Using Deposits to Rescue Banks is a Bad Idea; It Needs to Be Nipped in the Bud

Indian_ten_rupee_coin_(2008_Reverse)
I have been travelling for the past two weeks and a question that has been put to me, everywhere I have gone is: “will fixed deposits be used to rescue banks that are in trouble?

People have been getting WhatsApp forwards essentially saying that the Modi government is planning to use their bank deposits to rescue all the banks that are in trouble. As is usually the case with WhatsApp, this is not true. The truth is a lot more nuanced.

Let’s try and understand this in some detail.

Where did the idea of fixed deposits being used to rescue troubled banks come from?
The government had introduced The Financial Resolution and Deposit Insurance(FRDI) Bill, 2017, in August 2017. This Bill is currently being studied in detail by a Joint Committee of members belonging to the Lok Sabha as well as the Rajya Sabha.

The basic idea behind the FRDI Bill is essentially to set up a resolution corporation which will monitor the health of the financial firms like banks, insurance companies, mutual funds, etc., and in case of failure try and resolve them.

The Clause 52 of the FRDI Bill uses a term called “bail-in”. This clause essentially empowers the Resolution Corporation “in consultation with the appropriate regulator, if it is satisfied that it necessary to bail-in a specified service provider to absorb the losses incurred, or reasonably expected to be incurred, by the specified service provider.”

What does this mean in simple English? It basically means that financial firms or a bank on the verge of a failure can be rescued through a bail-in. Typically, the word bailout is used more often and refers to a situation where money is brought in from the outside to rescue a bank. In case of a bail-in, the rescue is carried out internally by restructuring the liabilities of the bank.

Given that banks pay an interest on their deposits, a deposit is a liability for any bank.
The Clause 52 of FRDI essentially allows the resolution corporation to cancel a liability owed by a specified service provider or to modify or change the form of a liability owed by a specified service provider.

What does this mean in simple English? Clause 52 allows the resolution corporation to cancel the repayment of various kinds of deposits. It also allows it to convert deposits into long term bonds or equity for that matter. Haircuts can also be imposed on firms to which the bank owes money. A haircut basically refers to a situation where the borrower negotiates a fresh deal and does not payback the entire amount that it owes to the creditor.

But there are conditions to this…
The bail-in will not impact any liability owed by a specified service provider to the depositors to the extent such deposits are covered by deposit insurance. This basically means that the bail-in will impact only the amount of deposits above the insured amount. As of now, in case of bank deposits, an amount of up to Rs 1 lakh is insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC). This amount hasn’t been revised since 1993.

Typically, anyone who has deposits in a bank tends to assume that they are 100 per cent guaranteed. But that is clearly not the case. Over the years, the government has prevented the depositors from taking a hit by merging any bank which is in trouble with another bigger bank.

So, to that extent the situation post FRDI Bill is passed, is not very different from the one that prevails currently. It’s just that the government has come to the rescue every time a bank is in trouble and I don’t see any reason for that to change, given the pressure on the government when such a situation arises and the risk of the amount of bad press it would generate, if any government allowed a bank to fail.

Over and above this, Clause 55 of the FRDI Bill essentially states that “no creditor of the specified service provider is left in a worse position as a result of application of any method of resolution, than such creditor would have been in the event of its liquidation.” This basically means that no depositors after the bail-in clause is implemented should get an amount of money which is lesser than what he would have got if the firm were to be liquidated and sold lock, stock and barrel.

While, this sounds very simple in theory, it will not be so straightforward to implement this clause.

So why is the government doing this?
In late 2008 and early 2009, governments and taxpayers all over the world bailed out a whole host of financial institutions which were deemed too big to fail. In the process, they ended up creating a huge moral hazard.

As Mohamed A El-Erian writes in The Only Game in Town“[It] is the inclination to take more risk because of the perceived backing of an effective and decisive insurance mechanism.”

If governments and taxpayers keep rescuing banks what is the signal they are sending out to bank managers and borrowers? That it is okay to lend money irresponsibly given that governments and taxpayers will inevitably come to their rescue.

In order to correct for this moral hazard, in November 2008, the G20, of which India is a member, expanded the Financial Stability Forum and created the Financial Stability Board. The Board came up with a proposal titled “Key Attributes of Effective Resolution Regimes for Financial Institutions”. This proposal suggests to “carry out bail-in within resolution as a means to achieve or help achieve continuity of essential functions”. India has endorsed this proposal. Hence, unlike what WhatsApp forwards have been claiming this proposal has been in the works for a while now.

