Month: February 2016

China Will Continue to Export Lower Prices Across the World

chinaIn June 2014, the Chinese foreign exchange reserves peaked at $3.99 trillion. Since then the foreign exchange reserves have been falling, first gradually and then at a very rapid pace. Between June 2014 and December 2014, the foreign exchange reserves fell by around $150 billion to $3.84 trillion.

In 2015, the foreign exchange reserves fell at a very rapid rate. During the course of the year, the foreign exchange reserves fell by a whopping $512.7 billion. As of December 2015, the Chinese foreign exchange reserves stood at $$3.33 trillion. They fell by a further $100 billion dollars and stood at $3.23 trillion as of the end of January 2016.

What is happening here? Money is rapidly leaving China. Wei Yao and Jason Dew of Societe Generale write in a recent research note: “China is waging an uphill battle against capital outflows. In the past six quarters a cumulative $657 billion of net capital has left China.”

Yao and Dew write that there are three major areas of outflows when it comes to the money that is leaving China. First, the resident banking outflows have amounted to $353 billion. What does this mean? The Chinese are allowed to move up to $50,000 out of China, every year. Hence, banking outflows of $353 billion means that the Chinese are moving their money out of China. It also means that the Chinese banking system is increasingly integrated with the global financial system.

Second, the non-resident banking outflows have been at $248 billion. This means that the non-resident Chinese are withdrawing their money out of the Chinese banking system.

Further, between 2005 and 2013, the Chinese yuan was allowed to gradually appreciate against the dollar. In late 2005, one dollar was worth around 8.3 yuan. By the end of 2013, one dollar was worth around 6.05 yuan.

Many companies used this era of the appreciating dollar to borrow money in dollars. With the yuan appreciating against the dollar, it made sense to borrow in dollars. At a very simplistic level, a company which borrowed a million dollars when one dollar was worth 8.3 yuan would get 8.3 million yuan when it converted the dollars to yuan. When returning this money in 2013, assuming the entire principal amount of the loan needed to be returned in the end, the company needed only 6.05 million yuan to buy the million dollars, it would need to repay the loan. The interest payments in yuan would also have been lower as the yuan appreciated.

Nevertheless, since the start of 2014, the yuan has been depreciating against the dollar. At the beginning of 2014, one dollar was worth 6.05 yuan. Currently it is worth around 6.52 yuan. This basically means that the Chinese companies which had borrowed in dollars will need more yuan to repay the loans. Hence, the loans are being repaid because the fear is that the yuan will continue to depreciate against the dollar in the time to come. These repayments are also showing up in non-resident banking outflows of $248 billion.

The third and the most interesting item of outflow is the net errors and omissions. This is typically a balancing number and is usually close to zero for most countries, write Yao and Dew of Societe Generale. In the Chinese case this number over the last six quarters stands at $327 billion.

What does this mean? It means that the Chinese are moving their money out of China circumventing the existing regulations. What this also tells us is that the Chinese are not confident about the state of the Chinese economy and are now moving their money out of China, through unofficial channels. And that is indeed worrying.

The People’s Bank of China, the Chinese central bank, manages the value of the Chinese yuan against the dollar. When a large amount of money leaves China, people and institutions taking their money out sell yuan to buy dollars. This essentially should cause a shortage of dollars in the market. A shortage would mean that the dollar would appreciate against the yuan or the yuan would depreciate rapidly. Over the years, the Chinese have not allowed the value of the yuan to vary rapidly against the dollar. The value has always been managed.

In order to ensure that the yuan maintains its value against the dollar, the Chinese central bank needs to sell dollars and buy yuan. This ensures that there are enough dollars going around in the financial system and hence, the value of the dollar does not appreciate rapidly against the yuan.

The trouble is that the Chinese central bank does not have an endless supply of dollars. Only the Federal Reserve of the United States, the American central bank, can create dollars of thin air. This explains why it has gone slow in defending the yuan against the dollar, in the recent past, and allowed its currency to depreciate against the dollar.

