Month: September 2015

Why bans don’t work

bansThis month, the Brihanmumbai Municipal Corporation (BMC) has decided to suspend the sale of chicken and meat in its markets on two days (down from four days initially), during the Jain fasting period of Paryushan. Several other governments around the country have also decided to do the same.

There are has been a lot of outrage against these decisions on the social media. In Mumbai, the Maharashtra Navnirman Sena (MNS) set up a meat stall on September 10, one of the two days on which the sale was banned.

Of course MNS is a political party and was just trying to score a few brownie points with its political constituency. Nevertheless, the question that crops up here is do bans work? Take the state of Gujarat, where prohibition is in force. Does that mean that alcohol is not available in Gujarat? Anyone who has ever been to the state knows that at best it takes a couple of phone calls and a bootlegger lands up at your door with whatever you want to drink.

The consumption of alcohol is alive and kicking in the state, with the government losing out on all the money that it could have made through taxes. This money is now being made by bootleggers and the police which tends to overlook these indiscretions.

Or take the fact that in India one cannot legally bet on cricket. What has this done? It has led to the creation of a reasonably sophisticated system of betting run by illegal bookies, spread throughout the country. Every few years a betting scandal erupts, there is a lot of noise made around it, until we forget about it and move on to other things.

The way of stopping these betting scandals is to legally allow betting, as is the case through large parts of the world. The government can also make some money through taxes in the process and things don’t need to work at the underground level.

All these transactions are what economists call repugnant transactions. In economics a transaction is referred to as repugnant if “if some people want to engage in it and other people don’t want them to.”

As economist Alvin E. Roth writes in Who Gets What and Why: “Let’s consider one…domain in which repugnant transactions are common: sex. People want to have sex with each other in circumstances that society disapproves of. But when we educate people our children, pass laws, and try to control the transmission of disease, we would be foolish not to recognise that sex is a powerful force…For this reason we sometimes try to promote “safe sex” rather than abstinence.”

Along similar lines the need to eat meat, drink alcohol and gamble, may be repugnant to some, but they are also powerful forces. Certain leaders of the Jain community may not like the idea of other communities eating meat during what is a period of fasting for them. But that doesn’t mean people will stop eating meat.

Alcohol cannot be sold in the state of Gujarat because it is the state where the father of the nation Mahatma Gandhi was born, but that doesn’t mean people will stop drinking alcohol.

We may find gambling to be morally wrong, but that doesn’t mean people will stop gambling. Like sex, these are powerful forces. And banning them doesn’t help because then the activity simply moves underground.

As Roth writes: “Banning markets is just one way of trying to control them, and preventing markets is easier legislated than done.” The point being that meat will be sold illegally on days it’s banned or people will simply stock up.

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

The column originally appeared in the Bangalore Mirror on Sep 16, 2015

Why is Modi govt protecting steel companies?

steel
The Prime Minister Narendra Modi met Indian industrialists some time back and encouraged them to take more risk. The Indian businessmen in turn asked him for lower interest rates, a weaker rupee and more sops.

Take the case of the steel industry. It has been successfully lobbying for import duties on different kinds of steel. In June 2015, the government imposed an anti-dumping duty of up to $316 per tonne on a type of stainless steel imported from China, South Korea and Malaysia. A Reuters newsreport points out: “India consumes about 1 million tonne of this type of stainless steel and more than 40 percent of that is imported, mainly from China.”

The duty was imposed after the Director General of Anti-Dumping Duty, which comes under the ministry of commerce, had conducted an enquiry and had said this: “the domestic industry has suffered material injury; and (c) the material injury has been caused by the dumped imports of the subject goods originating in or exported from the subject country.”

The investigation was carried out on an application filed by Jindal Stainless Steel for “initiation of an anti-dumping investigation concerning alleged dumping of certain “Hot Rolled Flat Products of Stainless Steel of ASTM Grade 304 with all its variants” originating in or exported from China, Korea and Malaysia,” a PTI newsreport points out.

Over and above this, the director general (safeguards) has recommended that a safeguard duty of 20% be implemented on flat steel. A government panel of consisting of steel, commerce and revenue secretaries has accepted this recommendation yesterday, media reports suggest.

The Section 8B of the Customs Tariff Act of 1975 gives power to the central government to impose a safeguard duty if the government “after conducting such enquiry as it deems fit, is satisfied that any article is imported into India in such increased quantities and under such conditions so as to cause or threatening to cause serious injury to domestic industry [emphasis is mine].”

