Month: November 2014

GDP growth at 5.3%: A lot needs to be done for the economy to see acche din again

deflationVivek Kaul

India has largely been a centrally planned economy since independence. The central planning increased dramatically in the second term of the previous United Progressive Alliance (UPA) government.
This led to a situation where India’s economy grew at greater than 8% in the aftermath of the financial crisis, when economic growth was collapsing all around the world. But this extra central planning has created many problems for the Indian economy since then.
As Bill Bonner writes in Hormegeddon—How Too Much Of a Good Thing Leads to Disaster, “Central planning can do a good job of imitating real progress at least in the short run.” And that is what precisely what happened in India, in the aftermath of the financial crisis.
The government expenditure exploded. In 2007-2008, the total government expenditure stood at Rs 7,12,671 crore. This doubled to Rs 14,10,372 crore by 2012-2013. This increased spending by the government landed up as income in the hands of the citizens, and they in turn spend the money. And this ensured that the Indian economy kept growing at a fast pace though economic growth was slowing down world over.
A substantial amount of this increased government spending was directly distributed to citizens through schemes like Mahatma Gandhi National Rural Employment Guarantee Scheme. The minimum support price offered on rice and wheat was also increased much more than was the case in the past.
This led to rural income growing at a faster rate than it had in the past. Initially, it did not matter. But as time passed this increased income translated into high inflation, particularly high food inflation.
Further, the trouble was that the government wasn’t earning all this money that it was spending. Between 2007-2008 and 2012-2013, the total income of the government did not go up at the same pace as its expenditure (it went up by around 57%), and the government borrowed more to make up for the difference.
The fiscal deficit in 2007-2008 was Rs 1,26,912 crore. This shot up by 286% to Rs 4,90,190 crore by 2012-2013. Fiscal deficit is the difference between what a government earns and what it spends. And the government makes up for the difference through increased borrowing.
This increased borrowing by the government crowded out other borrowers, that is, there wasn’t enough left on the table for other borrowers to borrow. This meant banks had to offer higher rates of interest to attract deposits. This pushed up interest rates at which they loaned out money as well.
Also, to control the high inflation, the Reserve Bank had to push up the repo rate, or the rate at which it lends to banks. Further, during the good years, the corporates loaded up on debt, borrowing much more than they could ever repay. A major portion these loans were taken by crony capitalists from public sector banks.
All these reasons led to what analysts call the “India growth story” coming to an end. High inflation forced people to cut down on spending as incomes did not keep pace with expenditure. Economic growth fell to around 5% from double digit levels and that is where it has stayed for a while now.
It was widely expected that with Narendra Modi taking over as the prime minister, the Indian economy will start seeing acche din soon. But that hasn’t happened. For the three month period July to September 2014, the economic growth, as measured by the growth in the gross domestic product (GDP), was at 5.3%. During the period April to June 2014 the economy had grown at 5.7%.
The financing, insurance, real estate and business services sector which formed a little over 22% of the GDP during the period, grew by an impressive 9.5%. But other sectors did not do so well.
Agriculture which formed around 10.8% of the total GDP during the quarter grew by 3.2%. It had grown by 5% during the same period last year. Manufacturing which formed around 14.6% of the total GDP during the quarter was more or less flat at 0.1%. In fact, the size of manufacturing sector has fallen by 1.4% in comparison to the period between April and June 2014.
What this tells us clearly is that sustainable economic growth cannot be created by the government giving away money to citizens and then hoping that they spend it and create economic growth. For sustainable economic growth to happen a country needs to produce things. As the Say’s Law states “A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value.” The law essentially states that the production of goods ensures that the workers and suppliers of these goods are paid enough for them to be able to buy all the other goods that are being produced. A pithier version of this law is, “Supply creates its own demand.”
In an Indian context this is even more important given that nearly 60% of the population remains dependent on directly or indirectly dependent on agriculture, even though agriculture now forms a minor part of the overall economy. What this tells us is that the sector has many more people than it should. Hence, people need to be moved from agriculture to other sectors like manufacturing. And for that to happen jobs need to be created in these sectors.
The government recently launched the Make in India programme to create jobs in the manufacturing sector. But just launching the programme is not good enough. For companies to make products in India a lot of other things need to be provided. They need access to electricity all the time and for that to happen we need to sort out the mess our coal sector is in. The physical infrastructure of roads, railways and ports needs to improve. The ease of doing business needs to go up considerably and so on.
As Daron Acemoglu and James A. Robinson write in Why Nations Fail—The Origins of Power, Prosperity and Poverty regarding the industrial revolution that happened in Great Britain in the 19th century: “The English state aggressively…worked to promote domestic industry…by removing barriers to the expansion of industrial activity.” Similar barriers need to be removed in India as well. Also, entrepreneurs need to be confident that their contracts and property rights will be respected.
These things are easier said than done. What makes the scenario even more difficult in the Indian case is that Indian businessmen who operate in the infrastructure sector are not the most honest people going around. Raghuram Rajan, the governor of the Reserve Bank of India, more or less hinted at it in a recent speech.
As he said “The amount recovered from cases decided in 2013-14 under DRTs (debt recovery tribunals) was Rs. 30,590 crore while the outstanding value of debt sought to be recovered was a huge Rs. 2,36,600 crore. Thus recovery was only 13% of the amount at stake. Worse, even though the law indicates that cases before the DRT should be disposed off in 6 months, only about a fourth of the cases pending at the beginning of the year are disposed off during the year – suggesting a four year wait even if the tribunals focus only on old cases.”
If incumbent businessmen do not repay their loans and then banks cannot recover those loans, banks will not lend or charge a higher rate of interest when they lend. And this does not help the businessmen currently looking to expand their businesses by borrowing.
To conclude, there is a lot that the government needs to do to get economic growth up and running again. The only action that one has seen from the government until now is demanding that the RBI cuts the repo rate. Now only if creating economic growth was simply about cutting interest rates.