While $3.23 trillion of foreign exchange reserves may sound like a lot of money, it isn’t. The International Monetary Fund has a methodology for calculating the adequate level of foreign exchange reserves. As Yao and Dew write: “Based on the IMF methodology…our calculations indicate that China’s reserves are at 118% of the recommended level. Reserve adequacy has been deteriorating sharply over the past five years.”

This means that adequate Chinese reserves are to the tune of $2.8 trillion. The rate at which Chinese foreign exchange reserves have been falling, reaching a level of $2.8 trillion shouldn’t take more than six months. Also, it is worth remembering here that these foreign exchange reserves aren’t exactly in a vault somewhere. They have been invested all over the world. And the question is how liquid these investments are. Until when can the Chinese keep selling these investments in order to defend the value of the yuan?

Interestingly, Yao and Dew feel that there is a greater than 60% probability that the People’s Bank of China will move towards a free-float and let the market decide the value of the yuan against the dollar. They also feel that there is a 30% probability that the Chinese central bank will continue to follow the current strategy of trying to defend the yuan and at the same time allow it to depreciate against the dollar, now and then.

Either ways, the value of the yuan against the dollar will be at much lower levels in the months to come.

What will this mean for the world at large? It will mean that Chinese exports will become even more competitive than they currently are. And this will lead to China exporting more deflation (i.e. lower prices) to other parts of the world.

The column originally appeared in Vivek Kaul’s Diary on Equitymaster on February 17, 2016

Moral problem of Swacch Bharat cess

narendra_modi

In November last year, the Narendra Modi government introduced a Swacch Bharat Cess of 0.5%. As the press release announcing the decision said: “Swachh Bharat Cess is not another tax but a step towards involving each and every citizen in making contribution to Swachh Bharat…The proceeds from this cess will be exclusively used for Swachh Bharat initiatives.”

In short, the money raised from this cess would be used for keeping India clean. The government hopes to raise close to Rs 10,000 crore through this cess, during the course of a full financial year.

There are several questions that this new cess raises. The first being that if the government has to introduce a cess to keep India clean, then what does it use its main tax revenues for? If a portion of these tax revenues are not being spent on something as important as keeping India clean, then what is the point in taxing citizens?

Nevertheless, there is a more important question that needs to be raised here. Should the government be taxing citizens to keep the country clean? An economist might believe that this is the right thing to do but the introduction of cess has diluted the moral incentive that citizens have to keep the areas that they live in, clean.

What does this mean? Let’s try and understand this through something that happened in Israel. As philosopher Michael Sandel writes in What Money Can’t Buy—The Moral Limits of Markets: “Often, market incentives erode or crowd out non market incentives. A study of some child-care centres in Israel shows how this can happen. The centres faced a familiar problem: parents sometimes came late to pick up their children. A teacher had to stay with the children until the tardy parents arrived. To solve this problem, the centres imposed a fine for late pickups. What do you suppose happened? Late pickups actually increased.”

What happened here? The child-care centres actually introduced a fine for parents turning up late. The idea was that with the threat of a fine hanging over their heads, the parents would come on time to pick-up their kids. Economic thinking was at work. But what happened was exactly the opposite.

The question is why? As Sandel writes: “Introducing a monetary payment changed the norms. Before, parents who came late felt guilty; they were imposing an inconvenience on the teachers. Now parents considered a late pickup as a service for which they were willing to pay. They treated the fine as it were a fee. Rather than imposing on the teacher, they were simply paying her to work longer.”

The introduction of a fine was basically treated by the parents as a fee and this led to the opposite result. As economist Dani Rodrik writes regarding the same study in his book Economics Rules: “A moral injunction that previously had kept parents’ behaviour in check was relaxed once the monetary penalty came into play.”

Now how is this linked to the Swacch Bharat Cess? Until the cess was introduced, any conscientious citizen would feel guilty when he saw garbage in his locality or in his area of work. He would think twice before littering as well.

This moral incentive changed the moment people started paying the Swacch Bharat Cess. Now the citizen is paying the government to make sure that his area of work or residence remains clean. And if that is not the case, then it is clearly not his problem, given that he has done his bit by paying a cess (or a fee) to the government.

Sandel summarises the situation best when he says: “Putting a price on the good in life can corrupt them…[and] also corrupt the meaning of citizenship.” And this is something those who introduced the Swacch Bharat Cess need to carefully think about.

