over five years may need to grow at least 2x. This should need spending - in F17- of about 15-20 bps of GDP more than in F16.
While the last two factors may nudge up the deficit -and the second one may be neutral- these factors will also boost the GDP growth thus to some extent preventing a wide surge in the deficit as a % of GDP.

Nothing ventured nothing gained

Looking at the above factors and the potential pay commission impact in combination with the potential Rs 650 b gain (about 0.45% of GDP) from crude oil prices in F17 and amid well controlled inflation, it does not look difficult to strike a balance between the two extreme positions. Summing up the impact of all the above factors, 30-40 bps expansion in the deficit - versus targets for F17 and F18, seems what the doctor has ordered for the Indian economy. It won’t bring down the skies on the deficit front, and at the same time will give enough boost to the economic growth. In any case, for a growing economy like India’s if some balanced and calculated aggression is not used to spur growth then the medium term targets for poverty alleviation and improvement in general quality of life too may get clouded.