The Final Nail in the Demonetisation Coffin…

narendra modi

The Prime Minister, Shri Narendra Modi addressing the Nation on the occasion of 71st Independence Day from the ramparts of Red Fort, in Delhi on August 15, 2017.

On August 30, 2017, the Reserve Bank of India(RBI) published its annual report. The annual report had data points looking at which we can finally say that demonetisation has not met any of the objectives that it set out to achieve.

On November 8, 2016, the prime minister Narendra Modi in an address to the nation said that the notes of denomination Rs 500 and Rs 1,000, would not be legal tender from November 9, 2016, onwards. People in possession of these notes could deposit them in banks until December 30, 2016. In value terms notes worth Rs 15.44 lakh crore were demonetised.

As per the press release accompanying the decision to demonetise, there were two aims of demonetisation: 1) Eliminating Black Money which casts a long shadow of parallel economy on our real economy. 2) Eliminating Fake Indian Currency Notes (FICN).

Let’s look at how successful demonetisation has been in achieving these two main goals. The idea was that people who had black money in the form of Rs 500 and Rs 1,000, would not deposit it in the banks for the fear of being identified by the government and in the process black money would be destroyed.

This was a point that was made over and over again by those in favour of demonetisation. As finance minister Arun Jaitley said in an interview“Obviously people who have used cash for crime purposes are not foolhardy enough to try and risk and bring the cash back into the system because there will be questions asked.”

Niti Aayog Member Bibek Debroy was specific on the proportion of demonetised money that would not come back. As he said in an interview“Even now, Rs 1.6 lakh crore is what will be missing at the end of it all. Those are the figures. If I take a base of roughly rounding off demonetised currency around Rs 16 lakh crore, 10 per cent of it is about Rs 1.6 lakh crore.” Hence, Debroy felt that currency worth Rs 1.6 lakh crore would not come back and this would lead to the destruction of black money.

The American-Indian economist Jagdish Bhagwati (along with two co-authors) was even more optimistic on this front, and in a column in the Mint newspaper on December 27, 2016, wrote“Suppose we accept the estimate that one-third of the approximately Rs 15 trillion [Rs 15 lakh crore] in demonetised notes is black money.” These economists did not bother to explain, what logic did they base their assumption on.

The RBI Annual Report on Page 195 says that demonetised notes worth Rs 15.28 lakh crore were deposited into banks, up to June 30, 2017. This basically means that almost 99 per cent of the demonetised money was deposited into banks. Hence, almost all the black money held in the form of cash, also made it back into the banks and wasn’t really destroyed, as had been hoped.

Given this, instead of destroying black money held in the form of cash, demonetisation seems to have become a legal money laundering scheme, where people with black money have found ingenious ways to deposit it into the banking system. So, the first objective of demonetisation of eliminating black money has not been achieved.

Now we are being told that just because the money has been deposited into banks that does not mean it is not black money. And given this, the Income Tax department now has the data and will go after those people who have deposited their black money into banks. So far so good.

Let’s look at the past record of the Income Tax department when it comes to going after people having black money and achieving convictions. Take a look at Table 1.

Table 1: Year wise details of number of cases in which prosecutions were launched by the Income Tax Department.

Financial Year No. of cases in which presecutions launched Cases coumpounded No. of persons convicted
2013-14 641 561 41
2014-15 669 900 34
2015-16 552 1,019 28
2016-17* 323 404 13

* Provisional figures upto 31st October, 2016

What does Table 1 tell us? It shows the extremely limited capacity of the Income Tax Department when it comes to bringing tax evaders to book. Even if the Income Tax department improves on these numbers, there isn’t much hope on the tax collection front. The prime minister Narendra Modi in his Independence Day speech said: “More than Rs 2 lakh crore black money has reached banks.” An impression is being created that this money is just waiting to find its way into government coffers. The people who have this black money aren’t exactly stupid. They aren’t waiting to hand it over to the government. They have access to good lawyers and chartered accountants and they know how the Indian system works.

Looking at this, it is safe to say the government is just trying to defend a bad decision and it is highly unlikely that it will earn a significant amount from all this black money.

In fact, the Pradhan Mantri Garib Kalyan Yojana, the income declaration scheme, launched by the government in the aftermath of demonetisation, failed miserably. The scheme which was launched on December 16, 2016, managed to collect all of Rs 2,300 crore as taxes. This tells us very clearly how much those who have black money fear the taxman in this country.

Now let’s jump to the second issue of eliminating fake currency notes. As far as detecting fake currency is concerned, nothing much seems to have happened on this front. Data from the RBI annual report tells us that the number of fake Rs 500 (old series) and Rs 1,000 notes detected between April 2016 to March 2017 was 5,73,891. The total number of demonetised notes stood at around 2,400 crore. This basically means that as a proportion the fake notes identified between April 2016 to March 2017 stands close to 0 per cent of the demonetised notes.

