Cut Interest Rates by 2 per cent: The New Economics of Nirmala Sitharaman

Nirmala Sitharaman Spokesperson 11, Ashoka Road, New Delhi - 110001.

BA Kiya Hai, MA Kiya,
Lagta Hai Wo Bhi Aiwen Kiya.
– Gulzar in Mere Apne

The commerce and industry minister Nirmala Sitharaman wants the Reserve Bank of India(RBI) to cut the repo rate by 200 basis points.

Yes, you read that right!

200 basis points!

The repo rate is the rate at which banks borrow from the RBI on an overnight basis. One basis point is one hundredth of a percentage. The repo rate currently stands at 6.5 per cent.

I still hold that the cost of credit in India is high. Undoubtedly, particularly MSMEs which create a lot of jobs contribute to exports… are all hard pressed for money and for them, approaching a bank is no solution because of the prevailing rate of interest. I have no hesitation to say, yes 200 bps, I would strongly recommend,” Sitharam told the press yesterday in New Delhi.

What Sitharaman was basically saying is that India’s micro and small and medium enterprises(MSMEs) are not approaching banks for loans because interest rates are too high. Given this, the RBI should cut the repo rate by 200 basis points and in the process usher in lower interest rates for MSMEs.

This, according to Sitharaman, was important because MSMEs create a lot of jobs and contribute to exports, and hence, should be able to borrow at a lower interest rates, than they currently are. As per the National Manufacturing Policy of 2011, the small and medium enterprises contribute 45 per cent of the manufacturing output and 40 per cent of total exports.

Hence, Sitharaman was batting for the MSMEs. But is it as easy as that?

That politicians don’t understand economics, or at least pretend not to understand it, is a given. But Sitharaman is a post graduate in economics from the Jawaharlal Nehru University in Delhi. (You can check it out here). For her, to make such an illogical remark, is rather surprising.

Not that the RBI is going to oblige her, but for a moment let’s assume that it does, and cuts the repo rate by 200 basis points, in the next monetary policy statement, which is scheduled for October 4, 2016, or over the next few statements.

What is going to happen next? Will banks cut their lending rates by 200 basis points? Only, when the banks cut their lending rates by 200 basis points, is the MSME sector going to benefit.

Banks only borrow a small portion of money from the RBI on an overnight basis and pay the repo rate as interest. A major portion of the money that they lend is borrowed in the form of fixed deposits. Hence, lending rates cannot fall by 200 basis points, unless fixed deposit interest rates fall by at least 200 basis points. (I use the word at least because banks tend to cut deposit rates faster than lending rates).

Wil the banks cut deposit rates by 200 basis points? Let’s assume that they do. If the deposit rates are cut by such a huge amount at one go, people will not save money in fixed deposits. Money will move into post office savings schemes, which offer a significantly higher rate of interest in comparison to fixed deposits (which they do even now, but with a cut the difference will be substantial).

Over a longer period of time, money will also move into real estate and gold, as people start looking for a better rate of return, higher than the prevailing inflation. This will lead to the financial savings of the nation as a whole falling. And banks in order to ensure that deposits keep coming in, will have to reverse the 200 basis points cut and start raising interest rates.

This is precisely how things played out between 2009 and 2013, when household financial savings fell from 12 per cent of the GDP to a little over 7 per cent of the GDP. Meanwhile, the interest rates went up, in order to attract financial savings.

This is Economics 101, which a post graduate in economics from a premier university in the country, should be able to understand.

Another important issue that our politicians seem to forget, over and over again, is the importance of fixed deposits, as a mode of saving, in an average Indian’s life. In 2013-2014, the latest year for which data is available, 69.23 per cent of total household financial savings, were in deposits.

Of this nearly 62.02 per cent was with scheduled commercial banks and 4.19 per cent with cooperative banks and societies. Nearly 2.61 per cent was invested in deposits of non-banking companies.

What does this tell us? It tells us that for the average Indian, the fixed deposit is an important form of saving. For the retirees it is an important form of regular income. Now what happens if fixed deposit interest rates are cut by 200 basis points? The regular income from the fresh money that retirees invest, will come down dramatically. Also, when their old fixed deposits mature, they will have to be invested at a significantly lower rate of interest.

This means that they will have to limit their consumption in order to ensure that they meet their needs from the lower monthly income that their fixed deposits are generating.

What about those who use fixed deposits as a form of saving? (I know that fixed deposits are a terribly inefficient way of saving, but that is really not the point here). Those who are using fixed deposits to save money, for their retirement, for the education and wedding of their children, will now have to save more money, in order to ensure that they are able to create the corpus that they are aiming at. This will also mean lower consumption.

Ultimately lower consumption will impact MSMEs as well, because there won’t be enough buyers for what they produce, as people consume less.

Those individuals who are not in a position to save the extra amount in order to make up for lower interest rates, will end up with a lower corpus in the years to come.

The point being that MSMEs do not operate in isolation. And the level of interest rates impacts the entire economy and not just the MSMEs, as Sitharaman would like us to believe.

Further, even if fixed deposit rates fall by 200 basis points, banks may still not be able to offer low interest rates to MSMEs, simply because they need to charge a credit risk premium i.e. factor in the riskiness of the loan that they are maing.

In case of the State Bank of India, the gross non-performing assets of SMEs stands at 7.82 per cent, as on March 31, 2016. This means that for every Rs 100 that the bank has lent to an SME, close to Rs 8 has been defaulted on. This risk of default needs to incorporated in the interest rate that is being charged.

