Markets are not panicking over Greece exiting the Eurozone. Here’s why

greece
In his wonderful book
How to Speak Money John Lanchester defines Grexit as the hypothetical exit of Greece from the Eurozone. Eurozone is a term used referring to countries which use euro as their currency.
As things stand as of now the chances of Grexit may have gone up. Over the weekend,
Alexis Tsipras of the Syriza party took over as the youngest prime minister of Greece. Breaking tradition Tsipras took a civil oath and not a religious one. He has also vowed not to wear a tie until he has negotiated Greece a new deal with Europe, reports the Guardian.
Tsipras and the Syriza party were elected on the plank to
end austerity in Greece and to write off its debt. “We will bring an end to the vicious circle of austerity,” Tsipras told the crowd after his party’s victory in the Greek elections.
Greece had joined the Eurozone on June 19, 2000, In the process it gave up its currency, the drachma. Before the euro was born, interest rates set by the Bundesbank, the German central bank were the benchmark for interest rates of other countries in Europe. Other central banks had to set interest rates accordingly.
Hence, Germany enjoyed the lowest interest rates in Europe. Some of this prestige was rubbed on to the European Central Bank (the central bank formed to manage the euro) and the euro. The countries which used the euro as their currency also started to enjoy low interest rates.
There were two reasons for the same. The first reason was that the weaker countries of the euro zone would no longer be able to print money to pay off their debt like they had done in the past. With the power to print money out of the hands of the government, it was widely expected that inflation would come under control. And with inflationary expectations (or the expectations that consumers have of what future inflation is likely to be) lower, interest rates came down.
The other reason for a fall in interest rates was the fact that the market assumed that in case there was any trouble with the weaker countries in the euro zone, the stronger ones (read Germany) would come to their rescue (which is how things have played out over the last few years).
As Neil Irwin writes in
The Alchemists—Inside the Secret World of Central Bankers: “In 1992, when low-inflation Germany could borrow money for a decade at 8 percent, Greece had to pay 24 percent…Greece gained the credibility of the European Central Bank, which itself was modelled after Germany’s Bundesbank.”
And this “credibility” in a few years ensured that interest rates in Greece were almost the same as they were in Germany. “Investors were willing to hand money over to the Greek government for pretty much the same interest rate they received for giving it to the German or the French governments. In 2007…German ten-year borrowing costs averaged 4.02 percent. Greek rates were 4.29 percent. Investors had become complacent, viewing Greek debt as an essentially risk-free substitute for bonds issued by better run countries like Germany, France of the Netherlands,” writes Irwin.
The Greek government made use of the low interest rates and went on a borrowing binge. The fiscal deficit of the Greek government was under 4% of the GDP In 2001. It went up to 15.7% of the GDP in 2009. The huge fiscal deficit was primarily on account of profligate public spending to finance the Greek welfare state. Fiscal deficit is the difference between what a government borrows and what it spends.
As author Satyajit Das wrote in an essay titled
Nowhere To Run, Nowhere to Hide in July 2010: “Profligate public spending, a large public sector, generous welfare systems, particularly for public servants, low productivity, an inadequate tax base, rampant corruption and successive poor governments created the parlous state of public finances.”
This led to the debt of the Greek government going up big time. When Greece joined the Eurozone in 2000 its government debt was a little over 90% of the GDP. By 2009 it had exploded to 129% of the GDP.