The total number of Rs 500 and Rs 1,000 fake notes detected between April 2015 and March 2016, stood at 4,04,794. And this happened without any demonetisation. Hence, demonetisation has failed on its two major objectives.

Now let’s look at the third objective of demonetisation. In the original scheme of things increasing cashless transactions wasn’t on the table at all. It came into the scheme of things once prime minister Modi talked about it in the Mann ki Baat programme on radio on November 27, 2016, where he said: “The great task that the country wants to accomplish today is the realisation of our dream of a ‘Cashless Society’. It is true that a hundred percent cashless society is not possible. But why should India not make a beginning in creating a ‘less-cash society’? Once we embark on our journey to create a ‘less-cash society’, the goal of ‘cashless society’ will not remain very far.”

How have we done on this front? Let’s take a look at Figure 1 and Figure 2. These figures plot the total number of cashless transactions through the years in terms of volume (i.e. number) and value of the transactions. I have ignored the Real Time Gross Settlement (RTGS) mode of transferring money because it can be used only for transactions of Rs 2 lakh and over. Hence, it clearly does not fall in the retail domain.

Figure 1: 

What does Figure 1 tell us? It tells us very clearly that the total number of cashless transactions rose in the aftermath of demonetisation. They have fallen since then and are now more or less back on the trend growth line (i.e. the red line in Figure 1). The trend growth line has been plotted in order to take care of the fact that cashless transactions had been growing anyway, irrespective of demonetisation.

In fact, between March 2017 when cashless transactions peaked and June 2017, the total number of cashless transactions have fallen by 10.1 per cent.

Now take a look at Figure 2.

Figure 2: 

Figure 2 clearly tells us that the total value of cashless transactions is now below the trend line. As former RBI governor said in a recent interview“If you look at electronic transactions, you see that there was a blip-up when demonetisation happened but it has come back to broadly the trend growth line.”

One form of cashless payments which has seen good growth is the United Payment Interface. But it forms just 0.6 per cent of the overall cashless transactions and it will be a while before it forms a substantial portion.

Given this, the 2+1 original aims of demonetisation have flopped. The data clearly shows us that.

Of course, we are now being told of new benefits of demonetisation. Take the case of the number of returns being filed going up. Very true. But has it led to increased tax collections? A press release put out by the ministry of finance on August 9, 2017, states the following: “The Direct Tax collections up to July,2017[i.e. between April 2017 and July 2017] in the Current Financial Year 2017-18 continue to register steady growth. Direct Tax collection during the said period, net of refunds, stands at Rs. 1.90 lakh crore which is 19.1% higher than the net collections for the corresponding period of last year.”

Basically, direct tax collections have grown by 19.1 per cent during the first four months of this financial year in comparison to the same period in the last financial year. Hence, has demonetisation led to an increase in the growth of collection of direct taxes?

A press release put out by the ministry of finance on August 9, 2016, had this to say: “The figures for direct tax collections up to July, 2016 show that net revenue collections are at Rs.1.59 lakh crore which is 24.01% more than the net collections for the corresponding period last year.”

Hence, in the period between April to July 2016, the direct tax collections had grown by 24 per cent, without the demonetisation of currency which was carried out in November 2016. What this tells us is that direct tax collections grew faster before demonetisation than they are growing after demonetisation.

Personal income tax collections have grown by 15.7 per cent during the first four months of this financial year. They had grown by 46.6 per cent during the first four months of the previous financial year. So much for increase in taxes collected.

What this tells us is that demonetisation has slowed down the economy and given that the growth in direct taxes has slowed down as well.

Another point being made is that with all the money coming into the banking system, the interest rates have come down. Yes, they have. But has it led to increased lending, is a question no one is asking. Between the end of October 2016 and the end of July 2017, the total non-food lending carried out by banks stood at Rs 2,75,690 crore. The total non-food lending carried out by banks between end of October 2015 and the end of July 2016 had stood at Rs 3,43,013 crore. Hence, bank lending after demonetisation has fallen by close to 20 per cent, if we were to compare it to a similar period in the years gone by.

This is a point that I keep making. People and companies borrow when they are in a position to repay and not simply because interest rates are down. Demonetisation has had a negative impact on the ability of people to repay loans.

Another point that needs to be made here is that 62 per cent of household financial savings in India are invested in deposits. A fall in interest rates hurts people who invest in deposits. This includes senior citizens who use fixed deposits a generate a monthly income. It also includes people saving for the future for their wedding and education of their children. These people are many more in number than borrowers. With lower interest rates, they have to cut down on their current consumption expenditure. This hurts overall economic growth.

Demonetisation has also slowed down on overall economic growth. Take a look at Figure 3. It plots the GDP growth rate of India since March 2016.

