Month: April 2017

Why is Narayana Murthy so angry

In the recent past, Infosys co-founder and former chairman NR Narayana Murthy, has been critical of the salary hikes the company has been giving its top management. Other former executives of the firm have also criticised it.

The most recent example is that of the company giving a hike to its chief operating officer UB Pravin Rao. The company has said that the hike will apply over a number of years. It said that the hike could “go up to 33.4% in year 4, assuming similar grants are made in subsequent years based on company and individual performance.”

Murthy on the other hand feels that the top management should not be taking such high salary increases when most employees have got just a 6-8 per cent hike.

The high salaries of top management vis a vis the salaries of normal employees, has been an issue across large parts of the world. The belief, at least at the board levels of companies is that the top management is getting paid adequately for bringing enough value to the company. Of course, nobody bothers to define the word value.

The question that arises here is: Does the top management impact the performance of companies? And with that logic, does it make sense to pay them more?

Of course the top management does impact performance. It would be silly to say no. The direction the company takes in the future is decided by the top management of the company. At the same time, the impact that the top management has on the performance of companies, is not as much as it is made out to be.

As Daniel Kahneman writes in Thinking, Fast and Slow: “CEOs do influence performance, but the effects are much smaller than a reading of the business press suggests.” The business press tends to make heroes out of the top managements of companies. If a company is doing exceptionally well, the typical conclusion that is drawn is that it is doing well because of the CEO and the other top management.

As James Kwak writes in Economism—Bad Economics and the Rise of Inequality: “The idea that good CEOs are entitled to enormous rewards is based on the belief that success or failure of a company depends on one person—what historian Nancy Koehn calls the Great Man theory of history”

Given this belief it is not surprising that the CEOs and the top management get paid as much as they do. But the link between top management pay and the continued success of a company isn’t so high. As Kahneman writes: “Researchers measure the strength of relationships by a correlation coefficient, which varies between 0 and 1… A very generous estimate of the correlation between the success of the firm and the quality of its CEO might be as high as .30, indicating a 30% overlap.”

Hence, the link between CEO quality and the success of the firm is not very strong. What is forgotten is that business at the end of the day is a team game. The top management sitting at the headquarters can only do so much to keep ensuring that the company continues to be as successful as it was in the past.

As Kwak writes: “Business is a team sport… Because no one knows what a CEO is worth, her pay is whatever she can convince her corporation’s board of directors to give her.”

Also, luck plays a big role in the success or failure of a CEO. As Kwak writes: “A 2001 study by Marianne Bertrand and Sendhil Mullainathan found that high CEO pay is often the result of dumb luck. For example, they found that heads of oil companies were paid more when profits increased, even when those profits were simply due to rising oil prices.”

Hence, as Kahneman concludes: “Because luck plays a large role, the quality of leadership and management practices cannot be inferred reliably from observations of success.” Once you take these factors into account, it is not surprising that Narayana Murthy is angry.

The column was originally published in the Bangalore Mirror on April 12, 2017

Why Suddenly There is No Cash in ATMs

Over the last few days there have been a spate of media reports about cash not coming out of ATMs. “Bengalureans were greeted with ‘No Cash’ boards at most ATMs on Monday [April 10,2017],” reports the Deccan Chronicle.

“The arid days of demonetisation are back to haunt Mumbaikars. Ten days after the banking sector’s yearly closing on March 31, ATMs continue to run dry across the city,” reports The Times of India.

The New Indian Express reports that the cash crunch has made a comeback to the city of Visakhapatnam, with majority of the ATMs running out of cash.

“Although the new financial year is in its second week, a majority of ATM kiosks in Pune continue to run dry while citizens run from one kiosk to another to withdraw cash,” reports The Indian Express.

The Hindu reports that “cashless ATMs and serpentine queues outside banks have once again become the norm,” in Hyderabad.

I guess I will stop here. This is enough to establish that there really is a problem and currency at ATMs is in short-supply.

So, what is happening here? The explanation that has been offered is that this cash shortage has been because of the March 31st, year-end for banks. While that clearly might be a reason, there are other reasons at work here as well. Allow me to explain.

Since January 2017, the currency in circulation has been increasing every week. This has been happening with the printing presses of the Reserve Bank of India and the government, printing and pumping money into the financial system through banks. Take a look at Figure 1.

