How Trustworthy are the Bad Loans Numbers of Banks?

The Reserve Bank of India (RBI) in the Financial Stability Report (FSR) released in January had said that by September, the bad loans of banks, under a baseline scenario, could shoot up to 13.5% of their total loans. In September 2020, the bad loans rate of banks had stood at 7.5%. Bad loans are largely loans, which haven’t been repaid for a period of 90 days or more.

If the economic scenario were to worsen into a severe stress scenario, the bad loans could shoot up to 14.8% of the loans. For public sector banks, the rate could go up to 16.2% under a baseline scenario and 17.8% in a severe stress one.

What this meant was that the RBI expected the overall bad loans of banks to shoot up massively in the post-covid world, even more or less doubling from 7.5% to 14.8%, under a severe stress scenario.

A past reading of the RBI forecasts suggests that in an environment where bad loans are going up, they typically end up at levels which are higher than the severe stress level predicted by the RBI.

Given all this, there should be enough reason for worry on the banking front. But as things are turning out the dire predictions of the RBI are still not visible in the numbers. The quarterly results of a bunch of banks for the period October to December 2020 have been declared and it must be said that the banks look to be doing decently well.

In a research note, CARE Ratings points out that the bad loans rate of 30 banks which form the bulk of the Indian banking system (including the 12 public sector banks, IDBI Bank and the big private banks), stood at 7.01% as of December 2020. The rate had stood at 8.72% as of December 2019 and 7.72% as of September 2020.

In fact, when it comes to public sector banks, the bad loans rate has improved from 11.22% as of December 2019 to 9.01% as of December 2020 (This calculation includes IDBI Bank as well, which is now majorly owned by the Life Insurance Corporation of India and not the union government, and hence is categorised as a private bank).

When it comes to private banks ( a sample of 17 banks), the bad loans rate has improved from 4.87% as of December 2019 to 3.49% as of December 2020.

On the whole, these thirty banks had bad loans amounting to Rs 7.38 lakh crore on loans of Rs 105.37 lakh crore, leading to a bad loans rate of a little over 7%. Do remember, the RBI’s baseline forecast for September 2021 is 13.5%. Hence, things should have been getting worse on this front, but they seem to be getting better.

What’s happening here? The Supreme Court in an interim order dated September 3, 2020, had directed the banks that loan accounts which hadn’t been declared as a bad loan as of August 31, shall not be declared as one, until further orders.

This has essentially led to banks not declaring bad loans as bad loans. Nevertheless, the banks are declaring what they are calling proforma slippages or loans which would have been declared as bad loans but for the Supreme Court’s interim order.

A look at the results of banks tells us that even these slippages aren’t big. The proforma slippages of the State Bank of India between April and December 2020, stood at Rs 16,461 crore, which is small change, given that the bank’s total advances stand at Rs 24.6 lakh crore. When it comes to the Punjab National Bank, the total proforma slippages were at Rs 12,919 crore between April to December 2020.

Similarly, when we look at other banks, the proforma slippages are present but they are not a big number. An estimate made by the Mint newspaper suggests that India’s ten biggest private banks have proforma slippages amounting to around Rs 42,000 crore.

The 30 banks in the CARE Ratings note had total bad loans of Rs 7.38 lakh crore or a rate of 7.01 %. If this has to reach anywhere near, 13.5-14.8% as forecast by the RBI, the overall bad loans need to nearly double or touch around Rs 14 lakh crore.

The initial data doesn’t bear this out. As the RBI said in the FSR, “[With] the standstill on asset classification… the data on fresh loan impairments reported by banks may not be reflective of the true underlying state of banks’ portfolios.”

Hence, the situation will only get clearer once the Supreme Court decision comes in and the banks need to mark bad loans as bad loans. While banks are declaring proforma slippages, it could very well be that the Supreme Court interim order along with restructuring schemes announced by the RBI and the fact the Insolvency and the Bankruptcy Code remains suspended, have led to a situation where they are under-declaring these numbers.

This is not the first time something like this will happen. Around a decade back in 2011, Indian banks had started accumulating bad loans on the lending binge carried out by them between 2004 and 2010, but they didn’t declare these bad loans as bad loans immediately.

Only after a RBI crackdown and an asset quality review in mid 2015, did the banks start declaring bad loans as bad loans. There is no reason to suggest that banks are behaving differently this time around.

It is important that the same mistake isn’t made all over again. Hence, the RBI should carry out an asset quality review of banks(and non-banking finance companies) and force them to come clean on their bad loans.

A problem can only be solved once it has been identified as one.

The article originally appeared in the Deccan Herald on February 14, 2021.

Rising Corporate Profits Aren’t Good News for Indian Economy

Salaam seth salaam seth kuch apne layak kaam seth,
Aap to khaayen murgh musallam apni to bus rice plate. 
­– Shaily Shailendra, Annu Mallik (now known as Anu Malik), Annu Mallik and Kawal Sharma, in Jeete Hain Shaan Se.

Corporates have reported bumper profits for the period July to September 2020.

This led a friend, who is generally unhappy with most of my writing given that he dabbles in the stock market which just keeps going up, to quip: “How are the corporates making profits if the economy is not doing well?