Figure 3: 

As can be seen from Figure 3, the GDP growth rate between July and September 2016 had stood at 7.53 per cent. This was before demonetisation was announced in November 2016. It has since fallen to 5.72 per cent. This is clearly an impact of demonetisation. As Rajan said in an interview: “Let us not mince words about it – GDP has suffered. The estimates I have seen range from 1 to 2 percentage points, and that’s a lot of money – over Rs 2 lakh crore and maybe approaching Rs 2.5 lakh crore.”

He points out other costs as well: “The hassle cost of people standing in line, the printing cost that the RBI says is close to Rs 8,000 crore, the cost to the banks of withdrawing the money, and the time spent by their clerks, by their managers and by their senior officers doing all this, and the interest being paid on all those deposits, which earlier were effectively an interest-free loan to the RBI.”

An argument is being made that in the period April to June 2017 the growth fell because of the Goods and Services Tax which was supposed to be introduced on July 1, 2017. That is really not true. (you can read about it in detail here).

Also, even this fall in growth may not capture the situation completely given that the informal sector suffered the most because of demonetisation, and the GDP calculation does not capture that well enough.

All in all, demonetisation was a massive flop. It was an act of self-destruction that has hurt the Indian economy majorly and put us back by at least 1.5 to two years, on the economic growth front. This is something that India can ill-afford given the fact that 1.2 crore youth are entering the workforce every year.


Why I continue to write about demonetisation

People have been telling me the real aim of demonetisation was political, so why am I going on and on about the economic impacts.

I am not a dolt I understand that.

The subject of economics before it got hijacked by mathematicians was called political economy. The only place where economics and politics are different things are in an economics classroom or an economics textbook.

Hence, all political moves have economic impacts and vice versa, irrespective of what politicians and economists like to believe.

Also, will demonetisation negatively impact the Modi government, is a question I am being asked. I don’t know. But it has been a huge negative for the Indian economy, a problem which in the normal scheme of things, we wouldn’t have had to deal with.

And given that it needs to be highlighted and talked about, irrespective of whether it has made Modi politically stronger or weaker. That only time will tell. So, keep watching this space.

To conclude, I am a full-time writer and I am paid to write. I can’t do anything else. This is an honest way to make a living. So, I write.

The column was originally published on Equitymaster on September 4, 2017.


What a Slowdown in Retail Loans Tell Us About a Slowing Economy

In the recent past a lot has been written about the overall slowdown in bank lending. Take a look at Figure 1. It essentially tells us about the loans given out by banks during the period between May 2016 and May 2017, and May 2015 and May 2016, before that.

Let’s start with non-food credit. These are the loans given out by banks after we have adjusted for food credit or loans given to the Food Corporation of India and other state procurement agencies, for buying rice and wheat directly from farmers at the minimum support price (MSP) for the public distribution system.

Figure 1:

Type of Loan Total Loans Given Between May 2016 and May 2017 (in Rs Crore) Total Loans Given Between May 2015 and May 2016 (in Rs Crore)
Non-Food Credit 4,22,001 6,25,975
Loans to industry -56,455 24,383
Retail Loans 1,94,553 2,27,863

Source: Reserve Bank of India 

The total amount of non-food credit given out between May 2016 and May 2017 is down by 33 per cent to Rs 4,22,001 crore, in comparison to the period between May 2015 and May 2016. Hence, there has been a huge overall slowdown in the total amount of loans given out by banks over the last one year, in comparison to the year before that.

Why has that been the case? The major reason for the same are loans to industry. Banks are in no mood to give out loans to industry. During the period May 2016 and May 2017, the total loans to industry actually shrunk by Rs 56,455 crore. This basically means that on the whole the banks did not give a single rupee of a new loan to the industry. During the period May 2015 and May 2016, banks had given fresh loans worth Rs 24,383 crore to industry, overall.

This is happening primarily because banks have run a huge amount of bad loans on loans they had given to industry in the past. As on March 31, 2017, the bad loans ratio of public sector banks when it came to lending to industry, stood at 22.3 per cent. Hence, for every Rs 100 of loan made to industry by public sector banks, Rs 22.3 had turned into a bad loan i.e. the repayment from a borrower has been due for 90 days or more.

Not surprisingly, these banks are not interested in lending to industry anymore. This has been a major reason behind the overall slowdown in lending carried out by banks, as we have seen earlier.

But one part of lending that no one seems to be talking about is retail lending carried out by banks. This primarily consists of housing loans, vehicle loans, consumer durables loans, credit card outstanding, loans against fixed deposits, etc. The assumption is that all is well on the retail loan front.

As far as bad loans are concerned, things are going well on the retail loans front. But what about the total amount of retail loans given by banks? Between May 2016 and May 2017, the total amount of retail loans given by banks stood at Rs 1,94,533 crore. This was down by around 15 per cent to the amount of retail loans given by banks between May 2015 and May 2016. This, despite the fact that interest rates on retail loans have come down dramatically in the post demonetisation era. You can get a home loan now at an interest of as low as 8.35 per cent per year.