Figure 1 

As can be seen form Figure 1, the currency under circulation has been going up from January 6, 2017, as the RBI and the government have printed and pumped money into the financial system.

But is that enough? What we also need to take a look at is the rate at which the currency in circulation has risen week on week since January 6, 2017. How is this obtained? The currency in circulation as on January 6, 2017, was at Rs 8,98,017 crore. This increased to Rs 9,50,803 crore as on January 13, 2017. This meant a jump of Rs 52,786 crore or around 5.9 per cent (Rs 52,786 crore divided by Rs 8,98,017 crore). A similar calculation is carried out for the remaining weeks as well.

Take a look at Figure 2. It plots the rate at which currency circulation has been increasing week on week since January 6, 2017.

Figure 2: 

Figure 2 makes for a very interesting reading. The highest increase in the rate of increase in currency circulation came in the period of one week ending January 13, 2017, at 5.9 per cent. Since then the overall trend has been down, with jumps in between. Having said that, the rate of increase in currency circulation has seen a downward trend between March 10 and March 31, 2017.

The rate of increase in currency in circulation for the week ending March 31, 2017, was at the lowest level since January 2017, at 1.7 per cent. What does this mean? It means that the RBI is not releasing currency to the banks at the same pace as it was in the past. The rate of currency release at RBI’s level has come down. And that basically means banks don’t have enough currency/cash to load into ATMs as they had in the past.

This explains why there has been shortage of currency at ATMs. It could also mean that the RBI and the government printing presses are not printing as much currency as they were doing in the past. Why is this happening is something only the central bank and the government can explain.

If this is being done knowingly to bring down the total amount of currency in the system, then it’s a rather stupid move. Any economy needs a certain amount of currency to function. The Indian economy as of now does not have an adequate amount of it. The total currency in circulation as on March 31, 2017, was at 74.3 per cent of the level of the pre-demonetisation level. Unless we get back to a similar level, some currency shortage is likely to continue.

If the government decides not to print and pump in as much currency as there was in the pre-demonetisation era, it will have an impact on the total number of economic transactions carried out in the economy. And that possibly is not a good thing.

Further, the fact that ATMs are running out of cash tells us that the demand for currency continues to be high. This basically means that the digital medium of payments hasn’t really caught on despite the best efforts of the government.

To conclude, as the old jungle saying goes, when you don’t know where you are going, the journey is the reward.

The column originally appeared on Equitymaster on April 11, 2017

Dear Mr Urjit Patel, Have You Ever Heard of Wasim Barelvi?

For a man who rarely and barely speaks, the Reserve Bank of India governor Urjit Patel spoke quite a lot in the press conference that happened after the first monetary policy of this financial year was presented on April 6, 2017.

In response to the question, “What do you think are the implications of the farm loan waiver schemes and is it a cause of concern for the RBI?”, Patel had this to say: “There are several conceptual issues, if one were to put one’s hat as an economist on. I think it undermines an honest credit culture, it impacts credit discipline, it blunts incentives for future borrowers to repay, in other words, waivers engender moral hazard. It also entails at the end of the day transfer from tax payers to borrowers. If on account of this, overall Government borrowing goes up, yields on Government bonds also are impacted. Thereafter it can also lead to the crowding out of private borrowers as higher government borrowing can lead to an increase in cost of borrowing for others. I think we need to create a consensus such that loan waiver promises are eschewed, otherwise sub-sovereign fiscal challenges in this context could eventually affect the national balance sheet.”

Basically in one paragraph, Patel summarised all that is wrong about waiving off farmer loans or in fact, any loan. I had discussed most of these issues in my Diary dated April 5, 2017, last week.

The first issue that a waive-off of bank loans creates is that of a moral hazard. The economist Alan Blinder in his book After the Music Stopped writes that the “central idea behind moral hazard is that people who are well insured against some risk are less likely to take pains (and incur costs) to avoid it.”

This basically means that once the farmer sees a loan being waived off today, he will wait for elections in the future for the newer loans he takes on to be waived off as well. Essentially, he will see little incentive in repaying loans that he takes on in the future. Or as Patel put it: “it impacts credit discipline, it blunts incentives for future borrowers to repay”.

The second issue that a waive-off of bank loans creates is that it can lead to the crowding out of private borrowers. The state government waiving off the bank loans needs to compensate banks which had given these loans. In case of the Uttar Pradesh government which recently wrote off the loans, this amounts to Rs 36,359 crore. The government will have to borrow this amount in order to pay the banks simply because its earnings are lesser than its expenditure.

