Did RBI just hint that Indian corporates have reached Ponzi stage of finance?

ARTS RAJAN
The Reserve Bank of India(RBI) releases the Financial Stability Report twice a year. The second report for this year was released yesterday (i.e. December 23, 2015). Buried in this report is a very interesting box titled In Search of Some Old Wisdom. In this box, the RBI has resurrected the economist Hyman Minsky. Minsky has been rediscovered by the financial world in the years that have followed the financial crisis which started with the investment bank Lehman Brothers going bust in September 2008.

So what does the RBI say in this box? “When current wisdom does not offer solutions to extant problems, old wisdom can sometimes be helpful. For instance, the global financial crisis compelled us to take a look at the Minsky’s financial stability hypothesis which posited the debt accumulation by non-government sector as the key to economic crisis.”

And what is Minsky’s financial stability hypothesis? Actually Minsky put forward the financial instability hypothesis and not the financial stability hypothesis as the RBI points out. I know I am nit-picking here but one expects the country’s central bank to get the name of an economic theory right. I guess given that the name of the report is the Financial Stability Report, someone mixed the words “stability” and “instability”.

The basic premise of this hypothesis is that when times are good, there is a greater appe­tite for risk and banks are willing to extend riskier loans than usual. Businessmen and entrepreneurs want to expand their businesses, which leads to increased investment and corporate profits.

Initially, banks only lend to businesses that are expected to gen­erate enough cash to repay their loans. But as time progresses, the competition between lenders increases and caution is thrown to winds. Money is doled out left, right, and centre and normally it doesn’t end well.

This is the basic premise of the financial instability hypothesis. In this column I will explain that the Indian corporates have reached what Minsky called the Ponzi stage of finance.  Minsky essentially theorised that there are three stages of borrowings. The RBI’s box in the Financial Stability Report explains these three stages. Nevertheless, a better explanation can be found in L Randall Wray’s new book, Why Minsky Matters—An Introduction to the Work of a Maverick Economist.

As Wray writes: “Minsky developed a famous classification for fragility of financing positions. The safest is called “hedge” finance (note that this term is not related to so-called hedge funds). In a hedge position, expected income is sufficient to make all payments as they come due, including both interest and principal.” Hence, in the hedge position the company taking on loans is making enough money to pay interest on the debt as well as repay it.

What is the second stage? As Wray writes: “A “speculative” position is one in which expected income is sufficient to make interest payments, but principal must be rolled over. It is “speculative” in the sense that income must increase, continued access to refinancing must be expected, or an asset must be sold to cover principal payments.”

Hence, in a speculative position, a company is making enough money to keep paying interest on the loan that it has taken on, but it has no money to repay the principal amount of the loan. In order to repay the principal, the income of the company has to go up. Or banks need to agree to refinance the loan i.e. give a fresh loan so that the current loan can be repaid. The third option is for the company to start selling its assets in order to repay the principal amount of the loan.

And what is the third stage? As Wray writes: “Finally, a “Ponzi” position (named after a famous fraudster, Charles Ponzi, who ran a pyramid scheme—much like Bernie Madoff’s more recent fraud”) is one in which even interest payments cannot be met, so that the debtor must borrow to pay interest (the outstanding loan balance grows by the interest due).”

Hence, in the Ponzi position, the company is not making enough money to be able to pay the interest that is due on its loans. In order to pay the interest, it has to take on more loans. This is why Minsky called it a Ponzi position.

Charles Ponzi was a fraudster who ran a financial scheme in Boston, United States, in 1919. He promised to double the investors’ money in 90 days. This was later shortened to 45 days. There was no business model in place to generate returns. All Ponzi did was to take money from new investors and handed it over to old investors whose investments had to be redeemed. His game got over once the money leaving the scheme became higher than the money being invested in it.

Along similar lines once companies are not in a position to pay interest on their loans they need to borrow more. This new money coming in helps them repay the loans as well as pay interest on it. And until they can keep borrowing more they can keep paying interest and repaying their loans. Hence, the entire situation is akin to a Ponzi scheme.