Since then Greece has had to be rescued by a series of bailout programmes involving the European Central Bank, the European Union and the International Monetary Fund. The total bailout amount stands at close to a whopping 240 billion euros or around $270 billion, as per the current exchange rate.
In order to ensure that the Greece government repaid its debt and the bailout amounts it was put on an austerity programme. As Mark Blyth writes in
Austerity—The History of a Dangerous Idea: “Cut spending raise taxes—but cut spending more than you raise taxes—and all will be well, the story went.”
But that did not turn out to be the case. The private sector wasn’t doing well and on top of that government spending also collapsed, leading to the Greek economy crashing. As Blyth writes: “In May 2010, Greece received a 110-billion-euro loan in exchange for a 20 percent cut in public-sector pay, a 10 percent pension cut, and tax increases. The lenders, the so-called troika of the ECB, the European Commission, and the IMF, forecast growth returning by 2012. Instead, unemployment in Greece reached 21 percent in late 2011 and the economy continued to contract.”
And the situation has only gotten worse since then. The current rate of overall unemployment in Greece is at 28% and among the youth it’s over 50%. In fact, the Greek GDP per head has shrunk by 22% since 2008,
reports the BBC. At the same time the Greek government debt has also soared to 176% of GDP by September 2014.
So, clearly the austerity programme wasn’t working and the Greek voters had had enough of it. In this environment the Syriza party came as a breath of fresh air. The rhetoric of the Syriza party and its leader Tsipras has toned down a little in the aftermath of the electoral win but it still remains very strong.
“The new Greek government will be ready to co-operate and negotiate for the first time with our peers a just, mutually beneficial and viable solution,” Tsipras said after winning the Greek election.
This posturing clearly has countries like Germany worried. The BBC reports that the German government spokesman Steffan Seibert said that it was important for Greece to “take measures so that the economic recovery continues”. What Germany is simply telling Greece here is to continue with the austerity programme and continue repaying the debt that it has accumulated over the years.
Tsipras and his party obviously don’t agree with this point of view.
As the Guardian reports: “His [i.e. Tsipras] first act as prime minister was to lay roses at a memorial to 200 Greek communists executed by the Nazis in May 1944. Analysts said the gesture left little room for interpretation: for a nation so humiliated after five years of wrenching austerity-driven recession, it was aimed, squarely, at signalling that it was now ready to stand up to Europe’s paymaster, Germany.”
And this is where the whole thing can snap. Germany wants Greece to continue with the austerity programme. Greece wants to re-negotiate the austerity as well as the total amount of debt that it owes. The question is who will blink first? Will Greece choose to leave the euro first? Will it be asked to leave?
The financial market does not seem to be unduly worried about this as of now.
One explanation that has been offered is that investors are now coming around to believe that the eurozone will emerge stronger if Greece leaves it, to the condition that other countries do not follow it.
But this is too strong an assumption to make. In case of Greece deciding to leave the euro, Greeks will start withdrawing their euros from their banks. This would happen primarily because the new currency (probably drachma in Greece’s case) would be less valuable than the euro. Hence, Greek banks would face bank runs. It would also mean that Greece would most likely default on its debt or repay them in less valuable drachmas. This could even influence the other countries( Portugal, Italy, Ireland, Spain) to do the same. Citizens of these countries expecting their countries to leave the euro would start withdrawing their euros from banks, leading to bank runs in these countries.
Long story short: The situation has become very murky to estimate how things will pan out.