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])
The column originally appeared in the Bangalore Mirror on February 17, 2016

Taxpayers will have to Pick-Up the Final Bill of the Mess in Govt Banks

rupee

 

In a column I wrote last week I said that I was happy that the profit of the State Bank of India, the country’s largest bank, had fallen by 62%. Along the same lines I need to say that I am happy that the Bank of Baroda has made a loss of Rs 3342 crore, for the period October to December 2015. This is the biggest loss ever made by any Indian bank. In fact, the losses would have been higher if not for a Rs 1,118 crore tax write-back that the bank got.

Over the years, banks have not been recognising bad loans as bad loans. This process that has started now and is bringing out the real state of the Indian public sector banks and that is a good thing. In case of Bank of Baroda, the gross non-performing loans (or bad loans) of the bank jumped by 152% to Rs 38,934 crore, in comparison to as on December 2014. In percentage terms, the bad loans as of December 2015 stand at 9.68% of total lending in comparison to 3.85% in December 2014.

What this clearly tells us is that the Bank of Baroda, like the other public sector banks, had been under-declaring its bad loans up until now. This can be easily said from the fact the bad loans as a percentage of total loans, as on September 2015, had stood at 5.56%. By December 2015, this had jumped up by 412 basis points to 9.68%. One basis point is one hundredth of a percentage.

The situation could not have become so bad over a period of just three months. This clearly tells us that the bank had not been putting out the correct situation of its loans earlier. But now that it is, the stock market is clearly happy about it, with the stock rallying by 22% to Rs 139.55 as on February 15, 2016.

It needs to be pointed out here that the public sector banks are finally getting around to presenting the right set of accounts because the RBI led by Raghuram Rajan has pushed them to do so, by unleashing the asset quality review on to them.

As Rajan pointed out in a recent speech: “ With markets generally in decline, the decline in bank share prices has been more accentuated. However, part of the reason is that some bank results, mainly public sector banks, have not been, to put it mildly, pretty. Clearly, an important factor has been the Asset Quality Review (AQR) conducted by the Reserve Bank and its aftermath.”

This leads to the question as to what was the RBI doing all these years, especially in the pre-Rajan years given that such a huge build-up of bad loans couldn’t have happened overnight.

Also, it needs to be clarified here that a bad loan doesn’t mean that the bank has lost all the money. This seems to be the general understanding and is incorrect. A loan is typically declared to be a non-performing asset (or a bad loan), 90 days after the borrower starts defaulting on the interest and principal payments. When this happens a bank can no longer continue to accrue interest on the portion of the loan that remains unpaid. It has to start making provisions i.e. start keeping money aside.

This basically means that the bank starts keeping money aside so that if the loan is totally defaulted on or partially defaulted on or the bank cannot recover enough money from the assets that it has as a collateral, then enough money has been set aside to meet the losses.

Along these lines, the Bank of Baroda has increased its provisioning. For October to December 2015, the bank set aside Rs 6,165 crore. This is an increase of 389% in comparison to the money it had set aside for September to December 2014.

The question is even with this huge jump in provisioning, is the bank setting aside enough? The Reserve Bank of India(RBI) Master Circular on Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances: “Banks should build up provisioning and capital buffers in good times i.e. when the profits are good, which can be used for absorbing losses in a downturn. This will enhance the soundness of individual banks, as also the stability of the financial sector. It was, therefore, decided that banks should augment their provisioning cushions…and ensure that their total provisioning coverage ratio…is not less than 70 per cent.”

The provisioning coverage ratio is defined as the total provisions set aside by a bank as on a particular date divided by the total gross non-performing assets (bad loans) of the bank as on the same day.

The RBI wants banks to maintain a provision coverage ratio of 70%. But that doesn’t seem to have happened. In fact, as a recent news-report in The Indian Express points out: “An analysis of provisioning coverage ratio data of 20 public sector banks for March 2011 to March 2015 shows a steady fall in the coverage ratio. It has dropped from an average of 72 per cent for the group of 20 banks in the year-ended March 2011 to 57 per cent for the year-ended March 2015.”