By now, dear reader, you must be wondering, why have I been rambling on about a single box in the RBI’s Financial Stability Report and an economist called Hyman Minsky.

In RBI’s Financial Stability Report the box stands on its own. But is the RBI dropping hints here? Of course, you don’t expect the central bank of a country to directly say that a large section of its corporates have reached the Ponzi stage of finance. And there are many others operating in the speculative stage of finance. Even without the RBI saying it directly, there is enough evidence to establish the same.

In the report RBI points out that as on September 30, 2015, the bad loans (gross non-performing advances) of banks were at 5.1% of total advances of scheduled commercial banks operating in India. The number was at 4.6% as on March 31, 2015. This is a huge jump of 50 basis points in a period of just six months.

The restructured loans of banks fell to 6.2% of total advances from 6.4% in March 2015.  A restructured loan is a loan on which the interest rate charged by the bank to the borrower has been lowered. Or the borrower has been given more time to repay the loan i.e. the tenure of the loan has been increased. In both cases the bank has to bear a loss.

The stressed loans of banks, obtained by adding the bad loans and the restructured loans, came in at 11.3% of total advances. They were at 11.1% in March 2015.
The numbers for the government owned public sector banks were much worse. The stressed loans of public sector banks stood at 14.1%. In March 2015, this number was at 13.2%. This is a significant jump in a period of just six months. The stressed loans of private sector banks stood at a very low 4.6% of total advances.

Let’s look at the stressed loans of public sector banks over a period of time. In March 2011, the number was at 6.6% of total advances. By March 2012, it had jumped to 8.8% of total advances. Now it is at 14.1%.

What is happening here? Banks are clearly kicking the can down the road by restructuring more loans, because many corporates are clearly not in a position to repay their bank loans. Why do I say that? As the Mid-Year Economic Review published by the Ministry of Finance last week points out: “Corporate balance sheets remain highly stressed. According to analysis done by Credit Suisse, for non – financial corporate sector (based on ~ 11000 companies in the CMIE database as of FY2014 and projections done for FY2015 based on a sample of 3700 companies), the number of companies whose interest cover is less than 1 has not declined significantly (this number was 1003 in September 2014 and is 994 in September 2015 quarter).”

Interest coverage ratio is essentially obtained by dividing the earnings before interest and taxes(operating profit) of a company during a given period, by the interest that it needs to pay on the loans that it has taken on.

In the Indian case, a significant section of the corporates have an interest coverage ratio of less than 1. This means that they are not earning enough to even pay the interest on their outstanding loans.

Further, the weighted average interest coverage ratio of all companies in the sample as on September 2015 was at 2.3. It was at 2.5 in September 2014. As the Mid-Year Economic Review points out: “Research indicates that an interest cover of below 2.5 for larger companies and below 4 for smaller companies is considered below investment grade.”

What this means that many corporates now are not in a position to even pay interest on their loans. They need newer loans to repay interest on their loans. They have reached the Ponzi stage of finance, as Minsky had decreed. Still others are in the speculative stage.

The RBI Financial Stability Report again hints at this without stating it directly. As the report points out: “Bank credit to the industrial sector accounts for a major share of their overall credit portfolio as well as stressed loans. This aspect of asset quality is related to the issue of increasing leverage of Indian corporates. While capital expenditure (capex) in the private sector is a desirable proposition for a fast growing economy like India, it is observed that the capex which had gone up sharply has been coming down despite rising debt. During this period, profitability and as a consequence, the debt-servicing capacity of companies has, seen a decline. These trends may be indicative of halted projects, rising debt levels per unit of capex, overall rise in debt burden with poor recoveries on resources employed.”

What the central bank does not say is that rising debt without a rising capital expenditure may also be indicative of the fact that newer loans are being taken on in order to pay off older loans as well as pay interest on the outstanding loans. The public sector banks are issuing newer loans because if they don’t corporates will start defaulting and the total amount of bad loans will go up even further.