This is an interesting question and needs to be addressed. Having said that, the right question to ask is, how are the corporates making profits with the economy not doing well.

Let’s look at it pointwise.

1) A newsreport published in the Business Standard on November 17, 2020, considers the results of 2,672 listed companies, including their listed subsidiaries, for the period July to September 2020. During this period, the net profit of these companies touched a record Rs 1.52 lakh crore, up by 2.5 times in comparison to the same period in 2019.

2) There is a base effect at play here, with last year’s low base making profits this year look very high. During the period July to September 2019, telecom companies faced massive losses. Their losses have come down during the period July to September 2020. Take the case of Vodafone Idea. The company reported a loss of Rs 50,000 crore last year. The loss during July to September 2020 was much lower at Rs 6,451 crore. Similarly for Airtel, the loss came down from around Rs 23,000 crore last year to Rs 776 crore this year.

These losses pulled down overall corporate profits by close to Rs 73,000 crore, during the period July to September 2019. This time around the losses of these two telecom companies were limited Rs 7,227 crore. Hence, these two companies had a disproportionate negative impact on the overall corporate profits last year. The same hasn’t happened this year and in the process has ended up pushing up the overall corporate profit growth this year.

3) Interestingly, companies have managed to report an increase in net profit despite shrinking sales. The Business Standard report referred to earlier suggests that the net sales of these companies shrunk by 5.2% during July to September 2020. This is the fifth consecutive quarter when the sales of listed companies have shrunk. Depsite shrinking sales, profits have gone up.

4) Economist Mahesh Vyas of the Centre for Monitoring Indian Economy, looked at a sample of 1,675 listed manufacturing companies. He found that their combined net profit stood at Rs 72,600 crore, despite their net sales shirking by Rs 96,100 crore.

5) The question is how have companies managed to increase their net profit, despite doing less business than last year, leading to lower revenues. There are sectoral reasons at play. Thanks to the ongoing case in the Supreme Court, the banks did not have to report bad loans as bad loans. This has led to banks setting aside lesser money to meet the losses that may arise from these bad loans. This has clearly pushed up the profit number in the banking sector.

More specifically, the companies managed to cut more costs than they saw a fall in sales and thus pushed up their net profit.  Take the case of the manufacturing sector that Vyas has considered in his analysis, while their sales shrunk by Rs 91,600 crore, their operating expenses came down by Rs 1,33,100 crore or around Rs 1.33 lakh crore. The companies managed to drive down the cost of raw materials thanks to a favourable shift in trade terms and drawing down their inventories.

6) Other than driving down raw material cost, companies have also managed to cut down on employee costs. Economist Sajjid Chinoy of JP Morgan in a column in The Indian Express writes that net profit of companies went up despite shrinking revenues because “firms aggressively cut costs, including employee compensation.” “Indeed, a sample of about 600 listed firms reveals employee costs (as a per cent of EBITDA) was the lowest in 10 quarters,” he writes further.

A survey carried out by the Mint newspaper and Bain found that half of the companies had reduced employee costs by either firing employees or cutting their salaries.

The above points explain why corporate profits have gone up disproportionately despite shrinking revenues. Let’s try and understand pointwise why this is not good for the Indian economy.

1) A major reason for raw material costs coming down is a favourable shift in trade terms. What does this mean? No company produces everything on its own. It uses inputs which are produced by other firms. In difficult times, companies are able to drive down the cost at which they purchase things from their suppliers, that is, inputs. The suppliers are other companies, which have  to drive down their costs as well, and this is how things are pushed down the hierarchy.

How do suppliers and suppliers to suppliers drive down their costs? They also try to shift the trade terms in their favour and at the same time cut employee costs, like companies have.

2) This leads to what economists call the fallacy of composition or what is good for one may not be good for many. A simple example of this is someone going to watch a cricket match. He stands up to get a better view of the game being played and he gets a better view. But then the person behind him also needs to stand up to get a better view. And so the story continues. In the end, everyone is standing and watching the match, instead of siting comfortably and enjoying it. To repeat, what is good for one, may not be good for many.

How does this apply in the current case? When companies cut down on input costs, they are obviously paying a lower amount of money to their suppliers or not buying new raw material or as much raw material as they did in the past, to increase their inventory.

By cutting down on employee costs, they are either paying a lower amount of money to their employees or simply firing them. The suppliers in turn have to cut their costs in order to continue to be profitable or lose a lower amount of money. So, the cycle continues and in the end leads to lower incomes for everyone involved.

3) This leads to what the economist John Maynard Keynes called the paradox of thrift. With incomes coming down, people spend a lower amount of money than they did before. It is worth remembering here that ultimately one man’s spending is another man’s income, leading to a further cut in spending. Even those who haven’t seen a drop in their income or been fired, cut down on their spending. They are trying to save more, given the risk of them getting fired and not being able to find another job. This is the psychology of a recession and it is totally in place right now.

4) One of the ways of measuring the size of any economy or its gross domestic product (GDP), is to add the incomes of its different constituents. This means adding up rents, wages, interest and profits. While, profits of companies have been going up, individual wages have been going down, leading to lower spending and hence, lower private consumption. This explains why despite corporate profits of listed companies increasing at a fast pace, the GDP during the period July to September 2020, contracted by 7.54%.

