The Banking Business…Note Quote

Why is lending indispensable to banking? This not-so new question has garnered a lot of steam, especially in the wake of 2007-08 crisis. In India, however, this question has become quite a staple of CSOs purportedly carrying out research and analysis in what has, albeit wrongly, begun to be considered offshoots of neoliberal policies of capitalism favoring cronyism on one hand, and marginalizing priority sector focus by nationalized banks on the other. Though, it is a bit far-fetched to call this analysis mushrooming on artificially-tilled grounds, it nevertheless isn’t justified for the leaps such analyses assume don’t exist. The purpose of this piece is precisely to demystify and be a correctional to such erroneous thoughts feeding activism. 

The idea is to launch from the importance of lending practices to banking, and why if such practices weren’t the norm, banking as a business would falter. Monetary and financial systems are creations of double entry-accounting, in that, when banks lend, the process is a creation of a matrix/(ces) of new assets and new liabilities. Monetary system is a counterfactual, which is a bookkeeping mechanism for the intermediation of real economic activity giving a semblance of reality to finance capitalism in substance and form. Let us say, a bank A lends to a borrower. By this process, a new asset and a new liability is created for A, in that, there is a debit under bank assets, and a simultaneous credit on the borrower’s account. These accounting entries enhance bank’s and borrower’s  respective categories, making it operationally different from opening bank accounts marked by deposits. The bank now has an asset equal to the amount of the loan and a liability equal to the deposit. Put a bit more differently, bank A writes a cheque or draft for the borrower, thus debiting the borrower’s loan account and crediting a payment liability account. Now, this borrower decides to deposit this cheque/draft at a different bank B, which sees the balance sheet of B grow by the same amount, with a payment due asset and a deposit liability. This is what is a bit complicated and referred to as matrix/(ces) at the beginning of this paragraph. The obvious complication is due to a duplication of balance sheet across the banks A and B, which clearly stands in need of urgent resolution. This duplication is categorized under the accounting principle of ‘Float’, and is the primary requisite for resolving duplicity. Float is the amount of time it takes for money to move from one account to another. The time period is significant because it’s as if the funds are in two places at once. The money is still in the cheque writer’s account, and the cheque recipient may have deposited funds to their bank as well. The resolution is reached when the bank B clears the cheque/draft and receives a reserve balance credit in exchange, at which point the bank A sheds both reserve balances and its payment liability. Now, what has happened is that the systemic balance sheet has grown by the amount of the original loan and deposit, even if these are domiciles in two different banks A and B. In other words, B’s balance sheet has an increased deposits and reserves, while A’s balance sheet temporarily unchanged due to loan issued offset reserves decline. It needs to be noted that here a reserve requirement is created in addition to a capital requirement, the former with the creation of a deposit, while the latter with the creation of a loan, implying that loans create capital requirement, whereas deposits create reserve requirement.  Pari Passu, bank A will seek to borrow new funding from money markets and bank B could lend funds into these markets. This is a natural reaction to the fluctuating reserve distribution created at banks A and B. This course of normalization of reserve fluctuations is a basic function of commercial bank reserve management. Though, this is a typical case involving just two banks, a meshwork of different banks, their counterparties, are involved in such transactions that define present-day banking scenario, thus highlighting complexity referred to earlier. 

Now, there is something called the Cash Reserve Ratio (CRR), whereby banks in India (and elsewhere as well) are required to hold a certain proportion of their deposits in the form of cash. However, these banks don’t hold these as cash with themselves for they deposit such cash (also known as currency chests) with the Reserve Bank of India (RBI). For example, if the bank’s deposits increase by Rs. 100, and if the CRR is 4% (this is the present CRR stipulated by the RBI), then the banks will have to hold Rs. 4 with the RBI, and the bank will be able to use only Rs. 96 for investments and lending, or credit purpose. Therefore, higher the CRR, lower is the amount that banks will be able to use for lending and investment. CRR is a tool used by the RBI to control liquidity in the banking system. Now, if the bank A lends out Rs. 100, it incurs a reserve requirement of Rs. 4, or in other words, for every Rs. 100 loan, there is a simultaneous reserve requirement of Rs. 4 created in the form of reserve liability. But, there is a further ingredient to this banking complexity in the form of Tier-1 and Tier-2 capital as laid down by BASEL Accords, to which India is a signatory. Under the accord, bank’s capital consists of tier-1 and tier-2 capital, where tier-1 is bank’s core capital, while tier-2 is supplementary, and the sum of these two is bank’s total capital. This is a crucial component and is considered highly significant by regulators (like the RBI, for instance), for the capital ratio is used to determine and rank bank’s capital adequacy. tier-1 capital consists of shareholders’ equity and retained earnings, and gives a measure of when the bank must absorb losses without ceasing business operations. BASEL-3 has capped the minimum tier-1 capital ratio at 6%, which is calculated by dividing bank’s tier-1 capital by its total risk-based assets. Tier-2 capital includes revaluation reserves, hybrid capital instruments and subordinated term debt, general loan-loss revenues, and undisclosed reserves. tier-2 capital is supplementary since it is less reliable than tier-1 capital. According to BASEL-3, the minimum total capital ratio is 8%, which indicates the minimum tier-2 capital ratio at 2%, as opposed to 6% for the tier-1 capital ratio. Going by these norms, a well capitalized bank in India must have a 8% combined tier-1 and tier-2 capital ratio, meaning that for every Rs. 100 bank loan, a simultaneous regulatory capital liability of Rs. 8 of tier-1/tier-2 is generated. Further, if a Rs. 100 loan has created a Rs. 100 deposit, it has actually created an asset of Rs. 100 for the bank, while at the same time a liability of Rs. 112, which is the sum of deposits and required reserves and capital. On the face of it, this looks like a losing deal for the bank. But, there is more than meets the eye here. 

Assume bank A lends Mr. Amit Modi Rs. 100, by crediting Mr. Modi’s deposit account held at A with Rs. 100. Two new liabilities are immediately created that need urgent addressing, viz. reserve and capital requirement. One way to raise Rs. 8 of required capital, bank A sells shares, or raise equity-like debt or retain earnings. The other way is to attach an origination fee of 10% (sorry for the excessively high figure here, but for sake of brevity, let’s keep it at 10%). This 10% origination fee helps maintain retained earnings and assist satisfying capital requirements. Now, what is happening here might look unique, but is the key to any banking business of lending, i.e. the bank A is meeting its capital requirement by discounting a deposit it created of its own loan, and thereby reducing its liability without actually reducing its asset. To put it differently, bank A extracts a 10% fee from Rs. 100 it loans, thus depositing an actual sum of only Rs. 90. With this, A’s reserve requirement decrease by Rs. 3.6 (remember 4% is the CRR). This in turn means that the loan of Rs. 100 made by A actually creates liabilities worth Rs. Rs. 108.4 (4-3.6 = 0.4 + 8). The RBI, which imposes the reserve requirement will follow up new deposit creation with a systemic injection sufficient to accommodate the requirement of bank B that has issued the deposit. And this new requirement is what is termed the targeted asset for the bank. It will fund this asset in the normal course of its asset-liability management process, just as it would any other asset. At the margin, the bank actually has to compete for funding that will draw new reserve balances into its position with the RBI. This action of course is commingled with numerous other such transactions that occur in the normal course of reserve management. The sequence includes a time lag between the creation of the deposit and the activation of the corresponding reserve requirement against that deposit. A bank in theory can temporarily be at rest in terms of balance sheet growth, and still be experiencing continuous shifting in the mix of asset and liability types, including shifting of deposits. Part of this deposit shifting is inherent in a private sector banking system that fosters competition for deposit funding. The birth of a demand deposit in particular is separate from retaining it through competition. Moreover, the fork in the road that was taken in order to construct a private sector banking system implies that the RBI is not a mere slush fund that provides unlimited funding to the banking system.  

The originating accounting entries in the above case are simple, a loan asset and a deposit liability. But this is only the start of the story. Commercial bank ‘asset-liability management’ functions oversee the comprehensive flow of funds in and out of individual banks. They control exposure to the basic banking risks of liquidity and interest rate sensitivity. Somewhat separately, but still connected within an overarching risk management framework, banks manage credit risk by linking line lending functions directly to the process of internal risk assessment and capital allocation. Banks require capital, especially equity capital, to take risk, and to take credit risk in particular. Interest rate risk and interest margin management are critical aspects of bank asset-liability management. The asset-liability management function provides pricing guidance for deposit products and related funding costs for lending operations. This function helps coordinate the operations of the left and the right hand sides of the balance sheet. For example, a central bank interest rate change becomes a cost of funds signal that transmits to commercial bank balance sheets as a marginal pricing influence. The asset-liability management function is the commercial bank coordination function for this transmission process, as the pricing signal ripples out to various balance sheet categories. Loan and deposit pricing is directly affected because the cost of funds that anchors all pricing in finance has been changed. In other cases, a change in the term structure of market interest rates requires similar coordination of commercial bank pricing implications. And this reset in pricing has implications for commercial bank approaches to strategies and targets for the compositional mix of assets and liabilities. The life of deposits is more dynamic than their birth or death. Deposits move around the banking system as banks compete to retain or attract them. Deposits also change form. Demand deposits can convert to term deposits, as banks seek a supply of longer duration funding for asset-liability matching purposes. And they can convert to new debt or equity securities issued by a particular bank, as buyers of these instruments draw down their deposits to pay for them. All of these changes happen across different banks, which can lead to temporary imbalances in the nominal matching of assets and liabilities, which in turn requires active management of the reserve account level, with appropriate liquidity management responses through money market operations in the short term, or longer term strategic adjustment in approaches to loan and deposit market share. The key idea here is that banks compete for deposits that currently exist in the system, including deposits that can be withdrawn on demand, or at maturity in the case of term deposits. And this competition extends more comprehensively to other liability forms such as debt, as well as to the asset side of the balance sheet through market share strategies for various lending categories. All of this balance sheet flux occurs across different banks, and requires that individual banks actively manage their balance sheets to ensure that assets are appropriately and efficiently funded with liabilities and equity. The ultimate purpose of reserve management is not reserve positioning per se. The end goal is balance sheets are in balance. The reserve system records the effect of this balance sheet activity. And even if loan books remain temporarily unchanged, all manner of other banking system assets and liabilities may be in motion. This includes securities portfolios, deposits, debt liabilities, and the status of the common equity and retained earnings account. And of course, loan books don’t remain unchanged for very long, in which case the loan/deposit growth dynamic comes directly into play on a recurring basis. 

Commercial banks’ ability to create money is constrained by capital. When a bank creates a new loan, with an associated new deposit, the bank’s balance sheet size increases, and the proportion of the balance sheet that is made up of equity (shareholders’ funds, as opposed to customer deposits, which are debt, not equity) decreases. If the bank lends so much that its equity slice approaches zero, as happened in some banks prior to the financial crisis, even a very small fall in asset prices is enough to render it insolvent. Regulatory capital requirements are intended to ensure that banks never reach such a fragile position. In contrast, central banks’ ability to create money is constrained by the willingness of their government to back them, and the ability of that government to tax the population. In practice, most central bank money these days is asset-backed, since central banks create new money when they buy assets in open market operations or Quantitative Easing, and when they lend to banks. However, in theory a central bank could literally spirit money from thin air without asset purchases or lending to banks. This is Milton Friedman’s famous helicopter drop. The central bank would become technically insolvent as a result, but provided the government is able to tax the population, that wouldn’t matter. The ability of the government to tax the population depends on the credibility of the government and the productive capacity of the economy. Hyperinflation can occur when the supply side of the economy collapses, rendering the population unable and/or unwilling to pay taxes. It can also occur when people distrust a government and its central bank so much that they refuse to use the currency that the central bank creates. Distrust can come about because people think the government is corrupt and/or irresponsible, or because they think that the government is going to fall and the money it creates will become worthless. But nowhere in the genesis of hyperinflation does central bank insolvency feature….

 

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Conjuncted: Balance of Payments in a Dirty Float System, or Why Central Banks Find It Ineligible to Conduct Independent Monetary Policies? Thought of the Day

If the rate of interest is partly a monetary phenomenon, money will have real effects working through variations in investment expenditure and the capital stock. Secondly, if there are unemployed resources, the impact of increases in the money supply will first be on output, and not on prices. It was, indeed, Keynes’s view expressed in his General Theory that throughout history the propensity to save has been greater than the propensity to invest, and that pervasive uncertainty and the desire for liquidity has in general kept the rate of interest too high. Given the prevailing economic conditions of the 1930s when Keynes was writing, it was no accident that he should have devoted part of the General Theory to a defence of mercantilism as containing important germs of truth:

What I want is to do justice to schools of thought which the classicals have treated as imbeciles for the last hundred years and, above all, to show that I am not really being so great an innovator, except as against the classical school, but have important predecessors, and am returning to an age-long tradition of common sense.

The mercantilists recognised, like Keynes, that the rate of interest is determined by monetary conditions, and that it could be too high to secure full employment, and in relation to the needs of growth. As Keynes put it in the General Theory:

mercantilist thought never supposed as later economists did [for example, Ricardo, and even Alfred Marshall] that there was a self-adjusting tendency by which the rate of interest would be established at the appropriate level [for full employment].

It was David Ricardo, in his The Principles of Political Economy and Taxation, who accepted and developed Say’s law of markets that supply creates its own demand, and who for the first time expounded the theory of comparative advantage, which laid the early foundations for orthodox trade and growth theory that has prevailed ever since. Ricardian trade theory, however, is real theory relating to the reallocation of real resources through trade which ignores the monetary aspects of trade; that is, the balance between exports and imports as trade takes place. In other words, it ignores the balance of payments effects of trade that arises as a result of trade specialization, and the feedback effects that the balance of payments can have on the real economy. Moreover, continuous full employment is assumed because supply creates its own demand through variations in the real rate of interest. These aspects question the prevalence of Ricardian theory in orthodox trade and growth theory to a large extent in today’s scenario. But in relation to trade, as Keynes put it:

free trade assumes that if you throw men out of work in one direction you re-employ them in another. As soon as that link in the chain is broken the whole of the free trade argument breaks down.

In other words, the real income gains from specialization may be offset by the real income losses from unemployment. Now, suppose that payments deficits arise in the process of international specialization and the freeing of trade, and the rate of interest has to be raised to attract foreign capital inflows to finance them. Or suppose deficits cannot be financed and income has to be deflated to reduce imports. The balance of payments consequences of trade may offset the real income gains from trade.

This raises the question of why the orthodoxy ignores the balance of payments? There are several reasons, both old and new, that all relate to the balance of payments as a self-adjusting process, or simply as a mirror image of autonomous capital flows, with no income adjustment implied. Until the First World War, the mechanism was the gold standard. The balance of payments was supposed to be self-equilibrating because countries in surplus, accumulating gold, would lose competitiveness through rising prices (Hume’s quantity theory of money), and countries in deficit losing gold would gain competitiveness through falling prices. The balance of payments was assumed effectively to look after itself through relative price adjustments without any change in income or output. After the external gold standard collapsed in 1931, the theory of flexible exchange rates was developed, and it was shown that if the real exchange rate is flexible, and the so-called Marshall–Lerner condition is satisfied (i.e. the sum of the price elasticities of demand for exports and imports is greater than unity), the balance of payments will equilibrate; again, without income adjustment.