And finally, the interest rates on fixed deposits of greater than one year are currently in the region of 7 to 7.5 per cent. This is when the rate of inflation has already crossed 6 per cent. In July 2016, the rate of inflation as measured by the consumer price index was at 6.07 per cent.

If fixed deposit rates are cut by 200 basis points, the interest rates will fall to around 5 to 5.5 per cent. This when the rate of inflation is greater than 6 per cent. This would mean that the real rate of interest (the difference between the nominal rate and the rate of inflation) would be in a negative territory. This is precisely how things had played out between 2009 and 2013 and look at the mess it ended up creating for the Indian economy.

Given these reasons, it is best to say that Sitharaman’s prescription would be disastrous for the Indian economy.

The column originally appeared in Vivek Kaul’s Diary on August 25, 2016

ONE PRODUCT, ONE PRICE

DietCoke_12oz

The one time I really feel fleeced is when I want to have a soft drink in the middle of a flight. The soft drink can that you get in the market for thirty bucks costs as high as Rs 100 on a flight. Sandwiches and noodles retail for Rs 200.

A similar rip-off happens inside cinema theatres as well. Everything from soft drinks to bottles of water to popcorn is exorbitantly priced. In fact, the companies help both airlines as well as cinema theatres by producing the same products for them, but at a different maximum retail price. Hence, the same can of soft drink which costs Rs 30 outside, costs Rs 100 on an airplane. The same bottle of water which costs Rs 10 otherwise, costs Rs 30 inside an airplane or a cinema theatre.

This essentially means that companies end up offering the same product at different price points at different places. This essentially violates what economists call the One Product-One Price principle. And what is this principle? As the Economic Survey of 2015-2016 points out, it is basically the “intuition that products which are essentially the same should be charged essentially the same price.”

What allows airlines and cinema theatres to charge more is the lack of an option. When one is inside an airline, there is no other option. And the same stands true for a cinema theatre as well. Hence, the violation of the one product, one price principle does not have any repercussions.

But the same cannot be said about other walks of life. Take the case of the subsidised goods that the government offers the citizens. This includes rice, wheat, kerosene and sugar, among other things When these goods are sold through the public distribution system constituting of around five lakh fair price shops all over the country, they are offered at a price which is much lower than their market price.

And what does this do? It violates the one product one price principle. Let’s take the case of rice. It is available at a price of Rs 3 per kg under the National Food Security Act. In the open market, rice sells at many times this price. Hence, it is but natural that the rice which has to be supposedly distributed through the public distribution system at an extremely cheap price finds its way into the open market.

This violation of the one product one price principle leads to “incentives to divert the subsidised commodity from eligible to ineligible consumers”. What is true about rice is also true about wheat, kerosene, sugar, domestic cooking gas and urea.

In a research paper dated January 2015 and titled Leakages from PDS (PDS) and the Way Forward, economists Ashok Gulati and Shweta Saini, put the leakage of the public distribution system for the distribution of rice and wheat at 46.7 per cent. In absolute terms the leakage was at 25.9 million tonnes. This basically means that nearly half of the rice and wheat distributed through the public distribution system doesn’t reach those it is meant for.

The leakage rate in case of kerosene is 41 per cent. In case of sugar it is 48 per cent. In case of urea the leakage rate is 41 per cent. As the Economic Survey points out: “The 75 per cent subsidy on agricultural urea creates a large price wedge which feeds a thriving black market diverting urea to industry
and possibly across the border to Bangladesh and Nepal.”

This basically means that the government ends up wasting a lot of money that it spends on subsidies. What is the way out of this? The answer may very well lie in cash transfers, wherein money is directly deposited into the Aadhar-linked bank accounts of citizens, allowing them to buy these goods at their market price from the open market.

This will ensure that the violation of one product one price principle comes to an end and the government subsidies are well spent.

The column originally appeared in Bangalore Mirror on August 24, 2016

 

 

Will Construction Sector Create Jobs that India Badly Needs?

India-Real-Estate-Market

Several estimates made by economists and analysts suggest that around one million Indians are entering the workforce every month.

That means around 1.2 crore individuals are entering the workforce every year. And it is expected that the trend is likely to continue over the next couple of decades. The number of jobs being created are nowhere near what is needed.

The government has tried to address this situation through doles. This has meant distributing food grains at a cheaper price, distributing kerosene at a cheaper price, distributing fertiliser at a cheaper price and even trying to create some work for citizens under the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA).

The problem with these doles is that they are extremely leaky and on many occasions they do not reach those they are intended for. In the process, the government loses a lot of money. The leakages have other serious consequences as well (which I have talked about in the past and which I will keep talking about in the future).

Also, there is a fundamental problem with this approach—it doesn’t create the badly required jobs. Take the case of MGNREGA. The scheme is mandated to “provide at least 100 days of guaranteed wage employment in a financial year to every rural household whose adult members volunteer to do unskilled manual work.[1]

It is widely believed that MGNREGA pushed up rural farm wages, during the second term of the Manmohan Singh government. The idea behind this was that MGNREGA set a sort of a minimum wage, and if farmers wanted workers to work on their farms, they had to offer more money than the government was offering through MGNREGA.

