Month: September 2015 | Page 3

21 September, 2015

Jaitley needs to talk about high home prices, not just high EMIs

Sometimes I think that the finance minister Arun Jaitley has this constant need to talk and in the process he ends up saying stuff which looks rather silly.
Like he said yesterday in Hong Kong: “RBI historically has been a very responsible institution. Now, as somebody who wants India’s economy to grow and who wants domestic demand to grow, I will want the rates to come down…Real estate, for example, can give a big push to India’s growth and this is a sector which is impacted by high policy rates. Therefore, if the policy rates come down over the next year or so, certainly this is one sector which has a huge potential to grow.”

In fact, this is something that Jaitley has said in the past as well. As he said in December 2014: “now time has come with moderate inflation to bring down the rates. If you bring down the rates, people will start borrowing from banks to pay for their flats and houses. The EMIs will go down.”

There is nothing wrong in Jaitley wanting interest rates to come down. Politicians all over the world like lower interest rates because they believe that lower interest rates lead to more borrowing which translates into economic growth. Hence, one really can’t hold that against Jaitley. He was only saying what others of his tribe firmly believe in.

But believing that lower interest rates will lead to the revival of the real estate sector is rather simplistic. The logic here is that since interest rates are high, the EMIs on home loans are high as well. And at higher EMIs people are postponing the home purchase decision.

If interest rates are cut, EMIs on home loans will come down, people will buy homes and this will lead to the revival of the real estate sector. QED.

But as I said earlier in the piece, this reasoning is rather simplistic. Allow me to explain. Every month the Reserve Bank of India puts out sectoral deployment of credit data. This data gives a breakdown of the various sectors banks have loaned money to, including home loans.

Between July 25, 2014, and July 24, 2015, the total amount of home loans given by banks grew by 17.8%. In comparison, the home loans between July 26, 2013 and July 25, 2014, had grown at 17.4%. So, home loans given by banks continue to grow at a very fast pace.

The overall lending by banks between July 2014 and July 2015 grew by 8.2%. Between July 2013 and 2014, the overall lending by banks had grown by 12.6%.

Hence, during the last one year, the growth of overall lending by banks has fallen. Nevertheless, the total amount of home loans given by banks has gone up at a much faster pace of 17.8%, in comparison to 17.4% earlier.

Hence, despite the high interest rates, home loans continue to grow at a fantastic pace. Also, in the last one year, home loans formed around 21.6% of the overall lending carried out by banks. Between July 2013 and July 2014, the number was at 13.2%.

What this clearly tells us is that home loan lending has not slowed down because of high interest rates. It continues to grow at a fast pace. Hence, Jaitley’s logic goes out of the window completely. But how do you explain the fact that the real estate developers are sitting with so many unsold homes?

In a recent research report PropEquity estimated that the “housing sales in the 19 tier II cities fell by 17 per cent as against a 32 per cent decline in the top 14 Tier I cities in the last two years.” Why are home sales falling despite home loans going up?

One of the possible answers is that the number of home loans being given by banks has come down over the years, as property prices have risen at a very rapid rate. This cannot be said with surety given that RBI does not share this data.

The basic problem with Indian real estate is high prices. And unless prices fall, there is no way sales are going to pick up, lower interest rates or not.

It is worth mentioning here that a fall in interest rates does not have a significant impact on EMIs. A home loan of Rs 50 lakh, at an interest rate of 10% and a tenure of 20 years, leads to an EMI of Rs 48,251. At 9.75%, it leads to an EMI of Rs 47,426, which is around Rs 800 lower. The point being that no one is going to buy a home because the EMI is Rs 800 lower.

Also, in order to get a home loan of Rs 50 lakh, the individual interesting in buying a home would need to arrange Rs 12.5 lakh for a down-payment (assuming an optimistic ratio of 80:20). Further, over and above this, some portion of the price will have to be paid in black as well. The question is even in Tier I cities how many people are in a position to spend this kind of money? Not many.

Jaitley needs to realise this. If the real estate sector has to pick up, the government has to go after real estate prices. And Jaitley given that he is so used to saying things, must also start talking about high real estate prices, instead of just high interest rates. That would be a nice change from the usual and will possibly have more impact as well.

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

The column originally appeared on Firstpost on September 21, 2015

19 September, 2015

Phillip’s curve: The economic theory that Janet Yellen is stuck with

The interest rate setters at the Federal Reserve of the United States, the American central bank, have decided not to raise the federal funds rate, for the time being. The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.

The federal funds rate has been maintained in the range of zero to 0.25% in the aftermath of the financial crisis which started in September 2008. The Federal Reserve has been aiming for an inflation of 2%.