The article appeared originally on www.FirstBiz.com on Nov 29, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Saudi emerges king at OPEC meet: Oil prices will remain low for now

oilVivek Kaul

The oil ministers of the Organization of Petroleum Exporting (OPEC) countries met in Vienna yesterday. They decided to keep the total production of oil coming from OPEC at 30 million barrels per day. This is one million barrels per day more than OPEC’s estimate of the demand for its oil in 2015.
“It was a great decision,” said Saudi Oil Minister Ali al-Naimi, after talks which lasted for around five hours. With this decision not to cut production the price of oil fell further, and as I write this the price of Brent crude oil stands at $72.2 per barrel of oil.
The decision not to cut production went against the demand of OPEC members like Iran and Venezuela, who had demanded that production be cut. A falling oil price is hurting these countries badly given that money earned from selling oil is a major source of revenue for the respective governments.
Also, in the past, OPEC has been quick to cut production whenever prices have fallen and that has ensured that prices don’t fall any further. But that doesn’t seem to be happening this time around. Saudi Arabia, the largest producer of oil within OPEC, wants to drive down the price of oil.
The question that crops up here is why did OPEC go with what Saudi Arabia wanted it to? It has 11 other countries as members as well. While OPEC has been regularly referred to as a cartel, it is important to understand that the structure of OPEC is different from that of a cartel. It is probably better to define the structure of OPEC as what economists call a “leading firm” model of oligopoly, a market which is dominated by a small number of sellers and in which the largest producer sets the price and the others follow.
Saudi Arabia is the largest producer within OPEC. Within OPEC, it also has the almost unquestioned support of what are known as the sheikhdom states of Bahrain, Kuwait, the United Arab Emirates, and Qatar.
These countries have faced threats from other OPEC members, like Iraq and Iran, in the past. For many years, Iraq had been eyeing Kuwait. It had tried to annex Kuwait in 1961 (and it tried again in the early 1990s). The support of Saudi Arabia, the largest nation in the region, is very important for these countries. Hence, these countries tend to go with Saudi Arabia, not leaving much space for the other member countries to disagree.
Moral of the story: OPEC does what Saudi Arabia wants it to do. And these days Saudi Arabia seems to want lower oil prices. Why is that the case? Look at the table that follows. The table shows the daily oil production in the United States, which had fallen to around 4 million barrels per day in 2008. It has since jumped up again to around 9 million barrels per day, the kind of level not since the mid 1980s.
This has happened primarily because of a boom in shale oil production in the United States. As Javed Mian writes in Stray Reflections newsletter for the month of November “The US pumped 8.97 million barrels a day by the end of October (the highest since 1985) thanks partly to increases in shale-oil output which accounts for 5 million barrels per day.”
The more shale oil United States produces the lesser it has to depend on OPEC and other parts of the world, to fulfil its massive oil requirements. The trouble is that shale oil is expensive to produce and is viable only if oil continues to sell at a certain price. Given this, Saudi Arabia wants to ensure that price of oil is driven down further, so that it can drive the shale oil producers out of business.
There are various estimates about the oil price at which it is viable to produce shale oil. A report brought out by Deutsche Bank said that around 40% of shale oil production in the United States next year, would be unviable if the price of oil fell below $80 per barrel. Very recently, this was a sentiment echoed by the chief economist of the International Energy Agency as well.
Nonetheless, Maria van der Hoeven, executive director of the International Energy Agency, contradicted her chief economist by telling Reuters recently that 82 percent of the American shale oil firms had a break-even price of $60 or lower.