In such a scenario, the public sector banks have also been helping corporates by restructuring more and more loans. By doing this they are essentially postponing the problem. A restructured loan is not a bad loan. Further, around 40% of restructured loans between 2011 and 2014 have turned into bad loans.

All this hints towards a large section of Indian corporates operating in what Minsky referred to as a Ponzi stage of finance. Many corporates are also in the speculative stage. And given that, it’s not going to end well.

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

The column originally appeared on SwarajyaMag on December 24, 2015

Banks having a bad time, as King of Good Times celebrates his sixtieth birthday

vijay-mallya1
A few days back sections of the media reported that Vijay Mallya, a part-time businessman and a full-time defaulter of bank loans, had celebrated his sixtieth birthday by throwing a huge party at the Kingfisher Villa in Candolim, Goa.

As the Mumbai Mirror reported: “International pop icon Enrique Iglesias belted out his 2014 chartbuster ‘Bailando’ (Dancing) hours after Sonu Nigam completed a nonstop two-hour session with ‘Tum jiyo hazaron saal, saal ke din ho pachaas hazaar’.”

This is while banks wait to recover thousands of crore of loans that Mallya has defaulted on, in his quest to own and run an airline.

While Mallya and other industrialists continue to have a good time, the bad loans of banks continue piling up. The Mid-Year Economic Analysis released by the ministry of finance last week points out towards the same. As it points out: “Gross Non Performing Assets (NPAs) of scheduled commercial banks, especially Public Sector Banks (PSBs) have shown an increase during recent years.

The total bad loans (gross non-performing assets) of scheduled commercial banks increased to 5.14 % of total advances as on September 30, 2015. The number had stood at 4.6% of total advances, as on March 31, 2015. This means a jump of 54 basis points in a period of just six months. One basis point is one hundredth of a percentage.

The situation is much worse in public sector banks.  The total bad loans of public sector banks stood at 6.21% of total advances as of September 30, 2015. This number had stood at 5.43% as on March 31, 2015. This is a huge jump of 78 basis points, within a short period of six months. The number had been at 4.72% as on March 31, 2014. This tells us very clearly that the bad loans situation of public sector banks has clearly worsened.

In fact, we get the real picture if we look at the stressed assets of public sector banks. The stressed asset number is obtained by adding the bad loans and the restructured assets of a bank. A restructured asset is an asset on which the interest rate charged by the bank to the borrower has been lowered. Or the borrower has been given more time to repay the loan i.e. the tenure of the loan has been increased. In both cases the bank has to bear a loss.

The stressed assets of the public sector banks as on September 30, 2015, stood at 14.2% of the total advances. Hence, for every Rs 100 of loans given by public sector banks, Rs 14.2 are currently in dodgy territory. In March 2015, the stressed assets ratio was at 13.15%. This is a significant jump of 105 basis points. In fact, if we look at older data there are other inferences that we can draw.

In March 2011, the number was at 6.6%. In March 2012, the number grew to 8.8%. And now it stands at 14.2%. What does this tell us? It tells us very clearly that banks are increasingly restructuring more and more of their loans and pushing up the stressed asset ratio in the process. And that is not a good thing. The banks are essentially kicking the can down the road in the hope of avoiding to have to recognise bad loans as of now.

In a research note published earlier this year, Crisil Research estimates that 40% of the loans restructured during 2011-2014 have become bad loans. Morgan Stanley estimates that 65% of restructured loans will turn bad in the time to come. What this tells us very clearly tells us that a major portion of stressed assets are essentially restructured loans which haven’t been recognised as bad loans.