But does this really prevent moral hazard?
A bulk of the banking sector in India is controlled by the government owned public sector banks. As of September 30, 2017, these banks had a bad loans rate of 12.6 per cent (for private banks it is at 4.3 per cent).  Bad loans are essentially loans in which the repayment from a borrower has been due for 90 days or more. The bad loans rate when it comes to lending to industry is even higher. In case of some banks it is close to 40 per cent.

This is primarily because banks over the years, under pressure from politicians and bureaucrats, lent a lot of money to crony capitalists, who either siphoned off this money or overborrowed and are now not in a position to repay. This is a risk that remains unless until the banking sector continues to primarily remain government owned in India.

Also, the rate of recovery of bad loans of banks in 2015-2016, stood at 10.3 per cent.  This does not inspire much confidence. In this scenario, having a clause which allows the resolution corporation to get depositors to pay for the losses that banks incur, is really not fair. The moral hazard does not really go away. The bankers, politicians and crony capitalists, can now look at bank deposits to rescue banks. As of now, the government and the taxpayers have kept rescuing public sector banks, by infusing more and more capital into them. Now the depositors can take over, if FRDI Bill becomes an Act.

It is worth pointing out here that the other G20 countries which have supported this proposal have some sort of a social security system in place, which India lacks. Given this, deposits are the major form of savings and earnings for India’s senior citizens and clearly, they don’t deserve to be a part of any such risk.

While, any government will think twice before using depositor money to rescue a bank, this is not an option that should be made available to governments or bureaucrats in India. It is a bad idea. It needs to be nipped in the bud.

These are my initial thoughts on the issue. Depending on how the situation evolves, I will continue to write on it.

The column originally appeared on Equitymaster on December 11, 2017.

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The Real Brave-hearts are Those Who Still Have Deposits in IDBI Bank

IDBI-Bank-Careers-Mumbai-3
IDBI Bank is the worst performing public sector bank when it comes to its gross non-performing advances or bad loans. Bad loans are essentially loans in which the repayment from a borrower has been due for 90 days or more.

As on September 30, 2017, the bad loans rate of the bank stood at 24.98 per cent. This basically means that the borrowers have defaulted on nearly one-fourth of the loans given by the bank. Now take a look at Figure 1. It plots the bad loans of IDBI Bank over the last three years.

Figure 1: 

The bad loans rate of IDBI Bank has jumped from around 5 per cent to around 25 per cent, over a period of just three years. What is happening here? What this tells us is that initially the bank did not recognise bad loans as bad loans. It probably did that by restructuring loans (i.e. giving the borrowers more time to repay or decreasing their interest rate or by simply postponing their repayment) or by issuing fresh loans to borrowers in a weak position, so that they could repay the loans that were maturing. In the process, the recognition of bad loans as bad loans was avoided.

Of course, any bank can’t perpetually keep kicking the can down the road, and after a point of time must do the right thing. IDBI Bank is now doing the right thing of recognising bad loans as bad loans and given this it has such a high bad loans rate. Given that, one-fourth of the loans advanced by the bank have been defaulted on, it is worth asking whether this bank should be in the business of banking at all.

Nevertheless, the more important issue here is how do depositors view this bank. The best way to find this out is to look at the total amount of deposits the bank still has. Take a look at Figure 2, which plots that.

Figure 2: 

What does Figure 2 tell us? The total deposits of the bank have fallen after peaking in December 2016. Nevertheless, the total deposits with IDBI Bank are still higher than they were three years back. Hence, the conclusion that we can draw here is that while bad loans of the bank have gone up from 5 per cent to 25 per cent over a period of three years, the total deposits with the bank are still at the level they were.

Why is this the case? Why would you continue banking with such a bank? First and foremost, this faith comes from the great faith in the government. The government will not allow any bank to go bust. Fair enough. But why wait for that to happen? Typically, when a bank lands up in major trouble, the government tends to merge it with a bigger bank and thus the depositors continue to be safe. Nevertheless, such a merger is never smooth and there might be a brief time period when the full money deposited in the bank cannot be withdrawn. Hence, liquidity can become an issue.

Also, it is worth remembering here that IDBI Bank is not a small bank. It is a relatively big bank and had total assets of close to Rs 3,61,768 crore, as on March 31, 2017. This means that if the government were to decide to merge it with another bank, the balance sheet and the profit and loss account of the combined entity, will be another big mess.

Secondly, many people are simply unaware of how badly the bank is placed. This lack of knowledge about their financial activities is a general trend among many people in this country. We spend more time gossiping and worrying about the state of the nation, than the state of our own finances.