The World Steel Association puts out the data for country wise production of steel every month. The latest data released on August 20, 2015, points out that between January and July 2015, Indian companies manufactured 52,889 thousand tonnes of steel. This is 9.2% more than what was manufactured during the same period last year. So where is the serious injury to domestic industry happening?

Further, why is only the situation of the steel companies being taken into account? As Henry Hazlitt writes in Economics in One Lesson: “The tariff has been described as a means of benefiting the producer at the expense of the consumer. In a sense this is correct. Those who favour it think only of the interests of the producers immediately benefitted by the particular duties involved. They forget the interests of the consumers who are immediately injured by being forced to pay these duties.”

Steel is used as an input to many products. As the World Steel Association puts it: “Steel is the world’s most important engineering and construction material.” It is used in the manufacture of cars, auto-parts, washing machines and other consumer goods, roads, railways, oil pipelines, wind turbines, real estate and so on.

So, industries which use steel as an input to manufacture their products, will find their costs rising. These industries may or may not be able to pass on the cost to the end consumer, given that consumer demand continues to remain subdued.

In case these industries are able to pass on the cost, then the end consumer will have a lesser amount of money to buy other things. And this lower capacity of a consumer to buy things will have an impact on some other businesses.

There is another important point that needs to be made here. For the bureaucrats and the politicians in decision making positions it is easy to go by the logic that steel companies are being hit by steel imports. Further, lobbyists working for steel companies also work on this angle.

What is not as clearly visible is the impact that the increase in duty on imported steel has on industries which use steel as an input. And the further impact this has on the end consumer. As Hazlitt points out: “[The] loss spread among all other productive activities of the country would be minute for each…The added amount which consumers pay for a tariff protected article leaves them just that much less with which to buy all other articles. There is no net gain to industry as a whole.” And this is a fundamental point those giving protection to the steel industry tend to ignore or perhaps not realise.

Further, if the industries which use steel as an input are not in a position to pass on the increase in the cost of steel to its end consumers, then the profits of these industries tend to go down. If they are loss making, then their losses go up. The point here being that essentially that there is no free lunch.

Also, it needs to be pointed out that the price of commodities that go into the making of steel have fallen as well. As TN Ninan writes in the Business Standard: “Since January, NMDC has cut its price for iron ore lumps by a third, and for iron ore fines by nearly half. Most of the major steel producers reported a profit for 2014-15, including Steel Authority of India. One private producer reported its highest profits in five years.”

The steel companies still making losses are primarily doing so because they took on an excessive amount of debt over the years, and are now finding it difficult to service as well as repay that debt.

The moot question that the Modi government needs to answer is – does it want to protect steel companies or does it want to ensure that companies that use steel in making their products, have access to steel at lower prices? I don’t think that is a difficult question to answer especially given the fact that India needs to build massive physical infrastructure in the decades to come. And for that it needs steel.

If the government still goes ahead and protects the steel companies, then it is essentially going back to practising the crony socialism of the sixties, seventies and the eighties, which protected big existing business from all competition and did not lead India anywhere.

The column appeared in The Daily Reckoning on Sep 15, 2015

The Great Indian banking Ponzi scheme

 ponzi

 

One of the themes that I have regularly explored in The Daily Reckoning newsletters is the mess that the Indian banking sector currently is in. This newsletter is another one in the series.

The RBI Financial Stability Report released in June earlier this year pointed out: “Five sub-sectors, namely, mining, iron & steel, textiles, infrastructure and aviation, which together constituted 24.8 per cent of the total advances of scheduled commercial banks, had a much larger share of 51.1 per cent in the total stressed advances. Among these five sectors, infrastructure and iron & steel had a significant contribution in total stressed advances accounting for nearly 40 per cent of the total.”

Within the infrastructure sector, the power sector is a big defaulter. Loans to the power sector form around 8.3% of the total loans. But at the same time they form around 16.1% of the stressed advances.

The stressed advances or loans are arrived at by adding the gross non-performing assets (or bad loans) 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 by increasing the tenure of the loan or lowering the interest rate.

So what would typically happen in such a scenario? Banks would go slow on lending to sectors that have been defaulting on their loans. But is that really the case? The sectoral deployment of credit data released by the Reserve Bank of India (RBI) earlier this month suggests otherwise. This despite the fact that banks claim every quarter that they continue to stay away from the sectors that have given them pain in the past.

People may not always tell the right story but numbers do. And here are the numbers. The RBI sectoral deployment data suggests that between July 2014 and July 2015 banks lent a total of Rs 1,20,900 crore to industry as a whole. The lending to industry went up by 4.8%, in comparison to 10.2% growth between July 2013 and July 2014.

