Indradhanush Framework: A Missed Opportunity For The Modi Government

Earlier this month, the ministry of finance recently came up with the seven step Indradhanush framework to transform the shape of the government owned public sector banks (PSBs). As the press release accompanying the announcement of the framework pointed out: “Indradhanush framework for transforming the public sector banks represents the most comprehensive reform effort undertaken since banking nationalisation in the year 1970. Our PSBs are now ready to compete and flourish in a fast-evolving financial services landscape.”

Given the marketing prowess of the Narendra Modi government, such a claim isn’t surprising. Nevertheless, the question is, does the framework address the basic issues at the heart of reforming the public sector banks.

In May 2014, the Committee to Review Governance of Boards of Banks in India (better known as the PJ Nayak Committee) had submitted a detailed report on reforming the public sector banks in India.

As the report submitted by the PJ Nayak committee pointed out: “Governance difficulties in public sector banks arise from several externally imposed constraints. These include dual regulation, by the Finance Ministry in addition to RBI; board constitution, wherein it is difficult to categorise any director as independent; significant and widening compensation differences with private sector banks, leading to the erosion of specialist skills; external vigilance enforcement though the CVC and CBI; and limited applicability of the RTI Act. A more level playing field with private sector banks is desirable.”

The committee had also proposed a solution to these problems. As it said: “If the Government stake in these banks were to reduce to less than 50 per cent, together with certain other executive measures taken, all these external constraints would disappear. This would be a beneficial trade-off for the Government because it would continue to be the dominant shareholder and, without its control in banks diminishing, it would create the conditions for its banks to compete more successfully. It is a fundamental irony that presently the Government disadvantages the very banks it has invested in.”

There is nothing in the Indradhanush framework which talks about either privatisation or the government bringing down its stake to lower levels in public sector banks. The Modi government like the previous Manmohan Singh government wants to continue owning 25 public sector banks. Also, by wanting to own 25 public sector banks, the government has gone totally against the “minimum government maximum governance” philosophy that Narendra Modi had espoused in the run-up to the Lok Sabha elections that happened last year.

The Nayak committee had also proposed that the government follow the Axis Bank model, where the government is an investor rather than the promoter. “The CEO is appointed by the bank’s board, and because the bank was licensed in the private sector, it sets its own employee compensation, ensures its own vigilance enforcement (rather than being under the jurisdiction of the Central Vigilance Commission), and is not subject to the Right to Information Act.”

The Nayak committee had also talked about the need to do away with the dual regulation of public sector banks by the ministry of finance as well as the Reserve Bank of India. This, the committee had said makes public sector banks uncompetitive. As the report of the committee had pointed out: “Any directions issued which are applicable to a subset of banks do damage to that subset, however laudable the objectives. Those banks not part of the subset are under no obligation to participate; if they do so the participation is voluntary, while for the subset it is coercive. Such discriminatory orders reduce the competitiveness of the subset. It is ironical that the Government seeks to make uncompetitive the very banks it has invested capital in.”

An excellent example of this is the lending carried out by public sector banks to many infrastructure companies over the last few years, where the private sector banks had stayed away from lending. A major part of the bad loans on the books of public sector banks come from lending to infrastructure companies.
As DN Prakash, President of Corporation Bank Officers’ Organisation and Vice-President All India Bank Officers’ Confederation, said in a press release: “A major part of NPAs of PSBs are in infrastructure, power and telecom sectors. When private sector banks had stayed away, PSBs had lent to these sectors as part of their commitment to economic growth and nation building. Today, they are blamed for the NPAs in these sectors.”

In order to rule out such problems the Nayak committee had recommended: “The Government should cease to issue any regulatory instructions applicable only to public sector banks, as dual regulation is discriminatory. RBI should be the sole regulator for banks, with regulations continuing to be uniformly applicable to all commercial banks.”

But the Indradhanush framework does nothing on this front. The idea of giving away control over public sector banks is a little too difficult for babus and politicians to digest. On this front, the Modi government is not very different from the previous governments.

Further, the public sector need a lot of money in the years to come, which the government as the major owner has to provide. But it cannot do so without ending in a big financial mess itself.

The Nayak committee between January 2014 and March 2018 “public sector banks would need Rs. 5.87 lakh crores of tier-I capital.” The committee further said that: “assuming that the Government puts in 60 per cent (though it will be challenging to raise the remaining 40 per cent from the capital markets), the Government would need to invest over Rs. 3.50 lakh crores.”