The measure of inflation that the Fed looks at is the core personal consumption expenditure (PCE) deflator. The deflator in July 2015 was at 1.2% in comparison to a year earlier, which is significantly lower than the 2% rate of inflation that the Federal Reserve is aiming for.

The statement released by the Federal Reserve on Sep 17, 2015 said: “Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports…Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability…The Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further.”

Before getting into analysing this statement, I would like to go back into history and talk about something known as the Phillips curve. The Phillips curve was the work of an economist called William Phillips. Phillips was a New Zealander by birth. At the end of the Second World War, he landed at the London School of Economics (LSE).

As Tim Harford writes in The Undercover Economist Strikes Back — How to Run — Or Ruin — An Economy: “As a part of his work on economic dynamics, Phillips gathered data on nominal wages (a good proxy for inflation) and unemployment, and plotted the data on a graph. He found a strong and surprisingly precise empirical relationship between the two; when nominal wages were rising strongly, unemployment would tend to be low. When nominal wages were falling or stagnant, unemployment would be high.”

There was great pressure on Phillips to publish something so that he could be offered a professorial chair at the LSE. As Harford points out: “So Phillips, under pressure from his colleagues to publish something, dusted off his weekend’s work and turned it into a paper. He was unimpressed with his own work, later describing it as ‘a rushed job’. [His] colleagues, ever eager to help his career along, got the paper published in LSE’s journal Economica, under the title ‘The

Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861-1957.’”

The research paper was published in 1958 and “became the most cited academic paper in the history of macroeconomics”. The inverse relationship between unemployment and wages was explained by the fact that during periods of low unemployment, companies would have to offer higher wages in order to attract prospective employees. And higher salaries would mean higher wage inflation.

Over the years, the phrase wage inflation was replaced by simply inflation, even though they are not exactly the same. Hence, during the period of the low unemployment, inflation is high and vice versa, is something that many economists came to believe.

The Phillips curve became extremely popular over the years. As Harford writes: “The reason the ‘Phillips curve’ became so popular is that other economists – notably Paul Samuelson – championed the idea that policymakers could pick a point on the curve to aim for. If they want wanted to reduce unemployment, they’d have to tolerate higher inflation; if they wanted to get inflation down, they’d have to accept higher unemployment.”

But that is not how things always work. Over the last few years, the official rate of unemployment in the United States has come down. As of July 2015 it stood at 5.3% of the total civilian labour force. In July 2014, the number had stood at 6.2%. Even though the unemployment data for August 2015 is available I have considered July 2015 data simply because the inflation data for August 2015 is not available as yet.

What has happened on the inflation front? In July 2015, the core PCE deflator was at 1.2 %. In comparison in July 2014, the core PC deflator was at 1.7%. Hence, what is happening here is the exact opposite of what the Phillips curve predicts.

As official unemployment has fallen, the inflation instead of going up, has fallen as well. Nevertheless, the faith in the Phillips curve still remains high. As Yellen said on Thursday: “We would like to bolster our confidence that inflation will move back to 2%. And of course a further improvement in the labor market does serve that purpose.”

This is nothing but a restatement of the Phillips curve—as the rate of unemployment falls further, the rate of inflation will move towards 2%. The question is will that happen? From the way things have gone up until now, the answer is no.

The Harvard economist Larry Summers in a recent blog explains why the Phillips curve does not work. As he writes: “The Phillips curve is so unstable that it provides little basis for predicting inflation acceleration. To take just two examples — first, unemployment among college graduates is 2.5 percent yet there is no evidence that their wages are accelerating. And unemployment in Nebraska has been below 4 percent for the last 3 years and growth in average hourly earnings has been basically constant at the national average level.”

Also, if Yellen continues to believe in the Phillips curve, there is no way she can be raising the federal funds rate, any time soon.

Further, the Federal Reserve is now worried about how things are panning out in China as well. As Yellen said: “The outlook abroad appears to have become more uncertain of late. And…heightened concerns about growth in China and other emerging market economies have led to volatility in financial markets.”

What this means is that Yellen feels that China is likely to devalue its currency more in the time to come to fire up its exports. A further devalued yuan will allow Chinese exporters to cut prices of the goods that they export to the United States.

These cheaper imports into the United States are likely to push down the rate of inflation further. This means that the rate of inflation is unlikely to get anywhere near the Federal Reserve’s 2% target anytime soon. Also, it will take time for the Federal Reserve (as well as others operating in the financial markets) to figure out the extent of China’s economic problem. Given this, I don’t see the Federal Reserve raising interest rates, any time soon. At least, not during the course of this year.