In modern theory, balance of payments deficits are assumed to be inherently temporary as the outcome of inter-temporal decisions by private agents concerning consumption. Deficits are the outcome of rational decisions to consume now and pay later. Deficits are merely a form of consumption smoothing, and present no difficulty for countries. And then there is the Panglossian view that the current account of the balance of payments is of no consequence at all because it simply reflects the desire of foreigners to invest in a country. Current account deficits should be seen as a sign of economic success, not as a weakness.

It is not difficult to question how balance of payments looks after itself, or does not have consequences for long-run growth. As far as the old gold standard mechanism is concerned, instead of the price levels of deficit and surplus countries moving in opposite directions, there was a tendency in the nineteenth century for the price levels of countries to move together in the same direction. In practice, it was not movements in relative prices that equilibrated the balance of payments but expenditure and output changes associated with interest rate differentials. Interest rates rose in deficit countries which deflated demand and output, and fell in surplus countries stimulating demand.

On the question of flexible exchange rates as an equilibrating device, a distinction first needs to be made between the nominal exchange rate and the real exchange rate. It is easy for countries to adjust the nominal rate, but not so easy to adjust the real rate because competitors may “price to market” or retaliate, and domestic prices may rise with a nominal devaluation. Secondly, the Marshall–Lerner condition then has to be satisfied for the balance of payments to equilibrate. This may not be the case in the short run, or because of the nature of goods exported and imported by a particular country. The international evidence over the past almost half a century years since the breakdown of the Bretton Woods fixed exchange rate system suggests that exchange rate changes are not an efficient balance of payments adjustment weapon. Currencies appreciate and depreciate and still massive global imbalances of payments remain.

On the inter-temporal substitution effect, it is wrong to give the impression that inter-temporal shifts in consumption behaviour do not have real effects, particularly if interest rates have to rise to finance deficits caused by more consumption in the present if countries do not want their exchange rate to depreciate. On the view that deficits are a sign of success, an important distinction needs to be made between types of capital inflows. If the capital flows are autonomous, such as foreign direct investment, the argument is plausible, but if they are “accommodating” in the form of loans from the banking system or the sale of securities to foreign governments and international organizations, the probable need to raise interest rates will again have real effects by reducing investment and output domestically.

17th Century England – Onwards to Restoration.

In the 17^th century England, the middle class had carried forward their rebellion against absolute monarchy based on divine rights. The Parliament was the representation of this class and its fight. The men who now fought the Stuart Kings were precisely those who had profited from Tudor absolutism, which now began to irritate them. The lower middle class then split from their upper counterpart and rallied Cromwell. So far as the untitled and unmoneyed class was concerned, they stood largely by the throne, although they had as little to gain by the King as by the Parliament. The middle class was so afraid of the poor people as of the King. When the parliamentarians talked of a government based on consent, they had no intention of extending the franchise to the people; it was to be their own consent. Right to property, which they held to be sacred, meant to them the principle that the King had no right to tax them without their consent; it also meant a denial of property to the people who were poor.

Coke, who was appointed the Attorney General (and also the Chief Justice) in 1594, was attacking the divine rights of Kings and he regarded both King and the Parliament, as subject to common law which, to him, was the truly sovereign power in the land. Common law had to be interpreted by the judges. Throughout Europe, absolute state was becoming the order of the day. Louis XI had first subjugated the feudal nobility. The Reformation then enabled the monarchs to better the Church. Henry VIII had claimed jurisdiction and powers, which earlier no British King had done. To the discomfiture of Hobbes, the cursed Puritans had undone the work so artistically done by Henry VIII and the price had to be redesigned so that the fabric may be saved from total destruction in the hands of the rabble. Someone, like Thomas Hobbes agrees with Machiavelli that man is selfish and that human nature is bad but insists that the state could transfer the man into a moral being by the exercise of the master’s rod.  He is indebted to Bodin for his concept of sovereignty, but, unlike Bodin, would impose no limitations of Divine, Natural or Constitutional law on his subjects. He agrees with Grotius that, reason is the basis of law but insists that it must be sovereign’s reason alone. He modifies the Divine Right theory by discarding the divine origin of state and by giving Divine Right to the State instead to the King. Hobbes like Machiavelli, subordinated ethics and religion to politics and was the first prophet of unlimited sovereignty.

Elizabeth (1558 – 1603)

Elizabeth was the daughter of Henry VIII and Anne Boleyn. She ascended to the throne at the age of 25 in 1558 on the death of Queen Mary. She was not only regal but also human. Like her father, she had courage, determination and self-confidence. She was willful and domineering in all matters. Like her mother she was fond of pomp and pleasure. Her great virtue was that she loved the people of England and for their sake she was prepared to make any sacrifices. Her conservative mind made extreme Protestantism suspect to her, separated the foreign policy from any enthusiasm and fitted her to be the real maker of Anglicanism.

When she ascended to the throne, she had to face many difficulties. There was the danger of the civil war in the country. The orthodox Catholics regarded Elizabeth as an usurper and they were prepared to take up arms against her in order to support the cause of Mary Stuart. The Protestants were also bitter. They were determined to carry the Reformation further. There was also a danger of foreign invasion and conquest. A lot of money had been wasted in the French war during the reign of Mary Tudor. The coinage had also been debased. The credit goes to Elizabeth that she not only surmounted all these difficulties but were also able to make her country great and strong.

Religion at her time of ascension

The first great achievement of Elizabeth was her religious settlement. The policy followed by her was that she stopped the burning of the people. The “Act of Supremacy” eliminated the authority of the Pope in England and made Elizabeth the head of the Church of England. She took up the title of “Supreme Governor” and not “Supreme Head” as had been done by her father. The monasteries were dissolved and their lands were passed to the crown. A Book of Common Prayer in English was issued. Extremists among the Catholics and the Protestants were not prepared to reconcile themselves with her religious settlement. However, Elizabeth did not take any strong action against them so long as the people attended the Church. The Church settlement got a setback after 1570, when the Pope issued an excommunication and deposed Elizabeth and declared her to be longer a Queen of England. Her subjects were absolved from their allegiance to her. In 1571, the British Parliament passed an Act, which declared to be high treason for anyone in England to call the Queen a heretic, and usurper or an infidel. The puritans also attacked the Church settlement. They were utterly dissatisfied by the moderate character of it. Most of the ceremonies prescribed by the Church were considered by them to be a relic of Popery and they would like to abolish the same. However, the fact remains that, Elizabeth succeeded in attaining a large unity in the Church and that is the reason why she was successful against Spain, when the Armada attacked England in 1558.

Her foreign policy

The foreign policy of Elizabeth was essentially that of peace. Since England had been weakened in the reigns of Edward VI and Mary Tudor, it was not in her interest to fight against any foreign power in that condition. Her great danger was an invasion from France or Spain, both Catholic countries. However, Elizabeth took advantage of the bitter rivalry going on between France and Spain and was successful in playing off the one against the other. Her foreign policy approach was not dogmatic, but was guided by enlightened national interest. The reign of Elizabeth saw the beginning of English maritime activity. It brought naval supremacy to England.

Her rule in general

Elizabeth can rightly be called as one of the greatest rulers of England. No other ruler was called upon to face so many difficulties and none else faced them so boldly and successfully. She addressed in these words a deputation of both the houses of Parliament: “Though I be a woman, I’ve as good a courage answerable to my place as ever my father had. I’m your anointed Queen. I’ll never be by violence constrained to do anything. I thank God that I’d been endued with such qualities that if I were turned out of the realm in my petticoat, I were able to live in any place in Christendom.” She was the child of the Renaissance rather than that of the Reformation. Skeptical and tolerant in the age of intolerance, she was born and brought up to re-establish the Anglican Church and to evade religious war by a compromise between the Catholics and Protestants.

Tudor rule 

Tudor rule was arbitrary and autocratic in nature. It was despotism, under more or less parliamentary forms. Though despots, their rule was not a tyranny. It was popular despotism based upon the assent of the people and it was assented to because in the main it identified itself with national interests. Their rule in nature was of the dictatorship. The rising middle class called for a strong ruler and was ready to overlook his violence and unconstitutional acts if he would maintain peace and order. The policy of the Tudors was to rule with the support of the subservient Parliament. As a result, Parliament was degraded into an instrument of royal will. The Tudors had broken the power of the great nobles. Monarchs could influence elections and so secure the return of members who favoured his views. Thus, as against the sovereign, Parliament had little influence. The Tudors, however, never sought to override the authority of the Parliament. On the contrary, they encouraged the parliamentary action of the commons. Grave and momentous questions were brought before it such as the anti-papal measures, which cut off Pope’s authority in England. As a consequence, the importance of Parliament increased. The commons grew more self-reliant and were gradually fitted to shake off their tutelage to the crown. There was little friction between the Crown and the Parliament. Parliament submitted to royal guidance and the sovereign in its turn never sought to override its legislative authority.

One of the most important characteristics of the Tudor rule was the growth of the strong monarchy built upon the ruins of the feudal system. That was partly due to the decline of the power of the nobility and the invention of the gunpowder. Another important point was the broadening of the people’s minds on account of the Renaissance movement. The new spirit paved the way for the Reformation movement.

James I (1603 – 1625) 

James I ruled from 1603 to 1625. He was born in 1556 and he came to the throne after the expulsion of his mother from Scotland. When his mother was a prisoner in England, he was the King of Scotland. He did nothing to support the cause of his mother. The result was that Elizabeth accepted him as her successor to the throne of England. He had been brought up under rigid Calvinist discipline. He failed as the King of England, even though he was a man of great learning. He was so fond of “unbuttoning his royal stores of wisdom for the benefits of his subjects” that Henry IV of France called him the “wisest fool in Christendom”. He was intolerant to any criticism. He believed that Kings should have supreme authority over all. He believed that people had no right to revolt. “The state of monarchy is the supremest thing on Earth; for Kings are not only God’s lieutenants upon Earth and sit upon God’s throne, but even by God Himself, they are called Gods…it is sedition in subjects to dispute what a King may do in the height of his power. I will not be content that my power be disputed on.” 

Here is an extract from the Vicar of Bray, an old ballad:

                  To teach his flock he never missed,

                  Kings are by God appointed,

                  And damned are they, who do resist,

                  Or touch the Lord’s Anointed.

He had fixed views about politics and the status of Kings. He believed in the Divine Rights of Kings. This view was that Kings were Kings because God made them Kings and they were responsible to God alone for whatever they did and the people had no right to either find fault with them or to challenge their authority. It was this concept of monarchy that was responsible for all his troubles. James I stood for universal peace. He raised the slogan of “Beati Pacifici” (Blessed are the peace makers). His ideas of religious toleration were a cry in the wilderness. In spite of his good intentions, he was a complete failure as a king.

His relations with the Parliament

The relations between James I and the Parliament were not cordial. He believed in the Divine Rights of Kings, but the Parliament claimed certain rights on the basis of tradition, customs and evolutionary growth. Parliament based its rights and privileges on the score of History. Parliament, during the reign of James I, asserted with success its right to impeach the ministers of the King. It protested against the new impositions. It passed its law against monopolies. It asserted its rights to discuss all the affairs of the State although the King strongly protested against the claim. It failed to secure the right of meeting regularly. From these relations, it was clear that the struggle between the two had begun.

Common law

No account of the reign of James I can be complete without a reference to the common law lawyers headed by the Chief Justice Coke. In 1594, Coke was appointed Attorney General. He was a great champion of the common law. His view was that the propriety of all actions must be judged by the common law. There was no place for the Divine Rights of the Kings. The judges alone could resolve the conflicts between the prerogatives and the statutes. The view of Coke was different from that of Bacon who held that judges were lions, but lions under the throne. It was during the reign of James I that many English colonies were established beyond the seas. In 1612, the English East India Company set up its factory at Surat (Gujarat, India). Thus, the beginnings of the future British Empire in India and America were laid during the reign of James I.

Charles I (1625 – 1649)

James I died on the 27^th March 1625 and was succeeded by his second son, Charles I. Charles I loved those who were close near him, but was cold towards others. He was devoted to the Church of England and was punctual in his devotion to it. To Charles I, the Divine Right was the question of his faith, as deeply rooted as his belief in the Church. He was a bad judge of public questions and political men. He viewed them through the lens of his affections. He saw only rebellion in the critics of the Church of England. The reign of Charles I can be divided into four periods. The first four years of his reign from 1625 to 1629 covered the first period. During this period foreign wars were fought but lost and the relations between the King and the Parliament were bitter. The second period was covered by the years from 1629 to 1640. During this period, he ruled without a Parliament. The third period was covered by the years 1640 to 1642. It was also a period of short and long Parliament. The fourth period is covered by the two Civil wars (1642 – 1649). Charles I was executed in January 1649.

Relations with the Parliament 

The fundamental dispute between the King and the Parliament was that the Parliament was determined to become the sovereign of the country and was not prepared to allow the King to do whatever he wanted to do. The execution of Charles I shocked the people. The people were not in favour of Parliament going to such an extreme. The dignified behaviour of the King at the time of his execution also excited universal admiration. There was a strong reaction in favour of the monarch. Many called him the martyr who died for the Church of England. There were others who gave him the credit for having died for the laws and liberties of the English men. A few days after his death, a book entitled “Sikon Basilike” was published. It purported to give the views of the King on Government. It was felt that the dictatorship of the army was no guarantee to safeguard the popular institutions of England and the liberties of the people. The army could fight but could not reconstruct society. This execution was followed by military despotism, which was as bad as the tyranny of the King himself. The question has been asked whether the execution of Charles I was justified or not. From the legal point of view, there was no justification for trying the King as no process could be issued against the monarch. Moreover, the members of the court were partisans and did not come up to the ideal of impartiality as required by the judges. The only justification for the execution of Charles I was moral and political. Cromwell was right in saying that it was a cruel necessity. It was cruel because it was an extreme measure involving the execution of the King. It was a necessity because without it there would have been no liberty for Englishmen. Charles I was not at all prepared to accept any limitations on his powers. He was given many opportunities both by the Parliament and the army to come to reasonable compromise but he was declared dishonest by these very bodies and hence it was difficult to come to any sort of an agreement with him. The Parliament and the army always thought of him as extremely cynical and his dealings with these two constitutional bodies were inherently insincere in nature and thus no wonder such an insincere man was put to death.

Commonwealth 

The Commonwealth was established in England on January 4, 1649 by a proclamation by the Rump Parliament that “the people are, under God, the origin of all just power…that the commons of England in Parliament assembled, being chosen by and representing the people have the supreme power in this nation”. On February 5, the Rump decided that the House of Lords, being dangerous and useless, should be abolished. On February 6, it was resolved that “it hath been found by experience and this House doth declare that the office of the King in this nation and to have power thereof in any single person, is unnecessary and burdensome and dangerous to the liberty, safety and public interest of the people of this nation and thereof ought to be abolished”. On March 17 and 19, 1649, two Acts were passed by which the offices of the King and the House of Lords were abolished. Thus the House of Commons became the sole governing body of England. The chief organ of administration of the Commonwealth was the Council of the State. It was annually chosen by the Parliament. The council was concerned with the army, the navy, foreign affairs etc. In July 1649, was passed the “Treason Act”, which made it treasonable for anyone who published maliciously that “the Government is usurped or unlawful or that the Commons assembled in Parliament are not the supreme authority of this nation”. In September 1649, was passed the “Press Act” which muzzled the freedom of the press. The publication of any printed material without a license from the Government was forbidden. A special court of justice consisting of 12 judges was established to liquidate the enemies of the Commonwealth.