The government on the other hand estimates that “the capital requirement of extra capital for the next four years up to FY 2019 is likely to be about Rs.1,80,000 crore.” Of this amount it proposes to invest Rs 70,000 crore. Where is this money going to come from is a question that the government hasn’t tried to answer.

Over and above this, the Indradhanush framework does not come up with any fresh thinking on the issue of bad loans that has been plaguing public sector banks. It lists out a series of things that the Reserve Bank of India has been doing for a while now. But as is well know these steps haven’t done much to stem the rot when it comes to burgeoning bad loans.

As Prakash of Corporation Bank puts it: “there is no resolve on part of the Government to recover NPAs from big corporates that constitute the major chunk of NPAs [non-performing assets] in the industry.”

There doesn’t seem to be any systematic solution in light to clean up the bad loans mess at public sector banks. The government had an opportunity to do this with the Indradhanush framework, which it has clearly missed. As Crisil Ratings pointed out in a brief research note, “A ‘surgical’ response to the challenge of NPAs by creating a ‘bad bank,’” could have been a step in the right direction.

The column originally appeared on Swarajya Mag on August 26, 2015

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

Ms Bhattacharya, teaser rate home loans are a bad idea


Vivek Kaul

The recent suggestion by the State Bank of India (SBI) Chairperson, Arundhati Bhattacharya, to get back teaser rate home loans into the system, has once again sparked the debate over this controversial product. Bhattacharya recently said at an event where the Reserve Bank of India governor Raghuram Rajan was also present: “In fact, the first suggestion that I made (was) that, for a limited period, home loans could be given at below base rate for the already heavy stock of housing.”

In early 2009, SBI had started a teaser home loan scheme at 8%. Bhattacharya went on to add: “Of course, at that time, it was tagged as a ‘teaser’, but, we at SBI, refute that because the due diligence conducted for those loans was same as for others. Even the eligibility (criteria) was same as for regular loans.”

Teaser home loans are essentially home loans in which the interest rate is fixed in the initial years and is lower than the normal floating interest rate on a home loan. The lower interest rate is limited only to the first two-three years after which the loan is priced at the prevailing interest rate on home loans.

For example, the interest rate on a teaser home loan may be fixed at 8% for the first two years, when the prevailing home loan rate is 10%. From the third year onwards, the prevailing interest rate on home loans is charged to the borrower.

The idea with teaser rate home loans is that at lower rates of interest initially, the EMI will also be lower. This will encourage more people to take on a home loan and buy homes. This Bhattacharya feels will help in clearing the inventory of unsold homes that has piled up all over the country. As she said: “Today, the base rate is 9.7%. I am told that real estate inventory is at a two-year high and I was thinking if it is possible for a little while… could something of this (teaser loan) kind be allowed.”

There are multiple problems if anything of this sort were to become a reality. First and foremost, is it the job of the nation’s largest public sector bank to help real estate companies’ clear unsold inventory? From whatever little I have learnt on how banks should operate, the primary objective of a bank is to lend to those who are likely to repay and also, make money in the process, without increasing the overall riskiness of the financial system. Second, why should a bank be allowed to lend below its base rate or the minimum interest rate a bank charges its customers?

Third, if a bank gives out a teaser rate home loan at let’s say 8%, is it making money on that lending? And if it’s not, why is it lending in the first place?
When SBI first started offering teaser rate home loans in February 2009, under the leadership of OP Bhatt, it received criticism from all fronts. Teaser loans were a major reason behind the financial crisis that had started in the United States in September 2008. The difference in the Indian and the American context was that the teaser home loans that SBI was offering, were nowhere as aggressive as the teaser home loans that had been offered in the United States.

In the American context some teaser loans were so structured that only a certain amount of interest had to be paid in the first few years. Hence, the difference between the initial EMI and the actual EMI which kicked in after the “teaser-rate” was over, was huge. Hence, it led to huge defaults. That wasn’t the case in India.

Nevertheless, given the environment in the immediate aftermath of the financial crisis, the teaser home loan did not go down well with the banking regulator. Also, as we shall see, a certain amount of risk did remain in the product. Further, even though, the other lenders such as HDFC, ICICI Bank etc., joined the teaser loan bandwagon and started offering teaser loans, they made it amply clear that they were only responding to competition.

In fact, Deepak Parekh, Chairman of HDFC had called teaser loans a “marketing gimmick”. He had also explained why the product remained risky, even in an Indian context. As he told the Mint newspaper in an interview: “Today what we are saying is, if it’s 8% or 8.25% for the first two years, the rate will be 9% afterwards and so the gap is very little. Suppose interest rates in India shoot up in the next three years, then what will happen? These are all floating rate loans and fixed only for first two years. So, 8% interest will become 12% or even more. Then, the gap will be too much and it’s a problem for the individual home-owners.”