In fact, for Bank of Baroda, the provisioning coverage ratio as on March 31, 2015, had stood at 64.99%. Since then, despite the absolute jump in provisioning, the provisioning coverage ratio of the bank has fallen to 52.70%. So, the bank clearly is not setting aside enough money against its bad loans, even though its setting aside more money in absolute terms, than it has done in the past.

How do things look for other banks? Let’s take the case of Punjab National Bank, the second largest public sector bank. The provisioning coverage ratio of the bank as on March 31, 2015, was at 58.21%, since then it has fallen to 53.85%. The same is the case with the State Bank of India. The ratio has fallen from 69.13% to 65.23%.

So none of the bigger public sector banks are fulfilling the provisioning coverage requirement of 70% as required by the RBI. What this tells us is that if the banks work towards achieving this ratio in the coming quarters, the losses of these banks will only go up. This would also mean eating into the capital of the bank.

Also, it is worth asking here what portion of the bad loans will the public sector banks be able to recover? The answer is not encouraging if we look at the numbers of the two biggest banks—the State Bank of India and the Punjab National Bank.

During the course of this financial year, the State Bank of India has managed to recover loans of Rs 2,761 crore. During the period its bad loans jumped up from Rs 56,725 crore to Rs 72,792 crore.

How do things look for Punjab National Bank? During the course of this financial year, the bank has managed to recover loans worth Rs 6,382 crore. During the same period, the bad loans of the bank have jumped from Rs 25,695 crore to Rs 34,338 crore. For both, State Bank of India as well as Punjab National Bank, there has been a huge jump in the loans recovered in comparison to April to December 2014. Nevertheless, the total amount of bad loans has gone up as well, in effect negating the recoveries. And this doesn’t augur well for the banks.

My guess is that public sector banks losses will eat into their capital in the months and years to come and the government (i.e. the taxpayer) will have to keep coming to their rescue by infusing fresh capital into these banks. Since 2010, the government has pumped in Rs 67,734 crore into public sector banks. It will have to put in a lot more money in the days to come.

As Michael Pettis writes in The Great Rebalancing: “Traditionally the cost of a banking crisis is borne directly or indirectly by households. Whether it is in the form of foregone deposits, government bailouts funded by household taxes…Households always foot the bill for banking crisis.”

The situation in India will be no different.

The column was originally published in the Vivek Kaul Diary on Equitymaster on February 16, 2016

Rajan Explains what’s Exactly Wrong with Public Sector Banks

ARTS RAJAN
In a speech he made last week Raghuram Rajan, the governor of the Reserve Bank of India, put forward some very interesting data points.

It is well known by now that the lending growth of public sector banks has been very slow as they grapple with burgeoning bad loans. Nevertheless, agglomerated data on the loan growth of public sector banks is generally not available in the public domain.

As Rajan said: “Non-food credit growth from public sector banks, the more stressed part of the system, grew at only 6.6% over the calendar year 2015. Industrial credit growth for PSBs was only 3.3% while growth in lending to agriculture and allied lending was only 10.4%. The only area of strength was personal loans, where growth was 16.9 %.”

Banks give out loans to the Food Corporation of India to run its operations. After adjusting for these loans, what remains is the non-food credit growth. The overall non-food credit in 2015 grew by around 9.3% (actually between December 25, 2014 and December 24, 2015) against 6.6% of public sector banks. This tells us very clearly that the loan growth of public sector banks has been significantly slower than the overall loan growth of banks.

In fact, the only area where lending of public sector banks has been robust enough is what RBI refers to as personal loans. These personal loans are different from what banks refer to as personal loans. Personal loans as categorised by RBI include home loans, vehicle loans, education loans, credit card outstanding, loans given against fixed deposits, shares and bonds and what banks call personal loans.

How does the situation of public sector banks look in comparison to private sector banks? As Rajan said: “In contrast, non-food credit growth in private sector banks was 20.2 %, in agriculture 25.4%, in industry 14.6%, and 23.5% in personal loans. Put differently, in each of these areas except personal loans, loan growth in private sector banks was at least 10 percentage points higher than public sector banks, while loan growth in personal loans was 6.6 percentage points higher.”