Thirdly, many people locked in their fixed deposits at high interest rates, a few years back. In the aftermath of demonetisation, interest rates have crashed as banks have been flush with funds that were deposited and at the same time their lending has crashed. Given this, even if some individuals understand the riskiness of the situation, they really can’t do much about it. In case they were to break their fixed deposits and move it to other banks, they would earn a much lower rate of interest.

And at that lower rate of interest, they would simply not be in a situation to meet their monthly expenses. This is another negative impact of demonetisation at play, with people having to continue to bank with risky public sector banks, which includes IDBI Bank.

While, some people are simply stuck with IDBI Bank, there are others who can easily move their money to other public sector banks, like State Bank of India, Vijaya Bank, Indian Bank, Syndicate Bank etc., which are in a comparatively much better position.

But given that they have chosen not to, they are the real brave-hearts.

The column originally appeared on November 6, 2017.

If PM Modi could sell Notebandi why not Bankbandi? Many banks do not deserve fresh capital

rupee

One of the examples of Big Government I have in my book India’s Big Government is that of government owned public sector banks. (The good news is that the book is available at a huge discount on Amazon till Friday, 27th October. The Kindle version is going at Rs 199, against a maximum retail price of Rs 749, and the paperback is going at Rs 499, against a maximum retail price of Rs 999).

When I wrote the book, the Indian government owned 27 public sector banks. As of April 1, 2017, the Bhartiya Mahila Bank and the five associate banks of State Bank of India, were merged with the State Bank of India. Due to this merger, the number of government owned banks fell to 21. This merger has pulled down the overall performance of the State Bank of India and is just a way of sweeping problems under the carpet. Over the years, the government plans to use mergers to reduce the number of banks it owns to anywhere between ten to fifteen. This as I have said in the past is a bad idea.

Yesterday afternoon, the finance ministry announced a plan to invest more capital in public sector banks, which are saddled with a massive amount of bad loans and restructured loans. The government plans to put in Rs 2,11,000 crore over the next two years, “with maximum allocation in the current year”.

Where will this money come from? Rs 18,139 crore has been allocated from the current financial year’s budget. Banks are expected to raise capital by issuing new shares. This is expected to raise around Rs 58,000 crore.

This leaves us with around Rs 1,35,000 crore. Where will this money come from? This money is expected to come in through recapitalisation bonds. How will this work? The government hasn’t specified the details of how these bonds will be issued. (This makes me wonder as to why have a press conference in the first place, when the most important part of the plan, has not been decided on).

From what I could gather speaking to people who understand such things, this is how it is supposed to work. The banks have a lot of liquidity because of all the money that has come in because of demonetisation. A part of these deposits will be used by public sector banks to buy recapitalisation bonds issued by the government.

The money that the government thus gets will be used to buy fresh shares that the banks will issue. Thus, the banks will be recapitalised.

Now on the face of it, this sounds like a brilliant plan, where money is moved from one part of the balance sheet to another and a huge problem is solved. But is it as simple as that?

a) By issuing recapitalisation bonds the debt of the government will go up. Over and above this, interest will have to be paid on these bonds. Both the debt and the interest will add to the fiscal deficit of the government.

b) Given that the debt of the government will go up, this would mean that the taxpayers will ultimately pick up the tab because the debt will have to be repaid. It makes sense to always remember that there is no free lunch in economics. The corollary to this is that there is no free lunch especially when something feels like a free lunch. Of course, the taxpayers aren’t organised and hence, they are unlikely to protest. And given that they finance all bailouts.

c) It remains to be seen what the banks do with this extra capital. Will they use it to write off restructured loans of corporates? Will this dull their enthusiasm (not that they had enough of it in the first place) to recover bad loans? As the situation changes, so will the behaviour of bankers.

This will also bring to the fore the issue of moral hazard. And what is moral hazard? As Mohamed A El-Erian writes in The Only Game in Town: “[It] is the inclination to take more risk because of the perceived backing of an effective and decisive insurance mechanism.” If the government bails them around this time around, the banks know that they can count on the government bailing them out the next time around as well. And this means that they can follow fairly loose standards of lending, in order to lend money quickly.

d) As I keep saying, bank lending among other things is also a function of whether there is demand for such lending. The public sector banks have gone slow on lending to corporates (in fact they have contracted their loan book) because of a lack of capital. Or so we are told. But this lack of capital doesn’t seem to have hindered their lending to the retail segment. Now that they will have access to more capital, will this reluctance to lend to corporates go away? I am not so sure.

e) Also, some of the banks are in such a bad state, that they really don’t deserve this capital. They shouldn’t be in the business of banking in the first place. Take a look at Table 1. Table 1, lists out the bad loans ratio of all the public sector banks. Bad loans are essentially loans in which the repayment from a borrower has been due for 90 days or more.