A major reason for this slowdown in retail loans are housing loans, which form the most significant part of retail loans. Between May 2016 and May 2017, the total amount of housing loans given by banks stood at Rs 92,469 crore down by 22 per cent in comparison to the housing loans given out by banks between May 2015 and May 2016.

Lower interest rates on home loans haven’t helped much. The only explanation of this lies in the fact that high real estate prices continue to be the order of the day across the country. How do things look with vehicle loans which form a significant part of the retail loans? Between May 2016 and May 2017, banks gave out vehicle loans worth Rs 18,447 crore, 26 per cent lower than the vehicle loans given out by banks between May 2015 and May 2016.

What does this tell us? It tells us very clearly that things have deteriorated even on the retail loans front. People take on retail loans only when they are sure that they will be able to continue repaying the EMIs in the years to come (unlike corporates). The fall in the total amount of retail loans lent by banks over the last one year clearly tells us that the confidence to repay EMIs, is not very strong right now.

This is another good indicator of the overall slowdown in the Indian economy, which has happened in the post demonetisation era.

The column originally appeared in Equitymaster on July 24, 2017.

The Bank Ponzi Scheme


Every six months the Reserve Bank of India (RBI) publishes a document titled the Financial Stability Report . In the December 2011 report, it pointed out that at 55 per cent, loans to the power sector constituted a major part of the lending to the infrastructure sector. It further said that restructured loans in the power sector were on their way up.

Restructured loans are essentially loans where the borrower has been given a moratorium during which he does not have to repay the principal amount. In some cases, even the interest need not be paid. In some other cases, the tenure of the loan has been increased.

This was nearly five and a half years back, and the first time the RBI admitted that there was a problem in the bank lending to the power sector. In the December 2012 report, the RBI said: “There are also early signs of corporate leverage rising among the several industrial groups with large exposure to infrastructure sectors like power.”

When translated into simple English this basically means that many big industrial groups which had taken on loans to finance power projects had borrowed more money than they would be in a position to repay.

In the years to come by, other sectors along with the power sector also became a part of the RBI commentary on loans which were likely not to be repaid in the future. In the June 2013 report, the central bank said: “Within the industrial sector, a few sub-sectors, namely; Iron & Steel, Textile, Infrastructure, Power generation and Telecommunications; have become a cause of concern.”

In the December 2013 report, the RBI said: “There are five sectors, namely, Infrastructure [of which power is a part], Iron & Steel, Textiles, Aviation and Mining which have high level of stressed advances. At system level, these five sectors together contribute around 24 percent of total advances of scheduled commercial banks, and account for around 51 per cent of their total stressed advances.”

Dear Reader, the point I am trying to make here is that the RBI knew about a crisis brewing in the industrial sector as a whole, and power and steel sector in particular, for a while. In fact, in the June 2015 report, the RBI pointed out: “the debt servicing ability of power generation companies [which are a part of the infrastructure sector] in the near term may continue to remain weak given the high leverage and weak cash flows.”

The funny thing is that while the RBI was putting out these warnings, the banks were simply ignoring them and lending more to these sectors. Between July 2014 and July 2015, banks gave out Rs 86,500 crore, or 71.5 per cent, of the Rs. 1,20,900 crore that they had lent to industry to the two most troubled sectors, namely, power and iron and steel.

What was happening here? The banks were giving new loans to the troubled companies who were not in a position to repay their debt. These new loans were being used by companies to pay off their old loans. A perfect Ponzi scheme if ever there was one. If the banks hadn’t given fresh loans, many of the companies in the power and the iron and steel sectors would have defaulted on their loans.

Hence, the banks gave these companies fresh loans in order to ensure that their loans didn’t turn into bad loans, and so, in the process, they managed to kick the can down the road. In the process, the loans outstanding to these companies grew and if they were not in a position to repay their loans 2-3 years back, there is no way they would be in a position to repay their loan now.

Many of these projects, as Raghuram Rajan put it in a November 2014 speech, “were structured up front with too little equity, sometimes borrowed by the promoter from elsewhere. And some promoters find ways to take out the equity as soon as the project gets going, so there really is no cushion when bad times hit.”

The corporates brought in too little of their own money into the project, and banks ended up over lending. Over lending also happened because many promoters in these sectors were basically crony capitalists close to politicians to whom banks couldn’t say no to.

Over and above this, the steel producers had to face falling steel prices as China dumped steel internationally. In case of power producers, plant load factors (actual electricity being produced as a proportion of total capacity) fell. Along with this, the spot prices of electricity also fell. This did not allow these companies to set high tariffs for power, required for them to generate enough money to repay loans.

All these reasons basically led to the Indian banks ending up in a mess, on the loans it gave to power and iron and steel prices.

