The Orwellian Economics of Indian Banking

George Orwell towards the end of his brilliant book Animal Farm writes: “There was nothing there now except a single Commandment. It ran: All animals are equal but some animals are more equal than others.”

Nowhere is this more visible these days than at Indian banks, in particular the government owned public sector banks, and the way they treat their different kind of borrowers. As is well known by now, Indian public sector banks have a massive bad loans problem. This basically means that borrowers who had taken loans over the years are now not repaying them. The bad loans of Indian banks are now among the highest in the world, only second to that of Russia.

The borrowers who have defaulted on their loans primarily consist of large borrowers i.e. corporates, who have taken on loans and are now not repaying them. As per the Economic Survey of 2016-2017, among the large defaulters are 50 companies which owe around Rs 20,000 crore each on an average to the banking system. Among these 50 companies are 10 companies which owe more than Rs 40,000 crore each on an average to the banking system.

These are exceptionally large amounts. Typically, when a borrower defaults the bank comes after him with full force, in order to recover the loan, by selling
assets offered as a collateral against the loan. But this force is not felt by the large corporates. It is felt by the small entrepreneurs who borrow from banks or people like you and me who take on retail loans like home loans, vehicle loans, credit card loans etc.

As former RBI governor Raghuram Rajan said in 2014 speech: “Its full force [i.e., of the banking system] is felt by the small entrepreneur who does not have the wherewithal to hire expensive lawyers or move the courts, even while the influential promoter once again escapes its rigour. The small entrepreneur’s assets are repossessed quickly and sold, extinguishing many a promising business that could do with a little support from bankers.”

Given that they have access to the best lawyers and are close to politicians, the large borrowers don’t feel the heat of the banking system.

In fact, the large borrowers given that they are large, get treated with kids gloves. In some cases, the repayment periods of their loans have been extended. In some other cases, the borrower does not have to pay interest on the loan for a specific period. But all this hasn’t really helped and the banking mess continues.

The Economic Survey of 2016-2017 has recommended based on the data for the year ending September 2016 that “about 33 of the top 100 stressed debtors would need debt reductions of less than 50 percent, 10 would need reductions of 51-75 percent, and no less than 57 would need reductions of 75 percent or more.”

This basically means that banks will have to take on what is technically referred to as a haircut. Let’s say a corporate owes Rs 100 to a bank. A haircut of 51 per cent would mean that he would now owe only Rs 49 to the bank. The bank would have to take on a loss of Rs 51.

The Economic Survey offers multiple reasons why haircuts will be required. The first and the foremost is that the borrowers simply do not have the money to repay. Secondly, large corporates owe money to many banks and these banks need to agree on a strategy to tackle the defaults. That hasn’t happened.

Of course, what the Economic Survey does not tell us is that the large borrowers are politically well connected. It also does not get into the moral hazard haircuts would create. Once corporates are bailed out this time around, why would they go around repaying loans the next time around? They simply won’t have the economic incentive to do so.

And finally, the Survey does not tell us anything about why only the large corporates are being treated with kids gloves? I guess it does not need to because that was something Orwell explained to us many years back.

The column originally appeared in Bangalore Mirror on March 29, 2017.


Here is Another Good Joke: New IT Data Shows Only 6 lakh Indians Are Repaying Home Loans


In yesterday’s column I explained that if official data is to be believed India has only 20 lakh individuals who earn an income out of house property.

To put it simply, as per official data, India has only 20 lakh landlords or 19.95 lakh to be very precise. This number can be inferred from the data for the assessment year 2012-2013 shared by the income tax department last week. Income tax returns for the income earned during 2011-2012 would have to be filed during assessment year 2012-2013.

In fact, there was another interesting data point, in the column. This means some amount of repetition from yesterday’s column, but kindly bear with me. I am repeating this point because of two reasons—a) I thought, it sort of got lost in yesterday’s column. b) I think it is an equally important point which people need to know about.

As per the data for the assessment year 2012-2013, there were only around 26.01 lakh individual assesses who had shown some income from house property. Of this, around 6.06 lakh (or 6,06,046 to be very precise) had shown a negative income.

This negative income amounted to around Rs 3,298 crore in total. This works out to an average negative income of Rs 54,418 per individual. The term negative income is actually an oxymoron. But what it essentially means is that instead of earning any money from a house, the owner is actually spending money on it.

