While excellent newsletters on specific themes within public policy already exist, this thought letter is about frameworks, mental models, and key ideas that will hopefully help you think about any public policy problem in imaginative ways. Audio narration by Ad-Auris. If this post was forwarded to you and you liked it, consider subscribing. It’s free. #188 Time and Tide Wait for NoneTaking stock of major political developments in October, Decoupling for Real, and Road Tax Arbitrage
Global Policy Watch: Catching Up with NewsInsights on global issues relevant to India— RSJ It is good to be back after a month-long break. Much in line with our expectations, we didn’t do anything productive during this time. No additional writing or reading than usual. And no, as they say, we didn't recharge our batteries either. Bereft of any source of power, they are still flashing red at below 10 per cent. While our life was drifting through a meandering river of ennui, the world around us was in a spate, making up for our dull existence. We couldn’t have asked for a more event-filled month to take a break. Maybe a quick run-through of these news items is a good way to get back into the groove of writing this newsletter. Here we go. Putting The Blight In Ol’ BlightyLiz Truss became the shortest-tenured PM in British history when she resigned last week. Columns have been written about what she and her Chancellor of the Exchequer, Kwarteng, got wrong. The lesson to learn from the complete shambles that the UK economy finds itself in is simple. Rabid adherence to an ideology may propel you to the top, but once you’re there, you’d be best advised to stop drinking the kool-aid. Pragmatism keeps your job secure. The problem in the UK, as with most developed economies right now, is you have to continue to increase interest rates to fight inflation while giving some fiscal relief in terms of tax cuts or spending from the Treasury to support growth. Overdo the inflation fight, and you kill growth for good and risk recession. This, anyway, seems inevitable now. On the other hand, go aggressive on tax cuts or increase fiscal spending to support growth, and you risk further inflation. That would unmoor future inflation expectations and spike bond yields. Nobody knows how to get this balance right. There’s no real solution except to hang tight and hope time solves it for all of us. Truss didn’t want to hang around hoping for this. She wanted action, which meant going all-in on supply-side economics with some £45bn of unfunded tax cuts without any explanation on how to fund this. The markets, already on the edge with all the other bad news to contend with, were spooked. There was a run on the sterling, pension funds were staring at defaults, and there was a freefall in the gilts market. The IMF, which has a template of press statements usually trudged out for any emerging market doing this kind of bonfire of policy prudence, had to apply it to the UK now. This is what it said:
Truss fired Kwarteng and his successor, Jeremy Hunt, did a U-turn to beat all U-turns. Everything the Truss team had announced was reversed. Truss was toast from then on. So is any Thatecherian dreams of another supply-side economics revolution. All I can see for the UK from here on are steady interest rate increases, tax hikes and spending cuts to balance the budget and the inevitable recession. Followed by stagflation by the end of the decade. Maybe in ten years, we will all agree that Truss was right in doing what she was doing. The pain would have been sharper but shorter. Hey Rishi, just don’t make it bad; take this sad economy and make it better - is all the Beatles gyaan that I have to offer to the first Hindu, Indian-origin PM of Britain. Baaki everything is Maya as he well knows. Xi Has Made Up His MindThe other event the world paid attention to during our break was the week-long National Congress of the Chinese Communist Party. I’m no China expert, and there’s always a bit of overreading of signals that emerge from such events. But Xi helped us all this time with the televised, gentle frogmarching of the former premier Hu Jintao from the conference. The message was clear. No more growth at all cost that has led to corruption and income inequality. Xi won’t have it any more. So, all pro-reform members from the Communist Youth League cohort who oversaw the rise of the Chinese miracle are out. Li Keqiang, Hu Chunhua, Liu He, and Yi Gang - all dropped from the central committee. The new politburo is packed with Xi loyalists, who will now lead the ‘struggle’ for a just and stable society. Xi used struggle 22 times in his speech if such things interest you. Even Mahatma Gandhi didn’t struggle so much. The legitimacy of the party and its ideology will be fully restored. Xi will spend the rest of his life fighting the odds to make this happen. What a man! Meanwhile, the economic data emerging from China remains weak. Covid lockdowns are still a feature, exports are weak, residential property prices are still falling, and the middle class will need a bailout soon. There is a risk of contagion otherwise. A meaningful economic decoupling from China is no longer an ‘if’ scenario. It is happening as we speak and will only catch speed. The new US semiconductor policy is a taste of things to come. The National Security Strategy document released last week by the Biden administration suggests the US is no longer coy about expressing the geopolitical threat that is the PRC. The language is way more explicit than in previous documents. Here is an excerpt:
And this will have economic consequences:
This kind of language that has become a feature of the Biden administration, Xi’s aggressive stance on Taiwan at the Congress and the turning of the screws on Putin in Ukraine is now prompting World War 3 predictions. A bit overblown, but surely a more probable event than any time since the days of the Cuban missile crisis. While a doomsday geopolitical scenario is still a stretch, ‘China + 1’ as a geoeconomic trend of the future is now a reality. There’s no going back to the scenario of putting all your manufacturing eggs in the China basket. This is a trend we have been anticipating since the first wave of the pandemic. Xi has only accelerated it with his somewhat delusional foreign policy and a crackdown on local entrepreneurs. He has handed India a free hit. India Policy Watch #1: Catching Up with NewsInsights on domestic policy issues— RSJ Remember the 20 lakh crores package that the FM unveiled in May 2020 to combat the economic impact of Covid. A vital part of that package was the Emergency Credit Line Guarantee Scheme (ECLGS) to help distressed micro and small-sized enterprises. Here’s a Moneycontrol piece to refresh your memory on the basic contours of the scheme:
Since then, the scheme has been extended twice (versions 2.0 and 3.0) with credit terms and the ceiling for outstanding credit raised. That is, the scheme was made more inclusive. Bottomline: Instead of giving out cheques to small businesses like the Treasury did in the US (as did other western nations), India could only promise its banks a sovereign backstop for the loans they disbursed to small businesses under this scheme. In case of loan default, the government would stump up the money for the banks. Many, including me, had doubts about whether this would be enough for these small businesses to survive. Many businesses had come to a halt because of the lockdown. They had serious cash flow issues. The scheme seemed like a band-aid when what the patient seemed to need was surgery. Anyway, two years later, how did the scheme fare? I have been keeping track of the performance of the banks since and their commentary on the ECLGS portfolio (yeah, yeah, sad life). Did banks embrace this scheme and disburse loans to a meaningful extent? Have they seen this portfolio build up more NPAs (non-performing assets)? Was there a moral hazard in having a sovereign backstop, and did it play out that way? Did the scheme work as it was envisaged? Well, here are the answers. Of the planned outlay of Rs. 5 lakh crores, about Rs. 3.5 lakh crores has been disbursed under the various versions of the scheme. Over 80 per cent of those who borrowed were micro-enterprises in dire need of liquidity. Both public and private sector banks participated in almost equal measure (a 55-45 split). Most importantly, the average NPA rate on March 22 was about 4.8 per cent for this portfolio in the system. This was lower by about 130 basis points for a similar portfolio that hadn’t availed of the scheme. Simply put, the defaults were lower than the performance in usual times. And way lower than the 20 per cent expectations that analysts had at the time of the scheme launch. Even in the latest quarter, no bank called out the ECLGS portfolio as an area of concern. In fact, a quick look at the disclosures suggests a continuation of the trend seen at the end of March. The portfolio asset quality is not just holding up, it might be improving. There’s a Transunion Cibil report with more data around this (updated till March 2022) if you are interested in knowing more. What do these numbers mean? An average 5 per cent default on the portfolio means that with a spend of Rs 17,500 crores, the government could get the system to disburse Rs. 3.5 lakh crores to a vulnerable and badly hit segment at the right time. Of course, the counterfactual can be asked. Would the banks have disbursed these loans even without the government backstop? It is difficult to say. But let me stick my neck out and say that the government backstop and a bit of ‘monitoring’ on who is disbursing these loans and who isn’t did go a long way in making the scheme work. This was possibly the most efficient of the proposals to offer support to micro-enterprises. It is a rare thing in public policy space in India. It worked. There are some long-term implications of such schemes' success in India and outside. This is a new tool for governments who pulled it out to combat an extraordinary emergency like Covid. It is a one-off use case that worked well. But the governments can soon argue that every new unfolding scenario is an emergency. The Ukraine war, rising oil prices and global inflation can also be considered emergencies. It is only a matter of time before we become indiscriminate with this. The government won’t then raise debt anymore. They will just issue credit guarantees. How will that pan out? It is worth exploring. It will fit into an overall theme of long-term financial repression that I see will be a consequence of everything happening around us now. I will pick this up next week. Matsyanyaaya: Decoupling, For RealBig fish eating small fish = Foreign Policy in action— Pranay Kotasthane During our month-long break, something big happened in my research area: on October 7th, the US government announced expansive unilateral export controls restricting Chinese semiconductor companies’ access to advanced hardware, software, chips, and machinery. Since then, several foreign policy analysts, businesspersons, and government officials have discussed the impact of these controls. Never before have semiconductors been such a rage in the political and policy discourse. To understand the gory details of these controls, head over to the post below from our Technopolitik newsletter or listen to our All Things Policy episode. 
