Who is a Babu?

This is a slightly different piece from the ones that I usually write for The Daily Reckoning newsletter. In this piece I will try and define a babu.

So who is a babu? More than coming up with an exact definition, it is easier to just visualise him, in a cynical sort of way. He is the quintessential government employee, not reaching office before 11PM, sitting on a chair all day and not working, taking regular breaks for having cups of tea under the banyan tree outside his office, with a constant eye on the watch, so that he can leave office the moment it strikes 5PM (or may be even 4PM in some cases). Oh and of course, to do any work the babu needs to be paid a bribe (how could have I missed out on that).

The Bangla singer Nachiketa has a fantastic song defining a babu, it’s called aami sorkari karamchari (I am a government employee). Those who do not understand Bangla can listen to the Hindi version of the song by the same singer here. I guess a better song has not been written stereotyping the government in India, since this song came out sometime in the 1990s.

Now to get back to the topic at hand. So we have some sort of a definition of who is a babu, in place. But why am I talking about babus today? The Seventh Pay Commission has recommended a 23.6% overall increase in the salaries of central government employees and the pensions of retired central government employees, who are typically referred to as babus.

This has led to a lot of outrage on the social media in particular and the media in general. People have raised a lot of rhetoric around whether lazy government employees need to be paid so much when they cannot seem to get any work done. Some people have asked why do salaries of corrupt babus need to be increased. Still others have asked, why can’t the government decrease its size and not need to pay so much to so many babus.

In fact, the Seventh Pay Commission report has some data which will surprise you on this front. At least, it did surprise me. As on January 1, 2014, the central government employed a total of 33.02 lakh people against a sanctioned strength of 40.49 lakh.

Of the 33.02 lakh employees, 9.80 lakh were employed by the ministry of home affairs. These primarily include individuals working for the central paramilitary forces like central reserve police force (CRPF), Border Security Force (BSF) etc. The Railways employed another 13.16 lakh. The Defence employed another 3.98 lakh in civilian positions. And the Postal department employed 1.98 lakh. Though there is some controversy here.

The data obtained by the Seventh Pay Commission puts the number of employees working for India Post at 1.98 lakh. The expenditure budget of 2014 puts the number at 4.6 lakh. And data from Directorate General of Employment and Training suggests that the number of postal employees is at 2.09 lakh.

In fact, the same variation is seen when it comes to the number of people employed in defence in the civilian position. The expenditure budget of 2014 suggests 34,813, the DGET 3.75 lakh and the data obtained by the Seventh Pay Commission puts it at 3.98 lakh. I wonder how can there be such a huge difference between different estimates.(Regular readers of The Daily Reckoning readers will also appreciate here, how difficult it is to write anything that is data oriented in India). Anyway, getting back to the matter at hand, for the sake of this analysis we will stick to the numbers that the Seventh Pay Commission has obtained.

If we were to leave out those employed by railways, post and ministry of home affairs, and those working in defence in civilian positions, the central government employs just 4.18 lakh people and that is clearly not huge in a country of more than 120 crore people.

Also, people working for the central paramilitary forces and even defence in civilian positions, clearly cannot be considered to be as babus, in the strictest sense of the term.

The India Post employees can possibly be considered as babus. If we add their numbers, then we get a 6.08 lakh central government employees who can be labelled as babus. While, the railway employees are not exactly known for their efficient way of working, but railways is an essential service and you need people to run it.

As the Seventh Pay Commission report points out: “In fact the number of personnel working in the Secretariat of ministries/departments, after excluding independent/statutory entities, attached and subordinate offices will add up to less than thirty thousand6. The ‘core’ of the government, so to say, is actually very small for the Government of India, taken as a whole.”