5) An August 2019 report in the Business Standard said that the combined net profit of companies that make up for the BSE 500 index was at 2.31% of the GDP. Other studies suggest that this figure has constantly been coming down over the years. Despite the fact that listed companies form a small part of the Indian economy, their influence on the initial GDP figure is very high.

A large part of the Indian economy is informal. The measures representing this part of the economy cannot be generated quickly. In this scenario, the statisticians assume the informal economy to be a certain size of the formal one. Corporate profits are an important input into measuring the size of the formal economy. This is something that needs to be kept in mind while looking at the economic contraction of 7.54%. .

To conclude, while corporate profits going up is good news for the companies, there are many ifs and buts, that need to be taken into account as well, and on the whole the way these profits are being generated, it’s not good news for the Indian economy.

Also, over a longer period, the only way to grow profits is by growing sales. This will start hitting the Indian corporates sooner rather than later.

13 Reasons RBI Shouldn’t Allow Large Corporates/Industrial Houses to Own Banks

Apna hi ghar phoonk rahe hain kaisa inquilab hai.

— Hasrat Jaipuri, Mohammed Rafi, Mukhesh, Ravindra Jain and Naresh Kumar, in Do Jasoos.

Should large corporates/industrial groups be allowed to own banks? An internal working group (IWG) of the Reserve Bank of India (RBI), thinks so. I had dwelled on this issue sometime last week, but that was a very basic piece. In this piece I try and get into some detail.

The basic point on why large corporates/industrial groups should be allowed into banking is that India has a low credit to gross domestic product (GDP) ratio, which means that given the size of the Indian economy, the Indian banks haven’t given out enough loans. Hence, if we allow corporates to own and run banks, there will be more competition and in the process higher lending. QED.

Let’s take a look at the following chart, it plots the overall bank lending to GDP ratio, over the years.


Source: Centre for Monitoring Indian Economy.

The above chart makes for a very interesting read. The bank lending grew from 2000-01 onwards. It peaked at 53.36% of the Indian GDP in 2013-2014. In 2019-20 it stood at 50.99% of the GDP, more or less similar to where it was in 2009-10, a decade back, at 50.97% of the GDP. Hence, the argument that lending by Indian banks has been stagnant over the years is true.

But will more banks lead to more lending? Since 2013, two new universal banks, seven new payment banks and ten new small finance banks have been opened up. But as the above chart shows, the total bank loans to GDP ratio has actually come down.

Clearly, the logic that more banks lead to more lending is on shaky ground. There are too many other factors at work, from whether banks are in a position and the mood to lend, to whether people and businesses are in the mood to borrow. Also, the bad loans situation of banks matters quite a lot.

In fact, even if we were to buy this argument, it means that the Indian economy needs more banks and not necessarily banks owned by large corporates/industrial houses, who have other business interests going around.

Also, the banks haven’t done a good job of lending this money out. As of March 2018, the bad loans of Indian banks, or loans which had been defaulted on for a period of 90 days or more, had stood at 11.6%. So, close to Rs 12 of every Rs 100 of loans lent out by Indian banks had been defaulted on. In case of government owned public sector banks, the bad loans rate had stood at 15.6%. Further, when it came to loans to industry, the bad loans rate of banks had stood at 22.8%.

Clearly, banks had made a mess of their lending. The situation has slightly improved since March 2018. The bad loans rate of Indian banks as of March 2020 came down to 8.5%. The bad loans rate of public sector banks had fallen to 11.3%.

The major reason for this lies in the fact that once a bad loan has been on the books of a bank for a period of four years, 100% of this loan has been provisioned for. This means that  the bank has set aside an amount of money equal to the defaulted loan amount, which is adequate to face the losses arising out of the default. Such loans can then be dropped out of the balance sheet of the banks. This is the main reason behind why bad loans have come down and not a major increase in recoveries.

This is a point that needs to be kept in mind before the argument that large corporates/industrial houses should be given a bank license, is made.

There are many other reasons why large corporates/industrial houses should not be given bank licenses. Let’s take a look at them one by one.

1) The IWG constituted by the RBI spoke to many experts. These included four former deputy governors of the RBI, Shyamala Gopinath, Usha Thorat, Anand Sinha and N. S. Vishwanathan. It also spoke to Bahram Vakil (Partner, AZB & Partners), Abizer Diwanji (Partner and National Leader – Financial Services EY India),  Sanjay Nayar (CEO, KKR India), Uday Kotak (MD & CEO, Kotak Mahindra Bank.), Chandra Shekhar Ghosh (MD & CEO, Bandhan Bank) and PN Vasudevan (MD & CEO, Equitas Small Finance Bank).

Of these experts only one suggested that large corporates/industrial houses should be allowed to set up banks. The main reason behind this was “the corporate houses may either provide undue credit to their own businesses or may favour lending to their close business associates”. This is one of the big risks of allowing a large corporate/industrial house to run a bank.

2) As the Report of the Committee on Financial Sector Reforms (2009) had clearly said:

“The selling of banks to industrial houses has been problematic across the world from the perspective of financial stability because of the propensity of the houses to milk banks for ‘self-loans’ [emphasis added]. Without a substantial improvement in the ability of the Indian system to curb related party transactions, and to close down failing banks, this could be a recipe for financial disaster.”