This clearly tells us that the balance sheets of public sector banks continue to remain stressed. Data from the Indian Banks’ Association shows that the public sector banks own a total of 77.4% of assets of the total banking system. This means they dominate the system. And if their balance sheets are in a bad shape it is but natural that they will go slow on giving ‘new’ loans. As the latest RBI Annual Report points out: “Private sector banks with lower NPA ratios, posted higher credit growth …At the aggregate level, the NPA ratio and credit growth exhibited a statistically significant negative correlation of 0.8, based on quarterly data since 2010-11.”
As the accompanying chart clearly points out the loan growth of private sector banks which have a lower amount of stressed assets has been much faster than that of public sector banks.
Source: RBI Annual Report

Also, it is worth asking here why are public sector banks continuing to pile up bad loans. The answer might perhaps lie in the fact that the interest paying capacity and the principal repaying capacity of corporates who have taken on these loans continues to remain weak. As the Mid-Year Economic Review points out: “Corporate balance sheets remain highly stressed. According to analysis done by Credit Suisse, for non – financial corporate sector (based on ~ 11000 companies in the CMIE database as of FY2014 and projections done for FY2015 based on a sample of 3700 companies), the number of companies whose interest cover is less than 1 has not declined significantly (this number was 1003 in September 2014 and is 994 in September 2015 quarter).”

Interest coverage ratio is arrived at by dividing the operating profit (earnings before interest and taxes) of a company by the total amount of interest that a company needs to pay on what it has borrowed during a given period. An interest coverage ratio of less than one, as is the case with many companies in the Credit Suisse sample, essentially means that the companies are not making enough money to even be able to pay interest on their borrowings.

Further, “the weighted average interest cover ratio has declined from 2.5 in September 2014 to 2.3 in September 2015 (research indicates that an interest cover of below 2.5 for larger companies and below 4 for smaller companies is considered below investment grade).

Given this, it is not surprising that bad loans of banks continue to pile up, while guys like Mallya continue to have a “good time”.

Postscript: I will be taking a break from writing The Daily Reckoning for the next few days. Will see you again in the new year. Here is wishing you a Merry Christmas and a very Happy New Year.

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

Why EMIs and interest rates fall more on front pages of newspapers than real life

newspaperRegular readers of The Daily Reckoning would know that I am not a great believer in the repo rate cuts leading to an increase in home buying and as well as consumption, with people borrowing and spending more, at lower interest rates. Repo rate is the rate at which the Reserve Bank of India (RBI) lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

A basic reason is that the difference in EMIs after the rate cut is not significant enough to prod people to borrow and buy things. Further, they should be able to afford paying the EMI in the first place, which many of them can’t these days, at least when it comes to home loan EMIs.

These reasons apart there is another problem, which the mainstream media doesn’t talk about enough. All they seem to come up with are fancy tables on how interest rates and EMIs are going to fall and how this is going to revive the economy. And how acche din are almost here. Now only if it was as simple as that.

A cut in the repo rate is not translated into exact cuts in bank lending rates. After any repo rate cut, banks quickly cut their deposit rates. They cut their lending rates as well, but not by the same quantum.

As a recent study carried out by India Ratings and Research points out: “In the recent policy cycle, RBI has cut policy rates since January 2015 by a cumulative 125 basis points, banks have cut one year deposit rates by an average 130 basis points and lending by 50 basis points, which includes the base rate cuts in the last one week. Base rate is the rate below which a bank cannot lend. In the last 18 months three-month commercial paper and certificate of deposit rates have fallen by 150 basis points. Thus transmission of policy rates has been more through market rates and banks deposit rates in the last one year.” One basis point is one hundredth of a percentage.

In an ideal world, a 125 basis points cut in the repo rate by the RBI should have led to a 125 basis points cut in the lending as well as deposit rates. But that doesn’t seem to have happened. While the one-year deposit rates have been cut by 130 basis points, the lending rates have gone down by just 50 basis points.

And this is a trend which is not just limited to the current spate of rate cuts by the RBI. This is how things have played out in the past as well. As Crisil Research had pointed out in a report released in February 2015: “Lending rates show upward flexibility during monetary tightening but downward rigidity during easing. Between 2002 and 2004, while the policy rate declined by 200 basis points, lending rates dropped by just 90-100 basis points. Conversely, in 2011-12, when the policy rate rose by 170 basis points, lending rates surged 150 basis points.