The situation gets even more interesting when we take a closer look at the numbers. The bank lending to the infrastructure sector between July 2014 and July 2015 grew by Rs 71,600 crore. Within the infrastructure sector lending to the power sector grew by Rs 59,400 crore.

Lending to the iron and steel sector grew by Rs 27,100 crore during the course of the year. Loans to the iron and steel sector form around 4.5% of the total loans and 10.2% of the total stressed advances.

What does this tell us? In the last one year banks gave Rs 98,700 crore of the Rs 1,20,900 crore that they lent to industry to the two most troubled sectors of infrastructure and iron and steel. This means that 81.6% of all industrial lending carried out by banks in the last one year went to the two most troubled sectors of infrastructure and iron and steel.

These sectors form around 19.5% of the total lending carried out by banks and 40% of their stressed assets. The overenthusiasm of banks to lend to these sectors comes even after the RBI in the Financial Stability Report had raised a red flag.

The report had warned that the “the debt servicing ability of power generation companies[which are a part of the infrastructure sector] in the near-term may continue to remain weak given the high leverage and weak cash flows. Banks, therefore, need to exercise adequate caution while dealing with the sector and need to continue monitoring the developments very closely.”

With regard to the iron and steel sector the report had said that “the sector holds very good long term prospects, though it is currently under stress, necessitating a close watch by lenders.” But the July numbers on the sectoral deployment of credit clearly suggest that banks are not listening to the RBI.
What does this really mean? By lending more and more money to sectors which are in trouble, banks are essentially kicking the can down the road.

The banks are giving new loans to companies operating in these troubled sectors so that they can repay their old loans. They are effectively running a Ponzi scheme. A Ponzi scheme is essentially a fraudulent investment scheme where money being brought in by new investors is used to pay off old investors.
Over and above this conversations I have had with some industry insiders I have come to know that banks(in particular public sector banks) have been using the 5/25 scheme in order to postpone dealing with the bad loans issue, in the hope that these loans will become viable in the years to come.

The 5/25 scheme allows banks to extend the loans given to infrastructure projects to up to 25 years while refinancing them every five to seven years. As a December 2014 newsreport in the Mint newspaper points out: “Banks were typically not lending beyond 10-12 years. As a result, cash flows of infrastructure firms were stretched as they tried to meet shorter repayment schedules.”

In fact when the scheme was first introduced it was available only for new projects. However, in December 2014, it was also extended to existing projects as well. Banks were allowed to increase the repayment tenure for companies which had borrowed money for infrastructure projects and come up with fresh amortisation schedules for repayment of loans.

Such an increase in the tenure of repayment would not be treated as a restructuring of assets. An increase in tenure brought down the amount of money that the companies had to pay during the course of a year, in order to repay the loan. And this increased their chances of continuing to repay the loan.

This 5/25 scheme is also available for projects lending against which has already been classified as a restructured asset (i.e. its repayment schedule has already been extended or the interest rate has been lowered). When such a loan is brought under the 5/25 scheme it continues to be classified as a restructured asset up until the project gets upgraded on the satisfactory servicing of the loan.

RBI’s rationale behind extending the 5/25 scheme to existing projects was that that instead of giving up on an asset under stress, if efforts were made to make it viable, then the loan could be paid back and therefore the pressure of bad loans could be eased.

As RBI governor Raghuram Rajan said on August 4, 2015, while addressing a press conference: “We have said that there is no problem to lend to a project even if it is a non-performing asset, so long as it has done something to bring the project back on track and not for evergreening the loan.” But is that really the way banks also look at it?

Rajan further said in a speech on August 24, 2015: “To deal with genuine problems of poor structuring, it has allowed bankers to stretch repayment profiles…to infrastructure and the core sector (the so-called “5/25” rule), provided the project has reached commercial take-off, has a genuinely long commercial life, and the value of the NPV of loans is maintained. RBI is undertaking periodic examination of randomly selected “5/25” deals to ensure they are facilitating genuine adjustment rather than becoming a back-door means of postponing principal payments indefinitely.”

I sincerely hope that RBI is carefully examining the 5/25 loans. As Rajan said, the RBI making it “easy for banks to “extend and pretend”, is not a solution.” I agree.

The column originally appeared in The Daily Reckoning on Sep 11, 2015

How corporates have turned Indian banks lazy

SBI-logo.svg

One of the data points that analysts like to refer to while talking about slow economic growth, is the slow growth in loans given out by banks. If we consider the one year period between July 25, 2014 and July 24, 2015, the overall lending by banks grew by 9.4%. In the period of one year between July 26, 2013 and July 25, 2014, the loan growth was much stronger at 12.8%.