In the Daily Reckoning dated March 20, 2015, I had said Janet Yellen’s excuses for not raising interest rates will keep coming. I don’t see that changing anytime soon.

The column originally appeared in The Daily Reckoning on Sep 19, 2015

18 September, 2015

Corruption in bank lending starts at very beginning

“Anyone with any sense had already left town…” – Bob Dylan in Lily, Rosemary and the Jack of Hearts

In the Daily Reckoning newsletter dated September 9, 2015, I had extensively quoted a survey carried out by EY. In this survey 64% of respondents believed that the bad loans of banks resulted primarily because of lapses in the due-diligence carried out by the banks, before the loans were sanctioned.
As the report which came along with the survey pointed out: “Third party agencies such as surveyors, engineers, financial analysts, and other verification agencies, etc., play a critical role in assuring financial information, proposals, work completion status, application of funds, etc. Lenders rely significantly on the inputs issued by such third parties.”

And this system is being manipulated. “Reports are made as a routine, with little scrutiny. In some situations, the reports may be drafted under the influence of unscrupulous borrowers,” the EY report pointed out.

In response to the column someone with a detailed knowledge of the loan processing and disbursal process of banks got in touch with me. He gave me two examples of the loan disbursal system being manipulated. This ultimately led to several banks ending up with bad loans.

The first case was of an unlisted entity in the business of manufacturing luggage, borrowing from two big public sector banks. The promoter of the company offered his equity in the company, as well as land and the factory, as a collateral. This transaction took place in 2007. The valuation report by a third party agency put the combined value of all the assets at Rs 35 crore. Against these assets the banks gave a loan of around Rs 27 crore. The promoter took this loan. He also borrowed Rs 3 crore more from the banks.

Later another valuer was brought in to examine the value of the assets, and the value of the assets was put at a much lower Rs 19 crore. The old valuer was dismissed but by then the damage had already been done. The company had given out a loan of Rs 30 crore against assets which were worth only Rs 19 crore.

Ideally the situation should have exactly been the other way around.

The second case involves a listed company in the building materials space. The company came out with an initial public offering in 2008-2009. The company was listed at a three digit price. Currently, the price of the stock is in lower single digits.

The company took loans amounting to Rs 325 crore from two big public sector banks and one of the bigger new generation private sector banks. The promoter did not stop at this. He borrowed more using his other listed entities as well. In 2013, he defaulted on the loans citing slowdown in construction activity.

Now he owes banks around Rs 1000 crore to the banks. The book value of the assets that banks have as a collateral is around Rs 225 crore. The market value is expected to be in the region of Rs 325-350 crore. The rest of the money was lent by banks against shares, which are now quoting in single digits.

In both the cases, the banks ended up with losses. Both the companies that we talked about are not very big companies and they were able to do so much damage to banks so easily. Now imagine what must be happening when the banks deal with the bigger corporates.

The Reserve Bank of India (RBI) governor, Raghuram Rajan, summarised the situation accurately in a speech last year when he said: “The promoter enjoys riskless capitalism – even in these times of very slow growth, how many large promoters have lost their homes or have had to curb their lifestyles despite offering personal guarantees to lenders?” Almost none.

In fact, these defaults have pushed Indian banks into a difficult situation. As R Gandhi, one of the deputy governors of the RBI, said in a speech he made on September 15: “The amount of non-performing assets [have] witnessed [a] spurt and as on March 2015, it was at 4.62. per cent of the gross advances of the banks in comparison with 2.36 per cent of the gross advances as at March 2011.”

Further, non-performing assets or bad loans have grown at a much faster pace than the overall lending in the last few years. Along with the growth in bad loans, as I have often pointed out in the past, the restructured assets (where the tenure of the loan or the interest on the loan has been changed in favour of the borrower) have also grown.

As Gandhi pointed out: “The ratio of restructured standard assets to gross advances grew to 6.44 per cent as at the end of March 2015 from 5.87 per cent of gross advances as on March 2014. The total stressed assets (i.e., NPAs plus Restructured Assets) as on March 2015 were 11.06 per cent of gross advances.”

All this has had a severe impact on profitability of banks. “The sharp increase in stressed assets has adversely impacted the profitability of the banks. The annual return on assets has come down from 1.09 per cent during 2010-11 to 0.78 per cent during 2014- 15,” Gandhi said.

This has become a drag on the economy. The increase in bad loans and restructured assets also hurts those borrowers who have been repaying their loans without fail, as they end up paying higher interest rates. As Rajan said last year: “One consequence of skewed and unfair sharing is to make credit costlier and less available. The promoter who misuses the system ensures that banks then charge a premium for business loans.” Hence, the next time the businessmen want the RBI to cut interest rates, they should understand they are a major part of the problem.