So, the point being that when the RBI starts to raise the repo rate, banks are quick to pass on the rate increase to their borrowers, but the vice-versa is not true.

As India Ratings and Research points out: “The policy cycle is being used by banks to their advantage. A study of the last 10 years shows, that in most cases when policy rates have reduced, deposit rates have comedown faster and the quantum has also been higher compared to lending rates. The same was also true when policy rates were hiked, where lending rates went up and the quantum was also higher compared to deposit rates.”

Also, this time around banks have been quick to cut their base rates, the minimum interest rate a bank charges its customers, after the RBI cut the repo rate by 50 basis points to 6.75%, in September. Having cut their base rates, banks have increased their spreads, and negated the cut in base rate to some extent.
Take the case of the State bank of India. The country’s largest bank cut its base rate by 40 basis points to 9.3%, in response to RBI cutting the repo rate by 40 basis points.

This meant that the interest rate on home loans should have fallen by 40 basis points as well. Nevertheless, the interest rate on an SBI home loan will fall by only 20 basis points. Why is that? Earlier, the bank gave out home loans to men at five basis points above its base rate (or what is known as the spread). To women, the bank gave out home loans at the base rate. Now it has decided to give out home loans to men at 25 basis points above the base rate. In case of women it is 20 basis points.

Hence, interest rate on a SBI home loan taken by a man will be now be 9.55% (9.3% base rate plus 25 basis points). Earlier, the interest rate was 9.75%. This means a fall in interest rate of 20 basis points only and not 40 basis points, as should have been the case.
ICICI Bank has done something along similar lines as well. And this step has essentially negated the cut in the base rate to some extent.

Further, the public sector banks have a problem of huge bad loans, which are piling on. Given this, they are using this opportunity to ensure that they are able to increase the spread between the interest they charge on their loans and the interest they pay on their deposits. This extra spread will translate into extra profit which can hopefully take care of the bad loans that are piling up.

The bad loans will also limit the ability of banks to cut their lending rates. As Crisil Research points out: “High non-performing assets [NPAs] curb the pace at which benefits of lower policy rate are passed on to borrowers. Data shows periods of high NPAs – such as between 2002 and 2004 (when NPAs were at 8.8% of gross advances) – are accompanied by weaker transmission of policy rate cuts. This time around, NPA levels are not as high as witnessed back then, but still remain in the zone of discomfort.”

Another reason banks often give for not cutting interest rates is the presence of small savings scheme which continue to give high interest when banks are expected to cut interest rates. As India Research and Ratings points out: “In the last decade small saving deposit schemes have offered rates between 8-9.3% unrelated to the up-cycle or down-cycle in policy rates. These rates are also politically sensitive since a bulk of this saving is made by elders, farmers and low income groups. In fact in 2009 when repo rates were at a low of 4.75%, PPF and NSC both continued to offer 8% return and in 2012 when the repo rate moved up to 8.5%, PPF offered 8.8% and NSC offered 8.6% return.”

Nevertheless, this time around banks have cut interest rates on their one year deposits by 130 basis points. This is more than the 125 basis points repo rate cut carried out by the RBI during the course of this year.

A more informed conclusion could have been drawn here if there was data available on the kind of interest rate cuts that banks have carried out on their fixed deposits of five years or more. This would have allowed us to carry out a comparison with small savings scheme which typically tend to attract long term savings.

Long story short—EMIs and interest rates fall more on the front pages of business newspapers than they do in real life.

The column originally appeared on The Daily Reckoning on October 8, 2015

Ajit Gulabchand: The man who built Bandra-Worli sea-link needs lessons in basic economics

220px-Ajit_Gulabchand_-_World_Economic_Forum_on_East_Asia_2011
Ajit Gulabchand, the chairman and managing director of Hindustan Construction Company (HCC) said  in an interview yesterday: “a 50 basis points (bps) rate cut is welcome, but it is insufficient. …I expected at least 300 bps but if not that, 200 bps as an initial cut to create the impact that is necessary.” Among other things, Gulabchand is famous for having built the Bandra-Worli sea-link in Mumbai.