The members of the Parliament were Presbyterians and they insisted on imposing “certain fundamentals before a man should be free to propagate his opinions”. Cromwell was in favour of religious toleration for all except the Roman Catholics. Certain changes were introduced in the Church whereby it became less Presbyterian. It lost its autonomy and became subordinate to the State. Rump Parliament was “the first English Government to appreciate the importance of sea power”. It also was responsible for England a great sea power. The Rump Parliament also attended to foreign trade and the overseas empire of England. In 1651, was passed the “Navigation Act”. This Act was intended to strike a blow at the commercial power of Holland and no wonder it aroused the indignation of that country. The Rump had become unpopular with the army because it was a small body, which did not represent the whole nation. Moreover, many of its members were guilty of favouritism and corruption. Cromwell and his army urged the dissolution of the Parliament but the Rump refused to be dissolved. Cromwell could not tolerate the pride ambition and self-seeking of the members of the Parliament. On April 20, 1653, Cromwell himself went to the House of the Commons and turned out the members of the House and had the doors locked. The same afternoon, the Council of State also fell before military violence. After the dissolution of the Rump, Cromwell set up a new council of State which recommended that a Parliament of saints composed of 140 Godly men, 129 from England, 5 from Scotland and 6 from Ireland be summoned. This Parliament met in 1653. it is also known as Barebone’s Parliament. This Parliament was a unique one and it passed many laws like the solemnization of marriage a civil institution, public registration of births, marriages and death. Another law provided for the better custody of insanes. But this Parliament too failed. Cromwell was essentially a reluctant and an apologetic dictator. Lambert drew up a constitutional document called the “Instrument of Government”. It was the first and the last written English constitution. By this instrument, Cromwell was made Lord Protector for life with Council of State to help him. England, Scotland and Ireland were to be united in a single commonwealth with a Parliament representing the three countries. Parliament consisting of one House was to possess the legislative power and was to be elected every three years by a reformed electorate. This instrument gave Cromwell a limited monarchy for life. While the peculiarity of the English constitution was that it was flexible and unwritten, but the instrument tried to make it rigid and written.

Cromwell

Cromwell was one of the greatest figures in the History of England. He was born in 1599 at Huntington. He was a son of a country gentleman and was educated in a college in Cambridge. He emerged as a leader of his country when she was plunged in a Civil war on account of the conflict between the King and the Parliament. He not only won victories for the Parliament but also restored law and order in the country. Cromwell was the first pronounced imperialist in the history of England. His objective was to extend the power of England overseas and he did not hesitate to use all possible means to achieve that end. In his foreign policy, he showed zeal for Protestantism, but while doing so, he did not ignore the trade and commerce of his country. He was himself a Republican, but circumstances forced him to act as a military despot. He tried to govern by a system involving the division of power between himself and the Parliament. When he failed in that objective, he ruled despotically. He levied taxes without the sanction of the Parliament. He imprisoned people without trial. As a matter of fact, he set up a military tyranny. He wished for the Parliament to be supreme and did not wish to take up the title of the King. His faith in God was both a source of his strength and his weakness. In all that he did, whether good or evil, in the three kingdoms, his conviction was that God would support him in everything that he undertook. What he judged to be necessary for the present, that he thought to be predestined for the future. His victories seemed to him, not the result of the means, which he employed, but proofs that his policies were also the will of the Divine. Although he is regarded by some as the greatest patriot and by others as the greatest traitor, he was without doubt one of the greatest men of his country. He possessed military capacity of a very high order. He organized and maintained an army, which was so efficient that he did not meet with any defeat. Oliver Cromwell died on September 3,1658. When his strong hand was removed, the country was plunged into confusion. The Levellers stood for a Republic in which the common people were to rule without Lords, Priests or Lawyers. They had a very treatment from Oliver Cromwell but now they felt that they could do whatever they pleased. Another set known as the Fifth Monarchy Men was led by Harrison. They foretold the immediate end of the world. According to their reading of Daniel, the four monarchies of antiquity, Babylonia, Persia, Greece, and Rome were to be succeeded by the fifth monarchy, now at hand, the reign of Christ and his Saints.

Oliver Cromwell had named his son Richard Cromwell to succeed as the Lord Protector. He lacked political capacity and had no advisers. The gulf between Richard and the army was widening. In order to strengthen his position, Richard decided to summon the Parliament and the members of the Parliament were hostile to the army. The army did not like the law, which forbade the army officers from having political meetings. Parliament was dissolved by force in April 1659 and the Rump was recalled. Richard resigned his charge. About the period between 1649 and 1660, monarchy had gone and the House of Lords was established as “useless and dangerous”. This “freedom” was to rise to a climax of Puritan democracy, to decline by reaction into military dictatorship and at last to expire through faction. But it left a legacy. Puritanism released an energy, which called for liberty in religion and every department of life with efficiency greater than anything England had seen. It took long strides towards union with Scotland and Ireland. Its administrative machinery pointed towards the cabinet and its economic doctrine led to the capitalist Britain of the next two centuries.

Restoration

The Restoration of Charles II to the throne of England in 1660 was not merely the restoration of the King but also of Parliament, the Anglican Church, the historic law courts and the old system of local governments in the country. It is wrong to say that the monarchy that was restored was the unlimited and absolute monarchy of Charles I and James I. The “Triennial Act” of 1641 had not been repealed and it meant that the King could not carry on Government without calling a Parliament at least once in three years. Thus, the “Triennial Act” put a check on the power of the King. The result was that Charles II had to be less arbitrary and act according to the law. The very fact that Parliament had made Charles II, the King of England implied that in the last resort Parliament could also unmake him. The Divine Right of Kings to rule was practically dead. A point of conflict between the first two Stuart Kings and the Parliament was the question of taxation. Charles I had levied taxes without the consent of the Parliament. Now it was clearly understood that new taxes could be levied only with the consent of the Parliament. It is clear that although monarchy was restored, it was restored with a difference. Restoration gave to Parliament its old form and organization, which had so radically been changed during the Commonwealth period. The two Houses of the Parliament were restored and the House of Commons became more powerful than the House of Lords. Charles II never questioned the privileges of the Parliament. As a matter of fact, most of his important laws were passed through the Parliament.

Restoration of the Church

Restoration was also the restoration of the Church of England. The Parliament, which was elected in 1661 after the dissolution of the convention Parliament, was predominantly Anglican in nature. The Presbyterian element had disappeared altogether. The so-called Cavalier Parliament ended the work of the Presbyterian majority and restored the Anglican Church to its former position. The “Act of Uniformity” of 1662 provided that all clergymen and teachers were to declare their acceptance of the Anglican Prayer Book. The “Conventicle Act” of 1664 forbade under severe penalties, attendance of any public worship, which was not of Anglican form, of more than four persons, unless they belonged to the same family. The “Test Act” of 1673 provided that all civil and military officers were to take the oath of allegiance and accept the supremacy of the Church of England. In 1679, was passed the “Parliamentary Test Act” which provided that no person was to be a Member of Parliament unless he belonged to the Church of England. 1679 was also the year of Hobbes’ death. It is clear that the Anglican Church was established as a State Church, but with the difference that the headship of the Church no longer belonged to the King as a prerogative right. The leadership of the Church lay with the King-in-Parliament. As has been rightly put by Sir D. L. Keir that the restoration of monarchy in 1660 was especially a return to Government by Law. In this period, the legislative union with Scotland and Ireland was dissolved.

The reign of Charles II

During the reign of Charles II, some constitutional progress was made. The system of appropriation of supplies was established. While granting money to the King, the Parliament laid down the specific purpose for which the money was granted. The responsibility of the Ministers of Parliament was also secured to some extent. During the reign of Charles II, parliamentary parties with definite political programmes were formed and that also added to the strength of the Parliament. The passing of the “Habeas Corpus Act” in 1679 has become a cornerstone of the liberties of the people of England. The Parliament, which placed Charles II on the throne, was known as the Convention Parliament because it was summoned without a royal writ. The lands of the Royalists, which were confiscated, were restored. The Royal revenue was fixed at a fixed sum. Feudal dues and purveyance were abolished. A permanent excise tax was granted to the King as a compensation for the loss of his feudal revenues. The Convention Parliament was dissolved in 1661 and fresh elections were held. The new Parliament, which met in 1661, sat for 18 years and is known as the Cavalier Parliament. It was so called because the cavalier spirit was present among its members. This Parliament was royalist in nature in politics and Anglican in religion. It hated the Puritans and stood for the strengthening of the Church of England. It is true that during the reign of Charles II, the court was corrupt and there were pleasures all around. However, during this period, humanity and refinement spread rapidly in England. Literature, art and science, architecture and etiquette and fashions were copied from the court off Louis XIV, the grand monarch of France. One of the most notable men of this age wasIsaac Newton (1642 – 1727). There were great strides made in the disciplines of Astronomy, Physics, Chemistry and Medicine.

Balance of Payments in a Dirty Float System, or Why Central Banks Find It Ineligible to Conduct Independent Monetary Policies?

Developing Countries: The developing countries, marked in light blue, may prefer a fixed or managed exchange rate to a floating exchange rate. This is because sudden depreciation in their currency value poses a significant threat to the stability of their economies.

Here is Von Mises on Balance of Payments:

The surplus of the balance of payments that is not settled by the consignment of goods and services but by the transmission of money was long regarded as merely a consequence of the state of international trade. It is one of the great achievements of Classical political economy to have exposed the fundamental error in this view. It demonstrated that international movements of money are not consequences of the state of trade; that they constitute not the effect, but the cause, of a favorable or unfavorable trade balance. The precious metals are distributed among individuals and hence among nations according to the extent and intensity of their demand for money….the proposition is as true of money as of every other economic good, that its distribution among individual economic agents depends on its marginal utility … all economic goods, including of course money, tend to be distributed in such a way that a position of equilibrium among individuals is reached, when no further act of exchange that any individual could undertake would bring him any gain, any increase of subjective utility. In such a position of equilibrium, the total stock of money, just like the total stocks of commodities, is distributed among individuals according to the intensity with which they are able to express their demand for it in the market. Every displacement of the forces affecting the exchange ratio between money and other economic goods [i.e., the supply and demand for money] brings about a corresponding change in this distribution, until a new position of equilibrium is reached.

Balance of Payments – whether this is a monetary or a real phenomenon? The Monetary approach stresses that the balance of payments is essentially a monetary phenomenon. To be specific, it claims that money plays a vital role in determining the balance of payments. This approach does not deny the importance of non-monetary factors such as productivity changes, tariffs, government spending and taxation on the balance of payments. Indeed, it stresses the links between these factors and the money market. The Monetary approach does not assert that balance of payments problems are caused solely by monetary mismanagement or that monetary policy is the only possible cure. Rather, it emphasizes that the monetary process will bring about a cure of some kind (not necessarily very attractive) unless frustrated by deliberate monetary policy action. Policies that neglect or aggravate the monetary implications of deficits or surpluses will not be successful in their declared objectives.

The Monetary approach to the balance of payments applies specifically to a fixed exchange-rate regime. In this environment, it is the money supply that adjusts to money demand through international flows of money, which brings about equilibrium in the balance of payments. In this case, the money market determines the balance of payments. In a regime of flexible exchange rates, it is the money demand that adjusts to the money supply, which in turn is determined by the central bank. In a “managed float”, or “dirty float” scenario, in which exchange rates fluctuate from day to day, but central banks attempt to influence their countries’ exchange rates by buying and selling currencies, both international money flows and exchange rate changes are anticipated, given the nature of the central bank intervention.

The Keynesian approach focuses mainly on the merchandise trade account, with the capital account incorporated in the analysis at a later date. Disequilibrium in the balance of payments is caused by both the current account and the capital account. The current account, however, is considered to be more important than the capital account for the balance of payments disequilibrium. The relative prices and relative income levels of domestic and foreign countries are responsible for the balance of payments disequilibrium condition.

The relative prices and exchange rate of a country, vis-à-vis its trading partners, will determine the competitiveness of that country’s goods and services. An adverse movement in the relative price structure of a country, ceteris paribus, would decrease its competitiveness relative to its trading partners. Keynesians argue that a devaluation of a country’s currency will improve the trade account and enhance competitiveness. In time, equilibrium will be restored in the trade account. From the Monetary approach’s point of view, the money market is the principal vehicle, if not the only one, that is responsible for a balance of payments disequilibrium. For the Keynesians, it is differences in relative prices and domestic absorption rates that determine the balance of payments outcome. In short, real factors are more important than monetary factors in determining the balance of payments outcome.

The Monetary approach states that in the long run, monetary variables cannot affect real variables such as output, employment and, in the case of the balance of payments, the trade account. In the short run, monetary variables will affect real variables. This is true in the case of the money supply, money demand, exchange rates, and interest rates. The influence of interest rates on foreign direct investment is not made clear in the Monetary approach. This is because the approach does not distinguish between different types and durations of capital flows and the money account.

The Keynesian approach considers the balance of payments as a real phenomenon. Factors such as relative prices, devaluations, and aggregate demand affect the real variables in the short as well as the long run. In addition, capital flows are divided into short and long term. Protagonists of this approach argue that it is the short-term capital flows and long-term portfolio investments that respond to monetary factors.

For the Monetary approach, the demand for money is a stable function of a few variables. In a world of stable money demand functions, the assumptions of this approach are all valid. However, the Keynesian approach is not anchored on the premise of a stable demand function. In fact, for Keynesians, money demand functions are not considered stable since velocity is not stable. Hence, the Monetary approach’s conclusions are not valid for the Keynesians. The Monetary approach does not specifically identify whether it is the current account or the capital account that is responsible for a balance of payments deficit or surplus. However, it may be important to be able to clearly attribute the deficit or surplus to either the current account or the capital account. This would have an implication on the determination of the net worth of a country. For example, a change in the net worth of country will occur if the capital account is in deficit, ceteris paribus. However, net worth declines if the deficit is in the current account. The Keynesian approach specifically identifies which account is responsible for balance of payments deficits or surpluses. The reason for this identification is due to the importance of a country’s net worth over time.

The Monetary approach argues that the response of wages to a change in the money supply is not symmetric due to resistance from workers and unions to wage reductions following a decrease in the money supply. Conversely, with an increase in the money supply, wages rise following an increase in prices caused by the money supply expansion. Strong resistance to a drop in wages may be due to contractual agreements and institutional rigidities. According to the Monetary approach, a given change in the money supply is similar to a change in exchange rates in terms of percentage changes. For the Keynesians, however, this is not the case. It is their belief that in the real world, exchange rates are motivated in part by political reasons as well as economic and monetary factors. Keynesians argue that the reaction of wage earners and unions to a decrease in the money supply compared to their reaction to a devaluation is different. A decrease in the money supply will reduce nominal wages, and such a reduction is unacceptable to labor and labor unions. On the other hand, all other things remaining equal, a devaluation lowers the real wage rate by increasing domestic prices. However, a devaluation normally does not bring forth resistance from labor unions, despite the fact that an outcome similar to a decrease in the money supply is produced. It is possible that labor unions tend to focus on the immediate, direct effects on wages rather than on the delayed, indirect effects produced by a devaluation. In essence, the results of a decrease in the money supply or a devaluation are the same in the Keynesian view.