Other than the fact, that the banks lent more money than they should have [i.e. due-diligence wasn’t proper], they also did not monitor the loans properly. In cases where money had been lent against shares, the falling share price should have led to some action from banks. But that doesn’t seem to have happened.

The RBI has since asked banks to follow a proper credit-risk management system. As Gandhi said during the course of his speech: “The guidelines entail involvement of top Management, including the Board of Directors of the bank in actively managing the credit risk of the banks. Banks are required to put in place proactive credit risk management practices like annual / half-yearly industry studies and individual obligor reviews, credit audit which entails periodic credit calls that are documented, periodic visits of plant and business site, and at least quarterly management reviews of troubled exposures / weak credits.”

While this will help banks in not making the same mistakes as they have in the past, it will do nothing about the mess that they already are in. For loans that have gone bad already or are in the process of going bad, all these steps are essentially too little and too late.

The column originally appeared on the Daily Reckoning on Sep 18, 2015

18 September, 2015

Here’s the real reason why US Federal Reserve did not raise interest rates

The Federal Open Market Committee (FOMC) of the Federal Reserve of the United States, the American central bank, has decided to stay put and not raise the federal funds rate for the time being, as it has for a very long time now.

The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.

The market was split down the middle on what they expected the Federal Reserve to do. The Federal Reserve has maintained the federal funds rate in the range of zero to 0.25% in the aftermath of the financial crisis which started in September 2008. This has been done in the hope of supporting an American economic recovery.

One view was that the Federal Reserve should start raising the federal funds rate now and get done with it. The other view was that the American economy is still in a fragile state and hence, the federal funds rate should not be raised. Also, any increase in the federal funds rate would have a bad impact on financial and asset markets all over the world, this school of thought held. And that couldn’t possibly be good for the American economy.

The FOMC led by the Federal Reserve Chairperson Janet Yellen chose to go with the latter view. There are several reasons for the same.
The unemployment rate in the United States fell to 5.1% of the civilian labour force in August 2015. Nonetheless, this number does not take into account those who are working part-time even though they want to work full time. It also does not take into account those who want to work but haven’t actively searched for a job recently.

In fact, the number to look at is the labour force participation ratio. The World Bank defines this as: “the proportion of the population ages 15 and older that is economically active: all people who supply labour for the production of goods and services during a specified period.”

The number had stood at 66% in January 2008 before the start of the financial crisis. As of August 2015 it stands at 62.6%. In August 2014 the number was at 62.9%. Hence, the labour force participation ratio has fallen over the last one year, despite the unemployment rate going down. This means that people have been dropping out of the workforce as they get discouraged at not finding a job and then stop looking for it.

Further, the Federal Reserve has been aiming for an inflation of 2%. As yesterday’s FOMC statement said: “the Committee expects inflation to rise gradually toward 2 percent over the medium term.”

The measure of inflation that the Federal Reserve likes to look at is the core personal consumption expenditure (PCE) deflator. The core PCE deflator is at 1.24%, which is nowhere near 2% that the Federal Reserve is aiming for. A stronger dollar which has made imports into America cheaper as well as lower oil prices are the major reasons for the same.

Interestingly, the FOMC in its statement yesterday said: “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” This is the first time this line has made it into the FOMC statement.

What does it mean by this? As Yellen said in a press conference that followed the release of the FOMC statement: “The outlook abroad appears to have become more uncertain of late. And…heightened concerns about growth in China and other emerging market economies have led to volatility in financial markets.”

In the press conference that nobody asked Yellen about what did she really mean by this. Chinese economic growth has been slowing down. Many analysts have argued that China is not growing at the 7% growth rate that it claims to be.

In this scenario it is likely that China might devalue the yuan against the dollar further in order to push up its exports. If China devalues the yuan, Chinese exports will become more competitive as Chinese exporters are likely to cut prices. In this scenario the value of imports coming into the United States will fall further, as exporters from other countries will also have to cut prices in order to compete with the Chinese. This will mean inflation falling further. In my opinion, this is what Yellen and the FOMC really meant.

In the press conference Yellen said that she expects that the FOMC will raise the federal funds rate before the end of this year. The direction in which the Chinese economic growth will unravel is unlikely to become clear so soon.

What this means is that the era of easy money unleashed by the Federal Reserve in late 2008, is likely to continue in the months to come. The Federal Reserve is unlikely to raise the federal funds rate this year. Not surprisingly the stock market in India is having a good day, with the BSE Sensex having rallied by more 470 points or 1.8%, as I write this.