The RBI has now put 12 stressed loan cases under the Insolvency Bankruptcy Code, in the hope of recovering bad loans from these companies. Not surprisingly, steel companies dominate the list.

The column originally appeared in the Daily News and Analysis on June 23, 2017.


The Banking Ordinance is no magic pill for ailing banks


Recently, the government promulgated the Banking Regulation(Amendment) Ordinance, 2017, to tackle the huge amount of bad loans that have accumulated in the Indian banking system in general and the government owned public sector banks in particular. Bad loans are essentially loans in which the repayment from a borrower has been due for 90 days or more.

This Ordinance is now being looked at the magic pill which will cure the problems of Indian banks. Will it?

The Ordinance essentially gives power to the Reserve Bank of India(RBI) to give directions to banks for the resolutions of bad loans from time to time. It also allows the Indian central bank to appoint committees or authorities to advise banks on resolution of stressed assets.

The basic assumption that the Ordinance seems to make is that the RBI knows more about banking than the banks themselves. This doesn’t make much sense for the simple reason that if the RBI was better at banking than the banks themselves, it would have been able to identify the start of the bad loans problem as far back as 2011, which it didn’t.

Over and above this, this is not the first time that Indian banks have landed in trouble because of bad loans. They had landed up in a similar situation in the early 1980s and the early 2000s as well, and the RBI hadn’t been able to do much about it.

In fact, at the level of banks, many banks have been more interested in postponing the recognition of the problem of bad loans. This basically means they haven’t been recognising bad loans as bad loans. One way of doing this is by restructuring the loan and allowing the borrower a moratorium during which he does not have to repay the principal amount of the loan. In some cases, even the interest need not be paid. In some other cases, the tenure of the loan has been increased. In many cases this simply means just pushing the can down the road by not recognising a bad loan as a bad loan.

Why have banks been doing this? The Economic Survey gives us multiple reasons for the same. Large debtors have borrowed from many banks and these banks need to coordinate among themselves, and that hasn’t happened. At public sector banks recognising a bad loan as a bad loan and writing it off, can attract the attention of the investigative agencies.

Also, no public sector banker in his right mind would want to negotiate a settlement with the borrower who may not be able to repay the entire loan, but he may be in a position to repay a part of the loan. As the Economic Survey points out: “If PSU banks grant large debt reductions, this could attract the attention of the investigative agencies”. What makes this even more difficult is the fact that some of defaulters have been regular defaulters over the decades, and who are close to politicians across parties.

Hence, bankers have just been happy restructuring a loan and pushing the can down the road.

Over and above this, writing off bad loans once they haven’t been repaid for a while, leads to the banks needing more capital to continue to be in business. In case of public sector banks this means the government having to allocate more money towards recapitalisation of banks. There is a limit to that as well.

Also, a bigger problem which the Economic Survey does not talk about is the fact that the rate of recovery of bad loans has gone down dramatically over the years. In 2013-2014, the rate of recovery was at 18.8 per cent. By 2015-2016, this had fallen to 10.3 per cent. Hence, banks were only recovering around Rs 10 out of the every Rs 100 of bad loans defaulted on by borrowers. This is clear reflection of the weak institutional mechanisms in India, which cannot change overnight.

Also, many of the companies that have taken on large loans are no longer in a position to repay. As the Economic Survey points out: “Cash flows in the large stressed companies have been deteriorating over the past few years, to the point where debt reductions of more than 50 percent will often be needed to restore viability. The only alternative would be to convert debt to equity, take over the companies, and then sell them at a loss.”

The first problem here will be that many businessmen are very close to politicians.
Hence taking over companies won’t be easy. Over and above this, it will require the government and the public sector banks, working with the mindset of a profit motive, like a private equity or a venture capital fund. And that is easier said than done.

The column originally appeared in the Daily News and Analysis on May 22, 2017.

Mr Subramanian, Lower Interest Rates Do Not Always Lead to More Bank Loans


“Lower interest rates lead to higher lending,” is something that most economists firmly believe in. The beliefs of Arvind Subramanian, the chief economic adviser to the ministry of finance, are not an exception to this rule.

Hence, not surprisingly in a lecture a few days back he came out all guns blazing against the Reserve Bank of India(RBI) for not cutting the repo rate. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loan. We say sort of a benchmark here because there are other factors which go into deciding what rate of interest that banks charge on their loans.

Subramanian wants the RBI to cut the repo rate further from its current level of 6.25 per cent. As he said: “Inflation pressures are easing considerably… the inflation outlook is benign because of a number of economic developments… Against this background, most reasonable economists would say that the economy needs all the macroeconomic policy support it can get: instead, both fiscal policy and monetary policy remain tight.

The point here being that current inflation is under control and from the looks of it, future inflation should also be under control. And given this, the RBI must cut its repo rate. The RBI last cut the repo rate in October 2016. And as and when it cuts the rate further, the hope is that the banks will cut their lending rates. Only then will people and industries both borrow and spend more. This will give a flip to the economy. QED.
Subramanian’s point is well taken. Nevertheless, does it make sense? We will deviate a little here before we arrive at the answer.