The Keynesian approach regards the exchange rate as a relative price of domestic and foreign goods. A change in relative prices will lead to a decrease in exchange rates. In the case of a devaluation, domestic prices of the devaluating country will decline in terms of foreign (goods) prices by the amount of the devaluation in percentage terms. In a regime of flexible exchange rates, the outcome of the current and capital accounts determines the exchange rate. According to the Keynesians, it is the capital account that exerts a more significant influence on exchange rates. This view is different from the Monetary approach, which argues that it is the money market outcome – money supply and money demand – that determines the exchange rate. The factors that influence the money supply and money demand will indirectly influence the exchange rate.

Foreign Exchange Regimes: The above map shows which countries have adopted which exchange rate regime. Dark green is for free float, neon green is for managed float, blue is for currency peg, and red is for countries that use another country’s currency.

The two approaches hold different views on currency substitution. The Monetary approach assumes the substitution of currencies and believes that in practice, this occurs to a high degree. This implies that monetary policy is independent. In the Keynesian approach, currencies of different countries are not really substitutable, and hence, monetary policies are not independent. In a managed float regime, changes in exchange rates as well as monetary flows will occur to restore equilibrium in the monetary market and in the balance of payments, because of the money flows generated by intervention, and thus central banks cannot truly be independent in conducting their monetary policies.

Hydropower Financing in India (Working Draft)

India is the seventh largest hydroelectric power generator in the world with a capacity approximating 45 GW comprising 13.5% of its total power generational capacity.¹ Add to that a capacity of 4.4 GW of smaller hydroelectric power units, the total installed and generational capacity is furthered by 1.3%. The hydroelectric power potential is almost double of what is installed at the moment and stands at 84 GW at 60% of the load factor.²

The history of hydroelectric power generation in the country dates back to more than a century, when the British engineered the Sidrapong-1 in Darjeeling in West Bengal in 1897, which is still under operation. What really drives the efficiency of hydropower technology is design-oriented, but the advantages of longevity and cost of generation face compromises via energy mix, cases where India is well positioned to offset the advantages with reliance on fossil fuels. This has been witnessed from the decade of the 1960s, when hydropower accounted for close to 65% of total utility till the present times, where the proportion has fallen to 13.5%, thanks largely due to offsets created by thermal power. Although, the plummeting slide has been arrested of late due to environmental, social, economic and political factors, the other major reason for the reduction in hydropower portfolio has been attributed to consistently non-attainability of energy installation and generation targets.

The Government of India has taken many policy initiatives for sustainable hydropower development. In 2008, the Government came out with a hydro policy³ with an objective to achieve the implementation of these projects. Thereafter, the Centre and the states initiated hydropower projects through Public Private Partnerships (PPPs) to attract investors for the development of water resources in an environmentally-friendly manner and generate revenue while ensuring project viability. Despite the mechanism of PPP, many of these projects have had to struggle due to rehabilitation and resettlement concerns, problems associated with land acquisition, clearance and approval procedures, capability of developers, to name a few. These factors have indeed given the projects a troubled track record, but what is concerning are inherent risks associated with the hydro sector that makes investors averse to entering the fray. Inherent risks include geological surprises, calamities, environmental and forest-related concerns, and commercial risks, the last of which include high capital costs, and long payback period resulting from long gestation period culminating in a deterrence for the entry by the private players. Furthermore, hydropower projects are capital-intensive and thus financing them for long periods become a challenge. But, textbook project financing still continues to place private players as the fulcrum of financing hydro as well as renewables for the simple reason that these players seek commensurate returns with respect to risks involved in the sector. For these risks to effectuate into implementation, it is the onus of the Government to remove impediments along the way by either restoring investor faith in the sector or by creating an enabling environment.

The Financial Ecosystem

This section gives an overview of what financial players are involved in the hydropower sector.

The Indian hydropower financial sector could be zeroed in National Hydroelectric Power Corporation (NHPC) to begin with. NHPC, though a centrally-owned institution is not a typical financial intermediary, in that, it invests the funds that it raises directly. With an investment base of Rs. 3,87,180 million, the authorized share of this Mini Ratna Category-1 Government of India Enterprise is close to Rs. 1,50,000 million, which is exclusively held by the Government. Though, the mandate might seem to be wide-ranging, the portfolio of NHPC is actually quite modest, and the only noticeable expansion is the inclusion of development of wood and tidal power. NHPC pays only a nominal dividend on the equity capital which the Government holds, and receives a considerable grant support from the Ministry of Power. The main income is through sale of electricity and consultancy services, where the main clientele happens to be state electricity boards. NHPC has to put up 30% of the cost of every project which it develops s share capital. as it cannot develop this equity from the limited revenues of its own projects, the government needs to regularly increase its share capital. The other 70% of the cost is financed through debt. during the initial period of NHPC’s existence, this debt was provided by the Government. However, since the decade of the 1980s, NHPC started raising debts through commercial loans and bonds, both as private placements and public issues. The international source of funds for NHPC is through export credit agencies, and not through the multilateral development banks like the World Bank, or the Asian Development Bank.⁴

The other main agency involved in financing power is Power Finance Corporation, which unlike NHPC is a financial intermediary. The major part of PFC’s funds are raised through rupee-denominated bonds. Bonds issued by PFC enjoy the highest ratings in Indian and international markets and are on par with India’s sovereign rating. It borrows short-term and long-term from various banks and other financial institutions in addition to raising external commercial borrowings through private placement in the US market. PFC is the primary institution of the government of India for financing generation, transmission and distribution projects of the state electricity boards. Hydro projects up to 25 MW are financed by the Rural Electrification Corporation. Like the NHPC, PFC also provides consultancy services to its clientele. Like the international financial institutions, PFC has an attached conditionality clause to its loans, where the borrowers need to carry out Operational Financial Action Plans (OFAPs) in order to avail loans. The divide is clear between states that have undertaken power restructuring reforms getting loans at lower rates, while the states that have failed to undertake any such reforms have eventually lost out on PFC loans. The Government of India supports PFC’s resource mobilization in that PFC is attributed a large share of tax-free bonds on the Indian capital market. Rupee-bonds, loans from the Government and loans from Indian banks and other financial institutions form the domestic sources, while multilateral and bilateral agencies form the major sources of funds from international sources.⁵

Other major financial players happen to be Industrial Credit and Investment Corporation of India (ICICI), which extends rupee and foreign currency loans by raising capital internally and externally through concessional bonds⁶ from the Reserve Bank of India, or from syndicated loans as sourced from foreign commercial institutions, and bilateral credit lines from JBIC, KfW DFID; Industrial Development Bank of India (IDBI) extending loans and other assistance in rupees and foreign currencies by raising capital on both the domestic as well as international markets; and Infrastructure Development Finance Corporation (IDFC), which came into existence in 1997 with the aim to provide additional financing for private infrastructure projects. With Vishnuprayag in Uttarakhand and Srinagar in Uttar Pradesh, IDFC made forays into the hydroelectric sector sourcing its funds from bonds sold in the Indian capital market along with its share capital. IDFC, which has signed on to equatorial principles is probably India’s only financial institution to have any environmental policy. It has been quite disciplinarian in refusing loans to questionable projects, and thus has next to no non-performing assets in its portfolio.

Speaking of non-performing assets, the largest commercial bank in India, state Bank of India is facing quite a quagmire. Engaged in long-term project finance in the infrastructure sector, the bank is ignominious with the largest share of non-performing assets. The State Bank of India has played an advisory role in the possible merger of NHPC and National Thermal Power Corporation (NTPC), and in assessing the escrow capacities of state electricity boards for independent power producers (IPPs). As part of long-term infrastructure financing, the bank has ventured into hydropower directly, as well as extending funds for financial institutions and operators in the power sector. The major source of funding for the State Bank of India are its retail deposits, while bonds make up for long-term lending. Other sources include mobilizing foreign currency funds through international branch network. Its strong international position enables it to extend foreign currency loans directly from its foreign deposits, and to arrange international loan syndications. For example, the Bank provided loans to Maheshwar Hydro Electric Project through its Frankfurt branch.⁷

Hydropower lending is not just confined to commercial banks and development financial institutions, but even non-banking financial institutions. The leader in this category happens to be Life Insurance Corporation of India, or LIC in short. LIC has taken up bonds from and extended loans to state electricity boards and centrally-owned institutions like NTPC, NHPC, PFC, and the Power Grid Corporation. The issue of non-performing assets has plagued LIC, and the insurance company is almost on par with the State Bank of India with its distressed assets. Other non-banking financial companies like the General Insurance Corporation of India (GIC) and Unit Trust of India (UTI) are fast picking up their stakes in the power sector, and the reason for their lagging in comparison to LIC is because their funds do not have the same extended maturity as the funds of life insurer.

Since most of these institutions are Government owned, the role of private sector participation isn’t very much evident, but this should not be taken to mean that private sector involvement is compromised by the involvement of these public institutions. On the contrary, private-sector involvement is considered to be a catalyst for infrastructural development, though there are differing opinions about their role, or even if at all they should be invited. Notwithstanding the rationale behind their involvement, it is obligated we look at what promoted their invitation to the electricity sector in general and to hydropower in particular.

In 1991, the Government of India opened the hydropower development in the country to private participation and allowed 16 per cent return on equity (ROE)⁸ in 1992. The doors to private participation were further greased by the Electricity Act 2003⁹, whose main objective was to promote competition for consumers to have the best possible price and quality of supply. The model to be adapted was similar to the World Bank model that was implemented in Odisha (then called Orissa) and thereafter picked up by other states. Called the “Single Buyer Mode”, the Act mandated that state electricity boards undertake unbundling of generation, transmission and distribution. The principal point in order to enhance generation, licensing had to be done away with completely excepting the need for techno-economic clearance for hydro projects. The Act was aimed at providing an investor friendly environment for potential developers in the power sector by removing administrative hurdles in the development of power projects by providing impetus to distribution reforms in India. Provisions like delicensing of thermal generation, open access and multiple licensing, and removal of surcharge for captive generation paved the basis for a competitive environment through private participation.

In 2008, Government came out with a policy called Power to All by 2012. Called the Hydro policy 2008, it encouraged private participation by giving incentives for accelerating the development of hydropower development in the country. Having failed in achieving its target of power to all by 2012, certain impeding factors like long gestation period, and capital intensive nature of the projects were held culpable. Private-sector implementation was augmented by the rise of Public Private Partnerships (PPPs), which are projects based on a contract or a concession agreement, between a government or statutory entity on the one side and a private sector company on the other side, for delivering an infrastructure service on payment of user charges. That PPP has been a policy game changer could be adduced from the fact that the Government is laying emphasis on it in order to resolve budgetary constraints, faster implementation of projects, reduced whole life costs, better risk allocation, improved quality of services, transfer of technology and project stability.¹⁰ though, how much of it is achieved and what are the likely hurdles in this model of development are subsequently discussed.

Private Engineering: Public Private Partnerships (PPPs) and Special Purpose Vehicles (SPVs)

India, undoubtedly has vast potential for renewables, but the execution is far from encouraging. One serious reason attributable to this has been the presence of strong coal-lobby in the country. Apart from this, energy economics plays its part, in that, any investment in hydropower development is decided by the cost of debt and the interest rate on capital. It is here that many of the private players who are majorly equity investors maintain focus on capital rates rather than on equity returns. Even if the operating portfolio of private investors is much larger thus facilitating easy accessibility to cheaper debt, unless the focus is on projects, which are profitable with adequate cash flow, renewable energy and infrastructure development in India would continue to face hurdles. For example, if a project is invested into with a debt-to-equity ratio of 70:30, with a typical interest rate of 14% and a repayment period of 8 years, an approximate 22% of the total project cost in the first year is outflow to service debt. It is well nigh difficult for projects to generate this kind of cash in the first year, simply owing to the fact that revenue assessment is not very critical. Bouncing off this critical gap are challenges that projects are more often than not over-advertised with under-estimation of revenue project costs and over-estimations of energy production potential leading to inconsistency in meeting the standard benchmark for haircuts. This is in close affinity with valuation expectations by developers where missing the woods for the trees is a high commonality due precisely to inadequate diligent processes.

But, does that mean this sector is riddled with detriments that cannot challenged off? It would be too far fetched to conclude this. Instead if the key issues like stringent adherence to budgets and timelines, reliable cash flow and accurate project valuations are held on to, these over-the-board-sounding-idealistic situations planned for contingencies, then most of the risks associated with financing and eventual implementation could be offset.

One of the two key instruments of private engineering happens to be Public Private Partnership (PPP). Public Private Partnerships are contractual arrangements between a public agency and a privately owned service provider. They are used to finance and operate projects that are considered important or desirable to the general public. Private agencies are incorporated because it has become increasingly apparent to both governments and donors that private enterprises are more cost-efficient and effective at delivering valuable products and services. The other instrument happens to be a Special Purpose Vehicle (SPV), which function as subsidiary entities for larger parent organizations and are typically used to finance new operations at favorable terms. The SPV can raise capital without carrying the debt or other liabilities of the parent organization even though the subsidiary is often operated by the same individuals and serves purposes that benefit the parent organization. SPVs are first and foremost an off-balance-sheet capital tool. This means that companies can change their overall asset/liabilities framework without having it show up in their primary financial statements. Many private partners in a PPP demand an SPV as part of the arrangement. This is especially true for very capital-intensive endeavors, such as an infrastructure project. The private company wants to limit its exposure to liabilities, so an SPV is created to absorb some of the risks. There isn’t a uniform operational role or legal design for the use of SPVs in a PPP; the particulars vary depending on the agreements of the actors and stakeholders in the project. However, every SPV needs to be created in accordance with the proper legal and accountancy rules in the jurisdiction. Most public projects rely on support from commercial banks or other financial institutions. Almost always, the SPV represents the financing wing and is used to attract funds from other lenders and investors. This protects the parent company and all financing parties from immediate counter-party risk. In the case of non-recourse financing, the lender’s only valid claims are limited to project assets in the case of default or non-completion. In turn, the SPV is not directly exposed to balance sheet issues with the parent or government agency. The government agency is often able to keep project debt and liabilities off its own balance sheet. This leaves more fiscal space for other public obligations. This can be especially important for governments that issue bonds because more fiscal space equates to higher bond credit ratings.¹¹

Although SPVs and PPPs have come under tremendous criticism, which we would look into shortly, an example to show why even in the first place are these instruments required would help ease matters a bit. Consider a $1 billion collection of risky loan, obligations of borrowers who have promised to repay their loans at some point in future. Let us imagine them sitting on the balance sheet of some bank XYZ, but they equally well could be securities available on the market that the Bank’s traders want to purchase and repackage for a profit. No one knows whether the borrowers will repay, so a price is put on this uncertainty by the market, where thousands of investors mull over the choice of betting on these risky loans and the certainty of risk-free government bonds. To make them indifferent to the uncertainty these loans carry, potential investors require a bribe in the form of 20% discount at face value. If none of the loans default, investors stand a chance to earn a 25% return. A good deal for investors, but a bad one for the Bank, which does not want to sell the loans for a 20% discount and thereby report a loss.

Now imagine that instead of selling the loans at their market price of $800 million, the Bank sells them to an SPV that pays a face value of $1 billion. Their 20% loss just disappeared. Ain’t this a miracle? But, how? The SPV has to raise $1 billion in order to buy the loans from the Bank. Lenders in SPV will only want to put $800 million against such risky collateral. The shortfall of $200 million will have to be made up somehow. The Bank enters here under a different garb. It puts in $200 million as an equity investment so that the SPV has enough money now to buy the $1 billion of loans.