The loan growth of private sector banks at 20.2% was significantly higher than that of public sector banks at 6.8%. As Rajan put it: “The most plausible explanation I have is that the stressed balance sheet of public sector banks is occupying management attention and holding them back, and the only way for them to supply the economy’s need for credit, which is essential for higher economic growth, is to clean up. The silver lining message in the slower credit growth is that banks have not been lending indiscriminately in an attempt to reduce the size of stressed assets in an expanded overall balance sheet, and this bodes well for future slippages.”

Hence, public sector banks have been going slow on lending primarily because they already have a huge amount of bad loans piled up and they don’t want to continue to lend indiscriminately and have more bad loans piling up. What Rajan is essentially saying here is that the public sector banks could have continued on their indiscriminate lending spree and expanded on their loan books. In the process, the total amount of bad loans as a proportion of the total loans given out by banks, would have come down, at least for a short-time.

The fact that they did not do that is a good thing, feels Rajan. But the damage of their indiscriminate lending in the past is now coming out in the open. Take a look at the following table.

 

Extent of the problem

The bad loans plus restructured assets plus the assets written off in total made up for 17% of the books of public sector banks. This means that for every Rs 100 of loan given by public sector banks, Rs 17 worth of loans are in dodgy territory. Rs 6.2 have become a bad loan, where the repayment of the loan by the borrower has stopped happening. Rs 7.9 has been restructured i.e. the repayment of the loan has been placed in a moratorium for a few years. In some cases, the borrower does not have to pay the interest during the moratorium period. In some other cases the tenure of the loan has been extended. Further, Rs 3 out of every Rs 100 has been written off, with no hope of recovery of the loan.

Now how do private sector banks and foreign banks perform on the same parameters? Take a look at the following table.

Divergent NPA trends

What the table tells us very clearly is that the situation in private banks and foreign banks is significantly better than public sector banks. In private sector banks Rs 6.7 out of every Rs 100 of loans is in dodgy territory. In case of foreign banks, the number is even lower at Rs 5.8.

What this tells us very clearly is that the problem of bad loans is largely limited to public sector banks. And it is interesting that the large borrowers are primarily responsible for the mess in the banking system. This becomes clear from the following table. Public sector banks make up for close to three-fourths of the Indian banking system.

Divergent NPA trends

 

As can be seen from the table medium and large industries are primarily responsible for the mess in the banking sector. Rajan also said during the course of his speech that all bad loans were not because of malfeasance.  As he said: “Let me emphasize that all NPAs are not because of malfeasance. Indeed, most are not. Loans can go bad even if the promoter has the best intent and banks do the fullest due diligence before sanctioning. Nevertheless, where there is evidence of malfeasance by the promoter, it is extremely important that the full force of the law is brought against him, even while banks make every effort to put the project, and the workers who depend on it, back on track.”

Let’s sincerely hope that this happens, else we will have a situation where banks will have to write off more and more of their bad loans, with the taxpayer having to pick up the ultimate bill. And that can’t possibly be a good thing.

The column originally appeared on the Vivek Kaul Diary on February 15, 2016

Do Lower Interest Rates Revive Consumption? Not Always

ARTS RAJAN
The Reserve Bank of India governor Raghuram Rajan presented the sixth monetary policy statement for this financial year, earlier this month. In the policy he decided to maintain the status quo and not change the repo rate. Repo rate is the rate at which RBI lends to banks, which acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

After the policy, the representatives of the industry protested and said that they were expecting a repo rate cut, which would revive consumption as well as investments. As Chandrajit Banerjee, director of business lobby CII, said: “A rate cut would have been spot-on for rejuvenating the investment cycle. We hope RBI would resume the rate-cutting cycle in the subsequent monetary policy soon after the Union Budget to complement the government’s efforts to revive private investments and bring the economy back to sustained growth.”

Getamber Anand, president of real estate lobby CREDAI, echoed Banerjee’s sentiments, when he said: “We are very disappointed. We were expecting a 25 basis points reduction in the repo rate.” He also said that home loan interest rates should be lower than 9%.