While it is not easy to compare one government with another, the Seventh Pay Commission does make an attempt to do that. As the report points out: “Available literature indicates that the size of the non-postal civilian workforce for the US Federal Government in the year 2012 was 21.30 lakh. This includes civilians working in US defence establishments. The corresponding persons in position in India for the Central Government in 2014 was 17.96 lakh8. The total number of federal/Central Government personnel per lakh of population in India and the US works out to 139 and 668 respectively.”

What these data points clearly tell us is that the Indian government is not big at the central government level, at least. There is a “concentration of personnel in a handful of departments” like home ministry and railways ministry. The department of revenue is other big employer, the report points out.

So what can we learn from this? First and foremost that the central government may have babus who are not efficient at work, but it doesn’t have too many of them. A major part of the increase in salaries recommended by the Seventh Pay Commission will go to the paramilitary forces, railways and defence personnel.

So a smaller government in terms of number of people at least at the central government may not be possible. Now this realisation has important repercussions.

The Seventh Pay Commission’s recommendations will cost the government Rs 1,02,100 crore. Hence, even though the number of people is not huge, the salary plus pensions bill is huge, given the earning capacity of the government. And if the government continues to work in the way it currently is, there is a very good chance that this increased expenditure will end up screwing up the finances of the government like it had after the recommendations of the Sixth Pay Commission had been accepted in August 2008.

Given this, the government needs to work in a very efficient way. It needs to get rid of loss making public sector enterprises like MTNL and Air India. It also needs to raise more money by strategically selling its stake in other profit making public sector enterprises. It needs to make an inventory of all the land held by public sector enterprises and look at various ways of monetising it.

Further, steps need to be taken to increase the tax base, instead of taxing the same set of people over and over again. Domestic black money needs to be concentrated on. Right now the government clearly does not earn enough to finance the increase in salaries and pensions recommended by the Central Pay Commission.

Also, with people living longer and other developments like one rank one pension (which the seventh pay commission has recommended for all central government employees), the pension bill of the government is set to shoot up. In this scenario it is important that the government move the sections of the government still on the defined-benefit pension to defined-contribution pension.

The Seventh Pay Commission has also recommended a minimum pay of Rs 18,000 with effect from January 1, 2016. The allowances and other facilities will be over and above this pay. At lower levels the government pays much more than the private sector. And this explains to a large extent why you hear engineers, PhDs and doctors applying for jobs at lower levels of the government. This is an anomaly that needs to be set right. But I am not sure how determined this government (or for that matter any other government would have been) is to challenge the existing way of doing things.

The column originally appeared on The Daily Reckoning on Nov 24, 2015

7th Pay Commission Report: What does govt ‘really’ spend its money on?

Late last week, the Seventh Pay Commission recommended a 23.6% overall increase in the salaries of central government employees and the pensions of retired central government employees. This increase is likely to cost the government Rs 1,02,100 crore in 2016-2017, the Pay Commission report estimates. This increase will work out to 0.65% of the gross domestic product (GDP) in 2016-2017. In comparison, the awards of the Sixth Pay Commission had worked out to 0.77% of the GDP.

Since the recommendations of the report came out in the public domain, there has been a lot of noise around whether the inefficient government employees need to be paid so much. Or does the government need to employ the number of people that it does? What seems like an obvious answer is not so obvious when you look at the actual numbers. But that is a question I will leave for tomorrow’s edition of The Daily Reckoning. Today I wanted to discuss something else. Something that will set the pretext for tomorrow’s edition of The Daily Reckoning.

The question I want to ask today is how much money does the central government spend on paying salaries and pensions. The accompanying table provides the answer.

Travel Expenses)

Source: www.indiabudget.nic.in; In Rs Crore

Looking at these numbers in isolation doesn’t tell us much, other than the fact that the latest salary plus pensions bill of the central government comes to Rs 2,38,045 crore. Let’s look at them as a proportion of the total expenditure as well as the total receipts of the government, to give us a much better idea how big the spending on salaries and pensions is.