Table 1:

Name of the bank Bad loans ratio (in per cent)
IDBI Bank 24.11
Indian Overseas Bank 23.6
UCO Bank 19.87
Bank of Maharashtra 18.59
Central Bank of India 18.23
Dena Bank 17.37
United Bank of India 17.17
Corporation Bank 15.49
Oriental Bank of Commerce 14.83
Allahabad Bank 13.85
Punjab National Bank 13.66
Andhra Bank 13.33
Bank of India 13.05
Union Bank of India 12.63
Bank of Baroda 11.4
Punjab and Sind Bank 11.33
Canara Bank 10.56
State Bank of India 9.97
Syndicate Bank 9.96
Vijaya Bank 7.3
Indian bank 7.21

Source: www.careratings.com 

As can be seen from Table 1, only two public sector banks have a bad loans ratio significantly lower than 10 per cent (Actually its four, but State Bank of India and Syndicate Bank are very close to 10 per cent).

Eight out of the 21 banks have a bad loans ratio of greater than 15 per cent. This basically means that out of every Rs 100 of lending carried out by these banks, at least Rs 15 is no longer being repaid.

Some of these banks with extremely high bad loans are way too small to make any difference in the overall lending carried out by banks. Take a look at Table 2.

Table 2:

Name of the Bank Total advances as a percentage of gross advances of banks (as on March 31, 2017) Bad loans rate (as on June 30, 2017)
United Bank of India 0.82% 17.17%
Dena Bank 0.90% 17.37%
Bank of Maharashtra 1.18% 18.59%
UCO Bank 1.48% 19.87%
Central Bank of India 1.73% 18.23%
Indian Overseas Bank 1.74% 23.60%

Source: Author calculations on Indian Banks’ Association data and www.careratings.com 

These public sector banks have now reached a stage wherein there is no point in the government trying to spend time and money, in reviving them. It simply makes more sense to shut them down and sell their assets piece by piece or to sell them, lock, stock and barrel, if any of the bigger private banks or any other private firms, are willing to buy them. But what the government is doing instead is using taxpayer money to maintain its control over banks.

f) Also, recapitalising banks does not take care of the basic problem at the heart of public sector banks, which is that they are public sector banks. Allow me to explain. Let’s take the example of the State Bank of India, the largest public sector banks. As of June 30, 2017, the bad loans ratio of the bank when it came to retail lending was 1.56 per cent. At the same time, the bad loans ratio when it came to corporate lending was 18.61per cent.This basically means that State Bank of India, does a terrific job at retail lending but really screws up when it comes to lending to industry. What is happening here? Thomas Sowell, an American economist turned political philosopher, discusses the concept of separation of knowledge and power, in his book Wealth, Poverty and Politics.

How does it apply in this context? In public sector banks, managers who have the knowledge to take the right decisions may not always have the power to do so. Take the case of retail lending. The manager looks at the ability of the borrower to repay a loan, and then decides to commission or not commission one. This explains why the bad loans ratio in case of retail lending is as low as 1.56 per cent (in fact, it was just 0.55 per cent before the merger). A proper process to give a loan is being followed in this case.

But when it comes to lending to corporates, there are people out there (or at least used to be) who are trying to influence the manager’s decision; from bureaucrats to ministers to politicians. In this scenario, the manager ends up giving out loans even to those corporates who do not have the wherewithal to repay it.

The separation between knowledge and power has led to a situation where bank loans were given to many crony capitalists who have defaulted, and what we are seeing now is a fall out of that. In many cases, the corporates have simply siphoned off the loan amounts by over declaring the cost of the projects they borrowed against.

Of course, as long public sector banks continue to remain public sector banks, this risk will remain. But this government (and the ones before it) likes the idea of owning banks, and because it gives some relevance to ministers and bureaucrats.

Also, the employee unions of public sector banks have a huge nuisance value. No government has had the balls to take them on, in the past. Neither does this one. And this basically means that taxpayers will have to continue rescuing the public sector banks.

The column originally appeared on Equitymaster The column originally appeared on Equitymaster with  a different headline on October 25, 2017.

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

RBI-Logo_8

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

RBI-Logo_8

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.