There are still other estimates. As Mian writes in his newsletter “The median North American shale development needs an oil price of $57 to breakeven today, compared to $70 last year according to research firm IHS.”
Analysts at Citibank recently said that the price of oil would have to fall below $50 a barrel for completely halting shale oil production in the United States. Also, many shale oil companies would continue to remain viable for an oil price of anywhere between $40 to $60 a barrel. It would be safe to say that there are as many break-even prices for shale oil as there are analysts. And it is very difficult to figure out which of these estimates is correct.
This is not the first time Saudi Arabia is following the strategy of bleeding out its competitors. It did the same nearly three decades back. “This has happened once before. By the mid-1980’s, as oil output from Alaska’s North Slope and the North Sea came on line (combined production of around 5-6 million barrels a day), OPEC set off a price war to compete for market share. As a result, the price of oil sank from around $40 to just under $10 a barrel by 1986,” writes Mian.
Hence, Saudis are putting to work a strategy that they have used in the past. Nevertheless, it doesn’t seem to have had the necessary impact on the production of oil by shale oil firms in the United States. On November 10, earlier this month, the US Energy Information Administration said that the seven largest shale oil players would be producing 125,000 barrels per day more in December than they had in November.
One reason for this is that the money that has already gone into producing shale oil is essentially a sunk cost. Hence, production is not going to be stopped immediately. As Ben Hunt who writes the Epsilon Theory newsletter puts it “There’s just too much non-cartelized money, technology, and political capital invested in US shale production to slow it down.”
Also, companies already have long term production contracts in place. These contracts require that they deliver a minimum level of production, even if it means selling at a loss. “Failure to comply could mean the loss of the lease and any future upside when prices [are] normalized,” writes Chip Register on Forbes.com.
Legendary oil man, T Boone Pickens feels that Saudi Arabia has entered into a stand-off to “see how the shale boys are going to stand up to a cheaper price.”
To conclude, Saudi Arabia driving down the price of oil hasn’t yet had an impact on shale oil production. Given this, it is likely that Saudi Arabia led OPEC will continue to drive down the oil price in the months to come. “In the current cycle, though, prices will have to decline much further from current levels to curb new investment and discourage US production of shale oil,” writes Mian.
It is also possible that the United States government may decide to intervene and introduce “tariffs on cheap foreign oil imports,” to keep the local shale oil industry viable.
The United States government will also have to take into account the fact that Saudi Arabia buys and sells oil in dollars. This ensures that in order to earn these dollars countries carry out international trade in dollars and accumulate a major part of their foreign exchange in dollars. This ensures that dollar continues to have an “exorbitant privilege” allowing United States to repay its debt to foreigners by simply printing them.
Further, it also helps keep the interest rates in the United States low, as countries line up to invest their foreign exchange reserves in treasury bonds issued by the United States government. Given this, its a Catch 22 situation for the United States. Does it encourage its local shale oil industry and reduce its dependence on importing oil from the Middle East? Or does it work against the “exorbitant privilege” of the dollar? Its not an easy choice to make.
Hence, its safe to predict that oil prices will continue to be low in the short-term. There are too many interplaying factors at work making it impossible to predict how things will turn out to be in the long run.
All I can say is, stay tuned.