Moving on, you might recall that in edition #184, I listed four likely scenarios for US-China decoupling. These controls unmistakably show that the fourth scenario — “Decoupling is happening, but only in a few strategic sectors, such as scientific research, semiconductors, strategic materials, etc.” — is now playing out. These stringent export controls are unlikely to decapitate China’s semiconductor ecosystem. But their value lies in the signal they send to US companies, allies, partners, and China. The fact that the US is willing to jeopardise the short-term economic interests of its own companies to score a geopolitical point increases its credibility as a geopolitical actor in the contest with China. We can shelve the speculations that the US and China might converge on a modus vivendi for some years. Meanwhile, in an article for Hindustan Times, Abhiram Manchi and I discussed the medium-term impact of these controls on China, the US, and countries like India. A draft version of that article follows. — In his report to the 20th National Congress of the Communist Party of China, Xi Jinping rattled out nine innovation areas where China had achieved “major successes”. There was one glaring omission — semiconductors. Decreasing dependence on foreign companies for chips is a critical pillar of China’s quest for self-reliance and strength in science and technology. Indeed, its own semiconductor ecosystem has come a long way over the past decade. But the omission in Xi’s speech suggests that semiconductors continue to remain a weak link in China’s impressive technology stack. Hence it is not surprising that the US has—once again—chosen semiconductor export controls to counter China. The new rules, announced on 7th October, increase the breadth and scope of licensing requirements to restrict the “PRC’s ability to obtain advanced computing chips, develop and maintain supercomputers, and manufacture advanced semiconductors”. In other words, the US has formally shifted its goal from outpacing China to actively denying it access to advanced chips. Impact on ChinaThree days after the US Bureau of Industry and Security (BIS) announced these controls, shares of leading Chinese chipmakers lost $8.6bn in market value. Analysts highlighted that rules controlling US citizens from working in China’s advanced chipmakers wreaked havoc on Chinese companies. While these controls are, without doubt, broader and deeper than ever, assessing their long-term impact needs more nuance. Undoubtedly, these extensive controls will hobble China's homegrown chip sector. Sectors that use advanced computing and AI chips—autonomous mobility, high-end mobile phone makers, and autonomous weapons system companies—will face difficulty accessing US-made chip-making software and specialised chips in the short term. They will also find it challenging to access chips made by non-US companies using US-made manufacturing equipment. Advanced computing research in universities will also be adversely affected. But it would be hubris to think that the controls have decapitated China’s semiconductor industry. Even though Chinese companies might not be able to produce cutting-edge AI training chips, they can still deploy cloud computing services for AI training, even as they develop homegrown alternatives. We can also expect a rise in industrial espionage, forced technology transfer, and targeted poaching of key executives. We should not underestimate non-linear technological breakthroughs to get around these controls. China’s ambition to be at par with Taiwan in advanced semiconductor manufacturing has taken a big hit. Still, in a decade or so, it might be able to develop credible alternatives. China is unlikely to take these controls lying down. But its retaliatory measures might emerge in another trade or technology domain, where it has the upper hand. China’s dominance in critical raw materials is one such area. But given that it employed a rare earth export ban against Japan in 2010 for geopolitical reasons, repeating the move would be entirely predictable and hence less impactful. Impact on the USNew export controls will have a sobering effect on US companies, as evidenced by chip stocks losing $240 billion worldwide in the immediate aftermath. For example, Apple's plan to use Yangtse Memory Technologies Co (YMTC) chips is unlikely to proceed, even though these are 20% cheaper than those by Samsung or Micron. All the US Semiconductor companies count China as one of their biggest markets and consequently will face significant revenue decline. Companies will begin lobbying for licenses to supply to Chinese companies. Although the US government first pacified direct opposition by bringing in the $52 billion CHIPS and Science Act of 2022, it might not be enough to fill the China-size vacuum. Moreover, the nuanced controls are not easy to implement. They will require coordination between multiple branches of the government, like compliance and licensing offices, and hundreds of companies. Even with a vast regulatory setup, it won't be easy to track the end-use of chips. The US government's next step could be to