While, the above report is a decade old, nothing has changed at the ground level to question the logic being offered. Combining banking and big businesses remains a bad idea.

3) Let’s do a small thought experiment here. One of the reasons why the government owned public sector banks have ended up with a lot of bad loans is because of crony capitalism. When a politician or a bureaucrat or someone higher up in the bank hierarchy, pushes a banker to give a loan to a favoured corporate, the banker isn’t really in a position to say no, without having to face extremely negative consequences for the same.

Along similar lines, if a banker working for a bank owned by a large corporate or an industrial house, gets a call from someone higher up in the hierarchy to give out a loan to a friend of a maalik  or to a company owned by the maalik, will he really be in a position to say no? His incentive won’t be very different from that of a public sector banker.

4) As Raghuram Rajan and Viral Acharya point out in a note critiquing the entire idea of large corporates/industrial houses owning banks: “Easy access to financing via an in-house bank will further exacerbate the concentration of economic power in certain business houses.” This is something that India has had to face before.

As the RBI Report of Currency and Finance 2006-08 points out:

“The issue of combining banking and commerce in the banking sector needs to be viewed in the historical perspective as also in the light of crosscountry experiences. India’s experience with banks before nationalisation of banks in 1969 as well as the experiences of several other countries suggest that several risk arise in combining banking and commerce. In fact, one of the main reasons for nationalisation of  banks in 1969 and 1980 was that banks controlled by industrial houses led to diversion of public deposits as loans to their own companies and not to the public, leading to concentration of wealth in the hands of the promoters. Many other countries also had similar experiences with the banks operated by industrial houses.”

This risk is even more significant now given that many industrial houses are down in the dumps thanks to over borrowing and not being able to repay bank loans. Hence, the concentration of economic power will be higher given that few industrial houses have their financial side in order, and they are the ones who will be lining up to start banks.

5) Another argument offered here has been that the RBI will regulate bank loans and hence, self-loans won’t happen. Again, this is an assumption that can easily be questioned. As the RBI Report of Currency and Finance 2006-08 points out: “The regulators temper the risk taking incentives of banks by monitoring and through formal examinations, this supervisory task is rendered more difficult when banking and commerce are combined.”

This is the RBI itself saying that keeping track of what banks are up to is never easy and it will be even more difficult in case of a bank owned by a big business.

6) The ability of Indian entrepreneurs to move money through a web of companies is legendary. In this scenario, the chances are that the RBI will find out about self-loans only after they have been made. And in that scenario there is nothing much it will be able to do, given that corporates have political connections and that will mean that the RBI will have to look the other way.

7) There are other accounting shenanigans which can happen as well. As the RBI Report of Currency and Finance cited earlier points out:

“Bank can also channel cheaper funds from the central bank to the commercial firm. On the other hand, bad assets from the commercial affiliate could be shifted to the bank either by buying assets of the firms at inflated price or lending money at below-market rates in order to effect capital infusion.”

Basically, the financial troubles of a large corporate/industrial house owning a bank can be moved to the books of the bank that it owns.

8) If we look at the past performance of the RBI, there wasn’t much it could do to stop banks from bad lending and from accumulating bad loans.  This is very clear from the way the RBI acted between 2008 and 2015. Public sector banks went about giving out many industrial loans, which they shouldn’t have, between 2008 and 2011. The RBI couldn’t stop them from giving out these loans. It could only force them to recognise these bad loans as bad loans, post mid-2015 onwards, and stop them from kicking the bad loans can down the road. So, the entire argument that the RBI will prevent a bank owned by a large corporate/industrial house from giving out self-loans, is on shaky ground.

9) Also, it is worth remembering that the RBI cannot let a bank fail. This creates a huge moral hazard when it comes to a bank owned by a large corporate/industrial house. What does this really mean? Before we understand this, let’s first try and understand what a moral hazard means.

As Alan S Blinder, a former vice-chairman of the Federal Reserve of the United States, writes in After the Music Stopped: “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. Here are some common non financial examples: …people who are well insured against fire may not install expensive sprinkler systems; people driving cars with more safety devices may drive less carefully.”

In the case of a large corporate/industrial house owned bank, the bank knows that the RBI cannot let a bank fail. This gives such a bank an incentive to take on greater risks, which isn’t good for the stability of the financial system.

As the Currency Report points out:

“The greatest source of risk from combining banking and commerce arises from the threat to the safety net provided under the deposit insurance and ‘too-big-to-fail’ institutions whose depositors are provided total insurance and the mis-channeling of resources through the subsidised central bank lending to banks. Because of the safety net provided, the firms affiliated with banks could take more risk with depositors’ money, which could be all the more for large institutions on which there is an implicit guarantee [emphasis added] from the authorities.”

Other than incentivising the other firms owned by the same large corporates/industrial houses to take on more risk in its activities, it also means that now the RBI other than keeping track of banks, will also need to keep track of the economic activities of these other firms. Does the RBI have the capacity and the capability to do so? 