However, there is a catch here. Lenders no longer expect to receive $1 billion, or a 25% return in compensation for putting up the $800 million. SPV’s payout structure guarantees that the $200 million difference between face value and market value will be absorbed by the Bank, implying treating $800 million investment as virtually risk-free. Even though the Bank has to plough $200 million back into the SPV as a kind of hostage against the loans going bad, from Bank’s perspective, this might be better than selling the loans at an outright $200 million loss. This deal reconciles two opposing views, the first one being the market suspicion that those Bank assets are somehow toxic, and secondly the Bank’s faith that its loans will eventually pay something close to their face value. So, SPVs become a joint creation of equity owners and lenders, purely for the purpose of buying and owning assets, where the lenders advance cash to the SPV in return for bonds and IOUs, while equity holders are anointed managers to look after those assets. Assets, when parked safely within the SPV cannot be redeployed as collateral even in the midst of irresponsible buying spree.

So, if an SPV is such a robust engineering tool, why does it have to face up to criticisms? The answer to this quandary lies in architecture, the architectural setup of SPVs drawing on the Indian context. SPVs are invested with responsibilities to plan, appraise, approve, releasing funds, implement, and evaluate development projects within the ambit of financing renewable projects, including hydropower. According to the Union Government, every SPV will be headed by a full-time CEO, and will have nomination from the central and state government in addition to members from the elected Urban Local Bodies (ULBs) on its Board. Who the CEO isn’t clearly defined, but if speculation is to be believed in concomitance with PPP, these might be from the corporate world. Another justification lending credence to this possibility is the proclivity of the Government to go in for Public-Private Partnerships (PPPs). The states and ULBs would ensure that a substantial and a dedicated revenue stream is made available to the SPV. Once this is accomplished, the SPV would have to become self-sustainable by inculcating practices of its own credit worthiness, which would be realized by its mechanisms of raising resources from the market. It needs to re-emphasized here that the role of the Union Government as far as allocation is concerned is in the form of a tied grant through creating infrastructure for the larger benefit of the people. This role, though lacks clarity, unless juxtaposed with the agenda that the Central Government has set out to achieve, which is through PPPs, Joint Ventures (JVs) subsidiaries and turnkey contracts.

If one were to look at the architecture of SPV holdings, things get a bit muddled in that not only is the SPV a limited company registered under the Companies Act 2013¹², the promotion of SPV would lie chiefly with the state/union territory and elected ULB on a 50:50 equity holding. The state/UT and ULB have full onus to call upon private players as part of the equity, but with the stringent condition that the share of state/UT and ULB would always remain equal and upon addition be in majority of 50%.¹³ So, with permutations and combinations, it is deduced that the maximum share a private player can have will be 48% with the state/UT and ULB having 26% each. Initially, to ensure a minimum capital base for the SPV, the paid up capital of the SPV should be with an option to increase it to the full amount of the first installment provided by the Government of India. This paragraph commenced saying the finances are muddled, but on the contrary this arrangement looks pretty logical, right? There is more than meets the eye here, since a major component is the equity shareholding, and from here on things begin to get complex. This is also the stage where SPV gets down to fulfilling its responsibilities and where the role of elected representatives of the people, either at the state/UT level or at the ULB level appears to get hazy. Why is this so? The Board of the SPV, despite having these elected representatives has in no certain ways any clarity on the decisions of those represented making a strong mark when the SPV gets to apply its responsibilities. SPVs, now armed with finances can take on board consultative expertise from the market, thus taking on the role befitting their installation in the first place, i.e. going along the privatization of services in tune with the market-oriented neoliberal policies in new clothes sewn with tax exemptions, duties and stringent labour laws in bringing forth the most dangerous aspect, viz. privatized governance.

In India, private engineering is plugged in with Government initiatives through a host of measures by the latter in creating fecund grounds furthering efficiency and faster execution. Responsibilities are no more split between Ministry of Power, Ministry of Coal and Ministry of New and Renewable Energy, for hitherto it was difficult managing projects under departments working in silos at the central level. Ever since the present ruling dispensation of National Democratic Alliance (NDA) stressed on making hydropower a cardinal component in the energy mix for the country, the Government of India has undertaken a number of initiatives in the recent past, supported by various policy-level changes to promote hydropower development and facilitate investment in the sector. As a part of these initiatives, the government has increased financial allocation, along with other non-financial support, and is also in the process of establishing a dedicated hydropower development fund¹⁴ to improve the investment attractiveness of the sector. Other than that, the government could use the clean energy fund to provide loans to hydro projects at a lower rate of interest. On a smaller scale, the Indian Renewable energy Development Agency (IREDA), National Clan Energy Fund (NCEF) has already launched a refinancing scheme by providing loans at 2% for the revival of operational small hydro-projects (SHP) and biomass projects which have been affected by low tariffs, low plant load factor (PLF) levels, or force majeure conditions.¹⁵ Government’s promise to offer long-term finance to infrastructure projects, and meet the country’s target of generating 15% of its energy from renewable sources affirms its commitment to providing financial and administrative assistance to hydropower generation, the economic viability of which would be determined by investors and developers. It needs to be noted that as of now, not all of hydropower is considered to be renewable, but the government is mulling over the fact that all of hydropower needs to be categorized as such. At present, hydropower projects below 25 MW are considered renewables, and comes under the purview of the Ministry of New and Renewable Energy. Large hydro is with the Ministry of Power, as is National Hydro Power Corporation (NHPC). If all of hydropower is categorized under renewable energy, it would facilitate the Government to meet its Intended Nationally Determined Contributions (INDC) targets, as committed in the Paris Climate-Change summit 2016. The Indian government had committed to 40% of its total energy generation from renewable sources. Solar and wind power cumulatively contribute 15% to the energy mix. Adding hydro would take the total close to 30%. The current generation capacity of hydro is 44,189 MW out of the total installed capacity of 314,000 MW. According to Piyush Goyal, Former Minister for Power, Coal, Mines and Renewable Energy, getting to consider all of hydropower as renewable would ensure coverage under RPO¹⁶ and qualify for dispatch priority. Recognising hydropower as renewable might, however, not mean that its purchase will be included in the renewable purchase obligation (RPO) of distribution companies. Currently, the government guidelines for the long-term RPO trajectory keep hydropower out of the calculation of total energy consumption, and thus for any change to be effectuated, the Government would have to discuss the details with the stakeholders, including segment regulators. ^{17 18}

 

Considering an energy elasticity of 0.8¹⁹, India is projected to require around 7% annual growth in electricity supply to sustain a GDP growth of around 8.5% p.a. over the next few years. This requires tapping all potential sources to address the deficit and meet the demand growth for accelerating economic development while taking into account considerations of long-term sustainability, environmental and social aspects. Though reservoir-based hydropower projects have come under criticism due to CO₂ and methane emissions beyond acceptable limits, most hydro-rich countries have followed an integrated full life-cycle approach for the assessment of the benefits and impacts to ensure sustainability²⁰. India is no different in this regard.

Financing Power: Generic Trends

This section focuses on the generic trends that involve financing power in the country, and many of the trends overlap across sectors, in that these are true for thermal, hydro and renewable energy generation. Moreover, the section, though slightly technical in nature, is interspersed with what may eventually count as accommodating structure for procurement of funds and thus departs from the norm in that it looks to policy and regulatory mechanisms in place and those that are aspirational or in the form of recommendations. Moreover, the section also delves into what is probably the hardest challenge facing the Indian Banking sector at the moment, viz. Non-Performing Assets (NPAs). There are documents and reports by the score that highlight how infrastructure development, including the power sector in India is riddled with NPAs.²¹ As a caveat, one maybe at a loss in linking this section with hydropower in particular due to its genericity, but one needs to comprehend the financial complexities from policy and regulatory points of view in order to appreciate the fuller magnitude of financing hydropower in particular and power sector in general.

Banks and Infrastructure Finance Companies (IFCs) are the predominant sources of financing of power sector in India. Balance sheet size of many Indian banks and IFCs are small vis-à-vis many global banks. Credit exposure limits of banks and IFCs towards power sector exposure is close to being breached. Any future exposure seems to be severely constrained by balance sheet size, their incremental credit growth and lack of incentives to lend to power sector. The desirability and sustainability of sectoral exposure norms of the banks in the future may be examined in view of the massive exposure of the banks and projected fund requirements for the power sector. Further, any downgrade in the credit rating of power sector borrowers would adversely impact the ability of the major Non Banking Financial Companies (NBFCs) viz. Power Finance Corporation (PFC) and National Hydro Power Corporation (NHPC) to raise large quantum of funds at a competitive rate from domestic as well as international capital markets. In such a scenario, the sources of funds available for power sector projects are expected to be further constrained.

The capital intensive nature of power projects requires raising debt for longer tenure (more than 15 years) which can be supported by life of the Power Project (around 25 years). However, there is wide disparity between the maturity profiles of assets and liabilities of banks exposing them to serious Asset Liability Maturity mismatch (ALM). Accordingly, the longest term of debt available from any bank or financial institution is for 15 years (door-to-door) which could create mismatch in cash flow of the Power project and may affect the debt servicing. Options like refinancing are explored to make funds available for the power project for a long tenor. Though maturity profiles of funds from insurance sector and pension funds are more suited to long gestation power projects, only a minuscule portion is deployed in power sector. At this stage, it becomes appropriate to talk of how and why pension funds are not really the funds to run after when it comes to financing Hydropower in the country. That these funds are not the de facto choice would be statement made in a hurry, for the government could in time switch financing instrumental gears to cater to investments in hydropower, provided these are amalgamated with Green bonds.  Internationally, the Green bonds base is up-north of $82 billion, whereas in India, the Green bonds are minuscule, but all slated for an exponential growth. Banks like Yes Bank and World Bank have launched green bonds. Green Bonds as a debt instrument by an entity raising funds ‘earmarked’ for use towards financing ‘green’ projects, assets, and business activities with environmental benefits. It attracts new class investor base – insurance funds, pension funds, sovereign wealth funds apart from the traditional investors. It helps in enhancing an issuer’s reputation illustrates green credentials of the issuer and demonstrates commitment towards the development and sustainability of the environment. The caution is that green bonds come with currency risk. However, if one raises green masala bonds, one will not have the risk of forex. To have the need for appropriating fiscal incentives in order to explore the ways to channelize savings, new debt instruments and sources of funds viz. Infrastructure Debt Fund, Clean Energy Funds etc. are identified for the purpose of infrastructure financing.

When it comes to cost of funds, cost of Rupee funding is high as compared to foreign currency funding due to currency fluctuations in the form of appreciation and depreciation. In a competitive bidding scenario, higher cost of borrowing could adversely affect the profitability and debt servicing of loan. External Commercial Borrowings (ECBs) for power projects is not well suited due to issues relating to tenor, hedging costs, exposure to foreign exchange risks etc. Project financing by multilateral agencies (World Bank, Asian Development Bank) has been low due to various issues.²² While bond offerings are a lower cost option to raise funds vis-à-vis syndicated loans, corporate bond market for project financing is virtually absent in India. Innumerable committees have opined on the reasons for the relative underdevelopment of India’s corporate bond market. However, despite several recommendations being implemented, there is still anaemic activity in existing corporate bonds, and anaemic issuance of new corporate bonds in relative terms. In addition, it appears that debt to equity ratios of Indian corporates have been falling steadily since the late 1990s, potentially a symptom of relative reductions in activity in the corporate debt market. Theoretically the presence of corporate bonds would provide an important alternative source of funding for corporations, which will enable them to optimize capital structure in an environment of friction. Such a market should enable additional cash to fund operations or long-term expansion plans without diluting corporate control. The government should also welcome the development of the corporate bond market because it would spur corporate activity and thus economic growth. Finally, investors such as pension funds and insurance companies should welcome corporate bonds as an additional set of instruments in which to invest, providing, in theory, a better overall risk to reward trade-off since there would be more opportunities for diversification. But, despite all these positives, the corporate bond market in the country is anemic. One important fact might hold the clue to explaining the lack of growth of this market. That is the huge pile of corporate debt that is currently being held in the form of loans, especially by state-owned banks. This massive inventory of loans generates significant incentives for three parties – banks, corporations and the government – to delay or inhibit the development of a significant corporate bond market. It goes without saying that large corporations with significant levels of unsustainable debt have no incentive to issue increased levels of debt, and indeed, have significant incentive to ensure the creation and perpetuation of information asymmetries that will inhibit liquidity in the market for their debt. So, the problem is not merely a problem of demand – from banks, but, also extends to debt supply. From the government’s point of view, there is a trade-off. In the short run, enabling a vibrant corporate bond market will result in significant losses to the banking sector, especially for nationalized banks, which are significantly exposed to bad corporate loans. This is because better price discovery will reveal the full extent of the problem of non-performing assets resulting from exposure to over-leveraged corporates. It is also the case that there may be more corporate failures if the full scale of the bad loans problem is revealed to the world. But, it must also be remarked that the credit rating of the power projects being set up under Special Purpose Vehicle (SPV) structure is generally lower than investment criterion of bond investors and thus there is a need for credit enhancement products.

Creation of specialized long-term debt funds to cater to the needs of the infrastructure sector; a regulatory and tax environment that is suitable for attracting investments is the key for channelizing long-term funds into infrastructure development. Reserve Bank of India (RBI) may look into the feasibility of not treating investments by banks in such close-ended debt funds as capital market exposure. Insurance and Regulatory Development Authority of India (IRDA) may consider including investment in Securities and Exchange Board of India (Sebi) registered debt funds as approved investments for insurance companies. Insurance Companies, Financial Institutions are encouraged/provided incentives to invest in longer dated securities to evolve an optimal debt structure to minimize the cost of debt servicing. This would ensure lowest tariff structure and maximum financial viability. Option of a moratorium for an initial 2 to 5 years may also reduce tariff structure during the initial years. One of the most serious contenders for acquiring funds and one that has been extensively experimented with is the Viability Gap Funding (VGF). The power projects that are listed under in generation or transmission and distribution schemes in remote areas like North-eastern region, J&K etc and other difficult terrains need financial support in the form of a viability gap for the high initial cost of power which is difficult to be absorbed in the initial period of operation. A scheme may be implemented in the remote areas as a viability gap fund²³ either in the form of subsidy or on the lines of hydropower development fund, a loan which finances the deferred component of the power tariff of the first five years and recovers its money during 11th to 15th year of the operation may be introduced. Any extra financing cost incurred on such viability gap financing should also be permitted as a pass through in the tariff by regulators.

Green Bonds

Shifting terrain here, it is obligatory to talk of green bonds and how they could be the next ‘big’ thing in financing. Green bonds are like other bonds with the key difference being the former are specifically used for ‘green’ projects that are environmentally friendly. These bonds could help reduce the cost of capital if there are open door policies aimed towards attracting foreign investment, and especially so, when Foreign Direct Investment policies in India are getting more and more market friendly. The history of ‘green’ bonds could be dated back to 2007, when the European Investment Bank and the World Bank launched these bonds. Subsequently, 2013 witnessed corporation participation leading to its overall growth. In India, Yes Bank became the first bank to issue these bonds worth Rs. 1000 crore in 2015.