In a research paper titled Rising Farm Wages in India: The ‘Pull’ and ‘Push’ Factors, published in April 2013, Ashok Gulati, Shweta Saini and Nidhi Satija point out that: “At all India level, the results reveal that a 10 percent increase in lagged GSDP (overall), GSDP (agri) and GSDP (construction) leads to 2.4 percent, 2.1 percent and 2.8 percent increase in farm wage rates respectively. This indicates that the growth in construction sector GDP has somewhat stronger influence on farm wages than the growth of overall GDP or even agri‐GDP. Impact of MGNREGA is also significant but is 4 to 6 times less effective than growth variables since 1990‐91.” (GSDP = Gross State Domestic Product).

What does this mean? It basically means that when the construction sector is doing well, the farm wages grow the fastest. In comparison, MGNREGA has a much smaller impact on farm wage growth. What this basically means that real economic activity leads to faster wage growth in comparison to the government trying to create some work through MGNREGA.

When the construction sector is doing well, a section of the farm workers drift towards jobs on offer, and this in turn pushes up wages for those who remain.

What also works in favour of construction is the fact that the jobs generated in the sector cater to India’s comparative advantage, which is the abundance of low-skilled labour. In fact, only 14.4 per cent of employees in the construction sector have secondary education.[2] As the Economic Survey of 2015-2016 points out: “Aggregate services employment grew faster than that in registered manufacturing and a number of service subsectors—transport, real estate and construction—registered substantially faster employment growth.”

This is not surprising given that the jobs in the construction sector cater to those with low-skills. In fact, it can continue to be a major creator of jobs in the days to come. A recent KPMG report titled Urban Indian Real Estate—Promising Opportunities expects the construction sector to be the largest employer in India by 2030. KPMG expects the sector to employ more than 7.5 crore Indians by then. The expectation is that at a size of one trillion dollars, the Indian construction sector will be the third largest in the world by 2030.

Like all reports put out by consultancies, this one also sounds good in theory. Nevertheless, many other things need to happen for India’s construction boom to take-off. Let me try and list a few here:

a) The mess that prevails in the area of land acquisition needs to be sorted out. Any construction happens only when there is some land. The Modi government (including the prime minister Narendra Modi) took a serious shot at this last year, but turned out to be unsuccessful. I don’t see the government spending more political capital on this any time soon.

b) One major factor that hinders the acquisition of land in this country is the lack of title records. This is something that needs to be addressed, if easier land acquisition, where the government role is limited, has to become the order of the day. The Rajasthan government has made a start on this front. Other states need to follow.

c) For any infrastructure boom to take off, banks should be in a position to lend. The government owned public sector banks are currently in a mess. The last thing they would want to do is to lend to infrastructure companies and infrastructure projects The gestation period for infrastructure projects is very long and there are many things that can go wrong in between.

d) To reduce the dependence of the infrastructure sector on banks for borrowing, India needs a well-functioning corporate bond market. (This is something that people have been writing about for the last 25 years). A well-functioning corporate bond market has the wherewithal to finance long-gestation infrastructure projects.

e) What does not help is the fact that the infrastructure sector in India is full of crony capitalists. And that stems from the fact that given the way the system functions, only a crony capitalist can perhaps manage it. This is like a chicken and egg story. Also, these crony capitalists in the past have had the habit of siphoning off the money lent to them by banks for infrastructure projects.

f) The construction sector can really take-off once the real estate sector takes off. The real estate sector has forward and backward linkages with 250 ancillary industries.[3] This basically means that when the real estate sector does well, many other sectors, right from steel and cement, to furnishings to paints etc., do well. The multiplier effect is huge.

The real estate sector has now been in the doldrums for more than five years. The simple reason for this lies in the fact that most Indian real estate has been unaffordable for a while now. For this anomaly to be corrected the nexus between politicians and builders needs to end. The system of electoral financing needs to evolve and move away from the way it currently is. And this is easier said than done.

[1] NREGA FAQs

[2] A.Amirapu and A.Subramanian, Manufacturing or Services? An Indian Illustration of a Development Dilemma, Working Paper 409, Centre for Global Development, June 2015

[3] Urban India Real Estate – Promising Opportunities, KPMG, August 2016

The column originally appeared in Vivek Kaul’s Diary on August 24, 2016

The Biggest Challenge for the New RBI Governor Urjit Patel is…

o-URJIT-PATEL-facebook-1

 

On Saturday, August 20, 2016, the Narendra Modi government appointed Urjit Patel, as the 24th governor of the Reserve Bank of India(RBI). He will take over fromRaghuram Rajan, on September 4, 2016.

Since Patel’s appointment two days back, a small cottage industry has emerged around trying to figure out what his thinking on various issues is. The trouble is that Patel has barely given any speeches, or interviews, for that matter, since he became the deputy governor of the RBI, in January 2013.

A check on the speeches page of the RBI tells me that he has given only one speech (you can read it here) and one interview (you can read it here) in the more than three and a half years, he has been the deputy governor of the RBI.

You can’t gauge much about his thinking from the speech which is two and a half pages long. As far as the interview goes, Patel has answered all of three questions. Some of his thinking can be gauged from the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework¸ of which he has the Chairman. The report was published in January 2014 and ultimately became the basis for the formation of the monetary policy committee, which will soon become a reality.

There are also a few research papers that he has authored over the years.