10) Another argument offered in favour of large corporates/industrial houses owning banks is that they already own large NBFCs. So, what is the problem with them owning banks? The problem lies in the fact that banks have access to a safety net which the NBFCs don’t. RBI will not let a bank fail and will act quickly to solve the problem. And that is the basic difference between a large corporate/industrial house owning a bank and owning an NBFC. Also, the arguments that apply to large corporates/industrial houses owning a bank are equally valid in case of them owning NBFCs, irrespective of the fact that large corporates already own NBFCs. Two wrongs don’t make a right.

11) We also need to take into account the fact many countries including the United States, which has much better corporate governance than India, don’t allow the mixing of commerce and business. As the Report of the Committee on Financial Sector Reforms (2009) had pointed out: “This prohibition on the ‘banking and commerce’ combine still exists in the United States today, and is certainly necessary in India till private governance and regulatory capacity improve.”

The interesting thing is that in the United States, the separation between banking and commerce has been followed since 1787.

As the Currency Report points out:

“Banks have frequently tried to engage in commercial activities, and commercial firms have often attempted to gain control of banks. However, federal and state legislators have repeatedly passed laws to separate banking and commerce, whenever it appeared that either (i) the involvement of banks in commercial activities threatened their safety and soundness; or (ii) commercial firms were acquiring a large numbers of banks.”

Also, anyone who has studied the South East Asian financial crisis of the late 1990s would know that one of the reasons behind the crisis was allowing large corporates to own banks.

12) This is a slightly technical point but still needs to be made. Banks by their very definition are highly leveraged, which basically means the banking business involves borrowing a lot of money against a very small amount of capital/equity invested in the business. The leverage can be even more than 10:1, meaning that the banks can end up borrowing more than Rs 100 to go about their business, against an invested capital of Rs 10.

On the flip side, the large corporates/industrial houses have concentrated business interests or business interests which are not very well-diversified. Hence, trouble in the main business of a large corporate can easily spill over to their bank, given the lack of diversification and high leverage. This is another reason on why they should not be allowed to run banks.

13) As Raghuram Rajan and Viral Acharya wrote in their recent note: “One possibility is that the government wants to expand the set of bidders when it finally sets to privatizing some of our public sector banks.”

This makes sense especially if one takes into account the fact that in recent past the government has been promoting the narrative of atmanirbharta.

In this environment they definitely wouldn’t want to sell the public sector banks to foreign banks, who are actually in a position to pay top dollar. Hence, the need for banks owned by large corporates/industrial houses looking to expand quickly and willing to pay good money for a bank already in existence.

Given this, the government wants banks owned by large corporates/industrial houses in the banking space, so that it is able to sell out several dud public sector banks at a good price. But then this as explained comes with its own set of risks.

 

To conclude, the conspiracy theory is that all this is being done to favour certain corporates close to the current political dispensation. And once they are given the license, this window will be closed again. Is that the case? On that your guess is as good as mine. Nevertheless, if this is pushed through, someone somewhere will have to bear the cost of this decision.

As I often say, there is no free lunch in economics, just that sometimes the person paying for the lunch doesn’t know about it.

Aa gaya aa gaya halwa waala aa gaya, aa gaya aa gaya halwa waala aa gaya
— Anjaan, Vijay Benedict, Sarika Kapoor, Uttara Kelkar, Bappi Lahiri and B Subhash (better known as Babbar Subhash), in Dance Dance.

Should You Buy a Home This Festival Season?

In the last decade, afternoon naps have become a very important part of my life. In fact, it is safe to say that I live so that I can have the pleasure of taking afternoon naps and reading crime fiction. (Imagine all the economics I have to break my head on, for such simple pleasures in life).

After taking an afternoon nap yesterday I was trying to get my brain going again by drinking a cup of overboiled masala tea. At around 4.54 pm, a mail titled 10 Reasons to Buy a Home This Festive Season, hit my mailbox. The headline ensured that my brain was back to functioning at full strength.

In the economic environment that currently prevails, only someone closely associated with the real estate business could come up with a headline/title like this. Not surprisingly, this piece was written by someone working at a senior position for a real estate consultant, whose well-being depends on the sector doing well. His incentive is clearly misaligned with that of a prospective buyer looking to buy a home to live in.

Also, the festival season sales pick up is something that the real estate sector has been trying to sell for more than half a decade now. This tells you that bad ideas rarely go out of circulation.

This headline motivated me to write this piece titled should you buy a home this festival season, which you are currently reading.
Let’s take a look at this pointwise.

1) One of the reasons offered to buy a home in the mail I got, is the oldest cliché in the game, which goes like this: “Living in a rented house is a recurring financial drain without returns on investment”. This reasoning is bought by one too many people even though it is the rubbish of the highest order.

Let me explain through an example. I stay in central Mumbai, in what is euphemistically termed as a studio apartment. My monthly rental outgo is Rs 23,000. What sort of a home loan will I get if I am willing to pay the same amount as an EMI? At an interest rate of 7% per year on a home loan to be repaid over twenty years, I will get a home loan of around Rs 29.67 lakh. On this loan, the EMI works out to Rs 23,003.

Let’s say to this home loan I add my own savings of around Rs 10.33 lakh and I have a total of Rs 40 lakh, with which I can buy a flat. I will not get anything at this price around where I live unless I am willing to move into a shanty.