The column originally appeared on www.FirstBiz.com on Nov 28, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

A 200 year old economic theory tells us what is wrong with the developed world today

Jean-baptiste_SayVivek Kaul

I like to quote a lot of John Maynard Keynes in what I write. The reason for that is fairly simple—Keynes is the Mirza Ghalib of economics. He has written something appropriate for almost every occasion.
Nevertheless, I’d like to admit that even though I have tried to read his magnum opus The General Theory of Employment, Interest and Money a few times, over the years, I have never been able to go beyond the first few chapters.
The economist whose books I find very lucid is the Canadian-American economist John Kenneth Galbraith. Galbraith unlike other economists of his era was a prolific writer and was one of the most widely read economists in the United States and other parts of the world between the 1950s and 1970s. He was even the US Ambassador to India in the early 1960s.
His most popular book perhaps was The Great Crash 1929, a fantastic book on the Great Depression, which he wrote in the mid 1950s. His other famous work was The Affluent Society published in 1958.
But the book I am going to talk about today is A History of Economics—the past as the present. In this book Galbraith looks at the history of economics and writes it in a way that even non-economists like me can understand it.
One of the laws that Galbraith talks about is the Say’s Law. This law was put forward by Jean-Baptise Say, a French businessman, who lived between 1767 and 1832. “Say’s law held that out of the production of goods came an effective aggregate of demand sufficient to purchase the total supply of goods. Put in somewhat more modern terms, from the price of every product sold comes a return in wages, interest, profit or rent sufficient to buy that product. Somebody, somewhere, gets it all. And once it is gotten, there is spending up to the value of what is produced,” wrote Galbraith explaining Say’s Law.
The Say’s Law essentially states that the production of goods ensures that the workers and suppliers of these goods are paid enough for them to be able to buy all the other goods that are being produced. A pithier version of this law is, “Supply creates its own demand.”
And this law explains to us all that is wrong with the developed world today. As Bill Bonner writes in his latest book Hormegeddon—How Too Much of a Good Thing Leads to Disaster “French businessman and economist, Jean-Baptiste Say, discovered that “products are paid for with products,” not merely with money. He meant that you needed to produce things to buy things; you could not just produce money…has anyone ever mentioned this to the Federal Reserve?”
The central banks in the developed world have printed close to $7-8 trillion in the aftermath of the financial crisis which broke out in mid September 2008, with the investment bank Lehman Brothers going bust. The Federal Reserve of the United States has printed around $3.6 trillion dollars in the aftermath of the crisis to get the American economy up and running again.
The standard theory that has emerged in the aftermath of the financial crisis is that consumer demand has collapsed in the Western world and this has led to a slowdown in economic growth. In order to set this right, people need to be encouraged to borrow and spend. As John Maynard Keynes put it: “Consumption—to repeat the obvious—is the sole end and object of economic activity.” (There I have quoted him again!)
To get borrowing and consumption going again central banks have printed a lot of money to ensure that the financial system remains flush with money and interest rates continue to remain low. At low interest rates the chances of people borrowing and spending would be more. And this would lead to economic growth was the belief.
Now only if economic theory worked so well in practice. Also, it was “excessive” borrowing and spending that led to the crisis in the first place.
Raghuram Rajan and Luigi Zingales explain this very well in a new afterword to Saving Capitalism from the Capitalists, “For decades before the financial crisis in 2008, advanced economies were losing their ability to grow by making useful things. But they needed to somehow replace the jobs that had been lost to technology and foreign competition… So in an effort to pump up growth, governments spent more than they could afford and promoted easy credit to get households to do the same. The growth that these countries engineered, with its dependence on borrowing, proved unsustainable.”
It is worth pointing out here that the share of United States in the global production of goods has fallen over the last few decades. Thomas Piketty makes this point in his magnum opus Capital in the Twenty First Century. Between 1900 and 1980, 70–80 percent of the global production of goods happened in the United States and Europe. By 2010, this share had declined to around 50 percent, around the same level it was at in 1860. Also, faced with increased global competition, Western workers were unable to demand the pay increases they used to in the past.
Piketty further points out that the minimum wage in the United States, when measured in terms of purchasing power, reached its maximum level in 1969 and has been falling since then. At that point of time, the wage stood at $1.60 an hour or $10.10 an hour in 2013 dollars, taking into account the inflation between 1968 and 2013. At the beginning of 2013, the minimum wage was at $7.25 an hour, more than 28 percent lower than that in 1969.
This slow wage growth has led to Western governments following an easy money policy by making it easy for people to borrow. As Michael Lewis writes in The Big Short—A True Story: “How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans.”
In case of the United States, trade with China had an impact as well. As the historian Niall Ferguson writes in The Ascent of Money: A Financial History of the World: “Chinese imports kept down US inflation. Chinese savings kept down US interest rates. Chinese labor costs kept down US wage costs. As a result, it was remarkably cheap to borrow money.”
Ironically, what worked earlier is not working now. What has happened instead is that financial institutions have borrowed money at low interest rates and invested it in financial markets all over the world, in search of a higher return. Despite the central banks printing a lot of money, Japan recently entered a recession, with two successive quarters of economic contraction.
Europe is staring at a deflationary scenario. And the economic recovery in the United States continues to remain fragile.
Further, over the coming decades, a billion more people are expected to join the work force in Asia, Africa and Latin America. This will apply a downward pressure on costs and prices in the years to come and hence, wages in developed countries aren’t going to go up in a hurry.
Moral of the story: Western nations need to go back to making things, if they want a sustainable economic recovery. But as the American baseball coach Yogi Berra once famously said “In theory there is no difference between theory and practice. In practice there is.”