Given this, Patel’s thinking on various issues will become clearer as we go along and as he interacts more with the media in the days to come. While he may have managed to avoid the media in his role as the deputy governor that surely won’t be possible once he takes over as the RBI governor. He may not make as many speeches as his predecessor did (which is something that the Modi government probably already likes about him), but there is no way he can avoid interacting with the press, after every monetary policy statement, and giving interviews now and then.

Given this, the policy continuity argument being made across the media about Patel being appointed the RBI governor, is rather flaky. There isn’t enough evidence going around to say the same. The only thing that can perhaps be said from what Patel has written over the years is that his views on inflation seem to be in line with Rajan’s thinking. Also, some of the stuff that is being cited was written many years back. And people do change views over the years. There is no way of knowing if Patel has.

The Challenges for the new RBI governor

While, his thinking on various issues may not be very clear, it doesn’t take rocket science to figure out what his bigger challenges are. Take a look at the following chart. It maps the inflation as measured by the consumer price index since August 2014.

Inflation as measured by the consumer price index

The chart tells us very clearly that the inflation as measured by the consumer price index is at its highest level since August 2014. In August 2014, the inflation was at 7.03 per cent. In July 2016, it came in at 6.07 per cent.

Why has the rate of inflation as measured by the consumer price index, spiked up? The answer lies in the following chart which shows the rate of food inflation since August 2014.

 

Food Inflation

 

Like the inflation as measured by the consumer price index, the rate of food inflation is also at its highest level since August 2014. In August 2014, the food inflation was at 8.93 per cent. In July 2014, the food inflation was at 8.35 per cent. Food products make for a greater chunk of the consumer price index.

What this tells us is that the inflation as measured by the consumer price index spikes up when the food inflation spikes up. And that is the first order effect of high food inflation. This becomes clear from the following chart.

Inflation

But what can the RBI do about food inflation?

There is not much that the RBI can do about food inflation. And this is often offered as a reason, especially by the corporate chieftains and those close to the government (not specifically the Modi government but any government), for the RBI to cut the repo rate. The repo rate is the rate of interest that the RBI charges commercial banks when they borrow overnight from it. It communicates the policy stance of the RBI and tells the financial system at large, which way the central bank expects interest rates to go in the days to come.

The trouble is that things are not as simplistic as the corporate chieftains make them out to be. While, the RBI has no control over food inflation (and not that the government does either), it can control the second-order effects of food inflation.

As D Subbarao, former governor of the RBI, writes in his new book Who Moved My Interest Rate?-Leading the Reserve Bank of India Through Five Turbulent Years: “What about the criticism that monetary policy is an ineffective tool against supply shocks? This is an ageless and timeless issue. I was not the first governor to have had to respond to this, and I know I won’t be the last. My response should come as no surprise. In a $1500 per capita economy-where food is a large fraction of the expenditure basket-food inflation quickly spills into wage inflation and therefore into core inflation…When food has such a dominant share in the expenditure basket, sustained food inflation is bound to ignite inflationary expectations.”

Given this, the entire logic of the RBI cutting the repo rate because it cannot manage food inflation is basicallybunkum. Food inflation inevitably translates into overall inflation and that is something that the RBI has some control over, through the repo rate. If this is not addressed, second order effects of food inflation can lead to an even higher inflation as measured by the consumer price index. And this will hurt a large section of the population.

As Subbarao writes: “The Reserve Bank of India cannot afford to forget that there is a much larger group that prioritizes lower inflation over a faster growth. This is the large majority of public comprising of several millions of low-and-middle-income households who are hurt by rising prices and want the Reserve Bank to maintain stable prices. Inflation, we must note, is a regressive tax; the poorer you are, the more you are hurt by rising prices.”

But one cannot expect corporate chieftains who have taken on a huge amount of debt over the years, in order to further their ambitions, to understand this rather basic point. Given this, this hasn’t stopped them from demanding a repo rate cut from the new RBI governor. (You can read more about it here). The government has also made it clear over and over again that it wants the RBI to cut the repo rate. Given that, it is the biggest borrower, this is not surprising. Since January 2015, the RBI has cut the repo rate by 150 basis points to 6.5 per cent. One basis point is one hundredth of a percentage.

As Subbarao writes: “The narrative of our growth-inflation debate is also shaped by what I call the ‘decibel capacity’. The trade and the industry sector, typically a borrower of money, prioritizes growth over inflation, and lobbies for a softer interest-rate regime.”

The people who invest in deposits unlike the corporate chieftains are not in a position to lobby. But it is important that the RBI does not forget about them.

Hence, it is important that people are offered a positive real rate of interest on their fixed deposits. The real rate of interest is essentially the difference between the nominal rate of interest offered on fixed deposits and the prevailing rate of inflation. A positive real rate of interest is important in order to encourage people to save and build the domestic savings of India, which have been falling over the last few years.

This was one of the bigger mistakes made during the second-term of the Manmohan Singh government.

As outgoing governor Raghuram Rajan told NDTV in an interview sometime back “When inflation was 9 per cent they [i.e. depositors] were getting 9 per cent. This meant earning nothing in real terms and losing everything in inflation.”

This wasn’t the case for many years. As Rajan explained in a June 2016 speech: “In the last decade, savers have experienced negative real rates over extended periods as CPI has exceeded deposit interest rates. This means that whatever interest they get has been more than wiped out by the erosion in their principal’s purchasing power due to inflation. Savers intuitively understand this, and had been shifting to investing in real assets like gold and real estate, and away from financial assets like deposits.”