To get an apartment at this price I will have to move 35-40 km or even more from where I stay. And that will beat the entire idea because I like staying where I do and renting is the only way I can afford it. I am not looking to build an asset here. I just want to stay bang in the middle of the town.

2) Also, the rental yield typically tends to be 1.5-2% (annual rent divided by the market price of the house) or slightly higher. Even the cheapest home loan is 7%. Plus there are other costs associated with owning a home. When you a buy a house a stamp duty has to be paid to the state government. A property tax needs to be paid every year. Then there is the maintenance charge that needs to be paid to the housing society. On top of this there is the general risk of owning property in India.

3) Further, if I go and live 35-40km from where I am, I will end up paying for it in terms of the time I will have to spend to get anywhere. And time ultimately is money. So, yes one might end up building an asset but with almost no control over one’s time.

Hence, equating living in a rented house to a financial drain is top class rubbish which only someone working in the real estate industry can come up with and propagate  over and over again. This argument starts to make sense only when the rental yields and home loan interest rates are in a similar sort of territory. For that to happen, rental yields need to double and home loan interest rates need to halve (both will then be around 4%).

4) Another reason offered in the mail, to buy a house is: “Buying now equals buying at the lowest possible price.” Lowest possible price, vis a vis what? Entry level flats in the biggest cities, where the bulk of the demand is, cost at least Rs 40-50 lakh. Let’s consider a flat which costs Rs 40 lakh. A 20% downpayment works out to Rs 8 lakh. This means a home loan of Rs 32 lakh. The EMI on this works out to Rs 24,809 (7% interest, 20 years repayment period).

A bank typically assumes that around 35-40% of the after tax take home salary can go towards paying this EMI. If the assumption is that around 35% of the salary goes towards EMI, the total after-tax take home salary works out to around Rs 8.5 lakh. The pre-tax salary has to be even higher, more than Rs 10 lakh. How many people make that kind of money in a country where the per capita income is just over Rs  1.5 lakh, is a question well worth asking. This very conservative example explains why real estate in India remains beyond the level of most Indians.

5) There is another problem with the lowest possible price argument. Given the opaqueness surrounding the real estate sector in India, there is nothing like a market price at any given point of time. So how do you even know that the price offered to you is the lowest possible price? Do you just believe what the builder or his broker are saying? Do you have any idea what the price was last year or the year before that?

6) Also, we are told that “home loan interest rates are at 15-year low”. Hence, you should buy a house. The economy during the period April to June contracted by a nearly fourth. It is expected to contract by 10% this year, a level of contraction never seen since Indian independence. Just because home loan interest rates are low should you go out and buy a house? The more important question to answer as always is whether you are in a position to pay the EMI payable against the low interest rates. No wonder this very important point has been missed out on.

It is worth remembering that home loans are floating interest rate loans and interest rates can keep changing in the years to come. If you take on a 20-year home loan now, it doesn’t mean that interest rates will continue to remain low for the next 20 years.

7) And then there is this, my absolute favourite, which I have been hearing for years now: “The property market is poised on the cusp of a full-fledged revival. Once the revival kicks in, property prices will harden and asset appreciation begins in all seriousness.”

This statement reminds me of the different chairpersons that the State Bank of India has had in the last twelve years. Starting with 2009, each one of them has said at some point of time that when it comes to the banking sector in India, the worst is behind us. Well, it’s 2020, the banking sector still has official bad loans of close to Rs 9 lakh crore and they are expected to go up dramatically post-covid.

Every festival season for the last six years the real estate sector has been talking about an impending revival. This revival did not happen when the Indian economy was growing.  And now they expect the revival to happen in a year when the economy is contracting big time. The size that the Indian economy achieved in 2019-20, will now most likely be achieved again only in 2022-23. Jobs have been lost. Incomes have fallen. Small businesses have shut-down or are on the verge of shutting down and the real estate sector is talking about asset appreciation beginning in all seriousness.

I mean all selling involves some amount of fibbing but if you keep doing it all the time and it doesn’t turn out to be true, it loses its power. People start believing in the opposite narrative. As the old fable of the jackal shouting sher aaya sher aaya goes.

8) Here’s another reason the mail offered, to buy a house: “After a protracted period of financial upheaval, it has become necessary to revisit all expenses which represent undue pressure on personal finances. Living in a rented house is a recurring financial drain without returns on investment [emphasis added].”

The part italicised in the above paragraph I have already dealt with in the first point. Nevertheless, the above paragraph needs to be tackled on its own as well. What is the writer saying here? Given the tough economic conditions created by covid, it is time to revisit all expenses. Yes, that makes sense.

But then he goes on to say that renting doesn’t make any sense and you need to make an even bigger expenditure in buying a house and paying an EMI. Buying a house would involve running down savings to make a downpayment and paying a stamp duty. Then there would be moving charges.

At the same time an EMI would have to be paid on a home loan. The chances are that the EMI will be much more than the rental.

Why would anyone who is in financial trouble and trying to cut down on his expenses, be expected to take on higher expenses by buying a house? What’s the logic here? There is no logic to this except to confuse the prospective buyer.

Essentially you are being asked to be penny wise and pound foolish.