YearSalary + PensionTotal govt expenditureSalary + Pension as a
% of govt expenditure

Source: www.indiabudget.nic.in ; In Rs Crore

As can be seen from the above table, the salary plus pensions bill of the central government as a proportion of the total expenditure has gone up over the years. From making up around 11.56% of the total government expenditure, ten years back, it has jumped to around 13.39% in 2015-2016.

A possible explanation for this might lie in the fact that the number of central government employees has gone up during the last ten years. In 2005-2006, the central government employed around 32.3 lakh people. In 2015-2016, it employs around 35.5 employees.

Further, the number of pensioners has also jumped from around 38.41 lakhs to 51.96 lakh (as on January 2014, I couldn’t find the latest number of pensioners). Given this, it is not surprising that the salary plus pensions bill of the government has gone up.

But that is just one way of looking at it. The other way of looking at is that more than 13% of government’s expenditure is on basically on around 88 lakh individuals (the salaried lot plus the pensioners of the central government). Consider the fact that India’s population is more than 120 crore, you realise that this spending is concentrated on a certain section of the population and their families. But does that mean that the government should be smaller than it currently is? The answer is not so straightforward. As I said, I will answer that question in tomorrow’s column.

It needs to be mentioned here that the total expenditure of the government is met through borrowing because the government doesn’t earn enough to meet all its expenditure. Given this, how do things look when we compare the salary plus pension bill to the total receipts of the government (i.e. tax and non-tax revenue less the borrowings).

YearSalary + PensionTotal receiptsSalary + Pensions as a
proportion of total receipts

Source: www.indiabudget.nic.in ; In Rs Crore

So what does the above table tell us? The government spends around one out of the every five rupees that it earns on paying pensions and salaries. And that is a pretty high portion of what it earns.

So how much money is left with the government to spend on important things like infrastructure, health, education, etc. Before I answer this question, I need to get some more data points in.

The government spends a lot of money in paying interest on the debt that it has taken on to finance its expenditure. And it also spends a lot of money repaying the debt as it falls due.

YearSalary +
Interest on
of Debt

Source: www.indiabudget.nic.in ; In Rs Crore

The above table makes for a very interesting reading. In 2013-2014, the government spent nearly 69.4% of its receipts on paying salaries, pensions and interest on its accumulated debt, and repaying the debt that fell due. In 2015-2016, this had gone up to nearly 75.3%. How does the scene look when we compare this to the total expenditure of the government?

YearSalary +
Interest on
of Debt
TotalTotal govt

Source: www.indiabudget.nic.in ; In Rs Crore

The first thing that the table tells us is that the situation is not as bad as it was in 2005-2006, when more than80% of the expenditure of the government was on salaries, pensions, paying interest on debt and repaying debt. Things have improved since then. Nevertheless, the government still incurs more than half of its expenditure on salaries, pensions, paying interest on debt and repaying debt. What this tells us very clearly is that the government doesn’t have much money left to be spending on the important areas of physical infrastructure, education, health etc.

With a further increase in pensions and salaries on the way, this is only going to get worse. The government will have even lesser money left to be spending on important things like education, health, infrastructure etc.

So what is the way out? For that you will have to wait for tomorrow’s column.

This column originally appeared on The Daily Reckoning on Nov 23, 2015

Will The Pay Commission Hikes Boost Consumption?

The Seventh Pay Commission has recommended an overall 23.6% increase in salaries of central government employees and the pensions of the retired central government employees. The total cost of this increase in 2016-2017 has been estimated at Rs 1,02,100 crore (as can be seen from the following table).


Source: Seventh Pay Commission Report

This increase of Rs 1,02,100 crore has led several analysts and economists to conclude that a consumption boom is on its way. As analysts at Kotak Institutional Equities point out in a research note: “We expect automobiles, consumer durables and real estate sectors to benefit from the largesse. Although current demand conditions are somewhat subdued in both the sectors, the additional funds in the hands of central…government employees should be a positive for volume growth.”