Inflation up, savings down

Take a look at the following chart clearly shows that between 2008 and 2013, the real rate of return on deposits was negative. In fact, it was close to 4 per cent in the negative territory in 2010.

 

Inflation as measured by the consumer price index

 

High inflation essentially ensured that India’s gross domestic savings have been falling over the last decade. Between 2007-2008 and 2013-2014, the rate of inflation as measured by the consumer price index, averaged at around 9.5 per cent per year. In 2007-2008, the gross domestic savings peaked at 36.8 per cent of the GDP. Since then they have been falling and in 2013-2014, the gross domestic savings were at 30.5 per cent of the GDP, having improved from a low of 30.1 per cent of GDP in 2012-2013.

This fall in gross domestic savings has come about because of a dramatic fall in household financial savings. Household financial savings is essentially a term used to refer to the money invested by individuals in fixed deposits, small savings schemes of India Post, mutual funds, shares, insurance, provident and pension funds, etc. A major part of household financial savings in India is held in the form of bank fixed deposits and post office small savings schemes.

Between 2005-2006 and 2007-2008, the average rate of household financial savings stood at 11.6 per cent of the GDP. In 2009-2010, it rose to 12 per cent of GDP. By 2011-2012, it had fallen to 7 per cent of the GDP. The household financial savings in 2014-2015, stood at 7.5 per cent of GDP. Chances of this figure having improved in 2015-2016 are pretty good given that a real rate of return on deposits is on offer for savers, after many years.

If a programme like Make in India has to take off, India’s household financial savings in particular and overall gross domestic savings in general, need to be on solid ground. And that is only going to happen if people are encouraged to save by ensuring that they make a real rate of return on their deposits. In fact, if India needs to grow at 10 per cent per year, an estimate made in Vijay Joshi’s book India’s Long Road suggests that the savings rate will have to be around 41 per cent of the GDP.

As Rakesh Mohan and Munish Kapoor of the International Monetary Fund write in a research paper titledPressing the Indian Growth Accelerator: Policy Imperatives: “In the near future, we expect financial savings to be restored to the earlier 10 per cent level, as inflation subsides, monetary conditions stabilize and households begin to obtain positive real interest rates on their deposits and other financial savings. Financial savings are then projected to increase gradually to around 13 per cent by 2027-32.”

And how is this going to happen? As Mohan and Kapoor point out: “A sustained reduction in inflation that leads to the maintenance of low nominal interest rates, but positive real interest rates, will help in restoring corporate profitability, while encouraging household savings towards financial instruments.”

The point is that a scenario where a positive real rate of return is available to depositors is very important. But is that how things will continue to be? Take a look at the following chart, which plots the repo rate and the consumer price inflation.

Inflation as measured by the consumer price index

As can be seen from the graph, the difference between the repo rate (the orange line) and overall inflation (i.e. inflation as measured by the consumer price index) has narrowed considerably and is at its lowest level in the last two years. This effectively means that the real rate of return on fixed deposits offered by banks has been falling as the rate of inflation has been going up. (Ideally, I should have taken the average rate of return on fixed deposits instead of the repo rate, but that sort of data is not so easily available. Hence, I have taken the repo rate as a proxy).

This is not a good sign on several counts. In a country like India where deposits are a major way through which people save, high inflation leading to lower real rates of interest which effectively means that they are not saving as much as they should. This is something that most people do not seem to understand.

The economist Michael Pettis makes a very interesting point about the relationship between interest rate and consumption in case of China. As he writes in The Great Rebalancing: “Most Chinese savings, at least until recently, have been in the form of bank deposits…Chinese households, in other words, should feel richer when the deposit rate rises and poorer when it declines, in which case rising rates should be associated with rising, not declining, consumption.”

Now replace China with India in the above paragraph and the logic remains exactly the same. Given that a large portion of the Indian household financial savings are invested in bank deposits, any fall in interest rates (as the corporate chieftains regularly demand) should make people feel poorer and in the process negatively impact consumption, at least from the point of savers.

Given this, the biggest challenge for Urjit Patel will be to not taken in by all these demands for lower interest rates and ensure that the deposit holders get a real rate of interest on their fixed deposits.

Further, it is unlikely that he will cut the repo rate given that as the monetary policy committee comes in place, the RBI needs to maintain a rate of inflation between 2 to 6 per cent. In July 2016, the rate of inflation was over 6 per cent.

The column originally appeared in Vivek Kaul’s Diary on August 22, 2016

 

Dear PM, If Things Are Improving for PSUs, Why Not Declare Complete Numbers?

narendra_modi

In the Independence Day speech made on August 15, 2016, the prime minister Narendra Modi talked about the turnaround of three public sector units(PSUs)—Air India, Bharat Sanchar Nigam Ltd(BSNL) and Shipping Corporation of India.

As the prime minister remarked: “The PSUs are formed to fall in a pit, to fail, to get locked or to be sold out. That has been the history. We have tried to bring in a new culture. And today for the first time, I can say with satisfaction that Air India which had a bad image, has succeeded in registering an operational profit last year. At a time when telecom companies all over the world were earning, BSNL was falling in a pit. For the first time, BSNL has succeeded in earning operational profit. Nobody knew whether Shipping Corporation of India would ever be in profit. Today Shipping Corporation of India is making profit.