This happens when someone has taken a home loan to buy a home and is paying an interest on it. The Income Tax Act allows the interest paid on borrowed capital (i.e. a home loan) to be deducted while calculating taxable income.

For 2011-2012, in case of a self-occupied home, a maximum amount of Rs 1.5 lakh could be taken as a deduction for the interest paid on a home loan. Individuals in such situation would end up having a negative income from house property.

For a non-self-occupied home, there was no upper limit to the amount of interest that could be taken as a deduction, though a notional rent would also have to be taken into account, if the house hadn’t been put out on rent.

If the interest to be paid on the home loan was greater than the rent earned or the notional rent, then the income from house property would turn out to be negative. Such individuals would also end up having a negative income from house property.

The surprising thing is that the number of such individuals in total is only a little over six lakh. Does this mean that India has only six lakh people who have taken on a home loan to buy a home? The official data seems to suggest that.

But this is simply bizarre. Some simple mathematics clearly shows us that. The Reserve Bank of India (RBI) puts out sectoral deployment of credit data. During 2011-2012, scheduled commercial banks gave out home loans worth Rs 41,907 crore.

Multiple newsreports point out that in 2012-2013, the average home loan financed by banks was Rs 10 lakh. I couldn’t find an average home loan number for 2011-2012, and hence will have to work with this.

Let’s assume that in 2011-2012, the average home loan financed was 10% lower at Rs 9 lakh than in comparison to 2012-2013. This essentially means that just in 2011-2012, around 4.66 lakh homes (Rs 41,907 crore divided by Rs 9 lakh) were financed by scheduled commercial banks.

Over and above banks, housing finance companies also give out home loans. Hence, it is safe to say that just in 2011-2012, more than six lakh home loans would have been given out.

Further, home loans would have also been given out even in years before 2011-2012. Hence, how is it possible that only around six lakh individuals have a negative income from their homes, as data from the income tax department suggests?

Something doesn’t really add up here. In fact, as I had pointed out in yesterday’s column, the number of home loan accounts with scheduled commercial banks in 2011 had stood at 47.32 lakhs.

Hence, the data from the Reserve Bank of India is completely at odds with the data from the Income Tax department.

Typically, when people do not declare details to the Income Tax department the idea is to hide income and save on tax. But in this case nothing of that sort is happening. If an individual does not declare in his income tax return that he is repaying a home loan, then he does not get the interest paid on the home loan as a deduction.

One explanation for this might be that many salaried individuals are declaring their home loan details to their employers, getting a deduction, and then not filing their income tax returns.

But that can at best be a very small explanation because the difference between six lakh people declaring a negative income from their house and 47.32 lakh home loan accounts with banks, is huge. And if we consider home loan accounts with housing finance companies, the number is even bigger. Also, the same logic will not work for the self-employed individuals.

So what is a possible explanation for this? One explanation that I can possibly think of is that the home loan has been taken on only as a bridge loan. This essentially means that people have used black money to pay a substantial part of the price of the home and have financed the remaining through taking on a home loan. This logic applies more to the self-employed individuals rather than the salaried class.

By not declaring the fact that they are paying an interest on their home loan, the hope is not to attract attention on their rather expensive home in comparison to the home loan amount that has been borrowed. But then in this day and age of big data, it shouldn’t be so difficult for the Income Tax department to figure out, who has taken a home loan and is not declaring it.

I don’t know if this explanation is correct, but this is something I can think of at this point of time.

To conclude, the Income Tax department needs to look at this anomaly in greater detail. The answers will be very interesting.

The column originally appeared in the Vivek Kaul Diary on May 5, 2016

Here’s a Good Joke: New Income Tax Data Shows India Has Only 20 Lakh Landlords


In yesterday’s column I had mentioned that only around 26 lakh Indians (to be precise the number is 26,01,777) filed for income from house property under the individual category, for the assessment year 2012-2013.

During the assessment year 2012-2013, income tax returns for the income earned during the year 2011-2012 had to be filed. A total income of Rs 29,927 crore was declared under this category.

Of this around 6.06 lakh individuals showed an income of less than zero from house property. This would primarily include people who have taken on a home loan to buy a house and are repaying it. During the financial year 2011-2012, an interest of up to Rs 1.5 lakh, paid on a home loan, in case of a self-occupied house, could be set off while calculating taxable income.