The column originally appeared on www.firstpost.com on Jan 27, 2015

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

Oil and dollar: Why Obama’s love for Taj lost out to Saudi King’s death

Obama

Barack and Michelle Obama were supposed to be in Agra on January 27, 2015, visiting the Taj Mahal. Instead they will now be going to Saudi Arabia to pay respects to  King Salman bin Abdulaziz, the recently crowned King of Saudi Arabia and the family of the late King Abdullah bin Abdulaziz, who died on January 23. Bloomberg reports that keeping with religious tradition, Abdullah was was quickly and quietly buried on the day he died.
A newsreport in The Indian Express points out that the “Supreme Court had earlier directed all visitors to the Taj Mahal to disembark at the Shilpgram complex, 500 metres away, and board an electric vehicle to the entry gate.” This was deemed to be a security risk by the Secret Service that guards President Obama and hence, the visit was cancelled.
This reason has since been denied by the White House. A more plausible reason lies in the shared history of Saudi Arabia and the United States. As Adam Smith (George Goodman writing under a pseudonym) writes in Paper Money: “In 1928, the Standard Oil Company of California, Socal, had failed to find oil in Mexico, Ecuador, the Philippines, and Alaska. As a last resort, it bought concession from Gulf on the island of Bahrain, twenty miles off the coast of Saudi Arabia, and found some oil. Socal sought out Harry St. John Philby, a local Ford dealer…who was a friend of the Saudi finance minister, Sheikh Abdullah Sulaiman…For 35,000 gold sovereigns, Socal got the concession for Saudi Arabia. Sheikh Abdullah Sulaiman counted the coins himself. Socal’s Damman Number 7 struck oil at 4,727 feet in 1937.”
This is how Saudi Arabia’s journey as an oil producer started. The United States was the world’s largest producer of oil at that point of time, but its obsession with the automobile had led to a swift decline in its domestic reserves.
President Franklin D. Roosevelt realized that a regular supply of oil was very important for America’s well-being. Immediately after attending the Yalta conference in February 1945, Roosevelt travelled quietly to the USS Quincy, a ship anchored in the Red Sea. Here he met King Ibn Sa’ud of Saudi Arabia, the country which was by then home to the largest oil reserves in the world. Ian Carson and V.V. Vaitheeswaran point this out in their 2007 book, Zoom—The Global Race to Fuel the Car of the Future.
Car production had come to a standstill in the United States during the course of the Second World War. Automobile factories became busy producing planes, tanks, and trucks for the War. Renewed demand was expected to come in after the end of the War. Hence, the country needed to secure another source for an assured supply of oil.
So, in return for access to the Saudi Arabian oil reserves, King Ibn Sa’ud was promised full American military support to the ruling clan of Sa’ud. It is important to remember that the American security guarantee made by President Roosevelt was extended not to the people of Saudi Arabia nor to the government of Saudi Arabia but to the ruling clan of Al Sa’uds.
Over the years, Saudi Arabia further returned the favour by ensuring that Organization of the Petroleum Exporting Countries (OPEC) continued to price oil in terms of dollars despite the fact that it was losing value against other currencies, especially in the 1970s.
Attempts were made by other members of the OPEC to price oil in a basket of currencies, but Saudi Arabia did not agree to it. This ensured that oil continued to be the international reserve and trading currency. Most countries in the world did not produce oil and hence, needed dollars to buy oil. This meant that they had to sell their exports in dollars in order to earn the dollars to buy oil.
If Saudi Arabia and OPEC had decided to abandon the dollar, it would have meant that the demand for the dollar would have come crashing down, as countries would no longer need dollars to pay for oil. Hence, oil will continue to be priced in dollars as long as Al Sa’uds continue to rule Saudi Arabia because they have the security guarantee from the United States.
Further, Saudi Arabia remains a close ally of the United States despite the fact that the late Osama bin Laden was a Saudi by birth. Osama was the son of Mohammed bin Awad bin Laden and his tenth wife, Hamida al-Attas. The senior bin Laden was a construction magnate who was believed to have had close ties with the Saudi Royal family.
Since 2008, a lot of shale oil has been discovered in the United States and the production of oil in the United States has gone up by four million barrels per day to nine millions barrels per day, with almost all of the increase coming from increased production of shale oil. This is only a million barrels per day lower than the daily oil production of Saudi Arabia.
Given this, why does the United States still need to continue humouring Saudi Arabia? It is now producing enough oil on its own. James K. Galbraith has an answer for it in The End of Normal: “There is no doubt that shale is having a strong effect on the American economic picture at present…But the outlook for sustained shale…production over a long time horizon remains uncertain, for a simple reason: the wells have not existed long enough for us to know with confidence how long they will last. We don’t know that they won’t; but also we don’t know that they will. Time will tell, but there is the unpleasant possibility that when it does, the shale gas miracle will end.”
Jeremy Grantham of GMO goes into further detail in a newsletter titled The Beginning of the End of the Fossil Fuel Revolution (From Golden Goose to Cooked Goose: “The first two years of flow are basically all we get in racking…Because fracking reserves basically run off in two years and can be exploited very quickly indeed by the enterprising U.S. industry, such reserves could be viewed as much closer to oil storage reserves than a good, traditional field that flows for 30 to 60 years.” The process used to drill out shale oil is referred to as fracking.
Hence, shale-oil might turn out to be a short-term phenomenon. As of now shale oil is not going to replace cheap traditional oil, which is becoming more and more difficult to find. As Grantham points out: “Last year for example, despite spending nearly $700 billion globally – up from $250 billion in 2005 – the oil industry found just 4½ months’ worth of current oil production levels, a 50-year low!”
It is worth remembering that the United States consumes 25 percent of the world’s daily production of oil and half of its daily production of petrol, or what Americans call gasoline. The fact that it is using way too much oil becomes even more obvious given that it has only five percent of the world’s population. Given this, it still needs Saudi Arabia.
Hence, the Obamas need to go to Saudi Arabia and offer their condolences on King Abdullah’s death as soon as possible. The Taj Mahal will have to wait.