The logic is very simple. If the recommendations of the Pay Commission are accepted the salaries of the central government employees will go up. The pensions of the retired central government employees will also go up. They are likely to spend this money and this spending will benefit the car, consumer durables (refrigerators, washing machines, television etc.) and the real estate companies. QED.

The truth might actually turn out to be a little more nuanced than this. There is no denying that there will be spending and that spending will benefit the economy, but the question is how much?

It is important here to consider those working for the central government and those who have retired from central government, separately. Let’s take the retired lot first. The increase in their case works out to Rs 33,700 crore (see above table). The Pay Commission report points out that as on January 1, 2014, the central government had a total of 51.96 lakh pensioners.

The increase of Rs 33,700 crore will be divided among these pensioners. This works out to Rs 64,858 on an average (Rs 33,700 crore divided by 51.96 lakh pensioners) or around Rs 5,505 per month (Rs 64,858 divided by 12). A portion of this will be taxed (I have no way of estimating how much, given that there is no way of estimating what is the average rate of income tax that India’s pensioners pay).

While this increase is substantial it is not substantial enough to make a huge impact on consumption. It will have an impact on consumer durables sales and two wheeler sales. But I don’t think this increase for pensioners will have an impact on sales of big ticket items like cars or homes for that matter. Also, it is worth mentioning here that pensioners are not as big spenders as those employed, anyway.

Those working for the central government will see a total increase of Rs 68,400 crore (Rs 1,02,100 crore minus Rs 33,700 crore of pensions). A portion of this increase in income will be taxed. Again, I have no way of estimating how much, given that I couldn’t find any data on what is the average rate of income tax that India’s central government employees pay. In fact, I could have used the average rate of income tax paid by individuals as a proxy, but I couldn’t find that number either. (Though the average rate of corporate income tax is available and is shared with every budget).

Assuming that the average rate of income tax paid by India’s central government employees is 10.3% (10% income tax + 3% education cess). This would leave around Rs 61,355 crore (Rs 68,400 crore minus 10.3% of Rs 68,400 crore) in the hands of the employees to spend.

The Pay Commission Report points out that there are currently 33.02 lakh central government employees. This means that Rs 61,355 crore will be shared among them. It works out to Rs 1,85,811 for the year (Rs 61,355 crore divided by 33.02 lakh employees), on an average. This works out to Rs 15,484 per month (Rs 1,85,811 divided by 12).

This is a substantial increase and will have an impact on consumption. It will lead to more two wheeler sales, more consumer durables sales and more car sales as well. But I still have my doubts whether this will lead to substantially more sales in real estate. Perhaps in smaller towns, yes.

Also, it is important to see how big this increase is with respect to the overall size of the economy. The increase of Rs 1,02,100 crore will work out to 0.65% of the gross domestic product (GDP) in 2016-2017.  In comparison, the awards of the Sixth Pay Commission had worked out to 0.77% of the GDP.

Some portion of this increase will be taxed away. Some portion will be saved. I guess it is fair to say that around half to two thirds of this increase will be spent and that works out to around 0.33-0.43% of the GDP. While that is a substantial number, it is not very big in the context of the overall economy.

Also, analysts and economists who have been talking about a huge revival in consumption have the Sixth Pay Commission experience in mind. As Crisil Research points out in a research note: “Sales of automobiles (two-wheelers and passenger vehicles) increased significantly (25-26%) while consumer durables saw a growth of 2.5-3% bps in fiscal 2010 and 2011 after the implementation of the Sixth Pay Commission report.”

The major reason for this big boost in consumption was that the increased payments to central government employees was made in 2009 and 2010, even though it had been due from 2006 onwards. This time the increase is due from January 2016. Even if the payments are made from April 1, 2016, onwards, the arrears will be minimal.