The article originally appeared on equitymaster.com as a part of The Daily Reckoning, on Nov 28, 2014

Beedis are fine, but smoking cigarettes stick by stick is injurious to health

beedisNews-reports suggest that the government is planning to ban the sale of loose cigarettes. Sagarika Mukherjee an analyst with SBI Caps points out that 70% of the cigarettes sold in India are sold loose.
Further, a November 26 news-eport in the Mumbai Mirror says “The union health ministry on Tuesday recommended a ban on the sale of unpackaged cigarettes to deter smokers from graduating to buying full packs.”
The health minister JP Nadda said in the Rajya Sabha on November 25 that the ministry had accepted the recommendations of a seven member committee on the “prohibition on sale of loose or single stick of cigarette, increasing the minimum legal age for sale of tobacco products, increasing the fine or penalty amounts for violation of certain provisions of the Act as well as making such offences cognizable”.
On the face of it this seems to be a good decision. We all know that cigarette smoking is injurious to health. Nevertheless, before the sale of loose cigarettes is actually banned there are several other points that need to be taken into account.
Governments normally tend to see what is only immediately obvious and ignore the secondary consequences. The economist Henry Hazlitt calls this the broken window fallacy. He explains this through an example in his book Economics in One Lesson.
A young hoodlum throws a stone at a shop’s window and breaks it. By the time the shopkeeper realises what has happened and comes out of the shop, the boy has already escaped. As often happens in these cases, a crowd gathers around, first trying to figure out what has happened and then offers its own analysis on the scenario. In sometime, the crowd decides rather philosophically that what happened was for the good.
As Hazlitt writes “After a while the crowd feels the need for philosophic reflection…It will make business for some glazier….After all, if windows were never broken, what would happen to the glass business?”
With the shopkeeper now having to repair the window, the glazier would earn more money. He would thus have more money to spend and would spend it in the days to come. And this would benefit other businessmen. “The smashed window will go on providing money and employment in ever-widening circles. The logical conclusion from all this would be…that the little hoodlum who threw the stone, far from being a public menace, was a public benefactor,” writes Hazlitt.
All this sounds very straightforward. But what it does not take into account is the fact that the shopkeeper would have to spend money in order to get the window repaired. And he may have earmarked to spend the money on something else.
In Hazlitt’s example, the shopkeeper wanted to buy a suit. Now that he has to spend money on getting the window repaired, he would have no money to buy a suit. As Hazlitt writes “The people in the crowd were thinking only of two parties to the transaction, [the shopkeeper] and the glazer. They had forgotten the potential third party involved, the tailor [who would have made the suit]. They forgot him precisely because he will not now enter the scene. They will see the new window in the next day or two. They will never see the extra suit, precisely because it will never be made. They see only what is immediately visible to the eye…It is the fallacy of overlooking secondary consequences.”
Many government decisions are plagued with the fallacy of overlooking secondary consequences. The recommendation to ban the sale of loose cigarettes also overlooks several secondary consequences. Also, it stinks of hypocrisy and is the kind of micromanaging which governments should be avoiding.
Typically, most people who buy loose cigarettes are ones who cannot afford to buy a packet at one go. If loose cigarettes are banned will these people stop smoking? Most likely not. They will either save up and buy a packet every few days.
Or they will simply move on to a cheaper substitute, which in this case would be beedis. Beedis because they do not have a filter are a bigger health hazard than cigarettes with filters are. And chances are the government will end up spending more money in trying to cure tobacco related illnesses, in the years to come.