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

The article originally appeared on www.Firstpost.com as on Jan 26, 2015 

Despite recent fall, oil prices will touch $100 per barrel again

light-diesel-oil-250x250Vivek Kaul

This column should complete the trilogy of columns on the price of crude oil. In yesterday’s column I had argued that it is difficult to predict which way the price of oil would go in the short-term, even though it seems that it will continue to remain low.
The more important question is which way the price of crude oil will go in the long term. While exact forecasting is risky business, the direction of the price rise can be predicted especially when structural factors are at work.
Nevertheless, before we get around to doing that, we first need to understand why is oil so important for the progress of human civilization. As Jeremy Grantham of GMO puts it in a newsletter titled
The Beginning of the End of the Fossil Fuel Revolution (From Golden Goose to Cooked Goose: “The quality of modern life owes almost everything to the existence of fossil fuels, a massive store of dense energy that for 200 years had become steadily cheaper as a fraction of income. Under that stimulus, the global economy grew ever larger.”
By fossil fuels Grantham means coal and oil. But what is it that makes oil so important? Grantham explains it through an example of one of his sons who is a forester. Grantham talks about a situation where wood is needed for heating purposes and hence, trees need to be cut. This can be done by hiring local labour who will use their axes to cut trees, and paying them a respectable minimum wage of $15 an hour. The other option is to fill a chainsaw with a gallon of gas and use that to cut trees.
As Grantham writes: “One of my sons, a forester, tells me he could cut all day, 8 to 12 hours, with a single gallon of gasoline and be at least 20 times faster than strong men with axes and saws, or a total of 160 to 240 man hours of labor. For one gallon!”
If people had to be hired to do the same job around $2,400 (160 x $15) to $3600 (240 x $15) would have to be paid. That’s the value created by one gallon(or 3.79 litres) of gasoline(or what we call petrol in India) which costs around $3 in the United States.
This “surplus value” created by gasoline and other petroleum products were a major reason which helped usher in the industrial revolution in the Western world. Before the world discovered fossil fuels it was totally dependent on wood from trees for its energy requirements.
As Grantham writes in another newsletter titled
Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever: “[Wood]…was necessary for producing the charcoal used in making steel, which in turn was critical to improving machinery – a key to progress. (It is now estimated that all of China’s wood production could not even produce 5% of its current steel output!) The wealth of Holland and Britain in particular depended on wooden sailing ships with tall, straight masts to the extent that access to suitable wood was a major item in foreign policy and foreign wars. Even more important, wood was also pretty much the sole producer of energy in Western Europe.”
Other than being used for making charcoal, wood was also used to power steam engines and for heating purposes. What this meant was that forests were rapidly cut down for wood which was required to produce energy. “Not surprisingly, a growing population and growing wealth put intolerable strains on the natural forests, which were quickly disappearing in Western Europe, especially in England, and had already been decimated in North Africa and the Near East. Wood availability was probably the most limiting factor on economic growth,” writes Grantham.
If the world had not discovered first coal and then oil, it would have run out of trees by around 1850, estimates Graham. And there would have been other impacts as well. “By 1900 wars would have been fought over forests, and the population – without oil-intensive agriculture, both for growing and transportation – would have peaked out probably well under two billion and our species would indeed have had its nose pushed up against the limits of food,” writes Grantham.
That is the importance that fossil fuels, in particular oil, have had on the human civilization over the last two hundred years. So, it is important that the world continues to have access to “cheap” oil. But will that be case?
As Niels C. Jensen writes in
The Absolute Return Letter for January 2015 titled Pie in the Sky: “The world will still run out of cheap oil (cheap as in approx. $25 per barrel of production cost, as is currently the average production cost in the Middle East) over the next decade or so. It is hard to predict exactly when, because OPEC members are not the most informative people in the world.”
This, despite the fact that over the last six to seven years the world has managed to increase the production of shale oil. In the United States oil production has gone up by 4 million barrels per day to 9 million barrels per day and almost all of it has come through shale oil production.
Even with this, the future does not look very encouraging. And there is a reason for the same. As James K. Galbraith writes in
The End of Normal: “There is no doubt that shale is having a strong effect on the American economic picture at present…But the outlook for sustained shale…production over a long time horizon remains uncertain, for a simple reason: the wells have not existed long enough for us to know with confidence how long they will last. We don’t know that they won’t; but also we don’t know that they will. Time will tell, but there is the unpleasant possibility that when it does, the shale gas miracle will end.”
Grantham goes into detail about the point that Galbraith makes. The process used to drill out shale oil is referred to as fracking. As Grantham points out: “The first two years of flow are basically all we get in fracking…Because fracking reserves basically run off in two years and can be exploited very quickly indeed by the enterprising U.S. industry, such reserves could be viewed as much closer to oil storage reserves than a good, traditional field that flows for 30 to 60 years.”
Hence, shale oil will be what Jensen calls a “relatively short-lived phenomenon”. It is not replacing cheap traditional oil which is becoming more and more difficult to find. “Last year for example, despite spending nearly $700 billion globally – up from $250 billion in 2005 – the oil industry found just 4½ months’ worth of current oil production levels, a 50-year low!,” writes Grantham.
Hence the oil industry in the “last 12 months” has replaced “only 4½ months’ worth of current production!” This, despite the boom in shale oil production.
What this clearly tells us is that the recent fall in the price of oil is at best a temporary phenomenon. Over the long term, oil prices can only go up. As Jensen puts it: “we will see the oil price at $100 again, and it won’t take many years, but it could be an extraordinarily bumpy ride.”
Meanwhile,watch this space.