As the Seventh Pay Commission report points out: “The awards of the previous Pay Commissions, both V as well as the VI, involved payment of arrears…However, Seventh Central Pay Commission recommendations entail, at best, payments of marginal arrears.”

Given that central employees will not be receiving bulk payments in the form of arrears, the impact on consumption will not be as much as it was the last time around. Also, sales went up in 2009 and 2010 because of a cut in excise duty and a huge drop in interest rates. Both scenarios are unlikely as of now.

Crisil estimates that: “The Seventh Central Pay Commission to boost sales of passenger vehicles and two-wheelers by 4-5% incrementally in fiscal 2017…Consumer durables, too, are expected to see additional growth of 1-1.5% in volume, while there could be broad-based growth in televisions, washing machines and refrigerators.” And that sounds reasonable.

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

The column originally appeared on SwarajyaMag.com on Nov 21, 2015

Point blank: 7th Pay Commission recommendations will hit govt finances hard

The Seventh Pay Commission has recommended a 23.6% increase in salaries of central government employees, as well as pensions of retired central government employees. This largesse will cost the government Rs 1,02,100 crore in 2016-2017, the report estimates.

The report estimates that this increase will work out to 0.65% of the gross domestic product (GDP) in 2016-2017.  In comparison, the awards of the Sixth Pay Commission had worked out to 0.77% of the GDP.

The report points out that “while projecting the GDP for 2016-17, we assumed that the real growth rate of GDP will be 7.5 percent and inflation will be 4 percent in 2016-17.” This is perhaps a little overoptimistic, but let me not nit-pick.

Also, the 0.65% of the GDP number may be lower than what the number might eventually turn out to be because it does not take into account the impact of recommending one rank one pension for central government employees as well as para-military personnel.

Further, the trouble with expressing amounts as a percentage of the GDP is that it does not always show the correct picture. It is important to understand what will be the impact of the ‘extra’ Rs 1,02,100 crore on government finances.

In 2005-2006, the total government expenditure had stood at Rs 5,06,123 crore. A decade later in 2015-2016, the total government expenditure is projected to be at Rs 17,77,477 crore. This means an increase in expenditure at around 13.4% per year.

In 2005-2006, the total receipts of the government (less its borrowings) or what it earned, stood at Rs 3,59,688 crore. Ten years later in 2015-2016, the total receipts of the government(less its borrowing) is expected to be at Rs 12,21,828 crore. This means an increase in earnings at around 13% per year.

I am calculating these numbers so as to be make a rough projection for the receipts as well as the expenditure of the government in 2016-2017, the next financial year. Looking at the long-term trend we will assumethat for 2016-2017, the receipts of the government will go up by 13%, whereas its expenditure will go up by 13.4%. While the chances of things playing out exactly like this are low, but please indulge me, in order to understand the broader point I am trying to make.

Hence, the government receipts for the year 2016-2017 are likely to be at Rs 13,80,666 crore (1.13 times Rs 12,21,828 crore, the projected receipts for 2015-2016). The government expenditure for the year is likely to be around Rs 20,15,389 crore (1.134 times Rs 17,774,77 crore, the projected expenditure for 2015-2016).

This expenditure for 2016-2017 does not include the Rs 1,02,100 crore cost of the recommendations of the Seventh Pay Commission. We need to add this.

Hence, the total expenditure is likely to be at Rs 21,17,489 crore. Against this, the government will earn Rs 13,80,666 crore as receipts.

This means that the government will run a fiscal deficit of around Rs 7,36,823 crore. Fiscal deficit is the difference between what a government earns and what it spends. In 2015-2016, the fiscal deficit is projected to be around Rs 5,55,649 crore or 3.9% of the GDP. So what will the fiscal deficit work out to be in 2016-2017 as a proportion of the GDP?

For 2015-2016, the nominal GDP(i.e. not adjusted for inflation) is assumed to be at Rs 14,108,945 crore. The Seventh Pay Commission assumed a real GDP growth of 7.5 percent and an inflation of 4 percent in 2016-17. We will stick to the same numbers and hence assume a nominal GDP growth of 11.5% (7.5% real GDP growth plus 4% inflation).