Gulabchand was reacting to the Reserve Bank of India’s decision to cut the repo rate by 50 basis points (one basis point is one hundredth of a percentage) to 6.75%. Repo rate is the rate at which the Reserve Bank of India (RBI) lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

While industrialists are used to being unreasonable, this is among the most irresponsible statements I have come across from an industrialist, in a while. Allow me to explain.

Central banks do not take extreme steps unless it’s an emergency. When was the last time you heard a big central bank dropping rates by 300 basis points at one go? Or even 200 basis points? Or even 100 basis points for that matter?

So, central banks work in a step by step process and not in a random manner. The question is why is Gulabchand sounding so desperate? The answer can be found out from his profit and loss account statement.

The operating profit (or earnings before interest taxes depreciation and amortisation) of HCC excluding its other income, for the period of April to June 2015 stood at Rs 161.8 crore. The total amount of interest that the company paid on its debt during the same period was at Rs 167 crore.

Hence, the interest coverage ratio of the company is less than one. The interest coverage ratio is calculated by dividing the interest on debt that a company pays during a period by its operating profit. An interest coverage ratio of less than one essentially shows that the company is not making enough money to be able to pay the interest on its debt. And that is not a good situation to be in.

What this basically means is that HCC has taken on more debt than it should have. In this scenario Gulabchand is desperate for the interest costs of the company to go down. The total debt of the company as on March 31, 2015, stood at Rs 5,011 crore. On this the company paid an interest of Rs 651.1 crore during the course of April 2014 to March 2015.

This means an effective interest rate of 13% (Rs 651 crore as a proportion of Rs 5,011 crore). If the interest rates fall by 300 basis points, HCC’s effective rate of interest will come down to 10%, assuming that the banks totally pass on the cut to the borrowers.

At 10%, the interest outflow for HCC would be Rs 501.1 crore (10% of Rs 5,011 crore). This is Rs 150 crore lower than the amount the company paid as interest during the period April 2014 to March 2015. And this is a huge amount given that the profit after tax of HCC during the period was Rs 81.6 crore.

So, it’s understandable why Gulabchand is desperate for significantly lower interest rates. The same logic holds true for a spate of other corporates who are deep in debt and are having a tough time servicing their debt. And given half a chance they talk about lower interest rates.

The question nonetheless is can India afford interest rates which are 300 basis points lower than they currently are. Let’s do a little thought experiment here.

The repo rate before the RBI cut it by 50 basis points was at 7.25%. Let’s say instead of cutting the repo rate by 50 basis points, the RBI had cut it by 300 basis points, as Gulabchand wanted it to. Let’s further assume that banks passed on this cut (I know I am being unreasonable here, but just humour me for a moment). They cut deposit interest rates by 300 basis points and they cut lending rates by 300 basis points as well.

What would happen here? Given that the repo rate would fall to 4.25%, we would have a situation where deposit rates would suddenly fall around 5%. So far so good.

In the monetary policy statement released yesterday the RBI expects consumer price inflation is to reach 5.8% in January 2016. So we will have a scenario where interest on fixed deposits are in the region of 5% and the inflation is at 5.8%. This will mean a negative real return on the fixed deposits, as the rate of inflation will be greater than the interest being offered on fixed deposits. And that will not be a good thing.

Take a look at the accompanying chart. The green line represents the consumer price inflation. The red line represents the average rate of interest at which the government borrows.

As can be seen from the chart, between 2007-08 and 2013-2014, the consumer price inflation was greater than the average interest rate at which the government borrowed. The rate of interest at which the government borrows is the benchmark for all other kinds of loans and deposits.

As can be seen from the chart, the government managed to borrow at a rate of interest lower than the rate of inflation between 2007-08 and 2013-14. And if the government could raise money at a rate of interest below the rate of inflation, banks couldn’t have been far behind.

Hence, the interest offered on fixed deposits by banks and other forms of fixed income investments was also lower than the rate of inflation. The inflation was consistently greater than 10% during the period, whereas the fixed deposit rates ranged between 8-10%.