The RBI Monetary Policy Report released in early April 2017 points out that the decline in the one-year marginal cost of funds based lending rates (MCLRs) of banks between April and October 2016 was just 15 basis points. This when the repo rate was cut by 50 basis points. Hence, even though the RBI cut its repo rate by 50 basis points, the banks cut their lending rates by just 15 basis points, a little under a one-third. One basis point is one hundredth of a percentage.

Post demonetisation “27 public sector banks have reduced their one-year median MCLR in the range of 50 to 105 bps, and 19 private sector banks have done so in the range of 25 to 148 bps.” This when the repo rate has not been cut at all. On an average the one year MCLRs of banks fell by 70 basis points to 8.6 per cent.

What has happened here? A cut in the repo rate barely makes any difference to the cost at which banks have already borrowed money to fund their loans. But demonetisation did. The share of the “low cost current account and savings account (CASA) deposits in aggregate deposits with the SCBs went up to 39.2 per cent (as on March 17, 2017) – an increase of 4.0 percentage points relative to the predemonetisation period”. This is because people deposited the demonetised notes into the banks and this money was credited against their accounts.

This basically meant that banks suddenly had access to cheaper deposits because of demonetisation. And this in turn led them to cut interest rates on their loans, despite no cut in the repo rate. The RBI’s repo rate continued to be at 6.25 per cent during the period.

A cut in lending rates is only one part of the equation. The bigger question has it led to higher borrowings? Are people and businesses borrowing more because lending rates are now lower than they were in the past? And this is where things become interesting.
The total deposits of banks between October 28, 2016 (before demonetisation) and December 30, 2016 (the last date to deposit demonetised currency into banks) went up by 6.41 per cent to Rs 10,568,17 crore. This was a huge jump during a period of two months. This sudden increase in liquidity led to banks cutting their deposit rates and then their lending rates.

Interestingly, the total deposits of banks have continued to remain stable and as of April 30, 2017, were at Rs 10,509,337 crore. This is a minor fall of 0.6 per cent since December 2016.

Between end October 2016 and end April 2017, only around 36 per cent of the incremental deposits raised by banks were loaned out. (We are looking at non-food credit here. The total bank loans that remain after we adjust for the loans that have been given to the Food Corporation of India and other state procurement agencies for the procurement of rice and wheat produced by farmers).

This means for every new deposit worth Rs 100, the bank loaned out just Rs 36, despite a cut in interest rates.

If we were to look the same ratio between end October 2015 and end April 2016, it projects a totally different picture. 116 per cent of the incremental deposits during the period were lent out. This means for every new deposit worth Rs 100, the bank loaned out Rs 116.  This means that deposits raised before the start of this period were also lent out.

Hence, a greater amount of lending happened at higher interest rates between October 2015 and April 2016. And this goes totally against Subramanian’s idea of the RBI needing to cut the repo rate. It also goes against the idea of banks lending more at lower interest rates.

Given this, low interest rates are only a part of the story. If that is not leading to higher lending, it doesn’t help in anyway. Lending isn’t happening due to various reasons, which we keep discussing. Demonetisation has only added to this issue.

Also, a fall in interest rates hurts those who depend on a regular income from fixed deposits to meet their expenditure. It also hurts those who are saving for their long-term goals. In both the cases, expenditure has to be cut down. In one case because enough regular income is not being generated and in another case in order to be able to save more to reach the investment goal. And this cut in spending hurts the overall economy. Interest rates are also about the saver and depositor.

We are yet to see a professional economist talk from this angle. To them it is always a case of garbage in garbage out i.e. lower interest rates lead to increased lending. This is simply because most professional economists these days get trained in the United States where the system is totally different and lower interest rates do lead to a higher borrowing by businesses and people.

But that doesn’t necessarily work in India. It is a totally different proposition here.

The column originally appeared in Equitymaster on May 15, 2017.

Six Months After Demonetisation Cash is King Again and Questions Still Remain


On November 8, 2016, the prime minister Narendra Modi announced his government’s decision to demonetise Rs 500 and Rs 1,000 notes, to an unsuspecting nation. The decision came into effect from the midnight between November 8 and November 9, 2016, and suddenly rendered 86.4 per cent of the nation’s currency in circulation, useless.