When a government borrows more, it leaves a lesser amount of money for others to borrow. This can push up interest rates and as Patel aptly puts it, “higher government borrowing can lead to an increase in cost of borrowing for others”. What also needs to be taken into account here is the fact that the Uttar Pradesh government waive-off might inspire other state governments to waive-off farmer loans as well. This will mean greater government borrowing and a higher crowding out effect.

It will also lead to the overall fiscal deficit of the nation (i.e. fiscal deficits of state governments plus that of the central government) going up. Fiscal deficit is the difference between what a government earns and what it spends during the course of a year. The difference between the earning and the spending is met through borrowing.

If several state governments waive-off bank loans and borrow more, it will lead to the national fiscal deficit going up. As Patel puts it: “sub-sovereign fiscal challenges in this context could eventually affect the national balance sheet.”

So far so good. It is nice to see the RBI governor speak out against what is essentially bad economics and can screw up the economic and financial situation of the nation. Nevertheless, the question is where has all this forthrightness been when it comes to the issue of corporate defaults and loan write-offs?

As is well known, corporates have defaulted on several lakhs of crore of bank loans over the years. These defaulters have been treated with kid gloves. Over the years, a huge amount of corporate loans have been written off. It needs to be mentioned here that loans written off are different from loans being waived off, at least theoretically.

This is something I discuss in detail in my new book India’s Big Government—The Intrusive State and How It is Hurting Us. The loans written off are no longer be a part of the balance sheet of the bank, even though they can be recovered in the future. There is no chance of recovery in case of a loan that is waived off. Hence, theoretically there is a difference between a write-off and a waive-off.

Let’s try and understand this issue in a little more detail. Let’s first take the case of the State Bank of India. As of April 1, 2015, the bank had Rs 56,725 crore of bad loans, or gross NPAs. During the course of the year, Rs 4,389 crore of bad loans was recovered. At the same time, the bank wrote off Rs 15,763 crore of bad loans. The loans written off would no longer be a part of the balance sheet of the bank, even though they could be recovered in the future.

As we can see in case of the State Bank of India, the total amount of the loans written off during the year was more than three times the total amount of the loans recovered. That tells us the sad state of the loan recovery process. There were also fresh bad loans that were added to the balance sheet of the bank during the course of the year, and by March 31, 2016, the total bad loans of the bank had slipped to Rs. 98,173 crore.

Or take a look at Table 1 which shows the overall scenario comparing write-offs and recoveries.

Table 1: Write-offs versus recoveries of public sector banks

Write-offs versus recoveries of public sector banks

YearWrites-Offs
(in Rs. Crore)		Recoveries
(in Rs. Crore)
2015-201659,54739,534
2014-201552,54241,236
2013-201434,40933,698
2012-201327,23119,832

Source: Reserve Bank of India

As is clear from Table 1, write-offs of public sector banks have been greater than their recoveries. And the absolute difference between the two has only gone up over the years. A bulk of these loans are corporate loans. Hence, it is safe to say on the basis of this data that a large portion of corporate loans which are written-off are over the years, are practically waived-off because banks are really not able to recover these loans.

Hence, if the issue of moral hazard comes up with farmer loan waive-offs, it also comes up with corporate loan write-offs. And given that a large portion of what is technically a write-off is actually a waive-off, the case for moral hazard in this case is really very strong. The RBI governor Patel could have talked about this as well, given that he has been in office for more than seven months now.

Over and above this, corporate loan write-offs have led to the situation of diminishing bank capital. This has led to the central government having to recapitalise the public sector banks over the years. Between 2009 and now, the amount of money put in has been greater than Rs 1,30,000 crore. This money is ultimately borrowed by the government and leads to crowding out, higher interest rates and a weaker national balance sheet. All these issues pointed out by Patel in case of farm loan waive-offs apply to corporate write-offs as well.

But a word hasn’t been spoken against them.

In the Diary dated March 22, 2017, I had quoted the British author George Orwell. In his book Animal Farm, Orwell writes: “All animals are equal, but some animals are more equal than others.” The point being, if there is a moral hazard for the farmer, there is also one for corporates. And if the RBI governor has pointed out one, he should have pointed out the other as well.