And this had negative consequences, as household financial savings fell. Household financial savings is essentially a term used to refer to the money invested by individuals in fixed deposits, small savings scheme, mutual funds, shares, insurance etc. A major part of household financial savings in India is held in the form of bank fixed deposits and post office small savings schemes.

The household financial savings have fallen from 12% of the GDP in 2009-10 to 7.5% in 2014-15. The number was at 7% in 2012-2013. This happened because the rate of return on offer on fixed income investments (like fixed deposits, post office savings schemes and various government run provident funds) was lower than the rate of inflation.

This led to people moving their money into investments like gold and real estate, where they expected to earn more. It also led to a huge proliferation of Ponzi schemes in several parts of the country.

Hence, the money coming into fixed deposits and post office income schemes slowed down leading to a situation where household financial savings fell. This, in turn, led to high interest rates. As mentioned earlier the effective rate of interest that Gulabchand’s HCC paid on its debt during the period between April 2014 and March 2015, was 13%.

If the household financial savings are to be rebuilt, the rate of interest on offer to depositors has to be significantly greater than the rate of inflation. A major reason why household financial savings have risen between 2012-2013 and 2014-2015 has been because the rate of interest on fixed income investments has been higher than the rate of inflation.

In fact, the RBI governor Raghuram Rajan has often talked about a real rate of interest of 1.5-2% on fixed income investments (i.e. fixed deposit interest rates are higher than the rate of inflation by 1.5-2%). This is a very important factor that needs to be kept in mind by the RBI while deciding on interest rates.

The basic point is that the interest rates are not just about corporates and borrowing, they are also about savers. If people don’t save enough through fixed deposits and other fixed income investments, the rate of interest is going to go up.

And in order to ensure that people save enough and do not divert their money into other investments, it is important that the rate of interest on offer on fixed income investments continues to be significantly higher than the rate of inflation.

This also ensures that over the long term interest rates will remain at more reasonable levels. Meanwhile, if that means that the corporates are hurt, then so be it.

The column originally appeared on The Daily Reckoning on Oct 1, 2015

EMIs down by Rs 20 per lakh, we will all buy cars now

 

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The Nobel Prize winning physicist Albert Einstein once said: “It can scarcely be denied that the supreme goal of all theory is to make the irreducible basic elements as simple and as few as possible without having to surrender the adequate representation of a single datum of experience.”

This line is believed to be the source of another quote that often gets attributed to Einstein: “Everything should be made as simple as possible, but no simpler.” Irrespective of whether Einstein said this or not, it remains a very powerful quote.

It is typically applicable in scenarios where we are trying to explain things to people. And in our zeal to explain things we end up making things much simpler than they actually are. Now take the case of the Reserve Bank of India’s decision to cut the repo rate by 50 basis points (one basis point is one hundredth of a percentage) to 6.75%, yesterday. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

This immediately led many analysts and experts who appear on television to conclude that EMIs will now fall and hence, people will borrow more and buy cars, bikes, homes, and so on. This simplistic sort of analysis you would have read by now in your daily newspaper as well.

Only if it was as simple as that.

The banks borrow deposits at a certain rate of interest. They lend these deposits as loans at a higher rate of interest. Hence, for banks to cut the interest rates at which they lend, they first need to cut interest rates at which they borrow.

Further, even if banks cut deposit rates, after a cut in the repo rate, they may not cut lending rates or they may not cut lending rates to the same extent as the deposit rates. As the RBI said in a statement released yesterday: “The median base lending rates of banks have fallen by only about 30 basis points despite extremely easy liquidity conditions. This is a fraction of the 75 basis points of the policy rate reduction during January-June, even after a passage of eight months since the first rate action by the Reserve Bank. Bank deposit rates have, however, been reduced significantly, suggesting that further transmission is possible.”