It’s been six months since then and more than four months since December 30, 2016, the last date for depositing the demonetised Rs 500 an Rs 1,000 notes, into bank accounts. But even after this period as far as the government is concerned, a few basic points remain.

a) How much demonetised money finally made it into bank accounts? When demonetisation was first announced, this number was shared regularly. Nevertheless, the last announcement on this front from the Reserve Bank of India(RBI) came on December 13, 2016. As of December 10, 2016, Rs 12.44 lakh crore of demonetised currency had made it back into the banks.
Given that Rs 15.44 lakh crore worth of currency notes had been demonetised, nearly 80.6 per cent of the currency had found its way back into banks, nearly three weeks before the last date to deposit demonetised notes into bank accounts.
Neither the Reserve Bank nor the government has told the nation how much money eventually made it back into the banks. This is an important question and needs to be answered.

b) The initial idea behind demonetisation was to curb fake currency notes and eliminate black money.
As far as fake currency goes the minister of state for finance Arjun Ram Meghwal told the Lok Sabha in early February 2017 that the total number of fake notes deducted in the currency deposited into banks after demonetisation stood at 2.46 lakhs. This amounted to a total value of Rs 19.5 crore.
As mentioned earlier, the total value of demonetised notes had stood at Rs 15.44 lakh crore. Given this, the proportion of fake notes deducted is almost zero and can be ignored. Hence, as far as detecting and eliminating fake notes was concerned, demonetisation was a total flop.
How did it do as far as eliminating black money is concerned? The hope was that the black money held in the form of cash will not make it back into the banks, as people wouldn’t want to get caught by declaring it. But by December 10, 2016, more than four-fifth of the demonetised notes had already made it back into the banks. Since then the government and the RBI have not given out any fresh numbers. It’s surprising that it has been more than four months since December 30, 2016, and this number is still not out in the public domain.
Also, it is important to point out here: “High denomination notes are known to facilitate generation of black money. In this connection, it may be noted that while the total number of bank notes in circulation rose by 40% between 2011 and 2016, the increase in number of notes of Rs.500/- denomination was 76% and for Rs.1,000/- denomination was 109% during this period.”
If high denomination notes facilitate generation of black money, then why replace Rs 1,000 notes with Rs 2,000 notes. Given that a Rs 2,000 note is twice the value of a Rs 1,000 note, it makes black market transactions even more easier. It also makes storage of black money in the form of cash easier, given that it takes less space to hide the same amount of money.
Again, this is a basic disconnect in what the government planned to achieve through demonetisation and what it eventually did. No effort has been made to correct this disconnect.

c) The government has still not offered a good explanation of what prompted it to demonetise. There has been no similar decision taken by any other country in a stable financial situation like India currently is, in the modern era. The best that the government has done is blamed it on the RBI. As Meghwal told the Lok Sabha in early February 2017: “RBI held a meeting of its Central Board on November 8, 2016. The agenda of the meeting, inter-alia, included the item: “Memorandum on existing banknotes in the denomination of Rs 500 and Rs 1000 – Legal Tender Status.””
Anybody who has studied the history of the RBI would know that the RBI would never take such an extreme step without extreme pressure from the government.

d) Other than eliminating black money and fake currency notes through demonetisation, in the aftermath of demonetisation, the government wanted to promote cashless transactions. As Modi said in the November 2016 edition of themann ki baat radio programme: “The great task that the country wants to accomplish today is the realisation of our dream of a ‘Cashless Society’. It is true that a hundred percent cashless society is not possible. But why should India not make a beginning in creating a ‘less-cash society’? Once we embark on our journey to create a ‘less-cash society’, the goal of ‘cashless society’ will not remain very far.”

How are things looking on that front? Look at the following table. It shows the volume of digital transactions over the last few months.

Month Volume of digital transactions (in million)
Nov-16 671.5
Dec-16 957.5
Jan-17 870.4
Feb-17 763.0
Mar-17 893.9
Apr-17 843.5

Source: Reserve Bank of India

While digital transactions picked up in December, they have fallen since then. The total number of digital transactions in April 2017 is higher than it was in November 2016. Nevertheless, it is worth asking, whether this jump of 25 per cent was really worth the trouble of demonetisation.

e) Falling digital transactions since December 2016 tell us that cash as a mode of payment is back in the system. There is another way this can be shown. Between November 2016 and February 2017, banks barely gave out any home loans. During the period, the banks gave out home loans worth Rs 8,851 crore. In March 2017, they gave out total home loans of Rs 39,952 crore, which was 4.5 times the home loans given out in the previous four months. It also amounted to 35 per cent of the home loans given out during the course of 2016-2017.

A major reason why people weren’t taking on home loans between November 2016 and February 2017 was demonetisation. There simply wasn’t enough currency going around. With this, the real estate transactions came to a standstill because without currency it wasn’t possible to fulfil the black part of the real estate transaction. Those who owned homes (builders and investors) were not ready to sell homes, without being paid for a certain part of the price, in black.

By March 2017, nearly three-fourths of the demonetised currency was replaced. This basically means that by March 2017, there was enough currency in the financial system for the black part of the real estate transactions to start happening all over again. Also, the Rs 2,000 note makes this even more convenient.

To conclude, six months after the declaration of demonetisation it is safe to say that demonetisation has failed to achieve what it set out to achieve i.e. if it set out to achieve anything on the economic front.