This meant that an individual repaying a home loan on a self-occupied house, could show a negative income of up to Rs 1.5 lakh when it came to income from house property. These are the individuals showing negative income against their house property. This negative income could be set off against taxable income and the taxable income could bethus  brought down.

Further, the limit of Rs 1.5 lakh applied only to self-occupied property and not on other homes that a tax payer may choose to buy by taking on a home loan. Any amount of interest paid on such home loans can be claimed as a deduction as long as a “notional rent” is added to the income.

We all know that over the last few years the “rents” have been very low in comparison to the EMIs that need to be paid in order to repay the home loan. The rental yield (rent dividend by market value of the home) is in the region of 2-3%.

Even after deducting a notional rent, the interest component tends to be massive during the initial years. Hence, the difference between the notional rent and the interest paid is negative. This essentially means income from house property is negative. Such individuals who own more than one home financed through a home loan, also earn a negative income from their house property. This negative income helps people with two or more homes, claim huge tax deductions.

This “deduction” has been used over the years by well-paid corporate employees to bring down their taxable income. Further, individuals who use this deduction benefit on two fronts—tax deduction as well as capital appreciation.

Even if, the capital appreciation is not huge, such individuals are happy in claiming just the deduction than actually making money from an increase in price. Hence, they may not sell the flat, even in a scenario where prices may be falling and thus prevent a faster fall in home prices.

Getting back to the point, there were only 6.06 lakh individuals in the assessment year 2012-2013 who had an income of less than zero or a negative income from house property. As I said, these are people essentially repaying their home loans. The interest they pay on their home loans can be set off against taxable income.

It is worth asking here that does India have less than 6.06 lakh individuals living in self-occupied homes on which home loans are being repaid? Something just doesn’t add up here. Honestly, this is bizarre.

As a newsreport in The Economic Times points out:In 2011, the number of accounts was 47.32 lakh, which went up to 47.78 lakh in 2012, with the disbursed amount also increasing from Rs 2.5 lakh crore to Rs 2.6 lakh crore.

If the banks had close to 47-48 lakh home loan accounts in 2011 and 2012, why are only around 6.06 lakh showing up in the income tax data?

Also, around 19.95 lakh people declared an income from house property in assessment year 2011-2012. This is another extremely low number. What does this mean? It means that the number of individuals in India who are earning a rental income from their homes (real as well as notional) is around 20 lakh. How is that possible?  It means is that there are around 20 lakh landlords in the country, if the data from the Income Tax department is to be believed.

It is worth recounting here something that Akhilesh Tilotia writes in The Making of India based on the 2011 Census data: India’s households increased by 60 million to 247 million from 187 million between 2001-2011. Reflecting India’s higher ‘physical’ savings, the number of houses went up by 81 million to 331 million from 250 million. The urban increases is telling: 38 million new houses for 24 million new households.”

This means India had 331 million or 33.1 crore houses in 2011. Now compare this with the fact that there are around 20 lakh individuals earning a rental income from their homes. This comparison clearly tells us how low the 19.95 lakh number, really is.

There are two things that become clear here. One, is that many individuals are just buying up homes as an investment and not putting it up on rent. Anshuman Magazine, chairman and managing director of CBRE South Asia Pvt. Ltd., in a 2015 article wrote that “around 1.2 crore completed houses” are “lying vacant across urban India”.

Further, this is a clear indication of the fact that most landlords are getting their rents paid in cash and not paying any income tax on it. It also leads to the question where did these people earn the money to build these houses in the first place?

Here is another interesting data point—Of the 19.95 lakh who have some rental income, around 14.55 lakh have an average rental income of around Rs 60,000 per year or Rs 5,000 per month. This number is very low as well.

The point being a major part of the black money in India continues to be generated in the real estate sector. The general impression we have had up until now is that black money is generated when real estate is bought and sold. Nevertheless, with this new data it is very clear, that black money is generated even when real estate is rented out.

The column originally appeared on the Vivek Kaul Diary on May 4, 2016

Does It Really Make Sense to Merge Public Sector Banks?


The government of India owns twenty-seven public sector banks(PSBs). It has often been suggested that the government should not be owning so many banks. Many of these banks are very small and hence, they should be merged so that they benefit from the economies of scale.

The situation was summarised by R Gandhi, deputy governor of the Reserve Bank of India, in a recent speech. As he said: “[The] banking system continues to be dominated by Public Sector Banks (PSBs) which still have more than 70 per cent market share of the banking system assets. At present there are 27 PSBs with varying sizes. State Bank of India, the largest bank, has balance sheet size which is roughly 17 times the size of smallest public sector bank.”