Before yesterday’s 50 basis points cut in the repo rate, the RBI had cut the repo rate by 75 basis points between January and June 2015. In response to this banks had cut their lending rates by around 30 basis points on an average. They had cut their deposit rates more.

Why was this the case? In some cases, banks were simply trying to make more money. In other cases, particularly in case of public sector banks, the banks also had to deal with a huge amount of bad loans that had been piling up. Basically banks had lent money to corporates, who were no longer returning it. In this scenario, in order to maintain their profit levels, banks decided to cut their deposit rates more than their lending rates.

Further, banks also need to compete with small savings schemes offered by India Post. Hence, they cannot cut interest rates on their deposits beyond a point, unless the interest rates offered on the small savings schemes are cut as well.

The larger point being the “transmission” as experts like to call it from a repo rate cut to falling interest rates on banks loans, is not so straightforward, as it is often made out to be.

In the press conference that happened soon after the RBI rate cut, the economic affairs secretary Shaktikanta Das said that the government would review the interest rate offered on small savings schemes like the Public Provident Fund (PPF) and post office deposits.

Soon after this, the State Bank of India cut its base rate by 40 basis points to 9.3%. The cut will be effective from October 5, 2015. Base rate is the minimum interest rate a bank charges its customers. This cut by the country’s largest bank is expected to force the big private sector banks to act as well and cut their base rates. Andhra Bank also cut its base rate by 25 basis points to 9.7%.

Hence, this time the transmission of lower interest rates after a repo rate cut is likely to be faster than in the past. Nevertheless, does that mean consumption will pick up because interest rates are now slightly lower?

Let’s do some basic maths to understand this. SBI currently offers a car loan at 10.05% to men, 35 basis points above its base rate of 9.7%. For women, the rate of interest charged is 10%.

A car loan of five years of Rs 5 lakh at 10.05% would mean paying an EMI of Rs 10,636 in order to repay the loan. With the base rate being cut by 40 basis points, a new car loan would be offered at an interest of 9.65%. This would mean an EMI of Rs 10,538 or around Rs 100 lower. Hence, for every Rs 1 lakh of loan, the EMI will come down by around Rs 20 (Rs 100 divided by 5).

So, does that mean people will now buy cars because the car loan EMI will be down Rs 20 per lakh? Does that also mean that people were earlier not buying cars because the car loan EMI was Rs 20 per lakh higher?

If the car industry is to be believed that seems to be the case. Rakesh Srivastava of Hyundai Motors told the news-agency PTI that the rate cut was a “festival gift” from the RBI. R S Kalsi of Maruti Suzuki said: “On the whole, it gives a good signal to customers. The market so far has been moving very slowly but with this (rate cut) sentiments will improve. It gives the much-needed boost to the market in the pre-festive season.”

In fact, Pawan Munjal of Hero Honda also joined the rate-cut kirtan and said: “It has come at an opportune time as it will help in raising customer sentiment during the festival season.”

Hero Honda as you would know is in the business of selling two-wheelers, motorcycles in particular. SBI currently charges 12.85% on its Superbike loan. The EMI on a Rs 50,000, three year loan, would work out to Rs 1681.1. With a 40 basis points cut, the new interest rate will be 12.45%. The EMI on this will be around Rs 1671.5, or around Rs 10 lower.

So people will go and buy bikes because the EMI is Rs 10 lower now? And they were not buying bikes earlier because the EMI was Rs 10 too high?

This sort of simplistic logic on part of corporates and analysis on part of the media, really beats me.

People will consume and buy things when they feel confident about their economic future. This will happen when they see job security and steady increments on the way. Steady increments will come when corporate profits start growing, which isn’t the case currently. Corporate profits will start growing when the corporates are able to clean up the excessive debt that they have on their balance sheets now, among other things. And all this is easier said than done.

At the end of the day, monetary policy can only do so much.

Postscript: I would also suggest that you read an excellent piece by Tanushree Banerjee, Co-Head of Research at Equitymaster, on yesterday’s rate cut. You can read the piece here

The column originally appeared on The Daily Reckoning on Sep 30, 2015