So, what of Sebi²⁴ and any of rules and regulations mandating additional information about these bonds? For designating an issue of a corporation bond as a ‘green’ bond, an issue apart from complying with the issue and listing of debt securities regulations, the corporation would have to disclose additional information in the offer document such as use of proceeds. Sebi’s board had considered and approval a proposal for issuance and listing of green bonds way back in January 2016 to help meet the huge financing requirements worth USD 2.5 trillion for climate change actions in India by 2030. It is to be noted that ‘green’ bonds can be key to help meet an ambitious target India has of building 175 gigawatt of renewable energy capacity by 2022, which will require a massive estimated funding of $200 billion. Hydropower has a significant role to play in achieving the goals of the Paris Agreement.²⁵ Supporting the growth of the green bonds market is an important step towards aligning emission reduction targets with appropriate market signals and incentives.²⁶ One example of Green bonds being used to finance hydropower in India is the Rampur Hydropower Project, across River Satluj in Simla and Kullu districts of Himachal Pradesh. This 412 MW installed capacity project has been financed on a 70:30 debt equity ratio basis, and is backed by a US$ 400 million by the World Bank.²⁷

Shifting terrain once more, let us now focus on policy-wide measures that feed into renewables.

Policy-wide Measures for Take-out Financing

The Reserve Bank of India (RBI) has stipulated guidelines for Take-out Financing through External Commercial Borrowings (ECB) Policy.²⁸ The guidelines stipulate that the corporate developing the infrastructure project including Power project should have a tripartite agreement with domestic banks and overseas recognized lenders for either a conditional or unconditional take-out of the loan within three years of the scheduled Commercial Operation Date (COD). The scheduled date of occurrence of the take-out should be clearly mentioned in the agreement. However, it is felt that the market conditions cannot exactly be anticipated at the time of signing of document and any adverse movement in ECB markets could nullify the interest rate benefit that could have accrued to the project. Hence, it is suggested that tripartite agreement be executed closer to project COD and instead of scheduled date of occurrence of the take-out event, a window of 6 or 12 months could be mentioned within which the take-out event should occur.

Further, the guidelines stipulate that the loan should have a minimum average maturity period of seven years. However, an ECB of average maturity period of seven years would entail a repayment profile involving door-to-door tenors²⁹ of eight to ten years with back-ended repayments. It is likely that ECB with such a repayment profile may not be available in the financial markets. Further, the costs involved in hedging foreign currency risks associated with such a repayment profile could be prohibitively high. Hence it is suggested that the minimum average maturity period stipulated should be aligned to maturity profiles of ECB above USD 20 million and up to USD 500 million i.e. minimum average maturity of five years as stipulated in RBI Master Circular No.9 /2011-12 dated July 01, 2011.³⁰ RBI exposure norms applicable to IFCs allow separate exposure ceilings for lending and investment. Further, there is also a consolidated cap for both lending & investment taken together. In project funding, the IFCs are mainly funding the debt portion and funding of equity is very nominal.³¹ Therefore, the consolidated ceiling as per RBI norms may be allowed as overall exposure limit with a sub-limit for investment instead of having separate sub-limits for lending and investment. This will leverage the utilization of un-utilized exposures against investment. It is well justified since lending is less risky as compared to equity investment. This will provide additional lending exposure of 5% of owned funds in case of a single entity and 10% of owned funds in case of single group of companies, as per existing RBI norms. RBI Exposure ceilings for IFCs are linked to ‘owned funds’ while RBI exposure norms as applicable to Banks & FIs (Financial Institutions, but also Financial Intermediaries) allow exposure linkage with the total regulatory capital i.e. ‘capital funds’ (Tier I & Tier II capital). Exposure ceilings for IFCs may also be linked to capital funds on the lines of RBI norms applicable to Banks. It will enable to use the Tier II capitals like Reserves for bad and doubtful debt created under Income Tax Act, 1961³², for exposures.

RBI norms provide for 100% provisioning of unsecured portion in case of loan becoming ‘doubtful’ asset. Sizable loans of Government IFCs like PFC and NHPC are guaranteed by State Governments and not by charge on assets. On such loans, 100% provisioning in first year of becoming doubtful would be very harsh and can have serious implication on the credit rating of IFC. Therefore, for the purpose of provisioning, the loans with State/Central Government guarantee or with undertaking from State Government for deduction from Central Plan Allocation or Direct loan to Government Department may be treated as secured. As per RBI norms, the provisioning for Non-Performing Assets (NPAs) is required to be made borrower-wise and not loan-wise if there is more than one loan facility to one borrower. Since Government owned IFC’s exposure to a single State sector borrower is quite high, it would not be feasible to provide for NPA on the total loans of the borrowers in case of default in respect of one loan. Further, the State/Central sector borrowers in power sector are limited in numbers and have multi-location and multiple projects. Accordingly, default in any loan in respect of one of its project does not reflect on the repaying capacity of the State/Central sector borrowers. A single loan default may trigger huge provisioning for all other good loans of that borrower. This may distort the profitability position. Therefore, provisioning for NPAs in case of State/Central sector borrowers may be made loan-wise. In case of consortium financing, if separate asset classification norms are followed by IFCs as compared to other consortium lenders which are generally banking institutions; the asset classification for the same project loan could differ amongst the consortium lenders leading to issues for further disbursement etc.

Prudential Norms relating to requirement of capital adequacy are not applicable to Government owned IFCs. However, on the other side, it has been prescribed as an eligibility requirement for an Infrastructure Finance Company (IFC) being 15% (with minimum 10% of Tier I capital). Accordingly, Government owned IFCs are also required to maintain the prescribed Capital Adequacy Ratio.³³ Considering the better comfort available in case of Government owned IFCs, it is felt that RBI may consider stipulating relaxed CAR requirement for Government owned IFCs. It will help such Government owned IFCs in better leveraging. RBI prudential norms applicable to IFCs require 100% risk weight for lending to all types of borrowers. However, it is felt that risk weight should be linked to credit rating of the borrowers. On this premise, a 20% risk weight may be assigned for IFC’s lending to AAA rated companies. Similarly, in case of loans secured by the Government guarantee and direct lending to Government, the IFCs may also assign risk weight in line with the norms applicable to banks. Accordingly, Central Government and State Government guaranteed claims of the IFC’s may attract ‘zero’ and 20% risk weight respectively. Further their direct loan/credit/overdraft exposure to the State Governments, claims on central government will attract ‘zero’ risk weight.

As per extant ECB Policy, the IFCs are permitted to avail of ECBs (including outstanding ECBs) up to 50% of their owned funds under the automatic route, subject to their compliance with prudential guidelines. This limit is subject to other aspects of ECB Policy including USD 500 million limit per company per financial year. These limits/ceilings are presently applicable to all IFCs whether in State/Central or Private Sector. Government owned IFCs are mainly catering to the funding needs of a single sector, like in Power sector where the funding requirements for each of the power project is huge. These Government owned IFCs are already within the ambit of various supervisory regulations, statutory audit, CAG audit, etc. It, is, therefore, felt that the ceiling of USD 500 million may be increased to USD 1 billion per company per financial year for Government owned IFCs. Further, the ceiling for eligibility of ECB may also be increased to 100% of owned funds under automatic route for Government owned IFCs to enable them to raise timely funds at competitive rates from foreign markets. Thus, these measures will ensure Government owned NBFC-IFCs to raise timely funds at competitive rates thereby making low cost funds available for development of the infrastructure in India.

Enabling and Disabling Environment for Hydropower (Conclusion)

Though some bottlenecks remain. With the present power scenario and major policy initiatives to increase renewable capacity (mainly solar and wind), it is becoming difficult to sell hydropower. There is reluctance on the part of distribution utilities to enter into long term Power Purchase Agreements (PPAs). The government should declare all Hydropower Projects, regardless of the capacity, as “Renewables”, particularly, the Run of the River ROR (with or without diurnal pondage) projects. Presently Ministry of Power gives pooled quota of electricity from Central Public Sector Undertakings to various states. Ministry of Power should include Hydropower projects in the pooled quota for enabling faster PPAs. There should be separate Hydropower Purchase Obligation (HPO), too. The other bottleneck remains to be addressed is Tariff. Tariffs from hydropower projects are higher in the initial years as compared to other sources due to lack of incentives like tax concessions, financing cost and construction of projects in remote areas with inadequate infrastructure. Mega Power benefits were terminated in 2012. Major benefits associated with the Mega Power status were custom duty exemption on import of capital equipment and excise duty exemption. Mega Power benefits should be reintroduced. Since taxes constitute 15-25 per cent of project cost, it is still too early to fathom the import of Goods and Services Tax (GST) on the sector to contour its full consequences. Long term funding for hydropower project development is essential and needs to be directed through a policy. Creation of sub sectoral limit for lending to hydropower projects on priority basis by banks is the need of the hour to revive hydropower sector in India. The Banks should be advised to earmark at least 40 per cent of the total lending to power sector dedicated only for hydropower projects. Since Hydro Electric Projects are prone to various risks and uncertainties, the Return on Equity should not be decreased, except in cases of delays on account of developer. Service tax exemption to services used for Hydro Power Projects shall also lead to reduction of tariff. To reduce the weighted average cost of capital for competitive tariff, it is suggested that Debt to Equity ratio should be kept flexible say 80:10:10 with mandatory incurrence of equity portion minimum of 50 per cent before any disbursement. Funding could be 80 per cent Debt and 10 per cent Subordinate Debt. This could, by way of promoting hydropower as a renewable source of energy be considered as a positive for India, but what really has not been accounted for is socio-environmental and economic consequences, which would in many a cases be irreparable. The third crucial aspect that needs to be addressed is financing, or rather hurdles to financing. Due to long construction period of hydro projects, interest on loan plays a very critical role in increasing project cost. Also, during operation period, higher interest on outstanding loan leads to higher yearly tariff. Non-availability of longer tenure loan necessitates higher provision for depreciation so as to generate resources required to meet repayment obligations. Benefits under section 10(23)g of IT Act, 1961 to Hydro Power Projects, which allowed for the exemption of tax on the interest income earned by the Financial Institutions from Infrastructure projects, were withdrawn and is not available with respect to infrastructure projects. As per the current regulations, State Government is to be provided 12 per cent free power as royalty from any Hydro Power Project to be developed in the State. This provision of free power to the State affects the financial viability of the project severely. Due to the very challenging and difficult logistics, cost of the Project in any case is high and provision of high royalty in terms of free power, makes the project even more costlier and tariff becomes almost unsustainable. A review and revision of the financing policies for hydro projects are required with a view to provide longer tenure debt to hydro sector (say 25-30 years). Subsidy on the rate of interest on debt during the construction period of the projects should be introduced to reduce the Interest During Construction (IDC). Softer interest rates should be extended to large Hydro Plants. Tax Holiday under Section 80I (A) of the Income Tax Act, 1956 should be made applicable for 15 years for all Hydro Power Projects including under implementation projects. Hydropower projects are subjected to various types of risks like hydrological risk, power evacuation risk, geological surprises, construction risk, connectivity issues due to remote locations, extreme terrain etc. But after the commissioning of the Hydro-Electricity Plant, the majority of the risks are mitigated. The Financial Institutions, along with consortium lenders should be advised to extend the interest rebate on long term loans post commissioning of the project.

It is not just financing alone that is driven by development banks, but even building policy and regulatory mechanisms that are taken on board for creating an enabling environment to realize the true potential of hydropower leading to a spur in investments. This is mostly done with an emphasis on treating hydropower potential as a solution to long-term energy goals. The private arm of the World Bank, International Finance Corporation (IFC) has classified a new source of finance termed “Infraventures”, also known as the IFC Global Infrastructure Project Development Fund, is a $150 million global infrastructure fund that aims to develop a “bankable” pipeline of public-private partnerships and private projects for infrastructure.  This fund and others are catalyzing the development of big hydropower by decreasing the initial financial barriers to investment and decreasing the financial risks so that the project is attractive to the private sector.  For IFC Infraventures, the IFC then gets an equity stake in return. It is not unreasonable to claim that such approaches are criticized by Civil Society Actors³⁴ citing serious implications for transparency, accountability and governance.

With the mushrooming of new development banks like BRICS Bank, Asia Infrastructure Investment Bank, consideration for financing of hydropower projects has got a fillip in complementing the agenda of the already existing development banks like the World Bank and the Asian development Bank. But, the main funding spigot in the sector has changed course in India. Even though the multilateral development banks and a host of bilateral financing arrangements, be they wrought by EXIMs or bilaterally negotiated, have the necessary influence to bring to realization projects of scales varying from big hydro to run-of-the-river schemes, their actual influx by way of funds has been reduced to a mere chunk compromised by national financial institutions, either banking or non-banking.

The majority of the funds are pumped in by these national institutions, even if their drive is monitored through equity investments by international financial institutions. Critics of the arrangement often point out to such a huge share as leading to stresses on the banking system eventually paving the way for NPAs. Experience has shown that the impacts of hydropower can be devastating, resulting in physical and economic displacement, the disenfranchisement of indigenous people’s rights, and the destruction of fragile ecosystems. Despite the historically significant impacts of hydropower, the information provided to affected communities and to the general public appears to be woefully inadequate.³⁵ As the authors³⁶ seem to vociferously declare that the all too common adverse consequences of hydro projects do not seem sufficient to prompt a modification on development banks’ investment priorities. The narrative that paints hydropower as source of clean and cheap energy continues to drive banks’ priorities while sweeping under the rug the unacceptable price paid by marginalized members of society.

1) Government of India, Ministry of Power, Central Electricity Authority. Power Sector 2017 <http://www.cea.nic.in/reports/monthly/executivesummary/2017/exe_summary-04.pdf>

2) Government of India, Ministry of Power, Central Electricity Authority. Hydro Planning and Investigation Reports. Page last updated: Mon Feb 13 2017 <http://www.cea.nic.in/monthlyhpi.html>

3) Government of India, Ministry of Power. Hydro Power Policy 2008 <http://www.ielrc.org/con- tent/e0820.pdf>

4) Bosshard, P. Power Finance: Financial Institutions In India’s Hydropower Sector. pp 36-38. January 2002. <http://www.sandrp.in/hydropower/Power_Finance.pdf&gt;

5) Bosshard, P. Power Finance: Financial Institutions In India’s Hydropower Sector. pp 43-48. January 2002. <http://www.sandrp.in/hydropower/Power_Finance.pdf&gt;

6) A concession is a selling group’s compensation in a stock or bond underwriting agreement. The amount of compensation is based on the underwriting spread, or the difference between what the public pays for the securities and what the issuing company receives from the sale.

7) Bosshard, P. Power Finance: Financial Institutions In India’s Hydropower Sector. p 66. January 2002. <http://www.sandrp.in/hydropower/Power_Finance.pdf&gt;

8) Return on Equity is a measure of profitability that calculates how many dollars of profit a company generates with each dollar of shareholders’ equity. Also referred to as return on net worth, it is formulaically ROE = (Net Income)/(Shareholders’ Equity).

9) Ministry of Law and Justice, Legislative Department. The Electricity Act, 2003. 2 Jun 2003. <http://www.cercind.gov.in/Act-with-amendment.pdf&gt;

10) Ullah, A. Public Private Partnership in Hydro-Power Development of India: Prospects and Challenges. In Journal of Business Management & Social Sciences Research (JBM&SSR). volume 4, No. 2, February 2015.