Gandhi further said: “Most PSBs follow roughly similar business models and many of them are also competing with each other in most market segments they are active in. Further, PSBs have broadly similar organisational structure and human resource policies. It has been argued that India has too many PSBs with similar characteristics and a consolidation among PSBs can result in reaping rich benefits of economies of scale and scope.”

The first thing that needs to be mentioned here is that most mergers fail. There is enough research going around to prove that. As the Harvard Business Review article titled The Big Idea: The New M&A Playbook points out: “Companies spend more than $2 trillion on acquisitions every year. Yet study after study puts the failure rate of mergers and acquisitions somewhere between 70% and 90%.

Hence, it is safe to say that most mergers fail and it is best to start with this assumption when any merger is proposed. And there is no reason to believe that the story for Indian public sector banks will be any different.

There have been two kinds of bank mergers in India. The first kind is when a bank which is about to fail is merged with a strong bank. The Sector 45 of the Banking Regulation Act 1949 empowers the RBI to “make a scheme of amalgamation of a bank with another bank if it is in the depositors’ interest or in the interest of overall banking system.”

The merger of Global Trust Bank with Oriental Bank of Commerce in 2004 is a good example of this. As Gandhi said in his speech: “Prior to 1999, most of the mergers were driven by resolution of weak banks under Section 45 of Banking Regulation Act 1949. However, after 1999, there has been increasing trend of voluntary mergers under Section 44A of Banking Regulation Act 1949.”

The second kind of merger is the voluntary merger. As far as voluntary mergers go, a good example is the recent merger of ING Vysya Bank with Kotak Mahindra Bank. This merger had the so called synergy necessary for a merger to take place.

As Gandhi said: “One and most obvious has been voluntary merger of banks driven by the need for synergy, growth and operational efficiency in operations. Recent merger of ING Vysya Bank with Kotak Mahindra Bank is an example of this kind of consolidation. ING Vysya Bank had a stronger presence in South India while Kotak had an extended franchise in the West and North India. The merger created a large financial institution with a pan-India presence.

The merger of Bank of Madura and Sangli Bank with ICICI Bank in 2001 and 2007, and the merger of Centurion Bank of Punjab by HDFC Bank in 2008, are other good examples of synergy based mergers.

But what does the word synergy really mean? One of former professors used to say that: “Since we are all born on this mother earth, there is some sort of synergy between us.” That was his way of saying that synergy is basically bullshit. Once a merger has been decided on then people go looking for reasons to justify it and that is synergy. While that may be a very cynical way of looking at things, there is some truth in it as well.

Nevertheless, author John Lanchester does define synergy in his book How to Speak Money. As he writes: “Synergy: Mainly BULLSHIT, but when it does mean anything it means merging two companies together and taking the opportunity to sack people.” He then goes on to explain the concept through an example.

As he writes “If two companies that make similar products merge, they will have a similar warehouse and delivery operations, so one of the two sets of employees will lose their jobs. The idea is that this will cut COSTS and increase profits, though that tends not to happen, and it is a proven fact that most mergers end by costing money…When two companies merge, the first thing that ANALYSTS look at when evaluating the deal is how many jobs have been lost: the higher the number, the better. That’s synergy.”

If two public sector banks are merged there are bound to be situations where both the banks have a presence in a given area. Synergy will demand that one of the branches be shut down. But given that the banks are government owned something like that is unlikely to happen.

Over and above this, there will be multiple people with the same skill at the corporate level. Will this duplicity of roles end, with people being fired? Highly unlikely.

Hence, the merger of two public sector banks, will give us a bigger inefficient bank. Further, there are very few examples of public sector banks being merged in the past.  So, there is nothing really to learn from.

As Gandhi said: “Recent merger of State Bank of Saurashtra and State Bank of Indore into State Bank of India may be seen as basically merger among group companies. The only example of merger of two PSBs is merger of New Bank of India with Punjab National Bank in 1993. However, this was not a voluntary merger.”

Also, it is worth remembering that public sector banks are facing huge bad loan problems. Many corporates who had taken on loans are not repaying them. In this scenario, if banks are merged without the bad loan problem being solved, we will have a situation where problems of two banks are basically passed on to one bank. That doesn’t make the situation any better.