Further, the question is how will the government implement such a ban? Cigarettes aren’t exactly sold through a few big stores around the country which can be monitored. They are sold by millions of paan wallahs through the length and the breadth of the country. Mukherjee of SBI Caps puts the number of shops selling cigarettes from anywhere between seven to eight million.
I used to live in Hyderabad in the early 2000s, when the erstwhile Andhra Pradesh government decided to ban gutka. All that happened was that the paan wallahs stopped displaying gutka packets in the open and started keeping them in their pockets.
Further, they even demanded a premium to the maximum retail price. The police was suitably bribed to look the other way. Gutka which was freely available in states around Andhra Pradesh continued to be smuggled in.
Another logic offered in support of not allowing the sale of single sticks is that when a packet is sold, it contains graphic images showing the ill-effects of smoking. When loose cigarettes are sold, individuals buying those cigarettes don’t see those graphic images. Hence, sale of loose cigarettes should not be allowed.
Other countries in Asia have banned the sale of loose cigarettes using the logic explained above. So, the cigarette companies there simply moved to producing smaller packets. The committee whose recommendations the health ministry has accepted has already recommended that smaller packets should not be allowed. But this is where you start to discriminate between those who can afford to buy a cigarette pack and those who can’t.
Mukherjee of SBI Caps points out that only 12% of the tobacco consumption in the country happens through cigarettes. And cigarette companies contribute a major portion of the excise duty and other taxes collected from the tobacco industry. So, if the government is serious about tackling tobacco consumption why not look where the real problem is? Attacking the beedi sector will be a difficult thing to do, given that the beedi barons are politically very well connected.
Another thing that needs to be pointed out here is that the government of India owns around one third of ITC, a company which controls 80% of the Indian tobacco market. The Life Insurance Corporation of India owns 14.5% stake, followed by the Specified Undertaking of the Unit Trust of India (SU-UTII) which owns 11.25% and the four general insurance companies together own 6.78% in the tobacco major.
This stake of LIC, SU-UTI and the four general insurance companies, in ITC, as on November 26, 2014, was worth a whopping Rs 94,241 crore. The actual stake of the government will be worth much more once one takes into account the holdings of government owned mutual funds as well.
If the government is serious about discouraging tobacco consumption, the first thing it needs to do is sell its stake in ITC and then take it on from there. This money could be put to good use by helping specialized cancer hospitals in the country to expand their infrastructure or to even set up new ones. Then there is also the case of the government subsidizing fertilizers, a portion of which goes into tobacco farming as well.
The beedi industry does not face the same kind of taxes that the cigarette industry does. Why not do away with that anomaly? In a recent column Swaminathan Aiyar talks about a column he wrote in 2009. At that point time Indians consumed around one trillion beedis per year against 106 billion cigarettes. If the taxes on beedis and nonfilter cigarettes were equalized it would have yielded an additional revenue of Rs 15,000 crore per year, back then. If taxes on beedis were equalised to the level of tax on a standard filter cigarette, it would have yielded an additional tax of Rs 80,000 crore per year. If such a tax is implemented now, the numbers will be higher.
What all this clearly tells us is that targeting just loose cigarettes doesn’t make any sense. If tobacco consumption is to be brought down, it needs a more holistic solution than what is being currently offered. The current government like most governments before it has fallen victim to the broken window fallacy.