The column originally appeared on Firstpost on May 9, 2017

Viral Acharya is Right About Re-privatising Public Sector Banks


Late last week Viral Acharya, a deputy governor of the Reserve Bank of India (RBI), said: “Perhaps re-privatising some of the nationalised banks is an idea whose time has come … this would reduce the overall money government needs to inject as bank capital.”

Regular readers of the Diary would know that we have said several times in the past that public sector banks should be privatised and the government should get out of the banking business, which it is clearly inept at.

Of course, the question is why has Acharya used the term re-privatising rather than privatising. Indira Gandhi nationalised 14 private banks on July 19, 1969. These banks had deposits of Rs 50 crore or more and among them accounted for 90 per cent of the banking business in the country. The funny thing is that at the time this happened, the then RBI governor LK Jha had no clue about it.

As TCA Srinivasa Raghavan writes in Dialogue of the Deaf—The Government and the RBI: “Volume three of RBI’s official history says that on July 17 she [Indira Gandhi] asked LK Jha, the RBI governor to come over to Delhi. Jha thought he was being asked to discuss social control and he took with him a comprehensive note on the subject. When he offered it to Mrs Gandhi she told him ‘that he could keep the note on her table and go to the next room and help in drafting the legislation on nationalising the banks.’”

In 1980, six other private banks were nationalised. This time the recommendation came from the then RBI governor, IG Patel.

Now getting back to what Acharya said, re-privatising is something we have advocated in the past. And it makes sense at multiple levels. We now have nearly two decades of evidence that suggests that the new generation private sector banks which were first set up in the mid-1990s, are much more efficiently run than their public-sector counterparts. Yes, there have been cases like the Global Trust Bank, but on the whole private banks are better run than their public sector counterparts. Even the old generation private sector banks, which are very small, are reasonably well run.

Take the case of the bad loans situation that currently plagues the Indian banking sector in general and the public sector banks in particular. As on December 31, 2016, the total bad loans of the public sector banks (gross non-performing assets (NPAs)) had stood at around Rs 6.46 lakh crore.

For the private sector banks, the same number stood at Rs 86,124 crore. Of this, two banks, ICICI Bank and Axis Bank, accounted for bad loans of Rs 58,184 crore. Of course, given that public sector banks give out more loans, it is not surprising that their bad loans are more.

The total loans of public sector banks are 2.9 times the total loans of private sector banks. But their bad loans are 7.5 times that of private banks. If both these set of banks were equally well run, then the two ratios just referred to, wouldn’t have been different.

Between 2013-2014 and 2015-2016, the total net profit made by the public sector banks stood at Rs 56,567 crore and that of private banks stood at Rs 1,13,801 crore. This, even though public sector banks are significantly bigger than India’s private banks.

These data points tell us that India’s public sector banks are inefficiently run. And this inefficiency has cost the government a lot of money over the years. Between 2009 and March 2017, the government has had to invest close to Rs 1.5 lakh crore in these banks to keep recapitalising their capital, in order to keep them going.

Indeed, this is a lot of money and could have gone towards other worthy causes. The basic problem with public sector banks is political meddling. Every government has its favourite set of industrialists and this ultimately leads to the public sector banks and in the process the taxpayer, picking up the bill for this politician-businessman nexus.

As Acharya writes in a paper titled Is State Ownership in the Indian Banking Sector Desirable?: “One, state ownership creates severe moral hazard of directing bank lending for politically expedient goals and of bailouts when such lending goes bad. Second, state ownership restricts the ability of state-owned banks from raising arm’s length capital against state’s stake, strangling their growth and keeping these banks—and certainly their private capital base—smaller than it need be.”

What does this mean in simple English? The economist Alan Blinder in his book After the Music Stopped writes that the “central idea behind moral hazard is that people who are well insured against some risk are less likely to take pains (and incur costs) to avoid it.” Hence, managers of government owned banks know that if loans given to businessmen close to politicians go bad, the government will ultimately pick up the tab by recapitalising the public sector bank to an adequate extent. Hence, they go easy on giving loans to borrowers who are likely to default. Of course, there is always the threat of transfers, which works very well. This has happened for years at end.

Secondly, given that the government has to continue owning a certain proportion of shareholding in these banks, the banks cannot raise as much capital as they require. They have to continue to be dependent on the government for capital. And the government of course does not have an unlimited amount of cash. This limits the ability of the government owned banks to raise as much capital as they may require at any point of time.

So, what are the actual chances of the government re-privatising some of the public sector banks, as suggested by Acharya? Zero. While Acharya, I and others, might think that the basic problem with public sector banks is government ownership, politicians don’t think so. This comes from the belief that if you own banks then you can direct lending to areas that you want to. But this as we have seen comes with its own set of costs.

The column originally appeared on Equitymaster on May 3, 2017.