As Gandhi summarises the situation: “PSBs as a group have not been performing well during the last few years. There has been a large increase in Non-Performing Assets (NPAs). As a part of managing large NPAs, some suggestions have been made that perhaps a consolidation of PSBs can render them more capable of managing such challenges relatively better…Merger of a weak bank with a strong bank may make combined entity weak if the merger process is not handled properly. The problems of capital shortages and higher NPAs may get transmitted to stronger bank due to unduly haste or a mechanical merger process.

The column originally appeared on the Vivek Kaul Diary on April 27, 2016

When it comes to bad loans of banking, the big boys are the bad boys

The Reserve Bank of India(RBI) released the Financial Stability Report on December 23, 2015. One of the key themes in this report was the fact that large borrowers are the ones who have landed the banking sector in trouble. As the RBI governor Raghuram Rajan wrote in the foreword to the report: “corporate sector vulnerabilities and the impact of their weak balance sheets on the financial system need closer monitoring.”

That is a euphemistic way of saying that corporates are essentially responsible for the rising bad loans of banks. As on September 30, 2015, the bad loans (gross non-performing advances) of banks were at 5.1% of total advances [i.e. loans] of scheduled commercial banks operating in India. The number was at 4.6% as on March 31, 2015. This is a huge jump of 50 basis points in a period of just six months. One basis point is one hundredth of a percentage.

What is the problem here? The inability of large borrowers to continue repaying the loans they have taken on in the years gone by. As on September 30, 2015, loans to large borrowers made up 64.5% of total loans. On the other hand, bad loans held by large borrowers amounted to 87.4% of total bad loans.

What this means is that for every Rs 100 of loans given by banks, Rs 64.5 has been given to large borrowers. At the same time of every Rs 100 of bad loans, large borrowers are responsible for Rs 87.4 of bad loans. Hence, large borrowers are clearly responsible for more bad loans.

As on March 31, 2015, bank loans to large borrowers made up 65.4% of total bank loans. At the same time, the bad loans of large borrowers constituted 78.2% of the total bad loans. What this means is that for every Rs 100 of loans given by banks, Rs 65.4 was given to large borrowers. At the same time of every Rs 100 of bad loans, large borrowers were responsible for Rs 78.2 of bad loans. This has since jumped to Rs 87.4 for every Rs 100 of bad loans.

What these numbers clearly tell us is that in a period of six months the situation has deteriorated big time and large borrowers have been responsible for it. As the RBI Financial Stability Report points out: “While adverse economic conditions and other factors related to certain specific sectors played a key role in asset quality deterioration, one of the possible inferences from the observations in this context could be that banks extended disproportionately high levels of credit to corporate entities / promoters who had much less ‘skin in the game’ during the boom period.”

What does this mean? Banks gave loans to corporates/promoters who had put very little of their own money in the project they had borrowed money for. Banks essentially gave more loans than they actually should have, given the amount of capital the promoters put in. And this is now proving to be costly for them.

In fact, lending to industry forms a major part of the stressed loans of banks. Stressed loans are essentially obtained by adding the bad loans and the restructured loans of banks.  A restructured loan is a loan on which the interest rate charged by the bank to the borrower has been lowered. Or the borrower has been given more time to repay the loan i.e. the tenure of the loan has been increased. In both cases the bank has to bear a loss.

As the RBI report points out: “Sectoral data as of June 2015 indicates that among the broad sectors, industry continued to record the highest stressed advances ratio of about 19.5 percent, followed by services at 7 per cent. The retail sector recorded the lowest stressed advances ratio at 2 per cent. In terms of size, medium and large industries each had stressed advances ratio at 21 per cent, whereas, in the case of micro industries, the ratio stood at over 8 per cent.”

Lending to the retail sector (i.e. you and me) continues to be the best form of lending for banks. The stressed loans ratio in this case is only 2%. This means that for every Rs 100 lent by banks to the retail sector (home loans, car loans, personal loans and so on), only Rs 2 is stressed.

Why is this the case? For the simple reason that it is very easy for banks to go after retail borrowers who are no longer in a position to repay the loans they have taken on. Further, there is no political meddling when it comes to loans to retail borrowers, hence, the lending is anyway of good quality.

In comparison, lending to industry has a stressed loans ratio of 19.5%. This means for every Rs 100 that the banks have lent to industry, Rs 19.5 is stressed i.e. it has either been defaulted on or has been restructured. Interestingly, even within industry, the situation with the micro industries is not as bad as the medium and the large industries.