And home loan interest rates did rise eventually in the years to come. There is no data available in the public domain to figure out what was the impact higher interest rates had on those who had taken on a teaser loan.

Further, as Parekh explained: “Financial innovation doesn’t take time; if one does it, everyone copies. It can be done in 24 hours.” If SBI were to launch a teaser rate home loan right now, every other bank would launch a similar product in quick time. This would increase the overall risk in the financial system.

Given all these reasons, teaser loans are a bad idea. And it is surprising that the idea to re-launch them has come from the head of the largest bank in the country. The good news is that it is unlikely that Raghuram Rajan is in the mood to listen to this suggestion.  In fact, he made it clear recently to real estate wallahs (real estate companies, lobbies and others associated with the sector) that they should stop asking for lower interest rates every time they open their mouths to speak. He asked them to start cutting prices instead.

As Rajan said: “It would be a “great help” if realty developers sitting on unsold stock bring down prices…Once the prices stabilise, more people will be keen to buy houses…I think we need the market to clear. With growing unsold stock, we need to see the ways to do it. Some of it might be by making loans easier, but we also don’t want to create a situation where prices stay high at the level which means demand can’t pick up.”

Also, as I have said many times in the past, real estate prices are at a level, where slightly lower EMIs really won’t make much of a difference. The real demand for homes to live in will only come in once builders start to cut prices.

The column originally appeared on The Daily Reckoning on Aug 26, 2015

Economic growth is just 200 years old

We live in a day and age where economic growth is taken for granted. China was growing at greater than 10% per year for a long time. In the recent past, the growth has slowed down to around 7% per year. If Chinese growth keeps slowing down, the world growth will also slow down.

The United States has grown at around 3% per year, over the long term. The world’s largest economy is now growing at a much slower pace. Economic growth in India has also slowed down over the last few years. And all this has got economists and people who follow such things worried.

Nevertheless, in the context of history, economic growth is a very recent phenomenon, and is just around 200 years old. As John Plender writes in Capitalism—Money, Morals and Markets: “The economist Angus Maddison calculated that in the period from 1500 to 1800, world domestic product per capita[income] grew at an annual average compound rate of just 0.04 percent—one-thirtieth of what has been achieved since 1820.”

While some economists have issues with the methodology Maddison used to arrive at the economic growth number, most agree with the broader point he makes. In fact, economic growth even before 1500 was nothing home to write about.

Why was this the case? There was a great fear of creative destruction that new inventions would unleash. As Daron Acemoglu and James A. Robinson write in Why Nations Fail—The Origins of Power, Prosperity and Poverty: “The fear of creative destruction is the main reason why there was no sustained increase in living standards between the Neolithic and Industrial revolutions. Technological innovation makes human societies prosperous, but also involves the replacement of the old with the new, and the destruction of the economic privileges and political power of certain people.”

Acemoglu and Robison take the example of the Roman Emperor Vespasian, who ruled between AD 69 and 79. The Emperor was approached by a man who had invented a device to cheaply transport heavy columns to the Capitol, the citadel of Rome. This cost the government a lot of money. By adopting the new invention, the government could have saved a lot of money.

The Emperor rejected the invention and declared: “How will it be possible for me to feed the populace?” The invention was rejected because it would have disturbed the way things stood at that point of time. The new device would have put many people out of work. As Acemoglu and Robinson explain: “The innovation was turned down because of the threat of creative destruction, not so much because of its economic impact…Vespian was concerned that unless he kept people happy and under control it would be politically destabilizing.”

A similar logic was used to put many inventions in the cold storage, including few in the textile industry, in the pre-industrial revolution era. The industrial revolution started in Great Britain in the second half of the eighteenth century and gradually spread to other parts of the Europe and the United States.
A major reason why the Industrial Revolution flourished was because governments no longer tried to stop creative destruction. They took it in their stride.  Further, as people and governments saw the benefits of economic growth that new inventions and creative destruction brought in, their approach towards economic activity changed as well. As Plender writes: “Economic activity was no longer perceived as a zero-sum game in which one man’s profit was another’s loss and thus morally questionable. It became easier to make great fortunes from industry and commerce than from land.”