9) In the last couple of weeks, the real estate industry has been trying very hard to convince us that the buyers are back in the market and they are lining up to buy homes. Like the mail I got put it: “The best home options are being snapped up at a rapid pace.”

Similar stories have been seen in the media as well. Like the Mumbai edition of The Times of India points out today: “Unlocked MMR shines with 60% rise in home sales in Q2”. Only when you read the story carefully you realise that sales in the Mumbai Metropolitan Region (MMR) during July and September were 60% higher than sales during April to June. And that’s hardly surprising. There were barely any sales in April and May, due to the lockdown. Hence, this was bound to happen.

The real question is how do things look in comparison to July to September 2019. This reveals the real story. Sales between July to September 2020 are 40% lower than the same period last year. Of course, the newspapers are trying to project a real estate revival story given that they are dependent on huge advertisements from real estate companies. Also, it is worth remembering that a lot of home sales that happened in July to September must be pent up demand from April to June, which has spilled over.

10) Another tactic being employed here is to project a lack of supply. As the mail I got puts it: “Developers have curtailed new supply”. Maybe they have. But the larger point here is that lakhs of apartments were bought as an investment in the decade leading to 2015. Many investors are still sitting on it, hoping for a better return. But now due to covid, there are bound to be quite a few distress sales going around. So, it’s a matter of hanging around and looking for one.

As I have said in the past, the real estate market right now is going through a weird low supply low demand situation. There is low demand for real estate (given the high price) and there is low supply as well (given that real estate companies and individual owners are unwilling to cut prices). I may want to buy a home but unless I have enough money and the ability to borrow to do so, I am really not adding to demand. Just wanting something, without having the money to finance it, doesn’t really add to demand.

This situation can only turnaround if the demand improves or if the supply improves. The demand will improve only when the economy turns around and India grows at 7-8% for a sustainable period of time, leading to increased incomes. The supply will improve if prices fall (which means more people are willing to sell the homes they own), of course, that will lead to an increase in demand as well.

Dear reader, you must be wondering by now, itna gyan de diya, now tell us if we should buy a home or not. First and foremost, what does buying a house have to with one year’s festival season or for that matter any other’s? You are not buying a mobile phone, which you buy almost every couple of years and wait for the best deal during the festival season. A home is only bought once or twice during a lifetime.

You should buy a house if you want to live in it, can afford to make the downpayment and most importantly, have a stable income which will allow you to keep paying the EMI on the home loan in the years to come. This also includes the idea of buying a bigger home to adjust to the new reality of working from home.

As mentioned earlier, the most important part here is stable income. If your job or business is on shaky ground, now is not the time to buy a house. If you want to continue living in the posher area of the city, but can only afford to pay a rent for it, then now is not the time to buy a house.

Remember, while you might be building an asset by not paying a rent but by paying an EMI, you are probably also making a compromise in terms of the time you have at your disposal to live the life you want to. If you are comfortable with the idea of a daily rat race then please go ahead and buy a house.

On the flip side, there are advantages to owning a home. One is the fact that you don’t have to change homes frequently, like you have to if you are living on rent. Over the years, I have come to the conclusion that this fear is oversold. The days when landlords used to be only landlords are gone (of course a lot of such people do survive).

Now there are many landlords who have full-fledged corporate careers and are more interested in a regular rental than changing people who they rent out their homes to, every 11 months. Remember it’s a pain for them as well. Also there is the risk of not finding a tenant on time and losing out on a month’s rent. And any sensible landlord will want to avoid that.

The biggest advantage to owning a home is that it tends to make your parents happy (in terms of getting settled in life). Also, the kids can have a slightly stabler life. But it all boils down to whether you can afford to buy a home. On this front, every individual’s situation is different and you need to figure that answer out for yourself. If you feel comfortable with buying a house right now then please go ahead and do that. Don’t wait.

As far as investing in real estate is concerned so that you can flip it later, that idea went out of style in 2013 or 2014 at best. If you still believe in it then either you deal in a lot of black money or probably don’t realise that the times have changed.

What’s the Logic Behind Govt’s मांडवली (compromise) on Interest on Interest with Supreme Court?

Three institutions, the Reserve Bank of India (RBI), the Supreme Court and the Department of Financial Services, have spent more than a few weeks in deciding on waiving off the interest on interest on all retail loans and MSME loans of up to Rs 2 crore.

Resources at three systematically important institutions have been used to arrive at something which is basically largely useless for the economy as a whole, is bad for banks and sets a bad precedent which can lead to a major headache for both the government as well as the Supreme Court, in the time to come.

This is India’s Big Government at work, spending precious time on things which it really shouldn’t be. Let’s take a look at this issue pointwise.

1) By waiving off interest on interest on all retail loans and MSME loans of up to Rs 2 crore, for a period of six months between March and August 2020 when many loans were under a moratorium, the government is essentially fiddling around with the contract that banks entered with borrowers. A government interfering with contracts is never a good idea. If at all, negotiations for any waiver should have happened directly between banks and their borrowers, under the overall supervision of the RBI.