11) Investopedia. What role do SPVs / SPEs play in public-private partnerships? Mar 09 2015 <http://www.investopedia.com/ask/answers/030915/what-role-do-spvs-spes-play-publicprivate-partnerships.asp>

12) Government of India, Ministry of Corporate Affairs. The Companies Act, 2013. <http://ebook.mca.gov.in/default.aspx>

13) Government of India, Ministry of Housing and Urban Affairs. Smart Cities Mission. 18 Jul 2017. <http://smartcities.gov.in/content/innerpage/spvs.php>

14) PricewaterhouseCoopers & ASSOCHAM India. Hydropower @ Crossroads. pp 7 and 14. 2016 <https://www.pwc.in/assets/pdfs/publications/2016/hydropower-at-crossroads-pwc-assocham-report.pdf>

15) Indian Renewable Energy Development Agency Ltd. IREDA-NCEF Refinance Scheme for Scheduled Commercial Banks/FIs for Refinancing of their outstanding loans against Biomass Power & SHP Projects. 31 JUL 2017 <http://www.ireda.gov.in/writereaddata/Revised%20-%20IREDA%20NCEF%20Refinance%20Scheme.pdf>

16) Renewable Purchase Obligation refers to the obligation imposed by law on some entities to either buy electricity generated by specified ‘green’ sources, or buy, in lieu of that, ‘renewable energy certificates (RECs)’ from the market. The ‘obligated entities’ are mostly electricity distribution companies and large consumers of power. RECs are issued to companies that produce green power, who opt not to sell it at a preferable tariff to distribution companies.

17) Jai, S. Uncharted waters for hydropower’s renewable energy status. Business Standard. 24 Mar 2017 <http://www.business-standard.com/article/companies/uncharted-waters-for-hydropower-s-re-status-117032301145_1.html>

18) Small hydro currently enjoys a slew of concessions such as tax benefits and easier environment and water clearance. To promote it as a RE source, the Centre also offers subsidy support of Rs 5 crore per MW and/or Rs 20 crore per project. To replicate these subsidies for a large project would be very heavy on government finances. Also, this move to make large hydro as renewable only benefits the country, not the sector. The sector would have to wait for the new GST (goods and services tax) regime to kick in, to know what concessions are in store for them. The earlier 10-year tax holiday for power projects has ceased to exist. Excise, Customs and like duties would be decided after the GST is notified for the sector. The Government could be looking at removing the whole subsidy mechanism for the sector, like it did in solar and wind power. So, the first target (of its proposed move) is obviously to meet the INDC and the other could be to reform the sector by linking it to market forces. The subsidy in hydro is for loan repayment and that can only happen when a project is operational. Hydro faces operational issues, regulatory hurdles and local issues. These need to be addressed. A speedy approval mechanism would entail growth of the sector.

19) Mohanty, A. & Chaturvedi, D. Relationship between Electricity Energy Consumption and GDP: Evidence from India. In International Journal of Economics and Finance; Vol. 7, No. 2; 2015. pp 186-202.

20) PWC & FICCI. Hydropower in India: Key enablers for a better tomorrow. 2014 <http://www.pwc.in/assets/pdfs/publications/2014/hydropower-in-india-key-enablers-for-better-tomorrow.pdf>

21) A Non-Performing Asset (NPA) is defined as a a credit facility in respect of which the interest and/or installment of Bond finance principal has remained ‘past due’ for a specified period of time. NPA is used by financial institutions that refer to loans that are in jeopardy of default. In the Indian context: You may note that for a bank, the loans given by the bank is considered as its assets. So if the principle or the interest or both the components of a loan is not being serviced to the lender (bank), then it would be considered as a Non-Performing Asset (NPA). Any asset which stops giving returns to its investors for a specified period of time is known as Non-Performing Asset (NPA). Generally, that specified period of time is 90 days in most of the countries and across the various lending institutions. However, it is not a thumb rule and it may vary with the terms and conditions agreed upon by the financial institution and the borrower. Has the hydropower sector been impacted? In March 2017, India Ratings Downgraded Indira Priyadarshini Hydro Power’s Loans to ‘IND D’. The downgrade reflects the instances of delays of up to 90 days in servicing of debt obligations by IPHPPL during the three months ended February 2017, due to tight liquidity position. IPHPPL is sponsored by the Ind Barath group of companies, which is mainly engaged in the power development business. The company is setting up a 4.8MW run-of-the-river hydel power plant on Manuni khad (tributary of Beas) in Kangra District, Himachal Pradesh. The power plant is yet to be commissioned. Bank facilities have low complexity levels which reflect that the relationship between the inherent risk factors and intrinsic return characteristics is straightforward.

22) The transition to private participation in infrastructure has not yet settled; consequently, the financing environment for developing-country infrastructure is not clearly defined. In many developing countries, the agenda of market liberalization, regulatory reform, and the restructuring of state-owned monopoly utilities remains unfinished. Furthermore, given the characteristics of certain infrastructure industries, including the huge sunk costs involved, elements of natural mono- poly, and their political saliency, there remains a strong rationale for state intervention, even in cases where privatization has been completed. Also, investors must factor in ongoing transformations of the global infrastructure industry, such as how to accurately price and gauge demand for new products resulting from rapid technological change. Together with a series of recent financial crises, these developments have taken their toll, presenting a hierarchy of risks at the industry, country, and project levels. Those risks raise the cost of capital and make investors and creditors averse to long-term investments in developing- country infrastructure.

23) According to New Hydropower Policy 2017, which is in the pipeline, there would be provisions with viability gap funding for projects, compulsory hydropower purchase obligations for distribution companies and a set of good practices that states would have to follow. The policy being prepared by the power ministry will have provisions for viability gap funding, which will help in meeting the shortfall in project costs and reducing hydroelectricity tariffs for consumers. Hydropower is expensive and in some cases more than double the cost of power from coal-based thermal plants. Compulsory hydropower purchase from large projects will either be made part of the existing renewable power purchase obligation of distribution companies or a separate requirement, so that its inclusion does not affect the market for other renewable sources of energy like wind, solar or biomass. In February 2015, India’s first proposed hydro-electricity project to be built on a viability gap funding (VGF) basis and PPP mode appears to have fallen flat as the Mizoram government signs an MoU with the North-East Electric Power Corporation (NEEPCO) to take up the planned project in northern Mizoram. The project 210 MW Tuivai HEP was cleared in 2013 to become the country’s first VGF-based HEP in 2013, meaning the Centre was willing to foot up to Rs 750 crores of the total Rs 1,750 crores the project is estimated to cost. The project was envisaged such that it fell under the state sector, meaning Mizoram would have the rights to use as much of power generated for its needs and sell the remaining as it deems fit. But even then, plans fell through towards the end of last year as banks and private developers shied away from going ahead with the project, leaving the state government to look for other alternatives. The Indian Express. India’s first VGF hydro-power project falls through, Mizoram hands it over to NEEPCO. 11 Feb 2015 <http://indianexpress.com/article/india/india-others/indias-first-vgf-hydro-powerproject-falls-through-mizoram-hands-it-over-to-neepco/>

24) Securities and Exchange Board of India. Memorandum to the Board: Disclosure Requirements for Issuance and Listing Green Bonds. <http://www.sebi.gov.in/sebi_data/meetingfiles/1453349548574-a.pdf>

25) International Hydropower Association Communications Team. What will the Paris Agreement mean for hydropower development? Jan 21 2016. <https://www.hydropower.org/blog/what-will-the-paris-agreement-mean-for-hydropower-development>

26) International Hydropower Association. Hydropower Status Report 2017. <https://www.hydropower.org/2017-hydropower-status-report>

27) The World Bank. Rampur Hydropower Project. <http://projects.worldbank.org/P095114/rampur-hydropower-project?lang=en>

28) External Commercial Borrowing (ECB) Policy – Take-out Finance. Jul 22 2010 <http://allindiantaxes.com/rbicir10-11-4.php>

29) Door to Door tenor/maturity is a term that is mostly used in finance sector. It is generally used to indicate the total period within which the total debt borrowed is to be paid, this total period also includes the period of moratorium (that is the period for which payment has been postponed).

30) Reserve Bank of India. RBI/2011-12/ 9, Master Circular on External Commercial Borrowings and Trade Credits. Jul 01 2011 <https://www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=6501>

31) Strategic investors, venture capital, private equity are the principal providers of equity funding to RE projects. Private equity funds have dominated the equity investment scene. Majority of the investments are in INR and the funds stay invested in the companies for a period of 5 to 7 years. Typically, the hurdle rates for direct equity investments range between 16 and 20 %, and are dependent on factors, such as the size of the project, the background of sponsor, the technology risk, the stage of maturity, and geographic and policy risks. On a related note, there have been talks of Mezzannine financing. So, what exactly is meant by this, and has India had an instance of such financing? Mezzanine Finance is a form of quasi debt/equity instrument, wherein sector-specific investors or short-term investors park their funds assuring higher returns (typically 15 % more than the debt instruments). This facilitates availability of low cost equity to project promoters. The investment is secured by charging on assets after assigning first charge to the term-loan lenders. Mezzanine Finance is typically associated with debentures offered to the investor with an option to convert them to equity at a later stage. This form of finance offers flexibility to meet both the investor’s and the company’s requirements, and also provides medium term capital without significant ownership dilution. Mezzanine finance is less risky than equity for investors, as it provides fixed interest along with principal repayment and minimum guaranteed returns to investors. It is normally used in situations where the company is generating adequate cash flows to service coupon payments and the promoters are unwilling to dilute their equity stake in the company. The Indian RE market has seen very few mezzanine finance transactions. Few of the noteworthy transactions are – Mytrah Energy raised USD 78.5 million from IDFC Project Equity and USD 19 million from PTC Financial Services. Solar IPP Azure Power raised USD 13.6 million from Germany’s DEG.

32) Government of India, Income Tax Department. Income Tax Act 1961. <http://www.incometaxindia.gov.in/pages/acts/income-tax-act.aspx>

33) Capital Adequacy Ratio is a measure of bank’s capital, and expressed as a percentage of a bank’s risk weighted credit exposures. Also known as capital-to-risk weighted assets ratio (CRAR), it is used to protect depositors and promote the stability and efficiency of financial systems.

34) Romero, M. J. Where is the public in PPPs? Analysing the World Bank’s support for public-private partnerships. BrettonWoods Project. Sep 29 2014 <http://www.brettonwoodsproject.org/2014/09/public-ppps-analysing-world-banks-support-public-private-partnerships/>

35) Medallo, J. & Sampaio, A. Ongoing Trends in Hydropower. Coalition for Human Rights in Development. <http://rightsindevelopment.org/project/trends-the-rise-of-hydropower/>

36) ibid.

Conjuncted: Banking – The Collu(i)sion of Housing and Stock Markets

There are two main aspects we are to look at here as regards banking. The first aspect is the link between banking and houses. In most countries, lending of money is done on basis of property, especially houses. As collateral for the mortgage, often houses are used. If the value of the house increases, more money can be borrowed from the banks and more money can be injected into society. More investments are generally good for a country. It is therefore of prime importance for a country to keep the house prices high.

The way this is done, is by facilitating borrowing of money, for instance by fiscal stimulation. Most countries have a tax break on mortgages. This, while the effect for the house buyers of these tax breaks is absolutely zero. That is because the price of a house is determined on the market by supply and demand. If neither the supply nor the demand is changing, the price will be fixed by ‘what people can afford’. Imagine there are 100 houses for sale and 100 buyers. Imagine the price on the market will wind up being 100000 Rupees, with a mortgage payment (3% interest rate) being 3 thousand Rupees per year, exactly what people can afford. Now imagine that government makes a tax break for buyers stipulating that they get 50% of the mortgage payment back from the state in a way of fiscal refund. Suddenly, the buyers can afford 6 thousand Rupees per year and the price on the market of the house will rise to 200 thousand Rupees. The net effect for the buyer is zero. Yet, the price of the house has doubled, and this is a very good incentive for the economy. This is the reason why nearly all governments have tax breaks for home owners.

Yet, another way of driving the price of houses up is by reducing the supply. Socialist countries made it a strong point on their agenda that having a home is a human right. They try to build houses for everybody. And this causes the destruction of the economy. Since the supply of houses is so high that the value drops too much, the possibility of investment based on borrowing money with the house as collateral is severely reduced and a collapse of economy is unavoidable. Technically speaking, it is of extreme simplicity to build a house to everybody. Even a villa or a palace. Yet, implementing this idea will imply a recession in economy, since modern economies are based on house prices. It is better to cut off the supply (destroy houses) to help the economy.

The next item of banking is the stock holders. It is often said that the stock market is the axis-of-evil of a capitalist society. Indeed, the stock owners will get the profit of the capital, and the piling up of money will eventually be at the stock owners. However, it is not so that the stock owners are the evil people that care only about money. It is principally the managers that are the culprits. Mostly bank managers.

To give you an example. Imagine I have 2% of each of the three banks, State Bank, Best Bank and Credit Bank. Now imagine that the other 98% of the stock of each bank is placed at the other two banks. State Bank is thus 49% owner of Best Bank, and 49% owner of Credit Bank. In turn, State Bank is owned for 49% by Best Bank and for 49% by Credit Bank. The thing is that I am the full 100% owner of all three banks. As an example, I own directly 2% of State Bank. But I also own 2% of two banks that each own 49% of this bank. And I own 2% of banks that own 49% of banks that own 49% of State Bank. This series adds to 100%. I am the full 100% owner of State Bank. And the same applies to Best Bank and Credit Bank. This is easy to see, since there do not exist other stock owners of the three banks. These banks are fully mine. However, if I go to a stockholders meeting, I will be outvoted on all subjects. Especially on the subject of financial reward for the manager. If today the 10-million-Rupees salary of Arundhati Bhatti of State Bank is discussed, it will get 98% of the votes, namely those of Gautum Ambani representing Best Bank and Mukesh Adani of Credit Bank. They vote in favor, because next week is the stockholders meeting of their banks. This game only ends when Mukesh Adani will be angry with Arundhati Bhatti.

This structure, placing stock at each other’s company is a form of bypassing the stock holders

– the owners – and allow for plundering of a company.

There is a side effect which is as beneficial as the one above. Often, the general manager’s salary is based on a bonus-system; the better a bank performs, the higher the salary of the manager. This high performance can easily be bogus. Imagine the above three banks. The profit it distributed over the shareholders in the form of dividend. Imagine now that each bank makes 2 million profit on normal business operations. Each bank can easily emit 100 million profit in dividend without loss! For example, State Bank distributes 100 million: 2 million to me, 49 million to Best Bank and 49 million to Credit Bank. From these two banks it also gets 49 million Rupees each. Thus, the total flux of money is only 2 million Rupees.

Shareholders often use as a rule-of thumb a target share price of 20 times the dividend. This because that implies a 5% ROI and slightly better than putting the money at a bank (which anyway invests it in that company, gets 5%, and gives you 3%). However, the dividend can be highly misleading. 2 million profit is made, 100 million dividend is paid. Each bank uses this trick. The general managers can present beautiful data and get a fat bonus.

The only thing stopping this game is taxing. What if government decides to put 25% tax on dividend? Suddenly a bank has to pay 25 million where it made only 2 million real profit. The three banks claimed to have made 300 million profit in total, while they factually only made 6 million; the rest came from passing money around to each other. They have to pay 75 million dividend tax. How will they manage?! That is why government gives banks normally a tax break on dividend (except for small stockholders like me). Governments that like to see high profits, since it also fabricates high GDP and thus guarantees low interest rates on their state loans.