convert these unilateral controls into more exhaustive multilateral export controls through the Wassenaar Arrangement—an export control regime for commercial and military use goods with 42 countries, including the likes of semiconductor giants such as Japan and South Korea. Impact on IndiaThe geopolitical impact of the new controls is perhaps the most significant. The US and China semiconductor ecosystems might recover, but this move is a critical juncture in technology geopolitics. The US has made it unequivocally clear that it is willing to actively constrain China’s progress in critical technologies, even if it means hurting its own companies and allies. It is clear that decoupling—at least in a few high-tech sectors—is the most likely outcome. It signifies that critical technologies will be seen through a “national security first” lens, even if they have mass commercial applications. Countries like India would have preferred a world where flows of capital, labour, goods and services remain largely independent of geopolitical concerns. But that world order is past us. A common understanding—if not complete alignment—on geopolitics might become a precondition for deepening technology engagement. India must attempt to become a vital node in the semiconductor ecosystem and build strong links with states that share its interests and values and with which it enjoys economic complementarities. It would be a mistake to think that we can substitute high-tech global value chains with national champions alone. In the changed world order, India’s foreign policy actions will play an outsized role in determining its technology outcomes. The current moment demands realism rather than idealism or grandstanding. India Policy Watch #2: The Highways of Tax EvasionInsights on burning policy issues in India— Pranay Kotasthane It’s commonplace to find buses, trucks, and trailers in many parts of India carrying number plates registered in smaller northeastern states such as Arunachal Pradesh or Nagaland. While it seems odd at first sight, we can intuitively—and correctly—guess that these anomalies result from tax arbitrage. States that have lower road tax rates attract higher vehicle registrations. But as public policy enthusiasts, you will also appreciate the other layers that can get masked by this tax arbitrage intuition. So here goes. From what I gather, bus operators have four big-ticket obligations to the government: they need to register their vehicles, pay a road tax on a per-seat basis in the state where the vehicle was registered, secure a fitness certificate to prove that the vehicle meets all safety rules, and obtain a permit from one or more states to ply the vehicle in those states. Crucially, road taxes paid by these bus operators are not subsumed under the GST. So, states have wildly different rates of taxation. Just like investors use tiny Mauritius’ low tax rates to channel investment into India, smaller states in India can gain significant revenue from bus registrations by lowering their road tax rates. This comment from a travel industry body in a Times of India report explains the significant differences in road tax rates:
While it is tempting to characterise this arbitrage as healthy competitive federalism, identifying other costs makes the case less clear. For instance, bus operators avoid revisiting the registration state and instead get doctored fitness certificates ‘remotely’ without any inspection. Thus, the cost of the high rate of taxation is a higher probability of safety failures. There are more angles to the story. Until 2021, states also controlled permits for bus operators. So if you operated a bus that travelled across three states, you needed to get permits from all three states ordinarily. Often, permits were denied in the bigger states. Specifically, governments had a problem with customised sleeper buses with sleeper and sitting seats. The reason? I will let a sarkaari babu explain it eloquently:
In other words, the desire to increase tax revenue per seat led to buses being registered in other states with lower safety requirements— a classic moral hazard. The situation about permits changed after the ‘One Nation, One Permit’ rule came into effect in 2021. Now, bus operators could register in lower tax-rate states and obtain nationwide operating permits. The number of buses registered via this circuitous route shot up. So the high tax-rate states are now trying to coerce these buses to re-register in their jurisdictions, but there doesn’t seem to be a move towards lowering taxes. In sum, this is another case of competitive federalism in which the coordinating function of the union government becomes vital. If the road tax regime were to move to a uniform tax rate and revenue-sharing arrangement as with GST, these arbitrage opportunities would melt away. While it’s fair to criticise the GST system for its multiple-rate structure, we forget that the situation without a uniform tax rate can be much worse for all stakeholders. HomeWorkReading and listening recommendations on public policy matters
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