The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 14, 2015

The stories that business media and market analysts tell us

bullfightingVivek Kaul

Over the last few days I have had great fun watching business news channels. After the BSE Sensex crashed by 855 points or over 3% on January 6, 2015, all kinds of explanations have been offered for the fall by the business media in general and market analysts in particular. Greece will soon be in major trouble. The dollar is rising against other currencies. The global cues are not good. Oil price has fallen to below $50 per barrel. This means that the world is entering an era of deflation (Deflation, a scenario of falling prices, is the opposite of inflation, and I am amazed how easily market analysts who appear on television use this term). The Modi effect is slowing down. The foreign investors need to realign their portfolios with the changing global economic scenario. And the proverbial, Indian economy is not doing well and corporate investment is needs to pick up. Two days later on January 8, 2015, the Sensex rallied 366 points or 1.4%. Market analysts and the business media told us that value buying was now coming in and this had led to the rally. What amazes me is that investors suddenly saw value in stocks with the market falling by just 3%? Benjamin Graham must be turning in his grave. He clearly never would have envisaged a day like this. Also, the investors did not see value on January 7, 2015, when the Sensex was almost flat. It fell by around 78.6 points or 0.3% on that day. But they suddenly saw value on January 8, 2015. What changed overnight? That no market analyst bothered to explain. In the Indian context, the foreign institutional investors have been driving the market for a while now. On January 6, 2015, they net sold stocks worth Rs 1,534.23 crore. But this was neutralized to some extent by domestic institutional investors buying stocks worth Rs 1,079.6 crore on the same day. Markets go up. Markets go down. And just because analysis exists doesn’t mean we analyse everything. I haven’t heard a single market analyst or a journalist in the business media till date say that today’s stock market movements were due to random fluctuations. As John Allen Paulos writes in A Mathematician Reads the Newspaper: “Almost never does a stock pundit say that market’s or a particular stock’s activity for the day or the week or the month was largely a result of random fluctuations.” With so many numbers and stories going around it is always possible to say something which on the face of it sounds very sensible. “The business pages, companies’ annual reports, sales records, and other widely available statistics provide such a wealth of data from which to fashion sales pitches that it’s not difficult for a stock picker to put on a good face…All that’s necessary is a little filtering of the sea of numbers that washes over us,” writes Paulos. This is precisely what has been happening over the last few days. The information and analysis being provided is essentially adding to the clutter. As Nassim Nicholas Taleb writes in Fooled by Randomness: “The difference between noise and information…has an analog: that between journalism and history. To be competent, a journalist should view matters like a historian, and play down the value of the information, he is providing.” This Taleb, feels can be done by saying: “Today the market went up, but this information is not too relevant as it emanates from noise”. But in an era of 24 hour news channels this is easier said than done. “Not only is it difficult for the journalist to think more like a historian, but it is, alas, the historian who is becoming more like the journalist [and to add my two bit so are market analysts]…If there is anything better than noise in the mass of “urgent” news pounding us, it would be like a needle in a haystack. People do not realize that the media is paid to get your attention. For a journalist, silence really surpasses any word,” writes Taleb. To be fair to the business news channels, the business newspapers follow the same formula of trying to come up with an explanation for market movements all the time. It’s just that since they do not have to react instantly to everything, some amount of noise gets filtered out in their reporting. A few years back I happened to interview valuation guru Aswath Damodaran and asked him a fairly straightforward question: How much role does media play in influencing investment decisions of people? The reply he gave was very interesting: “Media and analysts are followers…Basically when I see in the media news stories I see a reflection of what has already happened. It is a lagging indicator. It is not a leading indicator. I have never ever found a good investment by reading a news story. But I have heard about why an investment was good in hindsight by reading a news story about it. I am not a great believer that I can find good investments in the media. That’s not their job anyway.” This is something that investors need to keep in mind while following the media in their quest to understand why are the markets moving the way they are. It is worth remembering that business news channels and the business newspapers need to operate even when there is no major news. As Maggie Mahar writes in Bull—A History of the Boom and Bust, 1982-1984: “The perennial problem for the media is that balance sheets do not fluctuate on a daily basis. Once a reporter has laid out a company’s assets and debts, how does he fill the news hole the next day? Only by tracking market’s daily performance.” Analysts help the business press in filling up the daily space. This is something that former Morgan Stanley analyst Andy Kessler writes about in his book Wall Street Meat: “The market opens for trading five days a week… Companies report earnings once every quarter. But stocks trade about 250 days a year. Something has to make them move up or down the other 246 days [250 days – the four days on which companies declare quarterly results]. Analysts fill that role. They recommend stocks, change recommendations, change earnings estimates, pound the table—whatever it takes for a sales force to go out with a story so someone will trade with the firm and generate commissions.” And once analysts have a daily opinion, the media gets some masala to fill up its daily space. The trouble is that while the media ends up filling up space, investors who follow the media are bound to end up confused if they follow the media on a daily basis. It is worth remembering here what hedge fund manager Bill Fleckenstein told Mahar: “The trouble is that investing doesn’t lend itself to play-by-play reporting…Speculation does, but investing doesn’t.” The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 9, 2015