Actually, even without taxing, how will they manage to continue presenting nice data in a year where no profit is made on banking activity?

Sustainability of Debt

For economies with fractional reserve-generated fiat money, balancing the budget is characterized by an exponential growth D(t) ≈ D₀(1 + r)^t of any initial debt D₀ subjected to interest r as a function of time t due to the compound interest; a fact known since antiquity. At the same time, besides default, this increasing debt can only be reduced by the following five mostly linear, measures:

(i) more income or revenue I (in the case of sovereign debt: higher taxation or higher tax base);

(ii) less spending S;

(iii) increase of borrowing L;

(iv) acquisition of external resources, and

(v) inflation; that is, devaluation of money.

Whereas (i), (ii) and (iv) without inflation are essentially measures contributing linearly (or polynomially) to the acquisition or compensation of debt, inflation also grows exponentially with time t at some (supposedly constant) rate f ≥ 1; that is, the value of an initial debt D₀, without interest (r = 0), in terms of the initial values, gets reduced to F(t) = D₀/f^t. Conversely, the capacity of an economy to compensate debt will increase with compound inflation: for instance, the initial income or revenue I will, through adaptions, usually increase exponentially with time in an inflationary regime by If^t.

Because these are the only possibilities, we can consider such economies as closed systems (with respect to money flows), characterized by the (continuity) equation

If^t + S + L ≈ D₀(1+r)^t, or

L ≈ D₀(1 + r)^t − If^t − S.

Let us concentrate on sovereign debt and briefly discuss the fiscal, social and political options. With regards to the five ways to compensate debt the following assumptions will be made: First, in non-despotic forms of governments (e.g., representative democracies and constitutional monarchies), increases of taxation, related to (i), as well as spending cuts, related to (ii), are very unpopular, and can thus be enforced only in very limited, that is polynomial, forms.

Second, the acquisition of external resources, related to (iv), are often blocked for various obvious reasons; including military strategy limitations, and lack of opportunities. We shall therefore disregard the acquisition of external resources entirely and set A = 0.

As a consequence, without inflation (i.e., for f = 1), the increase of debt

L ≈ D₀(1 + r)^t − I − S

grows exponentially. This is only “felt” after trespassing a quasi-linear region for which, due to a Taylor expansion around t = 0, D(t) = D₀(1 + r)^t ≈ D₀ + D₀rt.

So, under the political and social assumptions made, compound debt without inflation is unsustainable. Furthermore, inflation, with all its inconvenient consequences and re-appropriation, seems inevitable for the continuous existence of economies based on fractional reserve generated fiat money; at least in the long run.

Political Ideology Chart

It displays anarchism (lower end) and authoritarianism (higher end) as the extremes of another (vertical) axis as a social measure while left-right is the horizontal axis which is an economic measure.

Anarchism is about self-governance, having as little hierarchy as possible. As you go to the left, the means of production are distrubuted more equally; and as you go to the right, individuals and corporations own more of the means of production and accumulate capital.

On the upper left you have an authoritarian state, distributing the means of production to the people as equally as possible; on the lower left you have the collectives, getting together voluntarily utilizing their local means of production and sharing the products; on the lower right you have anarchocapitalists, with no state, tax or public service, everything operated by private companies in a completely free and global market; and finally on the top right you both have powerful state and corporations (pretty much all the countries).

But after all, these terms change meanings through history and different cultures. Under unrestrained capitalism the accumulation of wealth both creates monopolies and more importantly political influence. So that influences state interference and civil liberties also. It also aspires for infinite growth which leads to the depletion of natural resources which is another diminishing fact for the quality of living for the people. At that point it favors conservatism rather than progressive scientific thinking. Under collective anarchism, since it’s localized, it is quite difficult to create global catastrophes, and this is why in today’s world, the terms anarchism and capitalism seems as opposite.

Techno-Commercial Singularity: Decelerator / Diagram.

H/T Antinomia Imediata

If the Cathedral is actually efficient, the more it happens, the less it happens. Decelerator.

1. taxation: this deviates resources from capital and buries them into the consumption of the tax-receivers (namely the Cathedral bureaucracy). trash and shit.
2. regulation: there are various ways this could work, insofar as regulation is very inventive. but the main pattern has to do with deviating capital from the most rentable (i.e., (self-re)productive) investments, into those that are most likely to become un-recyclable trash, at least in the long run.
3. politicization: this deviates brain-power from technological producing theories into, well, bullshit research departments, especially through politicization of academic funding of hard sciences.
4. protectionism: since this protects technical developments from properly feeding back into the commercial cycle, it breaks the link between technical advantage and capital accumulation, leading lots of resources into stupid gadgetry.

all these being forms of fucking up the incentive structures that allow the accelerative cycle to be. in diagram form:

 

 

How Permanent Income Hypothesis/Buffer Stock Model of Milton Friedman Got Nailed?

Milton Friedman and his gang at Chicago, including the ‘boys’ that went back and put their ‘free market’ wrecking ball through Chile under the butcher Pinochet, have really left a mess of confusion and lies behind in the hallowed halls of the academy, which in the 1970s seeped out, like slime, into the central banks and the treasury departments of the world. The overall intent of the literature they developed was to force governments to abandon so-called fiscal activism (the discretionary use of government spending and taxation policy to fine-tune total spending so as to achieve full employment), and, instead, empower central banks to disregard mass unemployment and fight inflation first. Wow!, Billy, these aren’t the usual contretemps and are wittily vitriolic. Several strands of their work – the Monetarist claim that aggregate policy should be reduced to a focus on the central bank controlling the money supply to control inflation (the market would deliver the rest (high employment and economic growth, etc); the promotion of a ‘natural rate of unemployment’ such that governments who tried to reduce the unemployment rate would only accelerate inflation; and the so-called Permanent Income Hypothesis (households ignored short-term movements in income when determining consumption spending), and others – were woven together to form a anti-government phalanx. Later, absurd notions such as rational expectations and real business cycles were added to the litany of Monetarist myths, which indoctrinated graduate students (who became policy makers) even further in the cause. Over time, his damaging legacy has been eroded by researchers and empirical facts but like all tight Groupthink communities the inner sanctum remain faithful and so the research findings haven’t permeated into major shifts in the academy. It will come – but these paradigm shifts take time.

Recently, another of Milton’s legacy bit the dust, thanks to a couple of Harvard economists, Peter Ganong and Pascal Noel, who with their paper “How does unemployment affect consumer spending?” smashed to smithereens the idea that households would not take consumption decisions with discretion, which the Chicagoan held to be a pivot of his active fiscal policy. Time traveling back to John Maynard Keynes, who outlined in his 1936 The General Theory of Employment, Interest and Money a view that household consumption was dependent on disposable income, and, that in times of economic downturn, the government could stimulate employment and income growth using fiscal policy, which would boost consumption.

In Chapter 3 The Principle of Effective Demand, Keynes wrote:

When employment increases, aggregate real income is increased. The psychology of the community is such that when aggregate real income is increased aggregate consumption is increased, but not by so much as income …

The relationship between the community’s income and what it can be expected to spend on consumption, designated by D1, will depend on the psychological characteristic of the community, which we shall call its propensity to consume. That is to say, consumption will depend on the level of aggregate income and, therefore, on the level of employment N, except when there is some change in the propensity to consume.

Keynes later (in Chapter 6 The Definition of Income, Saving and Investment) considered factors that might influence the decision to consume and talked about “how much windfall gain or loss he is making on capital account”.

He elaborated further in Chapter 8 The Propensity to Consume … and wrote:

The amount that the community spends on consumption obviously depends (i) partly on the amount of its income, (ii) partly on the other objective attendant circumstances, and (iii) partly on the subjective needs and the psychological propensities and habits of the individuals composing it and the principles on which the income is divided between them (which may suffer modification as output is increased).

And concluded that:

1. An increase in the real wage (and hence real income at each employment level) will “change in the same proportion”.

2. A rise in the difference between income and net income will influence consumption spending.

3. “Windfall changes in capital-values not allowed for in calculating net income. These are of much more importance in modifying the propensity to consume, since they will bear no stable or regular relationship to the amount of income.” So, wealth changes will impact positively on consumption (up and down).

Later, as he was reflecting in Chapter 24 on the “Social Philosophy towards which the General Theory might lead” he wrote:

… therefore, the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to invest, would seem to a nineteenth-century publicist or to a contemporary American financier to be a terrific encroachment on individualism, I defend it, on the contrary, both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative.

For if effective demand is deficient, not only is the public scandal of wasted resources intolerable, but the individual enterpriser who seeks to bring these resources into action is operating with the odds loaded against him …

It was thus clear – that active fiscal policy was the “only practicable means of avoiding the destruction” of recession brought about by shifts in consumption and/or investment. That view dominated macroeconomics for several decades.

Then in 1957, Milton Friedman advocated the idea of Permanent income hypothesis. The central idea of the permanent-income hypothesis, proposed by Milton Friedman in 1957, is simple: people base consumption on what they consider their “normal” income. In doing this, they attempt to maintain a fairly constant standard of living even though their incomes may vary considerably from month to month or from year to year. As a result, increases and decreases in income that people see as temporary have little effect on their consumption spending. The idea behind the permanent-income hypothesis is that consumption depends on what people expect to earn over a considerable period of time. As in the life-cycle hypothesis, people smooth out fluctuations in income so that they save during periods of unusually high income and dissave during periods of unusually low income. Thus, a pre-med student should have a higher level of consumption than a graduate student in history if both have the same current income. The pre-med student looks ahead to a much higher future income, and consumes accordingly.Both the permanent-income and life-cycle hypotheses loosen the relationship between consumption and income so that an exogenous change in investment may not have a constant multiplier effect. This is more clearly seen in the permanent-income hypothesis, which suggests that people will try to decide whether or not a change of income is temporary. If they decide that it is, it has a small effect on their spending. Only when they become convinced that it is permanent will consumption change by a sizable amount. As is the case with all economic theory, this theory does not describe any particular household, but only what happens on the average.The life-cycle hypothesis introduced assets into the consumption function, and thereby gave a role to the stock market. A rise in stock prices increases wealth and thus should increase consumption while a fall should reduce consumption. Hence, financial markets matter for consumption as well as for investment. The permanent-income hypothesis introduces lags into the consumption function. An increase in income should not immediately increase consumption spending by very much, but with time it should have a greater and greater effect. Behavior that introduces a lag into the relationship between income and consumption will generate the sort of momentum that business-cycle theories saw. A change in spending changes income, but people only slowly adjust to it. As they do, their extra spending changes income further. An initial increase in spending tends to have effects that take a long time to completely unfold. The existence of lags also makes government attempts to control the economy more difficult. A change of policy does not have its full effect immediately, but only gradually. By the time it has its full effect, the problem that it was designed to attack may have disappeared. Finally, though the life-cycle and permanent-income hypotheses have greatly increased our understanding of consumption behavior, data from the economy does not always fit theory as well as it should, which means they do not provide a complete explanation for consumption behavior.

The idea of a propensity to consume, which had been formalised in textbooks as the Marginal propensity to consume (MPC) – which described the extra consumption that would follow a $ of extra disposable income, was thrown out by Friedman.

The MPC concept – that households consume only a proportion of each extra $1 in disposable income received – formed the basis of the expenditure multiplier. Accordingly, if government deficit spending of, say $100 million, was introduced into a recessed economy, firms would respond by increasing output and incomes by that same amount $100 million. But the extra incomes paid out ($100 m) would stimulate ‘induced consumption’ spending equal to the MPC times $100m. If the MPC was, say, 0.80 (meaning 80 cents of each extra dollar received as disposable income would be spent) then the ‘second-round’ effect of the stimulus would be an additional $80 million in consumption spending (assuming that disposable and total income were the same – that is, assuming away the tax effect for simplicity). In turn, firms would respond and produce an additional $80 million in output and incomes, which would then create further induced consumption effects. Each additional increment, smaller than the last, because the MPC of 0.80 would mean some of the extra disposable income was being lost to saving. But it was argued that the higher the MPC, the greater the overall impact of the stimulus would be. Instead, Friedman claimed that consumption was not driven by current income (or changes in it) but, rather by expected permanent income.

Permanent income becomes an unobservable concept driven by expectations. It also leads to claims that households smooth out their consumption over their lifetimes even though current incomes can fluctuate. So when individuals are facing major declines in their current income – perhaps due to unemployment – they can borrow short-term to maintain the smooth pattern of spending and pay the credit back later, when their current income is in excess of some average expectation.

The idea led to a torrent of articles mostly mathematical in origin trying to formalise the notion of a permanent income. They were all the same – GIGO – garbage in, garbage out. An exercise in mathematical chess although in search of the wrong solution. But Friedman was not one to embrace interdependence. In the ‘free market’ tradition, all decision makers were rational and independent who sought to maximise their lifetime utility. Accordingly, they would borrow when young (to have more consumption than their current income would permit) and save over their lifetimes to compensate when they were old and without incomes. Consumption was strictly determined by this notion of a lifetime income.

Only some major event that altered that projection would lead to changes in consumption.

The Permanent Income Hypothesis is still a core component of the major DSGE macro models that central banks and other forecasting agencies deploy to make statements about the effectiveness of fiscal and monetary policy.

So it matters whether it is a valid theory or not. It is not just one of those academic contests that stoke or deflate egos but have very little consequence for the well-being of the people in general. The empirical world hasn’t been kind to Friedman across all his theories. But the Permanent Income Hypothesis, in particular, hasn’t done well in explaining the dynamics of consumption spending.

Getting back to the paper mentioned in the beginning, it finds deployment of a rich dataset arguing to point where the permanent income hypothesis of Friedman is nailed to the coffin. If the permanent income hypothesis was a good framework for understanding what happens to the consumption patterns of this cohort then we would expect a lot of smoothing going on and relatively stable consumption.

Individuals, according to Friedman, are meant to engage in “self-insurance” to insure against calamity like unemployment. The evidence is that they do not.

The researchers reject what they call the “buffer stock model” (which is a version of the permanent income hypothesis).

They find:

1. “Spending drops sharply at the onset of unemployment, and this drop is better explained by liquidity constraints than by a drop in permanent income or a drop in work-related expenses.”

2. “We find that spending on nondurable goods and services drops by $160 (6%) over the course of two months.”

3. “Consistent with liquidity constraints, we show that states with lower UI benefits have a larger drop in spending at onset.” In other words, the fiscal stimulus coming from the unemployment benefits attenuates the loss of earned income somewhat.

4. “As UI benefit exhaustion approaches, families who remain unemployed barely cut spending, but then cut spending by 11% in the month after benefits are exhausted.”

5. As it turns out the “When benefits are exhausted, the average family loses about $1,000 of monthly income … In the same month, spending drops by $260 (11%).”

6. They compare the “path of spending during unemployment in the data to three benchmark models and find that the buffer stock model fits better than a permanent income model or a hand-to-mouth model.”

The buffer stock model assumes that families smooth their consumption after an income shock by liquidating previous assets – “a key prediction of buffer stock models is that agents accumulate precautionary savings to self-insure against income risk.”

The researchers find that the:

the buffer stock model has two major failures – it predicts substantially more asset holdings at onset and it predicts that spending should be much smoother at benefit exhaustion.

7. Finally, the researchers found “that families do relatively little self-insurance when unemployed as spending is quite sensitive to current monthly income.” Families “do not prepare for benefit exhaustion”.