Disclosure: I do not smoke. And I would like to thank PV Subramanyan for explaining several points that I made in this piece.

The article appeared originally on www.equitymaster.com on Nov 27, 2014

What Arun Jaitley can learn from Rajan’s IRMA speech

ARTS RAJANVivek Kaul

A few days back I wrote a piece questioning the logic of the State Bank of India entering into a memorandum of understanding with Adani Enterprises to consider giving it a loan of up to $1 billion. My logic was fairly straightforward—Adani Enterprises already has a lot of debt (around  Rs 72,632.37 crore as on September 30, 2014) and is just about earning enough to service that debt.
Several readers wrote in on the social media saying what was the problem if Adani was offering an adequate security against the loan? Raghuram Rajan, the governor of the Reserve Bank of India, answered this question in a speech yesterday. Rajan was speaking at the third Dr. Verghese Kurien Memorial Lecture at IRMA, Anand.
As Rajan said “The amount recovered from cases decided in 2013-14 under DRTs (debt recovery tribunals) was Rs. 30,590 crore while the outstanding value of debt sought to be recovered was a huge Rs. 2,36,600 crore. Thus recovery was only 13% of the amount at stake. Worse, even though the law indicates that cases before the DRT should be disposed off in 6 months, only about a fourth of the cases pending at the beginning of the year are disposed off during the year – suggesting a four year wait even if the tribunals focus only on old cases.”
So, just because a bank has a collateral does not mean it will be in a position to en-cash it, as soon as the borrower defaults on the loan. As big borrowers (read companies and industrialists) have defaulted on loans over the last few years, the non performing assets of banks, particularly public sector banks have gone up.
As on March 31, 2013, the gross non performing assets (NPAs) or simply put the bad loans, of public sector banks, had stood at 3.63% of the total advances. Latest data from the finance ministry show that the bad loans of public sector banks as on September 30, 2014, stood at 5.32% of the total advances. The absolute number was at Rs 2,43,043 crore. During the same period the bad loans of private sector banks was more or less constant at 1.8% of total advances. Interestingly, public sector banks accounted for over 90% of bad loans in 2013-2014 (i.e. between April 1, 2013 and March 31, 2014).
All these points have several repercussions. The first is that banks need to charge a higher rate of interest in order to compensate for the higher credit risk (or simply put the risk of the borrower defaulting on the loan) they are taking on. As Rajan said in the speech “The promoter who misuses the system ensures that banks then charge a premium for business loans. The average interest rate on loans to the power sector today is 13.7% even while the policy rate is 8%. The difference, also known as the credit risk premium, of 5.7% is largely compensation banks demand for the risk of default and non-payment.”
Simply put, those who default in effect ensure that those who repay have to pay a higher rate of interest. The irony is that banks give out home loans to individuals at 10-11%. This shows that lending to individuals is a better credit risk for them than lending to infrastructure companies.
As Rajan put it “Even comparing the rate on the power sector loan with the average rate available on the home loan of 10.7%, it is obvious that even good power sector firms are paying much more than the average household because of bank worries about whether they will recover loans.”
Also, a report in the Business Standard today suggests that the RBI is “mulling action in terms of limiting loan-sanctioning powers of banks with stressed asset ratios.”
The stressed asset ratio is the sum of gross non performing assets plus restructured loans divided by the total assets held by the Indian banking system. The borrower has either stopped to repay this loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan (which also entails some loss for the bank) by increasing the tenure of the loan or lowering the interest rate.
The Business Standard report carries a list of 14 public sector banks that have a stressed asset ratio of 12% or more. Central Bank of India has the highest stressed asset ratio of 20.49%, followed by the United Bank of India at 19.7%.