The belief is that at lower interest rates people borrow and spend more, and industries also invest more. This sounds very convincing but is essentially very simplistic thinking that lobbyists try to peddle.

Conventional thinking assumes a negative relationship between consumption and interest rates. But that is also a function of how people save money. Michael Pettis in his book The Great Rebalancing—Trade, Conflict, And the Perilous Road Ahead for the World Economy makes a very interesting point about China.

As he writes: “Most Chinese savings, at least until recently, have been in the form of bank deposits. In a financial system in which deposit rates are set by the central bank, the value of bank deposits is positively, not negatively, correlated with the deposit rate. Chinese households, in other words, should feel richer when the deposit rate rises and poorer when it declines, in which case rising rates should be associated with rising, not declining, consumption.”

Given that a large portion of the financial savings are invested in bank deposits, any rise in interest rates should make people feel richer and in the process make them consume more.

Vice versa, any fall in interest rates should make people feel poorer and lead to lower consumption. Further, if the interest rate on deposits is lower than the rate of inflation, or around the rate of inflation, or not substantially different from the rate of inflation, any rise in interest rates should lead to a higher consumption.

As Pettis writes: “If deposit rates do not reflect market conditions—most important, inflation rates…then bank deposits, who measure their wealth in terms of the expected real return on their depositors, should welcome rising rates and deplore declining rates.  The former should make them feel richer and so increase their consumption and the latter make them feel poorer.”

This is something that is largely applicable to India as well. While the central bank does not set interest rates on fixed deposits as such, large portions of household financial savings are invested in bank deposits, provident and pension fund schemes (with a significant portion of these schemes being run by the post office). In these investments, as interest rates go up, people feel richer.

In 2012-2013, the 54.4% of household financial savings were in bank deposits and provident and pension fund schemes. Nearly 16.2% of household financial savings were held in the form of cash. Only 6.62% of household financial savings were invested in stocks and debentures. 24.4% of the savings were invested in life insurance, where it is next to impossible to figure out what returns to expect.

In 2011-2012, 56.7% of the household financial savings were invested in bank deposits and provident and pension fund schemes. In 2010-2011, 51% of the savings were invested in deposits and provident and pension fund schemes.

The point being that a major portion of household financial savings get invested in bank deposits and pension and provident fund schemes. This means when interest rates go up or are high, people are more likely to spend more.

Also, the another point that people forget is the multiplicity of needs. Not everyone is looking to borrow and spend when interest rates fall. As Malhar Nabar writes in an IMF Working Paper titled Targets, Interest Rates, and Household Saving in Urban China: “China’s households save to meet a multiplicity of needs – retirement consumption, purchase of durables, self-insurance against income volatility and health shocks – and act as though they have a target level of saving in mind. An increase in financial rates of return, which raises the return on saving, makes it easier for them to meet their target saving.”

This is a point that needs to be taken into account. It applies as much to India as it does to China. People are trying to save money for emergencies as well their retirement, education and weddings of their children and so on. And this lot gets hurt every time the interest rate on their deposits goes down.

This means they need to save more and consume less when interest rates go down. Hence, lower interest rates do not lead to an increase in consumption for everybody. The truth is a lot more nuanced than that.

There is another point that needs to be made here. Between December 2014 and December 2015, the disbursal of personal loans (the term RBI uses for home loans, education loans, vehicle loans, loans against shares, bonds and fixed deposits, and what we call personal loans) went up by 16.1%. This after the RBI cut the repo rate by 125 basis points during the course of the year. One basis point is one hundredth of a percentage.

How good was the personal loan growth between December 2013 and December 2014? 15.3%.

Hence, the difference in personal loan growth for the one-year period ending December 2014 and the one-year period ending 2015 is not substantial, despite lower interest rates. One explanation for this lies in the fact that banks have not passed on the entire benefit of the repo rate cut to the end consumers.

The other reason lies in the fact that not everybody is looking to borrow. Those looking to save are hurt by lower interest rates and end up consuming lesser in order to meet their target saving. And this is a point that doesn’t get discussed enough, given that it isn’t so obvious.

The column originally appeared in the Vivek Kaul Diary on Equitymaster on February 11, 2016