This would mean the nominal GDP in 2016-2017 would be Rs 15,731,474 crore (1.115 times Rs 14,108,945 crore, the GDP projected for 2015-2016). Hence, the fiscal deficit as a proportion of GDP for 2016-2017 would work out at 4.7% (Rs 7,36,823 crore expressed as a proportion of Rs 15,731,474 crore).

This means the Seventh Pay Commission recommendations if accepted, will push up the fiscal deficit to 4.7% of the GDP from this year’s 3.9%. And this isn’t a good thing, given that the government is trying to achieve a fiscal deficit of 3.5% of the GDP by 2016-2017 and 3% of the GDP by 2017-2018.

The broader lesson here is that if things continue in the way they are now the Seventh Pay Commission recommendations are likely to screw up the government finances big time by pushing up the fiscal deficit.

The way to avoid this situation is by increasing receipts or cutting down on expenditure. If salary expenditure goes up, then other productive expenditure like capital expenditure may have to be cut. And that can’t be good news for the economy.

Further, if the government believes in good economics it needs to shut down loss-making public sector enterprises, but that is unlikely to happen.

On the receipt side the option to raise income tax rates is always there. But that will be a very unpopular move. The finance minister Arun Jaitley in his last budget speech had said: “I, therefore, propose to reduce the rate of Corporate Tax from 30% to 25% over the next 4 years.” So if corporate tax rate is likely to be brought down, that doesn’t leave the government with many options in order to increase its receipts. Perhaps, we may see the service tax rate being raised further in the next budget.

We may also see the government resorting to more standalone surcharges and cesses, like it already has in the form of Swacch Bharat cess. The government will also have to fasten the pace of disinvestment, something most governments haven’t shown interest in doing up until now.

Also, this year the government benefitted substantially from lower oil prices. It captured a major part of the gains by raising excise duty and not passing on the gain to consumers. Next year, any incremental help from falling oil prices may not be available.

All in all, the recommendations of the Seventh Pay Commission, if accepted, will not work out well for the government finances, unless it chooses to change the current way of doing things. Further, it is best that the government instead of accepting an increase of 23.6%, settles at a lower number between 12-15%, to control the damage on its finances.

The government as expected remains optimistic. As the finance secretary Ratan Watal put it: “We will handle this.” I really hope it does.

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

The column originally appeared on Firstpost.com on Nov 20, 2015

Why private equity cannot rescue real estate

3D chrome Dollar symbolRegular readers of The Daily Reckoning would know that I have been bearish on the real estate sector for a while now. There is no way that the current price level in real estate is sustainable. It has gone way beyond what most people can afford and hence needs to fall. That’s the basic logic I offer in almost all the columns that I write on real estate.

In response to these columns I get different kind of feedback. Some people agree with me totally. Some grudgingly. Some are coming around to the idea. And some don’t agree at all and ask me to revisit everything that I have been saying on real estate up until now.

The latest reason offered to me on why real estate prices will not crash is that the private equity firms are now investing in real estate. This will help real estate companies get the money they need. And in the process they won’t cut prices.

This logic doesn’t hold on multiple counts. But before I get into explaining why, let me first talk about a term called “availability heuristic” from behavioural economics. As Jason Zweig writes in The Devil’s Finance Dictionary: “Availability [is] essentially a mental shortcut, or HEURISTIC, that leads people to judge the frequency or probability of events by how easily examples spring to mind. The vividness of rare events can make them seem more common and likely to recur than they are.”

Initial public offerings of companies in stock markets are a good example. As Zweig writes: “The vast majority of initial public offerings (IPOs) fail to outperform the market, but it takes only a few spectacular successes like Google to create the illusion that investing in IPOs is the road to riches.”