To conclude, there is a lesson in this for Indian government. The only way sustained economic growth can be unleashed is by encouraging new ideas and inventions. This will only happen if the ease of doing business in this country improves. And on that front, there is a lot that still needs to be done.
The column originally appeared in the Bangalore Mirror on August 26, 2015

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

It’s no good blaming just China for the global stock market sell-off

It’s around 12.30 am at night as I start writing this column and I am watching the television coverage of the flip-flopping stock markets in the United States.
The Dow Jones Industrial Average started the day on August 24, 2015, around 1000 points down, from its previous close on Friday (August 21, 2015). It recovered more than 800 points and then started to fall all over again. Ultimately, it closed the day at 15,871.28 points, down 588.47 points or 3.58%, from its previous close.

Earlier in the day, the Shanghai Composite Index was down by 8.5% to close at around 3209.91 points. The BSE Sensex also saw a massive fall of 1624.51 points or 5.94% to close at 25,741.56 points. Stock markets around the world fell.

Analyst after analyst has blamed China for this massive fall in stock markets all over the world. And so have politicians. Before I get into this, here is some background. Until August 10, 2015, around 6.2 Chinese yuan made up for one US dollar. Between August 11 and August 14, the People’s Bank of China, devalued the yuan against the dollar. Since then the value of the yuan has moved between 6.38-6.40 yuan to a dollar. This was the biggest devaluation in the value of the yuan in two decades.

The yuan has been devalued in the hope of getting Chinese exports going again. In July 2015, the Chinese exports fell by around 8.3%. The fear is that the Chinese will continue to devalue the yuan in the days to come to prop up their exports.

A devalued yuan will lead to cheaper Chinese exports. Let’s understand this through an example. Let’s say a product exported out of China is sold at $50. At around 6.4 yuan to a dollar, the exporter makes 320 yuan every time he sells one piece of the product. We assume no other expenses for the ease of calculation.

Now let’s say the Chinese gradually devalue the yuan to around 7 yuan to a dollar. Then for every piece of the product that is sold the Chinese exporter makes 350 yuan. Instead of taking on the entire gain, the exporter may decide to cut the price in dollars and make his product more competitive. Let’s say he cuts the price of his product to $46. At this price he still makes 322 yuan, which is a little more than the 320 yuan he was making earlier. Nevertheless, given that he has cut his price by a significant $4, chances are he will sell more pieces of the product and make more money in the process. Chinese exports will go up and this will perk up economic growth as well.

Data from 2014 shows that China exports nearly 63% of its exports to the developed world (i.e. United States, European Union, Hong Kong, Japan, South Korea, Russia and Taiwan). Prices of products made in these countries would have to be cut, in order to compete with similar products which are made in China and exported to these countries.

This would lead to prices falling (or what economists like to call deflation) in these countries and that can’t be good for the overall economy. The stock markets are adjusting to this “new reality”. The Economist estimates that “more than $5 trillion has been wiped off on global stock prices,” since August 11, the day China first devalued the yuan against the dollar.

China has been largely blamed for this massive fall in stock markets all over the world. It is being said that China will export deflation to other parts of the world.

In fact, even Donald Trump, who is a Presidential candidate for the Republican Party in the United States, has an opinion on this. Speaking to reporters after the Chinese started devaluing the yuan he had this to say:I think you have to do something to rein in China. They devalued their currency today. They’re making it absolutely impossible for the United States to compete, and nobody does anything. China has no respect for President Obama whatsoever, whatsoever.
Well, you have to take strong action. How can we compete? They continuously cut their currency. They devalue their currency. And I have been saying this for years. They have been doing this for years. This isn’t just starting. This was the largest devaluation they have had in two decades. They make it impossible for our businesses, our companies to compete.
They think we’re run by a bunch of idiots. And what’s going on with China is unbelievable, the largest devaluation in two decades. It’s honestly – great question – it’s a disgrace

Economist John Mauldin had this to say regarding Trump’s comment on the devaluation of the yuan: “Before you dismiss this as nonsense, remember that it comes from a Wharton School graduate.” These MBAs I tell you.

The larger point is why is everyone blaming China for the massive stock market crash all around the world? What led to China letting its currency fall a little against the dollar between August 11 and August 14, 2015? Now that is a question worth asking and answering.

In October 2012, around 80 yen made up for a dollar. Since then, the Bank of Japan has been printing yen (or rather creating them digitally) to drive down the value of the yen in a bid to make Japanese exports more competitive and Japanese imports more expensive.

The idea was that if Japanese exports became more competitive on the price front (as a result of the devaluation of the yen, as we saw with the yuan example earlier), the total amount of Japanese exports would go up. At the same time, if Japanese imports became more expensive, the sale of goods produced locally would go up.