Over the weekend, I came across a very interesting couplet which makes the same point has George Orwell did in the Animal Farm, but rather more forcefully.

As Wasim Barelvi, probably the greatest Urdu poet alive today, writes:

“Garib lehron par pehren bithaye jaate hain
samundaron ki talashi koi nahi leta”.

(I couldn’t come across a good translation of this couplet. Hence, I am leaving it untranslated. But its basic meaning is the same as the line from Orwell’s Animal Farm, quoted earlier).

The column originally appeared on April 10, 2017 on Equitymaster

When the Bank Has a Problem

In last week’s column, I wrote about the Orwellian Economics of Indian banking. The basic premise of the column came from something that George Orwell wrote in his book Animal Farm: “All animals are equal but some animals are more equal than others.”

This is clearly being seen in Indian banking, in the way the banks treat loan defaulters. The small borrowers including small businesses, feel the full force of the bank’s system, in case they end up defaulting on the loan. Banks make all the effort to sell the collateral offered against the loan in order to recover the loan. In comparison, big corporates who default on the big loans, are treated with kid gloves.

A few readers emailed and wanted me to write a little more on this issue. So, here we go.

John Kenneth Galbraith writing in The Culture of Contentment makes an excellent point about the structure of the banking system. As he writes: “The man or woman who borrows $10,000 or $50,00 is seen as a person of average intelligence to be dealt with accordingly. The one who borrows a million or a hundred million is endowed with a presumption of financial genius that provides considerable protection from any unduly vigorous scrutiny.”

And how does this impact the way the banks lend money to prospective borrowers? As Galbraith writes: “This individual deals with the very senior officers of the bank of financial institution; the prestige of high bureaucratic position means that any lesser officer will be reluctant, perhaps fearing personal career damage, to challenge the ultimate decision. In plausible consequence, the worst errors in banking are regularly made in the largest amount by the highest officials.”

This is the self-destructive nature of the system. What this essentially means that the managers running banks are in awe of the promoters and managers of large corporates, who come to them to borrow money.

In the Indian context, what also does not help is the fact that public sector banking makes up for close to three-fourths of the banking system. A major part of the public-sector banks are ultimately owned by the central government. In this scenario, politicians end up influencing who the banks lend money to.

This at times includes companies and promoters whom the politicians are close to. The lending has nothing to do with the investment potential of a project for which money is being borrowed. This is a sort of a quid pro quo for the corporates financing the electoral costs of politicians and political parties.

In fact, sometimes the corporate promoter taking the loan brings in very little of his own money into the project. As former RBI governor Raghuram Rajan said in a November 2014 speech: “The reason so many projects are in trouble today is because they were structured up front with too little equity, sometimes borrowed by the promoter from elsewhere. And some promoters find ways to take out the equity as soon as the project gets going, so there really is no cushion when bad times hit.”

What this means in simple English is that lenders with political connections invest very little of their own money into the project they are majorly financing through the bank debt. This is something that the banks should catch on to during the time they carry out the due diligence of the project. But they clearly don’t due to the reasons offered above and that is why the Indian banks are currently in the mess that they are.

So, what is the way out of it? The long-term solution lies in the fact that politicians stop interfering with the lending process of public sector banks. And that can only happen if most even if not all these banks are privatised.

Until then, it is worth remembering what John Maynard Keynes said about banks: “If you owe your bank a hundred pounds, you have a problem. But if you owe your bank a million pounds, it has.”

 

The column originally appeared in the Bangalore Mirror on April 7, 2017

Of Section 269ST and Black Money-The More Things Change, the More They Remain the Same

In the budget speech made on February 1, 2017, the finance minister Arun Jaitley had said: “The Special Investigation Team (SIT) set up by the Government for black money has suggested that no transaction above Rs 3 lakh should be permitted in cash. The Government has decided to accept this proposal.” Black money is basically money earned through legal or illegal means but on which tax has not been paid.

In the Finance Bill (which is what the budget is) that was finally passed on March 30, 2017, this limit was reduced to Rs 2 lakh. This has led to the addition of Section 269 ST in the Income Tax Act. This is how the Section 269 ST reads: “No person shall receive an amount of two lakh rupees or more— (a) in aggregate from a person in a day; or (b) in respect of a single transaction; (c) in respect of transactions relating to one event or occasion from a person, otherwise than by an account payee cheque or an account payee bank draft or use of electronic clearing system through a bank account.”