Further, the availability heuristic leads to people making confident conclusions. As Dan Gardner writes in Future Babble—Why Expert Predictions Fail and Why We Believe Them Anyway: “The availability heuristic is a tool of the unconscious mind. It churns out conclusions automatically, without conscious effort. We experience these conclusions as intuitions. We don’t know where they come from and we don’t know how they are produced, they just feel right. Whether they are right is another matter.”

Hence, how did the availability heuristic evolve is a question worth asking? As Gardner writes: “The availability heuristic is the product of the ancient environment in which our brains evolved. It worked well there. When your ancestor approached the watering hole, he may have thought, “Should I worry about crocodiles? Without any conscious effort, he would search his memory for examples of crocodiles eating people. If one came to mind easily, it made sense to conclude that, yes, he should watch out for crocodiles.

Nevertheless, the world has changed since then. But looks like our minds haven’t and the availability heuristic instead of helping us, continues to trick us.
Getting back to the topic at hand, people who believe that the private equity money coming into real estate will lead to real estate prices not falling, have essentially become victims of the availability heuristic. These people, the smart lot, read business newspapers religiously every day. And in these newspapers they read that a lot of private equity money is being invested in Indian real estate companies. This leads them to conclude that the money problems of all Indian real estate companies are over and hence, real estate prices will not fall. Their “unconscious mind churns out conclusions automatically, without conscious effort.”

Those who believe real estate prices will not fall because of private equity money can easily recall examples of private equity investment in real estate companies. These examples are very easy to recall given that the smart lot reads business newspapers regularly. But the business newspapers only report the news of real estate companies getting investment from private equity firms.

No newspaper talks about those real estate companies which have not received any private equity money and the situation that they are in. And that’s simply because there is no news in it for them. The situation is similar to newspapers and the media talking about airplane crashes though no newspaper or media talks about the thousands of safe airplane landings that happen all over the world every day. This leads people to conclude that airplane travel is unsafe, though it is not.

Along similar lines, the examples of real estate companies getting investment from private equity firms are fairly easy to recall. The opposite is not. The availability heuristic is at work. Hence, the idea that private equity firms are investing in real estate companies seems more common than it actually is.

Now the question is how many Indian real estate companies have actually seen investments from private equity firms? The real estate lobby the Confederation of Real Estate Developers’ Associations of India (CREDAI) claims to have 11,500 real estate developers from 156 cities across 23 states as its members. Only a very small portion of these real estate companies have seen private equity investment.  And those that have seen investments operate largely in the bigger cities.

So that was one part of the analysis. Now let’s get to the second part with some numbers. Crisil has carried out an analysis of India’s top 25 listed real estate companies which make up for 95% of the market capitalization of India’s real estate sector. The analysis is titled The realty reality.

In this analysis Crisil points out that “Rs.35,000 crores or 50 per cent of their residential debt will continue to remain at high refinancing risk.” “With the demand pick-up expected to remain tepid in the near term, developers are heavily dependent on refinancing their existing debt given their highly leveraged balance sheets.”

What does this mean? It means that real estate companies that Crisil studied need to repay Rs 35,000 crore to banks soon. With real estate companies not being able to sell enough homes they are not earning enough to be able to repay these loans. Hence, they need to refinance these loans i.e. borrow more to repay these loans.

The question is with their highly stretched balance sheets will the banks be interested in lending more to developers? The monthly sectoral deployment of credit data released by the Reserve Bank of India (RBI) points out that the total bank lending to commercial real estate grew by a minuscule 2% between September 19, 2014 and September 18, 2015. This, when the overall lending by banks grew by 8.4%.

Now compare this to how things were in September 2014. Bank lending to commercial real estate between September 20, 2013 and September 19, 2014, had grown by a massive 20%. The overall bank lending by banks had grown by a similar 8.6%.