This would mean that exports as well as consumption of goods produced within the country would go up. And this would benefit the Japanese economy. As William Pesek recently wrote on “The yen’s 35 percent drop since late 2012 made Japanese goods cheaper, companies more profitable and Nikkei stocks more attractive.” Further, with a fall in the value of the yen, Japanese exports became more competitive in comparison to exports from countries like Taiwan and South Korea.

Further, imports into Japan became more expensive and this hit countries like China. The Chinese exports to Japan fell by more than 10% in July 2015. By trying to devalue the yuan, China was only doing what the Bank of Japan has been doing for a while.

Other than the Bank of Japan, the European Central Bank, the central bank of the euro zone(essentially countries which use the euro as their currency), has also been printing money, in the hope of driving down the value of the euro. The ECB is printing around 60 billion euros a month.

As Mauldin points out: “First off, the two largest currency manipulating central banks currently at work in the world are (in order) the Bank of Japan and the European Central Bank. And two to four years ago the hands-down leading manipulator would have been the Federal Reserve of the United States…Today, the euro is off over 30% from its highs, as is the Japanese yen. Numerous other currencies are likewise well into double-digit slides. China has moved maybe 3 to 4%. Oh, wow.”

Also, it needs to be pointed out here that the Chinese yuan had been rising against the dollar, all this while, unlike what Trump pointed out. As Mauldin writes: “The rest of the world (Japan, Europe, Great Britain, Brazil, India, among others) [has been] letting their currencies drift down. The simple fact is that the Chinese currency rose by 20% over the last five years…It is utterly wrong-headed to call a 20% rise over almost 10 years “continuous devaluation.”

Hence, why blame only China? The currency wars are on, and China is just one part of it.
The column originally appeared on The Daily Reckoning on August 25, 2015

Currency wars are driving down the Sensex

Vivek Kaul

The BSE Sensex fell by around 1624.51 points or 5.94% to close at 25,741.56 points yesterday (August 24, 2015). Sensex is an index of 30 major stocks that are traded on the Bombay Stock Exchange.

By now, dear reader, you may have read at many places that this was the biggest fall of the Sensex ever. That is incorrect. It was the 29th biggest fall of the Sensex, if we look at falls in percentage terms, which is the right way of looking at the situation.

Further, it was the biggest fall of the Sensex in more than six and a half years. On January 7, 2009, the Sensex had fallen by 7.25%. That was the day when B Ramalinga Raju of Satyam Computers confessed to a fraud. All falls after January 7, 2009, have been lower than yesterday’s fall.

So the question is why did the Sensex fall as much as it did yesterday?

The simple answer is—currency wars. In October 2012, the 80 Japanese yen were worth a dollar. As I write this on August 24, 2015, around 118 Japanese yen make for a dollar. The Bank of Japan (their equivalent of Reserve Bank of India) has been printing yen in the hope of driving down the value of the yen.

Why has it been doing this?

This is being done to make Japanese exports more competitive. A fall in the value of a currency means exporters can make more money. It also allows them to cut prices and hopefully boost exports and in turn economic growth. At the same time, the idea is to make Japanese imports more expensive.
China competes with Japan when it comes to exports. In July 2015, Chinese exports were down by 8.3%. During the same period Chinese exports to Japan were down by more than 10%.

Between August 11 and August 14, the People’s Bank of China, the Chinese central bank devalued its currency, the yuan, against the dollar. Before August 11, 6.2 yuan were worth a dollar. Now around 6.4 yuan are worth a dollar. This was done in the hope of boosting Chinese exports and in turn Chinese economic growth. The fear is that China will devalue the yuan further.

But why is that driving down the stock market?

If China devalues the yuan further, Chinese exports will become cheaper. This will mean that prices of goods produced in countries like United States and in large parts of Europe will have to be cut, in order to remain competitive with Chinese imports. This will lead to a scenario of what economists call “deflation” or falling prices in these countries. The Western economies will contract or not grow at the same speed. The stock markets around the world are adjusting to this “expected” situation. The Indian market is not an exception to this, as most of the money invested in the Indian stock market belongs to foreign investors.

What should you do?

A lot of experts have said that this is a good time to buy. That may actually not be the case. As I write this, the Dow Jones Industrial Average, one of the premier stock market indices in the United States, is down by more than around 500 points or 3%. Chances are the Sensex’s fall may continue as well. This is a risk not worth taking.

Also, it is worth remembering the old adage of drinking stocks SIP by SIP, where SIP stands for a systematic investment plan. Since the start of January 2008, Sensex has given a return of 5% per year. But an SIP on a good mutual fund would have given you a return of higher than 15% per year. This is timeless advice and works at most points of time.

The column originally appeared in the Bangalore Mirror on August 25, 2015

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