Basically, the introduction of Section 269ST into the Income Tax Act does not allow transactions of greater than Rs 2 lakh in value to be carried out in cash. On the face of it, like many other government moves in the past, this seems like a good move. Indeed, this seems like a move with noble intentions given that it intends to move people towards digital transactions. And as people move towards digital transactions, the number of transactions carried out in black will come down.

In fact, the history of the Indian government (and I don’t just mean the current one) is littered with examples of decisions carried out with noble intentions. But in the end these decisions either do not make a material difference or go against the people they are supposed to benefit. Much of my new book India’s Big Government—The Intrusive State and How It is Hurting Us deals with this basic issue.

Getting back to the issue at hand. What does the Rs 2 lakh limit on cash transactions really mean? You cannot receive more than Rs 2 lakh in cash from a single person in cash in a day. So, if you receive Rs 3 lakh from the same person during a single day, even for two or more different transactions, then a penalty will be levied on you.

As the newly inserted Section 271DA of the Income Tax Act points out: “If a person receives any sum in contravention of the provisions of section 269ST, he shall be liable to pay, by way of penalty, a sum equal to the amount of such receipt.” This basically means that in the above example, the penalty shall work out to Rs 3 lakh.

Further, the penalty shall also apply in other situations. Let’s say there’s a single transaction of Rs 3 lakh and cash payments are made on three different days. Even in this case, the receiver of the payment will be liable to pay a penalty.

The third situation is the most tricky of the lot. It limits cash payments of greater than Rs 2 lakh relating to one event or occasion from a person. The words event and occasion have not been defined.  Now let’s consider a marriage. In case of a marriage, this would mean that any payment of more than Rs 2 lakh in cash cannot be made to one of the suppliers. If such a payment is made, then the suppler is liable to pay a penalty.

One could also interpret this section with regard to cash gifts that are received during the course of a wedding. One interpretation of this can possibly be that a cash gift of more than Rs 2 lakh cannot be received from a single person. This would also include gifts from “relatives” as defined by the Income Tax Act, who are allowed to gift any amount of money.

So far so good. As I said the intentions are very noble indeed. Nevertheless, the first question is how will the government and more specifically the Income Tax department figure out that cash transactions of greater than Rs 2 lakh are taking place? Typically, such large cash transactions are carried out only if the two parties do not want the government to know about it, and in the process avoid paying tax on the transaction.

How does Section 269ST change that in anyway? Let’s say you go to buy a luxury good which costs more than Rs 2 lakh. The shopkeeper may not want to take cash for an amount greater than Rs 2 lakh. Then the Section 269ST becomes fully useful. But one always has the option to go over to another shopkeeper who is willing to accept cash and fudge his books of account. My point is that this new section will not have a major impact on black money in India, its noble intentions notwithstanding.

Also, the Section 269ST and or any other move of the government, doesn’t do anything regarding the demand for cash as a form of payment. This was and continues to remain the main problem when it comes to black money. Take the case a real estate builder. If you want to buy a flat, the builder will more likely than not demand cash from you. What will you do in such a situation? Tell him that under Section 269ST he is liable to pay a penalty if he receives a payment of greater than Rs 2 lakh?

Why does a builder take a portion of the payment when he sells a flat or a house, in cash? I think it is very important to understand this. He takes a payment in cash because he needs to make payments in cash. He needs to pay his suppliers in cash. But more importantly he needs to pay politicians and bureaucrats in cash.

Unless a builder has politicians and bureaucrats in his pocket, it is very difficult for him or her to be in the business of real estate, given how complicated the regulations governing the sector are. The speed money paid to politicians and bureaucrats essentially helps builders stay in the game. And this speed money cannot be paid in cheque or through NEFT/RTGS/IMPS and so on. It has to be paid in cash.

And this cash can only come from the buyer who is buying the flat or the homes that the builder has built. Unless this nexus between politicians and builders is struck down, the government can keep coming up with all the new sections and all the new changes, the demand for cash is not going to go anywhere.

As I keep saying, this can only happen if the system of electoral financing in India is cleaned up. Given the high cost of elections in India, the politicians need cash. And the builders and the corporates provide this cash. And there is nothing that the government has done on this front till date.

The column originally appeared in Equitymaster on April 6, 2017