This clearly shows that the lending by banks to real estate companies has slowed down dramatically. Between September 2013 and September 2014 banks lent Rs 26,958 crore to real estate companies. This has crashed to Rs 3,157 crore between September 2014 and September 2015.

In fact, the overall lending to real estate companies by banks is down by 1% during the course of this financial year (actually between March 20, 2015 and September 2015, to be very precise).

And this is clearly reason for worry for real estate companies. As Crisil points out: “Traditionally, bank loans have been the primary source of funding, meeting ~90% of the requirements of India’s top 25 developers. The net exposure of banks to the real estate sector declined 1% in the first half of the current fiscal…However, going forward, incremental bank funding is expected to decline ~5%.”

What this clearly tells us is the banks are not really gung-ho about lending to real estate companies anymore. (As can be seen from the accompanying table).

So what happens from here on? The slowdown in lending from banks explains why real estate companies have been looking at alternative sources of finance through non-convertible debentures and private equity. Data from Crisil points out that the issuances of non-convertible debentures have grown at the rate of 68% per year over the last four years and reached Rs 8,500 crore in 2014-2015. The private equity investments in real estate have also jumped at a very fast rate of 32% per year from Rs 6,600 crore in 2012 to Rs 15,600 crore in 2015.

Over and above this, the recent government moves on foreign direct investment in real estate is also expected to help bring in money into the sector. Earlier foreign direct investment could come into real estate only if the project size was a minimum 20,000 square meters with a minimum capital of $5million.

Further, it was required that foreign investors bring in money within six months. This requirement has also been done away with.

All this is good news for some cash-strapped real estate companies. But can we conclude from all this that with the money flowing back into the sector again, real-estate companies will not cut prices? The first point I would like to make here is that only a small portion of the builders have received money from the alternative routes. The second point is that the alternative routes of raising money come with a very high cost of funding.

As Crisil points out: “The cost of alternative funding has increased over the last two years as pressure on developers financial position intensified. About one-third of the non-convertible debentures issuances last fiscal yielded an internal rate of return of more than 20%, compared with no issuances of similar yields in 2012.”

The same stands true for private equity firms as well. As Crisil points out: “As for private equity [firms], the higher return expectation will increase the refinancing risk for the realtors over the longer term, unless the demand picks up substantially. CRISIL estimates payout for private equity funds for the sector as a whole at Rs 85,000 crore, assuming a return of 20% over a 5 year period. Hence, alternative funding sources such as non-convertible debentures and private equity [firms] are expected to continue providing some respite in the short term only.

What does this mean in simple English? The real estate companies are essentially kicking the can down the road. The money being brought in through the alternative route will also have to be returned. And where will that money come from is a question worth asking?

My guess here is that the money being brought in through non-convertible debentures and private equity firms is being used to pay-off the bank loans of real estate companies that are falling due (It would be great if any Daily Reckoning readers in know of this trend can confirm it by commenting on this column or writing to me at [email protected]). This has allowed the real estate companies to not cut prices. If this money hadn’t come in then the real estate companies would have had to cut prices in order to sell unsold homes to repay their bank loans.

Nevertheless, the non-convertible debentures as well as private equity firms will also have to be repaid in the years to come. As mentioned earlier the returns expected by those providing the alternative sources of finances are very high. They will also have to be eventually be repaid.

And how will that happen? The only way real estate companies can do that is by selling homes. Homes will only sell if they are reasonably priced. At current prices the demand will continue to remain muted. As a recent 99acres’ Insite report points out in the context of the Mumbai real estate market:The market is witnessing demand in the affordable and mid-range segments (Rs 25 lakh to Rs 60 lakh), while supply is in the bracket of Rs 1 crore or more.” So there is clearly good demand at lower prices.

Further, as Crisil puts it: “demand recovery and deleveraging are the only sustainable solutions to the problems staring at the real estate developer community.”

And that ain’t happening without prices falling.

The column originally appeared on The Daily Reckoning on November 20, 2015