In absolute terms, in the last one year, the banks gave out Rs 5,71,820 crore of loans. This is lower than the total amount of Rs 6,88,640 crore, that banks gave out between July 2013 and July 2014.

So banks are not lending as much as they were in the past. And that clearly is a problem. But this does not apply to the money that banks have lent to the government.

Between July 2014 and July 2015, the banks invested Rs 3,40,750 crore in government securities. The government issues financial securities to finance its fiscal deficit or the difference between what it earns and what it spends. Banks buy these financial securities and thus lend to the government.

Interestingly, the investment by banks in government securities during the period July 2013 and July 2014 had stood at Rs 1,298,50 crore. Hence, between July 2014 and July 2015, the investment by banks in government securities has jumped a whopping 162.4%.

In fact, the comparison gets even more interesting when we get deposits raised by banks between July 2014 and July 2015 into the picture. In the last one year banks raised Rs 9,34,090 crore as deposits. Of this 36.6% (or Rs 3,40,750 crore) found its way into government securities. Between July 2013 and July 2014, only 14.7% of deposits raised had been invested in government securities.

What do all these numbers tell us? They tell us loud and clear that the Indian banking system currently wants to play it safe. In other words this is “lazy” banking. Lending to the government is deemed to be the safest form of lending. This is primarily because government can borrow more money to repay the past borrowers. It can also print money and repay its loans. Private borrowers cannot do that.

What is also interesting is that banks are also giving out more home loans than they were in the past. Between July 2014 and July 2015, home loans formed around 17.6% of the total lending. This number between July 2013 and July 2014 had stood at 12.2%. This is primarily because a house is a very good collateral. Also, the rate of default on home loans is very low. In case of HDFC (which is not a bank but a housing finance company) the default rate is at 0.54%, which means that almost no one defaults on a home loan.

In case of State Bank of India, for retail loans, the default rate stands at 1.17%. The bank does not give out a separate default number for home loans. Auto loans, education loans and personal loans, are the other forms of retail loans. The default rates in case of these loans is likely to be higher. Hence, the default rate, in case of home loans given out by the State Bank of India, should be lower than 1.17%.

Compare this to what happens when the State Bank of India lends to mid-level corporates. The default rate is at a very high 10.3%. Hence, for every Rs 100 that India’s largest bank gives out as a loan to a mid-level corporate, more than Rs 10 goes bad.

If one factors all this into account it is not surprising that banks are comfortable lending only to the government and giving out home loans. In fact, over the last one year, banks have lent 47.3% of the total deposits they have raised during the period either to the government or as home loans. The number during the period July 2013 and July 2014 had stood at 24.3%.

Hence, banks are clearly trying to play it safe. This is lazy banking at its best.

Prime Minister Narendra Modi in his meeting with businessmen on September 8, 2015, asked them to increase their risk appetite and increase their investments. This is clearly not going to happen without banks being ready to lend to corporates.

The problem is that the last time banks went on an overdrive while lending to corporates they burnt their fingers badly, with corporates defaulting big time on their loans. And there is no easy way to solve this problem.

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

The column originally appeared on Firstpost on Sep 11, 2015

Why India missed out on the industrial revolution and might miss it again

narendra_modi
The Prime Minister Narendra Modi met representatives of Indian business on September 8, 2015. The Indian businessmen as usual asked for lower interest rates, weaker rupee and so on, to get economic growth going.

Modi on the other hand emphasized on job creation and the role the private sector could play in it. A report in the Mint newspaper points out that Modi also prodded the banks to help small and medium enterprises in the so-called informal sector as “they have great potential for generating new jobs”.

As I have mentioned in previous newsletters of The Daily Reckoning, creating new jobs should be a top priority of the Modi government. This is primarily because 13 million Indians are entering the workforce every year.

Also, as I have mentioned in the past, the only way countries have gone from being developing to being developed is by unleashing a manufacturing/industrial revolution. Despite having a huge labour force and initiating economic reforms in 1991, India has missed out on the manufacturing revolution.

Why is that the case? As Sanjeev Sanyal writes in The Indian Renaissance—India’s Rise After a Thousand Years of Decline: “The country [i.e. India] appears to have shifted from farming to services without having gone through an industrial stage. This not only goes against conventional wisdom but also the experience of other fast-growing Asian economies particularly China.”