2) Some media houses have equated this waiver with a Diwali gift and an additional stimulus to the economy etc. This is rubbish of the highest order. The government estimates that this waiver of interest on interest applicable on loans given by banks as well as non-banking finance companies (NBFCs) is going to cost it Rs 6,500 crore. Other estimates made by financial institutions are higher than this. The rating agency Crisil estimates that this waiver is going to cost Rs 7,500 crore. Another estimate made by Kotak Institutional Equities put the cost of this waiver at Rs 8,500 crore.

Whatever be the cost, it is worth remembering here that the money that will go towards the waiver, is money that the government could have spent somewhere else. In that sense, unless the government increases its overall expenditure because of this waiver, it cannot be considered as a stimulus. Even if it does increase its overall expenditure, it will have to look at earning this money through some other route. The chances are, we will end up paying for it in the form of some higher tax (most likely a higher excise duty on petrol and diesel).

3) Also, the question that is bothering me the most on this issue, is a question that no one seems to be asking. Who is this move going to benefit? Let’s take an extreme example here to understand this. Let’s say an individual took a home loan of Rs 2 crore to be repaid over 20 years at an interest rate of 8%. He or she took a loan in early March and immediately put it up for moratorium once it was offered.

The moratorium lasted six months. The simple interest on the loan of Rs 2 crore for a period of six months amounts to Rs 8 lakh (8% of Rs 2 crore divided by 2).

This is not how banks operate. They calculate interest on a monthly basis. At 8% per year, the monthly interest works out to 0.67% (8% divided by 12). The interest for the first month works out to Rs 1.33 lakh (0.67% of Rs 2 crore).

Since the loan is under a moratorium and is not being repaid, this interest is added to the loan amount outstanding of Rs 2 crore.

Hence, the loan amount outstanding at the end of the first month is Rs 2.013 crore (Rs 2 crore + Rs 1.33 lakh). In the second month, the interest is calculated on this amount and it works out to Rs 1.34 lakh (0.67% of Rs 2.013 crore).

In this case, we calculate interest on the original outstanding amount of Rs 2 crore. We also calculate the interest on Rs 1.33 lakh, the interest outstanding at the point of the first month, which has become a part of the loan outstanding. This is interest on interest.

At the end of the second month, the loan amount outstanding is Rs 2.027 crore (Rs 2.013 crore + Rs 1.34 lakh). This is how things continue month on month, with interest being charged on interest.

At the end of six months, we end up with a loan outstanding of Rs 2.081 crore. This is Rs 8.134 lakh more than the initial loan outstanding of Rs 2 crore. As mentioned initially, the simple interest on Rs 2 crore at 8% for a period of six months works out to Rs 8 lakh.

Hence, the interest on interest works out to Rs 13,452 (Rs 8.134 lakh minus Rs 8 lakh).

Why did I consider this extreme example? I did so in order to show the futility of what is on. An individual who has taken a home loan of Rs 2 crore is not in a position to pay a total interest on interest of Rs 13,452, is a question well worth asking? Who are we trying to fool here? Given that the moratorium was for a period of six months, the average interest on interest works out to Rs 2,242 per month.

Even at a higher interest rate of 12% (let’s say for MSMEs), the average interest on interest works out to a little over Rs 2,500 per month. Are MSMEs not in a position to pay even this?

So, who are we doing this for? No one seems to have bothered asking and answering this most important question.

4) I guess it’s not fair to blame the government, at least for this mess. The petitioners wanted interest on loans for the period during the moratorium waived off. The Judges entertained them and the government had to find a way out so that the Judges could feel that they had done something at the end of the day and not feel embarrassed about the entire situation.

Crisil estimates that an interest rate waiver of retail and MSME loans of up to Rs 2 crore (including interest on interest) would have cost the government a whopping Rs 1,50,000 crore. Both the government and the RBI wanted to avoid this situation and ended up doing what in Mumbai is called a मांडवली or a compromise. Hence, clearly things could have been worse. Thankfully, they aren’t.

5) The case has dragged on for too long. Currently, banks are not allowed to mark any account which was a standard account as of August 31, as a default. The longer the case goes on, the longer it will take the banking system to recognise the gravity of the bad loans problem post-covid. Bad loans are loans which haven’t been repaid for a period of 90 days or more.

Also, this isn’t good news for banks which had provisioned (or set money aside) to quickly deal with the losses they would face due to the post-covid defaults.

Even at the best possible rate, the gravity of the problem facing banks will come out in the public domain only by the middle of next year now. And that’s just too long. Instead of the government, this time around, the Supreme Court has helped kick the bad loans can down the road.

Ideally, banks should have started recognising post-covid bad loans by now and also, started to plan what to do about it.

6) The banks will have to first pass on the waiver to the borrowers and will then get compensated by the government. As anyone who has ever dealt with the government when it comes to payments will assure you, it can be a real pain. Thankfully, the amount involved on the whole is not very large and the banks should be able to handle any delay on part of the government.

7) This is a point I have made before, but given the seriousness of the issue, it needs to be repeated. Interest is nothing but the price of money. By meddling with the price of money, the Supreme Court has opened a Pandora’s box for itself and the government. There is nothing that stops others from approaching the Courts now and asking for prices of other things, everything from real estate to medicines, to be reduced. Where will it stop?

To conclude, India’s Big Government only keeps getting bigger in its ambition to do much more than it can possibly do. The interest on interest issue is another excellent example of this.