The large industries have a stressed loans ratio of 21% i.e. for every Rs 100 lent to large industries by banks, Rs 21 has either been defaulted on or has been restructured. In case of micro industries, the number is at 8%. This is because banks can unleash their lawyers on the small industries in case the loan is in trouble. They can’t do the same on large borrowers. And even if they do it does not have the same impact.

Five sectors have been responsible for a major part of the trouble. These are mining, iron & steel, textiles, infrastructure and aviation. These “together constituted 24.2 per cent of the total advances [i.e. loans] scheduled commercial banks as of June 2015, contributed to 53.0 per cent of the total stressed advances.” “Stressed advances in the aviation sector6 increased to 61.0 per cent in June 2015 from 58.9 per cent in March, while stressed advances of the infrastructure sector increased to 24.0 per cent from 22.9 per cent during the same period.”

To conclude, when it comes to the bad loans of banking, the big boys are the bad boys who are responsible for a majority of the mess.

The column originally appeared on The Daily Reckoning on January 5, 2016

Why banks still haven’t cut interest rates

Fostering Public Leadership - World Economic Forum - India Economic Summit 2010
Vivek Kaul

Today is the first day of the new financial year. And banks still haven’t cut interest rates. This despite the Reserve Bank of India(RBI) of cutting the repo rate twice by 50 basis points (one basis point is one hundredth of a percentage) between January and March 2015. 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 loans.
Other than the RBI cutting the repo rate, the finance minister has also been very vocal about the entire issue.
On March 22, 2015, he remarked:We do not put pressure on them (i.e. public sector banks) We only expect and our expectations come true.”
A few days later on March 25 2015, Jaitley said: “I mentioned a few days ago in the presence of the (RBI) Governor (Raghuram Rajan) that we do not pressurise the banks to cut rates. But we do expect the banks after assessing the situation to act in a prudent manner. Our banks have been by and large responsible. And I am quite certain we will see more cuts in future.”
Despite this overt pressure, the banks haven’t gone around cutting the interest rates on their loans.
A recent Bloomberg newsreport pointed out that 43 out of the 47 scheduled commercial banks haven’t cut their base rates or the minimum interest rate a bank charges its customers.
Unless, banks cut their base rate there is no point in the RBI cutting the repo rate simply because the borrowers as well as the prospective borrowers do not benefit from lower interest rates. Having said that, just because the RBI has cut the repo rate or the fact that the finance minister thinks interest rates should be lower, doesn’t mean that banks should lower interest rates. One thing that they need to look at is their deposit growth vis a vis their loan growth. Latest data from the RBI suggests that deposit growth over the last one year was at 11.6%. In comparison, the loan growth of banks was at 10.2%. Also, the deposit growth was on a higher base. Hence, it is safe to say that deposits of banks have grown much faster than their loans.
This conclusion can also be made by calculating the incremental credit deposit ratio. The incremental credit deposit ratio over the last one year stands at 67.3%. This means that for every Rs 100 raised as deposit, banks have given out loans worth Rs 67.3. Ideally, banks should be lending around Rs 74.5 for every Rs 100 they raise as a deposit. This, after adjusting for the Rs 25.5 of Rs 100 that they need to maintain as cash reserve ratio and statutory liquidity ratio.
Around this time last year, the incremental credit deposit ratio had stood at 73.7%. Hence, what this clearly tells us is that lending by banks is growing at a significantly slower pace in comparison to the increase in deposits. Given this, banks should be in a position to cut their base rate, but they still haven’t.
Why? While banks are quick to raise interest rates when the RBI raises the repo rate, they are slow to cut interest rates when the RBI cuts the repo rate. Also, if banks lower their base rate, the interest they earn on the money that they have lent comes down immediately. But the interest that they pay on their deposits does not change. While loans rate are floating, deposit rates are not. Hence, banks continue to hold on to interest rates on their loans.
As a March 11 report by the International Monetary Fund on India points out: “Pass-through to deposit and lending rates is relatively slow and the deposit rate adjusts more quickly to monetary policy changes than does the lending rate.” What this means is that after the RBI cuts the repo rate, banks tend to cut their deposit rates more quickly in comparison to their lending rates. Further, it takes around 9.5 months for deposit rates to change and 18.8 months for the lending rates to change,after the RBI has cut the repo rate, the IMF stated. Given this, it will be a while by the time banks start to cut their lending rates. And this assuming that the RBI does not change its direction on repo rate cuts.
What has not helped is the fact that banks continue to accumulate bad loans. As the IMF report on India points out: “Evidence of corporate India’s worsening financial performance is found in the rising share of stressed loans in banks’ portfolios—both non-performing assets (NPAs) and restructured loans have continued to increase, and are at their highest levels since 2003…Corporates in the manufacturing and construction sectors, plus the infrastructure sector, contributed notably to banks’ non performing assets. Between 2002/03 and 2013/14 corporate debt increased by 428 percent for a sample of 762 firms.”
With such high levels of borrowing the pressure on the balance sheets of banks (in particular public sector banks) is likely to continue in the days to come. As the IMF reports points out: “Some corporates are likely already credit constrained due to high leverage, which in turn continues to put pressure on the health of the financial system, in particular on the balance sheets of public sector banks (PSBs). This will further affect bank risk taking as well as the ability of the banking system to finance economic recovery.”
The bad loans will also limit the ability of banks to cut their lending rates. As Crisil Research pointed out in a recent report: “High non performing assets curb the pace at which benefits of lower policy rate are passed on to borrowers. Data shows periods of high NPAs – such as between 2002 and 2004 (when NPAs were at 8.8% of gross advances) – are accompanied by weaker transmission of policy rate cuts. This time around, NPA levels are not as high as witnessed back then, but still remain in the zone of discomfort.”
Given this, the finance minister Jaitley may keep asking banks to cut their lending rates, but the banks are not likely to oblige him any time soon.