Operational profit is the profit that a company makes from its business operations. It is what accountants call earnings before interest and taxes. In case of Air India, as I have written in the past, the airline has made an operational profit primarily because of the fall in oil prices. I will not repeat the argument here. (You can read the column explaining this here). Also, just because the airline has made an operational profit doesn’t mean that the airline is not losing money.

What Mr Modi forgot to tell us is that the airline lost Rs 2,636 crore in 2015-2016. Herein we need to differentiate between the operational profit of the company and the net profit/loss. Anyone who has studied Finance 101 knows that operational profit and net profit are two different things all together.

Operational profit is the profit that a company makes from its business operations. After this, the company needs to pay interest on its debt, as well as taxes to the government. What remains is the net profit or net loss, as is the case with Air India. In case of Air India, the airline had a debt of Rs 51,367 crore as on March 31, 2015 and interest needs to be paid on this debt. After paying this interest, the airline ended with a net loss.

Also, the complete profit and loss statement of the airline for 2015-2016, hasn’t been made public yet. From the data that is available in the public domain it can be said that the airline made an operating profit primarily because of a fall in oil prices. If there is anything more to it, then the government needs to make available the complete set of numbers, as soon as possible, in the public domain.

Further, the Modi government, in the process of projecting itself positively, has shown a tendency in the past, to take credit for falling oil prices as well. Take the case of the total savings made through Pahal, the scheme in which the subsidies available on domestic cooking gas are transferred directly into the bank accounts of citizens, after they have bought a cooking gas cylinder at the full price and not the subsidised price as was the case in the past.

In June 2016, the finance secretary Ashok Lavasa said that the government had saved Rs 14,872 crore by paying the subsidy amount directly into the account of people. This turned out to be incorrect.

A CAG Audit Report on Pahal published in August 2016 eventually pointed out that while there were some savings from Pahal, they were nowhere near the claims being made by the government as well as the oil companies which sell cooing gas cylinders.

In a report the CAG said that the reduction of Rs 23,316 crore in cooking fuel subsidy for the first three quarters of 2015-2016, in comparison to 2014-2015, was largely due to a sharp fall in oil prices and not due to the Pahal scheme.

As the report pointed out: “While implementation of PAHAL scheme coupled with the LPG ‘Give it up’ campaign has resulted in the reduction of offtake of domestic subsidised LPG cylinders, the resultant savings was not as significant as that generated through fall of subsidy rates.”

The CAG said that the savings due to implementation of Pahal were only Rs 1,764 crore. The remaining Rs 21,552 crore fall in cooking gas subsidies was largely due to a fall in oil prices. Another interesting point that the CAG made was that while calculating the fall in subsidy, the national average offtake of 6.27 cylinders a year should be used and not the maximum number of 12 cylinders that consumers are allowed subsidy on, during the course of the year.

This isn’t surprising given that politicians and governing political parties all over the world, like numbers which show them in good light. As Philippa Malmgren writes in Signals—How Everyday Signs Can Help Us Navigate the World’s Turbulent Economy: “Why would politics demand that the numbers be skewed in a particular direction? Power. Politicians and policymakers want power. They want votes. They want the mathematics to show whatever will favour them in an election. If they want a different answer they simply change the assumptions or the parameters of the algorithm.”

The thing is that Pahal is actually working and has helped whittle down a good number of bogus domestic cooking gas connections which were being used to divert domestic cooking gas in the black market. Also, Rs 1,784 crore is a very good amount of saving and need not have been misrepresented in the way it eventually was.

If the government had reported the correct number, that in itself would have been a good beginning. By doing what it did, the government gave an opportunity to naysayers to say that “we told you that economic reforms don’t work in India”. And that is not a good message to spread.

The other company that prime minister Modi talked about in his speech was BSNL. Talk about BSNL having made an operating profit in 2015-2016 has been there in the media for some time now. In fact, the former telecom minister Ravi Shankar Prasad in July had said that the company would report an operating profit of around Rs 2,000 crore in 2015-2016.

A news-report in The Economic Times now suggests that the company might have made an operational profit of Rs 3,378 crore in 2015-2016. Again, there is no data available in the public domain on this. The latest numbers I could find where from the department of telecommunications annual report for 2015-2016.

Figure in * Crore

Financial Year 2012-13 2013-14 2014-15 2015-16 (Up to September 30, 2015)*
Total Income 27,128 27,996 28,645 12,929
Total expenditure 35,012 35,016 37,292 16,734
Net profit (-) 7,884 (-) 7,020 (-) 8,234 (-) 3,462

Note: * Data is Provisional & Un-audited

For the first six months of the year, it seems BSNL was on its way to make massive losses that it usually does. What changed over the next six months will become clear only once the complete profit and loss statement of the company is available in the public domain. Right now we only have statements from the government, and a few leaks, and nothing more.

Both Air India and BSNL are unlisted companies. But given that they are eventually owned by the taxpayers, it is only fair that the government puts out their complete set of numbers as soon as possible. While these numbers will eventually be declared but by then it will be too late.

So that leaves us with Shipping Corporation of India, which is listed on the stock exchanges. In 2011-2012, the company made losses of around Rs 428 crore. In 2015-2016, the company made a net profit of around Rs 377 crore. How did this turn around happen?

In fact, the cost of fuel (bunker fuel is the main type of oil used aboard ships) in 2011-2012 was at Rs 1,560.3 crore. By 2015-2016, this had fallen by more than 59.3 per cent to Rs 637.5 crore. In 2011-2012, the cost of fuel amounted to 36.2 per cent of net sales. In 2015-2016, the cost of fuel amounted to 15.5 per cent of the net sales of the company. In fact, the sales of the company have gone down during the period.