Also, now that the FOMC hasn’t raised interest rates, calls for the RBI governor Raghuram Rajan to cut the repo rate are going to get louder.

The column originally appeared on Firstpost on Sep 18, 2015

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

16 September, 2015

Demographic dividend – The biggest risk to the India growth story

In an interview last week I was asked what is the biggest risk to the India growth story. The term India growth story made me think about a period ten years back when I was just starting up in business journalism as a personal finance journalist.

Back then, every fund manager I met said the same thing—the India growth story is still intact. But no one ever bothered to explain what the India growth story actually was. In fact, for a while I even thought that the fund managers were talking in some sort of a code.

As John Lanchester writes in How to Speak Money: “Practitioners of almost every metier [profession], from plumbers to chefs to nurses to teachers to police, have a gap between the way they talk to each other and the way they talk to their customers or audience.”

Over a period of time I realised that it was much more than that. As Lanchester writes: “There are a lot of things…in the world of money, where the explanation is hard to hold on to because it compresses a whole sequence of explanations into a phrase, or even just into a single word.”
India growth story was that kind of term. In three words fund managers encapsulated a whole sequence of things that that they thought would lead to the

Indian economic growth continuing to remain strong in the years to come. Or if I were to look at it in a cynical sort of way, fund managers wanted to sound like other fund managers. I guess it was a bit of both.

Having said that over the years I have come to realise that one fundamental point behind what has come to be known as the India growth story is the demographic dividend of India. The demographic dividend of a country essentially is a period of two to three decades when the birth rates go down and this leads to a situation where the workforce of the country is growing at a faster rate in comparison to its population.

Sanjeev Sanyal explains this in his book The Indian Renaissance—India’s Rise After a Thousand Years of Decline, where he defines three stages: “In the first stage, there is an increase in the proportion of the young in the population as birth rates stay high but infant mortality declines.”

In the second stage, the birth rates come down and the number of old people in the population increases at a modest pace. In this stage, the workforce of the country increases dramatically. This is the demographic dividend. In the third and final stage, the working population falls and the number of old people goes up.

India is currently in the second stage. As Sanyal writes: “The UN’s projections suggest that India’s working age population will rise from 691 million in 2005 to 829 million in 2015 and 942 million in 2025 before stabilizing at around 1050 million in the late 2030s…By this time, India will have the single largest pool of workers in the world, by passing an aging China. This means that we have entered a phase where the labour supply will be growing at a very rapid pace for a prolonged period of time.”

What this means is that India needs to create jobs and that too at a very rapid rate for the huge number of people that is entering the workforce every year. And that does not seem to be happening. As the latest Economic Survey points out: “The power of growth to lift all boats will depend critically on its employment creation potential. The data on longer-term employment trends are difficult to interpret because of the bewildering multiplicity of data sources, methodology and coverage. One tentative conclusion is that there has probably been a decline in long run employment growth in the 2000s relative to the 1990s and probably also a decline in the employment elasticity of growth: that is, a given amount of growth leads to fewer jobs created than in the past. Given the fact that labour force growth (roughly 2.2-2.3 percent) exceeds employment growth (roughly about 1½ percent), the challenge of creating opportunities will remain significant.”

If this trend continues in the years to come, the demographic dividend can easily turn into a demographic nightmare. And this remains the biggest risk to the India growth story.

Another impact of the demographic dividend is an increase in savings. As Sanyal writes: “When the demographic bulge raises the share of working-age adults in the population, the overall propensity to save rises sharply…The bottled up savings cause a sharp decrease in the domestic cost of capital and a sharp increase in the quantum of resources available to the financial system…In turn, this results in a lending boom, job creation and consequently even more savings.”

In the Indian case, the savings instead of going up, have been falling. In 2007-2008, the financial savings had stood at 11.7% of the gross domestic product (GDP). In 2014-2015, the number was at 7.5%, having stood at 7.2% in 2012-2013. There has been a dramatic fall in financial savings over the years. Further, even though the financial savings have improved over the last two years, the improvement has been at a very slow pace. This dramatic fall in financial savings has primarily been on account of high inflation that prevailed between 2007 and 2013.

In an Indian case given the semi-skilled nature of the workforce, the construction sector could have been a huge creator of jobs. But one reason that doesn’t seem to be happening is because the construction activity in the real estate sector has come to a standstill. This is primarily because real estate prices continue to remain high and hence, unaffordable to a large section of the population.

And all this has me worried. And it irritates me no end when fund managers say: “The India growth story is still intact.” It makes me wonder what they have been smoking.

The column originally appeared in The Daily Reckoning on Sep 16, 2015