China and other Asian countries (Japan, Taiwan, South Korea and countries of South East Asia) essentially followed an export oriented manufacturing strategy to create economic growth. They started with low-end exports and then gradually started going up the value chain. “These economies usually started out by scaling up low-skill exports like making ready-made garments, toys, cheap household items and so on. With time, they all move up the value chain as wages rise and their workforce become more skilled. Exports shift to things like high-end electronics and automobiles,” writes Sanyal. The services sector becomes a driver of growth only later.

In the Indian case, nothing like that happened. After the 1991 economic reforms, we moved on to exporting complex automobile parts and pharmaceuticals. We also exported information technology and became a global hub of the business process outsourcing industry. India also saw a huge expansion in banking, hotels, airlines, cable television, telecom and so on. None of this was low-end, like was the case of Asian countries as well as China. Hence, we jumped from farming to services, without going through an industrial/manufacturing stage.

And this jump from farming to services, without going through an industrial stage, is counter-intuitive. In fact, India should have latched on to a low end export oriented manufacturing strategy much before the 1991 reforms. But that did not happen.

In order to understand why, we need to go back in history and talk about a gentleman called Prasanta Chandra Mahalanobis. Mahalanobis founded the Indian Statistical Institute in two rooms at the Presidency College in Calcutta (now Kolkata) in the early 1930s. He became close to Jawahar Lal Nehru, the first Prime Minister of India, and was appointed as the Honorary Statistical Advisor to the government of India.

As Gurcharan Das writes in India Unbound –From Independence to the Global Information Age “His biggest contribution was the draft plan frame for the Second Five Year Plan…In it he put into practice the socialist ideas of investment in a large public sector (at the expense of the private sector), with emphasis on heavy industry (at the expense of consumer goods) and a focus on import substitution (at the expense of export promotion).”

Hence, big heavy industry became the order of the day at the cost of small consumer goods. The alternative vision of encouraging the production of low-end consumer goods was put forward as well. As Das writes “It belonged to the Bombay [now Mumbai] economists CN Vakil and PR Brahmanand. It was neither glamourous nor as technically rigorous as Mahalnobis’s, but it was more suited to the underdeveloped Indian economy. Its starting point was that India lacked capital but had plenty of people…The thing to do was to put these people into productive work at the lowest capital cost.”

And how could this be done? “The Bombay economists suggested that we employ the surplus labour to produce “wage goods,” or simple consumer products – clothes, toys, shoes, snacks, radios, and bicycles. These low-capital, low-risk, business would attract loads of entrepreneurs, for they would yield quick output and rapid returns on investments. Labour would produce the goods it would eventually consume with the wages it earned in producing the goods,” writes Das.
Nevertheless, with the focus on the public sector, nothing like that happened.

But why did India miss out on a manufacturing/industrial revolution even after the process of liberalization started in 1991? India’s domestic savings through much of the 1990s stood at around 23% of the GDP. A major portion of these savings went into financing the government fiscal deficit. Given this, interest rates were high and “the country was forced to use capital sparingly,” writes Sanyal. Any industrial revolution needs a massive amount of capital, which wasn’t easily available in the Indian case.

Further, even with economic reforms many things on the ground did not change. As Sanyal writes: “The easing of big-picture impediments like industrial licensing and import tariffs did not get rid of the underlying framework of over-regulations, bureaucratic delays and erratic judicial enforcement. The country had built up a huge baggage off laws, by-laws and regulations at every layer of government during the half-century under socialism.” Much of this still remains to be dismantled.

Take the case of labour laws. There are more than fifty labour laws just at the central government level. As Jagdish Bhagwati and Arvind Panagariya write in India’s Tryst with Destiny: “The ministry of labour lists as many as fifty-two independent Central government Acts in the area of labour. According to Amit Mitra (the finance minister of West Bengal and a former business lobbyist), there exist another 150 state-level laws in India. This count places the total number of labour laws in India at approximately 200. Compounding the confusion created by this multitude of laws is the fact that they are not entirely consistent with one another, leading a wit to remark that you cannot implement Indian labour laws 100 per cent without violating 20 per cent of them.”

These laws prevent small Indian firms from growing bigger. They also prevent big Indian industrialists from entering sectors that can employ a huge amount of labour. Bhagwati and Panagariya recount a story told to them by the economist Ajay Shah. Shah, asked a leading Indian industrialist about why he did not enter the apparel sector, given that he was already backward integrated and made yarn and cloth. “The industrialist replied that with the low profit margins in apparel, this would be worthwhile only if he operated on the scale of 100,000 workers. But this would not be practical in view of India’s restrictive labour laws.”

If Narendra Modi wants Indian businesses to create jobs, he first needs to sort out the labour laws. And that will be easier said than done.

The column originally appeared on The Daily Reckoning on Sep 10, 2015