The difference in performance of the company lies in the fall in the fuel bill of more than Rs 900 crore. This has pushed the company into a profitable zone. There is nothing more to it.

Also, in 2014-2015, 77 out of the 234 PSUs were loss-making. The number was 70 in 2013-2014. How have things changed on this front, is something that the government needs to tell us.

Currently, the government is busy making out a positive case for itself, on the basis of incomplete data and taking credit for fall in oil prices, as well. It can do better than this.

The column originally appeared in Vivek Kaul’s Diary on August 19,2016

India’s Economic Growth and the Power of Compounding

discount-10

On August 2, 2016, I had talked about a bungalow on the posh Nepean Sea Road in Mumbai, being up for sale.

The bungalow was last sold in 1917, at a price of over Rs 1 lakh.  Further, similar properties in the vicinity in the recent past had been sold for Rs 400 crore, or so, The Times of India reported.

Essentially, something that was bought for around Rs 1 lakh, 99 years back, is now expected to be sold for around Rs 400 crore.

This works out to a return of 11.3 per cent per year.

How how much would have the bungalow been worth now in 2016, if the rate of return had been just 30 basis points lower, at 11 per cent per year? One basis point is one hundredth of a percentage.

Would like to take a guess, dear reader?

Rs 395 crore? Or Rs 375 crore? Or even lower than that?

In fact, the answer will surprise you.

At a return of 11 per cent per year, the bungalow would have been worth around Rs 306.9 crore, or almost Rs 93.1 crore lower.

This would mean that the bungalow would be worth 23.3 per cent lower in comparison to Rs 400 crore.

And how much would the bungalow be worth at a return of 10.5 per cent per year? Would you like to take a guess?

Actually let me not prolong the agony. At 10.5 per cent per year, the bungalow would have been worth around Rs 196.3 crore. This is less than half of Rs 400 crore. Hence, a fall in return of 80 basis points per year, wipes off the value by more than half, over a 99-year period.

And how much would the bungalow be worth at 10 per cent per year? Rs 125.3 crore. This is around 68.7 per cent lower than Rs 400 crore.

So what is the point I am trying to make here? This is what the power of compounding can do. Even a small difference in return over a long period of time can make a huge difference to the amount of corpus you end up accumulating.

Of course, a normal person who is trying to accumulate wealth does not invest over a 100-year time frame. And further, even if he or she did, there is no way of knowing in advance what strategy would work best, over such a longish period of time.

Nevertheless, this piece is not about which is the best investment strategy in the long run. It is about the fact that what applies to investment returns also applies to the economic growth rate. Even a small difference in the annual economic growth rate over a longish period of time, can have a huge impact on how a country eventually turns out to be.

As Vijay Joshi writes in India’s Long Road—The Search for Prosperity: “The ‘power of compound interest’ over long periods is such that even a small change in the growth rate of per capita income makes a big difference to eventual income per head.”

And how do things look for India? Where would it end by 2040 at different rates of economic growth? As Joshi writes: “At a growth rate of 3 per cent a year, income per head would double, and reach about the same level as China’s per capita income today. At a growth rate of 6 per cent a year, income per head would quadruple to a level around that enjoyed by Chile, Malaysia and Poland today. If income per head grew at 9 per cent a year, it would increase nearly eight-fold, and India would have a per capita income comparable to an average high-income country of today.”

The question is what will make India a prosperous country. How do we define prosperity? As Joshi writes: “At a first pass, it could be defined as the level of per capita income enjoyed by the lower rung of high-income countries today, with the rider that national income should be widely shared and even the poorest people should have decent standards of living. To reach the said goal, India would require high-quality per-capita growth of income of around 7 per cent a year for a period of twenty-four years, from 2016.”

 The trouble is that there is almost no track record of any country (except China) growing at a rapid rate of 7 per cent per year, for a very long period of time, which is what India needs to achieve if it has to be prosperous.

When it comes to superfast growth China grew by 8.1 per cent per year between 1977 and 2010. Only two other countries came anywhere near. As Lant Pritchett and Lawrence H. Summers write in a research paper titled Asiaphoria Meets Regression to the Mean: “There are essentially only two countries with episodes even close to China’s current duration. Taiwan had a growth episode from 1962 to 1994 of 6.8 per cent (decelerating to growth of 3.5 percent from 1994 to 2010). Korea had an episode from 1962 to 1982 followed by another acceleration in 1982 until 1991 when growth decelerated to 4.48 percent—a total of 29 years of super-rapid growth (>6 per cent)—followed by still rapid (>4 per cent) growth. So, China’s experience from 1977 to 2010 already holds the distinction of being the only instance, quite possibly in the history of mankind, but certainly in the data, with a sustained episode of super-rapid (> 6 per cent per annum) growth for more than 32 years.

Hence, the odds are stacked against India. And it will mean the governments doing many things right in the years to come, if the country has to get anywhere near a sustained growth rate of 7 per cent or more, for a longish period of time.

The trouble though is that most policymakers seem to take a growth rate of 7 to 8 per cent as a given, in their calculations, even though history shows otherwise.

The column originally appeared in Vivek Kaul’s Diary on August 18, 2016

पापा कहते थे बड़ा नाम करेगा, कोई इंजीनियर का काम करेगा?

papa kehte hain

An education entrepreneur, I used to once know, liked the idea of offering MBA courses at various price points.