If the RBI decides to limit the loan-sanctioning power of these banks, it will do so in the backdrop of the finance minister Arun Jaitley asking banks to lend more. A few days back Jaitley said “We have asked banks to go out there and lend without any fear. They should do proper appraisals of projects and provide loans to infrastructure projects.” Like in almost everything else, he was following the tradition set by his predecessor P Chidambaram.
The stressed assets of many public sector banks did not cross 12% because they did not carry out proper project appraisals. It crossed such high levels because the banks were forced to lend to crony capitalists close to the political dispensation of the day i.e. leaders of the previous United Progressive Alliance (UPA).
Take the case of GMR Infra. For the period of three months ending September 30, 2014, the company paid a total interest of Rs 845.04 crore on its debt. Its operating profit was Rs 101.14 crore. The company had a total debt of Rs 39,187.45 crore as on March 31, 2014. What this clearly tells us is that the company is not earning enough to pay the interest that it has to, on the total debt that it has managed to accumulate.
This is true about many other companies as well particularly in the infrastructure sector, which is dominated from crony capitalists. These companies borrowed much more than they should have been allowed to in the first place. Also, many promoters got away without putting much of their own money in the business.
As Rajan said “The reason so many projects are in trouble today is because they 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.” This could not have happened without the tacit support of the political dispensation of the day.
And this perhaps led Rajan to quip that India is “a country where we have many sick companies but no “sick” promoters.” “In India, too many large borrowers insist on their divine right to stay in control despite their unwillingness to put in new money. The firm and its many workers, as well as past bank loans, are the hostages in this game of chicken — the promoter threatens to run the enterprise into the ground unless the government, banks, and regulators make the concessions that are necessary to keep it alive. And if the enterprise regains health, the promoter retains all the upside, forgetting the help he got from the government or the banks – after all, banks should be happy they got some of their money back!” Rajan added.
Another implication of the massive increase in bad loans for public sector banks has been that the law has become “more draconian in an attempt to force payment.” As Rajan put it “The SARFAESI (Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests) Act of 2002 is, by the standards of most countries, very pro-creditor as it is written. This was probably an attempt by legislators to reduce the burden on DRTs and force promoters to pay. But its full force 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.” This leads to a situation where upcoming entrepreneurs do not want to take the risk of growing bigger by taking on more loans and may choose to continue to remain small.
To conclude, Rajan’s speech at IRMA was an excellent summary of all that is wrong with the Indian banking sector. He also made suggestions on how to set it right. The promoters should not try and finance mega projects with tiny slivers of equity, he suggested. Banks needed to react quickly to borrower distress. And the government needed to set up more debt review tribunals. These are simple solutions that need political will in order to be implemented.
Arun Jaitley has been asking the RBI to cut interest rates for a while now. He has also asked banks to lend more. Nevertheless, it’s not as simple as Jaitley thinks it is. First and foremost the government needs to ensure that big borrowers cannot just get away with defaulting on loans. This in itself will have a huge impact on interest rates.
As Rajan put it “It is obvious that even good power sector firms are paying much more than the average household because of bank worries about whether they will recover loans. Reforms that lower this 300 basis point risk premium of power sector loans vis-a-vis home loans would have large beneficial effects on the cost of finance, perhaps as much or more than any monetary policy accommodation.”
This is something that Jaitley should be thinking about seriously in the days to come, if he wants banks to genuinely bring down lending rates.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)