The column was originally published on The Daily Reckoning on April 1, 2015

Why Raghuram Rajan finally cut the repo rate


I have never run a full marathon, and my wife will not let me run one…She says that’s tempting fate. – Raghuram Rajan in an interview to The New York Times

I am not an early riser. These days with no full time job, I rarely wake up before 10 AM. Yesterday was not any different and by the time I woke up, I had already got a few messages on WhatsApp from friends and ex-colleagues informing me that Raghuram Rajan, governor of the Reserve Bank of India (RBI), had finally cut 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 loans. Rajan cut the repo rate by 25 basis points(one basis point is one hundredth of a percentage) to 7.75%.
For the past few months there was tremendous political pressure on the governor to cut the repo rate. So what prompted Rajan to finally cut it? “
To some extent, lower than expected inflation has been enabled by the sharper than expected decline in prices of vegetables and fruits since September, ebbing price pressures in respect of cereals, and the large fall in international commodity prices, particularly crude oil…Weak demand conditions have also moderated inflation excluding food and fuel, especially in the reading for December,Rajan said in a statement released early morning yesterday.
The massive crash in crude oil price has contributed to lowering inflation to some extent. But more than that it has helped save precious foreign exchange spent on importing oil. As, Urjit Patel, one of the deputy governors of the Reserve Bank of India (RBI),
recently explained “The dramatic fall in oil prices is a boon for us. It saves, on an annualised basis, around US$ 50 billion, roughly, one-third of our annual gross POL (petroleum, oil and lubricants) imports of about US$ 160 billion.”
The fall in the price of crude oil
as I have pointed out in the past, has also ensured that the government’s fiscal deficit hasn’t gone totally for a toss. Even with the massive fall in crude oil prices the fiscal deficit for the period April to November 2014 was at 99% of the annual target. Now imagine where the fiscal deficit would have been if this fall in crude oil price had not happened.
On December 2, 2014,
the day the Fifth Bi-Monthly Monetary Policy Statement for the last year was released, the Rajan led RBI had kept the repo rate unchanged. The price of the Indian basket of crude oil on December 2, 2014, had stood at $70.08 per barrel. By January 14, 2015, the price of the Indian basket of crude oil had fallen by a massive 38.1% to $43.36 per barrel.
This was a huge change from the time of the last monetary policy statement was released around six weeks back. Clearly, Rajan and the RBI, like almost all other experts, did not see this massive fall in oil price coming.
If that had been the case, the RBI would have cut the repo rate last month itself.
As The New York Times reports: “Mr. Rajan also defended his decision not to lower interest rates at his last monetary policy review in December. While oil prices had already fallen considerably by then, he said there was no way to foresee the abrupt plunge that followed.”
The RBI expects the oil prices to continue to remain low. “Crude prices, barring geo-political shocks, are expected to remain low over the year,” the central bank said yesterday.
Another reason which led to the RBI cutting interest rates in between meetings are the falling inflation expectations (or the expectations that consumers have of what future inflation is likely to be).
As per the previous 
Reserve Bank of India’s Inflation Expectations Survey of Households, the inflationary expectations over the next three months and one year were at 14.6 percent and 16 percent. In the latest inflation expectations survey released yesterday, these numbers have crashed to 8.3% and 8.9% (See chart that follows). “ Households’ inflation expectations have adapted, and both near-term and longer-term inflation expectations have eased to single digits for the first time since September 2009,” Rajan said. This would have been another reason which led the Rajan led RBI to an inter-meeting cut in the repo rate.