If someone can afford to pay Rs 1 lakh, we should charge him Rs 1 lakh. If someone can afford to pay Rs 7 lakh, we should charge him Rs 7 lakh,” was the basic argument he used to make (I am paraphrasing here).

His justification for it was fairly straightforward. “Hindustan Lever Ltd (now Hindustan Unilever Ltd) sells Lifebuoy. It also sells Lux,” he used to offer as a way of explanation of different price points.

And he wasn’t just a speaking type. He acted on what he said and had different business schools offering an MBA at various price points. Another peculiar feature of this entrepreneur was that he opened and shutdown business schools depending on how good the economy and in turn, his business was looking.

So, if he felt, that in the coming years, the demand for business school education would drop, he would not hesitate in shutting down a few business schools as well. That way he had a control over costs and at the same time there were no seats going around vacant in the years to come.

Now imagine what it did to the morale of students who had just passed out? Having studied at a business school, which had already shut down. Of course, the entrepreneur wasn’t running a charity, he was simply running a business which was responding to supply and demand, like every other business does.

And that is how he operated, until he had a run-in with the education authorities and had to scale down his operations dramatically.

Having said that he had a reasonably good record in shutting-down business schools just before the demand for business school education fell. At least, that is what the old-timers who had worked with him for a long period of time, used to say. This primarily was a function of the fact that most of his business schools operated out of a few floors of rented buildings and did not have a campus, so to speak.

The same cannot be said about many entrepreneurs who in the last few years set up engineering colleges, to cash in on what they thought was an education boom. But as happens in case of many bubbles, by the time the supply of the new engineering seats hit the market, the demand for engineers had already started to slowdown and in the years to come things only became worse.

Given the fact, that many of these engineering colleges were set up by politicians, the All India Council for Technical Education(AICTE) went easy on approving these institutions. For politicians, establishing engineering colleges, on cheap government land, was a good way of putting their ill-gotten black money to use.

Also, once the college was in place, the hope was that the management quota seats, would keep bringing in the black money. Hence, education made for a great business model. The key assumption here was that the demand for engineers in information technology companies would keep exploding. Of course, the model also worked on the assumption that an engineering degree would continue to be aspirational for the middle class and the lower middle class households.

And all this made for an excellent business model, or so people thought. Nevertheless, this wasn’t rocket science exactly and many people had figured it out, including, you, me and our mothers. It’s just that we didn’t have the money or the political connections to execute it, like the politicians did.

As Philippa Halmgren writes in Signals—How Everyday Signs Can Help Us Navigate the World’s Turbulent Economy: “Whenever the majority of the population seeks to pursue the same idea at the same time, it usually ends in tears. It is a sure sign of trouble when 85 per cent of business school graduates want a job in the financial markets.”

And it is a sure sign of trouble when many politicians want to set up engineering colleges and many prospective students want an engineering degree which gets them a job in an information technology company.

The number of engineering seats exploded from around 5 lakh in 2005-2006, to 10 lakh in 2009-2010 and to more than 15 lakh, currently. India produces more engineers than the United States and China, put together. Given this, it isn’t surprising that many of these engineering seats are going vacant.

Take the case of Maharashtra which has 1.35 lakh engineering seats. Newsreports point out that around 51,000 seats went vacant this year. That is around 38 per cent of the total seats. In Tamil Nadu, close to 1.19 lakh seats in engineering colleges found no takers. Tamil Nadu has the highest number of engineering seats in the country at around 2.79 lakh. Maharashtra comes in second.

In Karnataka, another state, known for its obsession with the engineering degree, 15,561 engineering seats found no takers. I can go on state by state, but the results will nonetheless remain the same. There is a surfeit of engineering seats across the country.

In fact, as the government recently told the Lok Sabha, “overall there is surplus capacity in the engineering sector with 8,44,328 seats remaining vacant in 2014-15.” The surplus capacity does not mean that the competition to get into an engineering college has become any easier.

While, the number of seats may have exploded, the number of good colleges continues to be few and far between. In fact, various studies over the years have found that a majority of Indian engineering students are unemployable. A recent study carried out by Aspiring Minds found that 80 per cent of the engineers who graduated in 2015, were unemployable.

This isn’t surprising given that starting an engineering college by acquiring the land and putting up buildings, is the easiest part of the job. What an engineering college (or for that matter any college) requires are good teachers. And there is a clearly a huge shortage of even half-decent teachers going around.

Having taught and studied at private colleges (MBA and journalism) I can vouch for the fact that they are extremely poor pay masters, once we take into account the kind of fee that they charge to their students.

There have been gainers out of the entire process as well. And these are the information technology companies. With the number of engineering colleges exploding, the starting salaries in these companies has more or less remained the same, over the last few years.

Also, the AICTE after allowing the establishment of all these colleges has now plans of shutting them down. As Anil Sahasrabudhe, chairman of the All India Council of Technical Education (AICTE), told Mint in September 2015:We would like to bring it down to between 10 lakh and 11 lakh (one million and 1.1 million) from a little over 16.7 lakh now.”

And that is how government institutions operate. First they create the problem and then they think they will be able to solve it, by simply shoving it away. The good thing is, at least in one area in India, the market is doing a good job of cleaning up the mess that prevailed.

The column was originally published in Vivek Kaul’s Diary on August 17,2016

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