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Posted on 22-Feb-2019 Comments  0

EPF Rate Hike

Higher EPF rates actually distort the Yield Structure in India

During the last week, the government hiked EPF rates from 8.50% to 8.65%. As a pre-election move, it is surely going to impress the vast middle class population in India. But the hike in EPF rates could have larger macroeconomic import which India cannot ignore. Here are 3 important things that the Indian people must understand before celebrating the hike in EPF rates.

It will hike borrowing cost

EPF rates are, in a way, a major signal of interest rate direction in the economy. Being government sponsored, the EPF rates set the benchmark for risk free rates in the economy. The government has already projected the fiscal deficit to go beyond the FRBM commitments in the next two years. That means; the government will have to borrow more aggressively to bridge that gap. In the last few weeks we saw that government paper is not really getting a good response from the bond investors due to the low yield levels. By hiking the EPF rates to 8.65%, the government has indirectly done two things. Firstly, it has created an anomalous interest rate situation that is at cross purposes with the dovish monetary policy that the MPC outlined in its minutes. If the EPF rates are hiked then it is unlikely that rate cuts can be passed on to the ban borrowers as it will make debt expensive in the first place. Banks will be unwilling to pass on rate cut, so credit off-take suffers.
Distorts the yield curve

This is a much bigger problem and economists have time and again spoken about the same. EPF is a totally safe form of investment, albeit with a lock in period. But that is not the point. The interest rate of 8.65% is just one of the benefits. The investment in EPF entitles the individual to get 30% (peak rate) tax exemption under Section 80C of the Income Tax Act. That raises the effective yields on the EPF investment. Secondly, interest earned on the EPF is fully tax exempt in the hands of the investor. While the government pays just 8.65% to the investor, if you add up the Section 80C benefit and the interest exemption, the actual yield is much higher and government is actually paying a steep cost for the EPF monies. That is what distorts the yield curve.

Pressure on EPF fund managers

Most savers erroneously assume that the returns on EPF will continue to be assured. But, recently the EPF has been forced to take a hit on its investments in IL&FS bonds. One does not really know the shortfall that EPF has but that will be known sooner rather than later. At some point, the government is going to be able to ill-afford these giveaways. Either the government reduces the rates sharply or it will be forced to take on greater risks (as in the case of IL&FS). One only hopes that the EPF does not end up becoming another US-64!

Trade War

The US and China may finally have found a Trade War solution

Finally, the US and China have made some headway on the trade talks. At least, it looks like the March 01st deadline to hike tariffs to 25% will now be put off. That itself is a good start. There are other things to worry about for the US and China. Firstly, the US is too deeply entrenched in the trade war and there is no way they can now withdraw without, at least, a moral victory over the Chinese. For China, there are enough problems at home. A reasonable compromise is what they would be look for. Here is how!

Crunch the trade deficit

That seems to be Donald Trump’s single point agenda now. With a trade deficit of $600 billion, the US was literally becoming a consumption bowl for Chinese products. Now China has agreed to work towards a gradual and phased reduction in this trade deficit. How will this be done? China has committed to infuse nearly $1.2 trillion over the next few years buying goods and services from the US. A sharp reduction in trade deficit with China between now and 2020 will be a good starting point for Trump to again stake his claim for the US Presidency. Work has already started on the Mexican Wall via imposition of national emergency and a Chinese victory to top it will be icing on the cake. The US may not have an economic case, but they surely have a political case to make. China realizes that it cannot afford growth to falter.
What about IP protection

That remains a bone of contention between the US and China and is likely to remain an irritant in their relationship. In fact, neither side would want to cede any room on this front. The US has long been accusing China of allegedly misusing US intellection property and using it to enhance its own scientific body of knowledge as well as the profits of its businesses. That may not be far from the truth but all economies from the US in the 1950s to Japan in the 1970s have essentially growth through the reverse engineering. That is exactly what China is doing today, albeit on a much bigger scale. While China will be happy to purchase more goods from the US, it is unlikely to relent on structural issues. Donald Trump may not really mind that concession.

What about world trade?

If the US and China enter into a trade deal, it could seriously undermine the role of the WTO. Increasingly, free trade could give way for regional trade blocs and preferential treatment to select nations. The US and China may have just triggered off that trend. The impact is already visible. The EU and UK have become more tractable on the BREXIT issue. For India, the mandate is clear. It is time to build serious partnerships if it wants its trade and exports to get the big push. That seems to be the trade trend in the coming years!

Saudi Promises

India must take Saudi promises on Pakistan with a pinch of salt…

A couple of days after the Saudi Prince committed investments worth $20 billion to Pakistan, he also committed total investments worth $100 billion to India. Of course, these are commitments and it needs to be seen how much of these would actually translate into flows. But that is not the point. The question is; how much can India rely on Saudi promise vis-à-vis Pakistan. Actually, India will have to take Saudi promises on Pakistan with a pinch of salt. But, first the background!

Indo-Saudi: A two way affair

India’s relationship with Saudi Arabia has been a two-way story. For a long time, Saudi Arabia has been one of the largest employers of expat Indians and hence has also been one of the major sources of NRI remittances into India. That is something India has been quite sensitive about. At the same time, Saudi Arabia is the second largest supplier of crude oil to India (after Iraq) and Saudi is looking to deepen its reach in the Indian oil market. For Saudi Arabia, its relationship with India goes beyond oil and remittances. It sees India as the platform for diversifying its economy much beyond oil. In fact, after the oil price crash of 2014, Prince Salman has already begun the exercise to diversify Saudi Arabia’s dependence on oil revenues. India has an important role to play in this diversification. But how will that alter links with Pakistan? India will have to play its cards cautiously.

An Islamic partnership

If there is one country that has literally given a blank check to Imran Khan in the midst of an economic crisis, it is Saudi Arabia. Apart from financial and crude oil assistance, Saudi Arabia is going to be a key investor in Gwadar refinery. Also, Saudi Arabia has looked at Pakistan as the last major bastion in Asia where it can promote its Sunni version of Islam. One must not forget that most of the funding for the Afghan war against the Soviets came from Saudi Arabia. With Pakistan’s physical proximity to Afghanistan, Iran, China and Central Asia, it will continue to be a key player in the larger Saudi scheme of things. In short, India should not expect Saudi Arabia to act on curbing terror by Pakistan, either financially or morally.

Iran could be another factor

Between Saudi Arabia and Iran, it is not just a clash between the Sunni and Shia sects of Islam. It is also a battle for supremacy in the Middle East region. The US needs the help of Saudi Arabia to keep Iran in check and Saudi Arabia needs the US to keep the arms cache flowing. That relationship is unlikely to change in a hurry. India must not expect too much of help either from the US or Saudi Arabia in its war against terror motivated by Pakistan. India’s two-way relationship with Saudi Arabia is already delicate. Beyond words and promises; it will be limited!


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