Trends in Inflation Perceptions and Expectations

In the statement released on December 2, 2014, RBI had hinted that rate cuts would start in early 2015. “If the current inflation momentum and changes in inflationary expectations continue, and fiscal developments are encouraging, a change in the monetary policy stance is likely early next year, including outside the policy review cycle,” the statement had said.
And that is precisely what the Rajan led RBI has done. It had also said that: “The Reserve Bank has repeatedly indicated that once the monetary policy stance shifts, subsequent policy actions will be consistent with the changed stance.” What this meant in simple English is that once the RBI was convinced that inflation has been brought under control it would cut interest rates rapidly.
Crisil Research expects the RBI to “
cut rates by 50-75 basis points over the next fiscal (i.e. 2015-2016).”
Analysts Chetan Ahya and Upasana Chachra of Morgan Stanley are more bullish. They said in a research note released yesterday: “We believe that this is a beginning of a big rate cut cycle. We expect a further 125bps rate cuts over the next 12 months, cumulative 150bps in this cycle (compared with our earlier forecast of 50bps rate cuts). We expect a further rate cut of 25bps in the next monetary policy review on Feb 3.”
Personally, I don’t think Rajan will cut the repo rate on February 3. He will wait for the government to present the annual budget and then decide further course of action. As he said in yesterday’s statement: “Key to further easing are data that confirm continuing disinflationary pressures.” This means that if inflation keeps falling or remains stable, the RBI will cut the repo rate more in the days to come.
Crisil Resarch pointed out in a research note yesterday: “Retail inflation has stayed within 5% and core inflation [non food-non fuel inflation] continues to decline. Core inflation fell to 5.5% from 5.8% in November, the lowest recorded since the beginning of the new CPI series in 2012. Current momentum suggests inflation could fall below the RBI’s target of 6% by March 31, 2015. Wholesale price index based inflation (WPI) has hit the rock-bottom, coming at 0% in November and 0.11% in December…In addition, the fall in WPI is accompanied by a mirroring decline in the CPI index, something that was missing in 2009. This points to the sustainability of the current disinflationary trend, and strengthens the case for lower policy rates.”
Nevertheless Rajan also said that “also critical would be sustained high quality fiscal consolidation.” As Crisil Research pointed out: “The speed of the cuts will hinge on continued fiscal consolidation, and measures to improve the potential of the economy so that higher GDP growth does not set off fresh price fires.” And that is something to watch out for.
And to decide whether “fiscal consolidation” is happening Rajan would have to wait for the government to present its budget. Another reason why a rate cut is unlikely on February 3 is that no key economic data points are to be released between now and then.

Postscript: Economist Surjit Bhalla told Reuters yesterday that : “If there is a deal between Rajan and Jaitley, that’s very very positive…Monetary and fiscal policy should be coordinated.” This isn’t the best way to approach the issue, for the simple reason that politicians want interest rates to remain low all the time.
Alan Greenspan, the former chairman of the Federal Reserve of the United States, recounts in his book 
The Map and the Territory that in his more than 18 years as the Chairman of the Federal Reserve, he did not receive a single request from the US Congress urging the Fed to tighten money supply and thus not run an easy money policy.
In simple English, what Greenspan means is that the American politicians always wanted low interest rates. India is no different on that front. The current finance minister Arun Jaitley has made several comments in the recent past asking the RBI to cut the repo rate. The previous finance minister P. Chidambaram was no different.
To conclude, it is well worth remembering here what  economist Stephen D King writes in 
When the Money Runs Out “A central banker who jumps into bed with a finance minister too often ends up with a nasty dose of hyperinflation.”

The column originally appeared on as a part of The Daily Reckoning on Jan 16, 2015