The one assurance that Narendra Modi needs to give bankers…

narendra_modi
Vivek Kaul

The ministry of finance has organised a two day retreat for public sector banks in Pune over January 2 and 3, 2015. The retreat is being attended by the RBI governor Raghuram Rajan and the deputy governors as well. It will end today with brief presentations being made to the prime minister Narendra Modi. After the presentations the the prime minister will interact and address the gathering.
A press release issued by the ministry of finance basically outlined four objectives for this retreat, which are as follows:
(i) To create a platform for formal and informal discussions around the issues which are important for banking sector reforms.

(ii) To achieve a broad consensus on what has gone wrong and what should be done both by banks as well as by the government to improve and consolidate the position of PSBs.

(iii) To get some out of box ideas from prominent experts in the field as also from the top level managers attending the retreat.

(iv) The final objective would be to prepare a blue print of reform action plan once adopted which could then be implemented by the banks as well as by the government.

On paper this sounds like a good idea. It shows that the government is serious about figuring out what is wrong with the banking sector in India and working on it, instead of just letting things drift. Nevertheless, the retreat shouldn’t boil down into an excercise of exerting pressure on the public sector banks (PSBs) to lend more. With officials of ministry of finance attending the retreat as well, there are chances of that happening.
The total amount of loans being given by banks have slowed down in the recent past. Data released by the RBI shows that in November 2014 loans to industry increaed by 7.3% in comparison to November 2013. The loans had increased by 13.7% in November 2013 in comparison to November 2012. “Deceleration in credit growth to industry was observed in all major sub-sectors, barring construction, beverages & tobacco and mining & quarrying,” a RBI press release pointed out. Loans to the services sector grew at 9.9 per cent in November 2014 as compared with an increase of 18.1 per cent in November 2013.
The finance minister Arun Jaitley has time and again blamed high interest rates for this slowdown in bank lending as well as economic growth.
In a speech he made on December 29, 2014, Jaitley said: “The cost of capital…I think in recent months or years…is one singular factor which has contributed to slowdown of manufacturing growth itself.”
This and other statements that Jaitley has made over the last few months tend to look at credit (or banks loans) as a flow. But is that really the case? As James Galbraith writes in
The End of Normal: “Credit is not a flow. It is not something that can be forced downstream by clearing a pie. Credit is a contract. It requires a borrower as well as a lender, a customer as well as a bank. And the borrower must meet two conditions. One is creditworthiness…The other requirement is a willingness to borrow, motivated by the “animal spirits” of business enthusiasm. In a slump, such optimism is scarce. Even if people have collateral they want security of cash.”
Further, as Jeff Madrick points out in
Seven Bad Ideas—How Mainstream Economists Have Damaged America and the World: “Business investment is not just affected by the supply of national savings but by the state of optimism. If consumer demand for goods is not strong, a business will have little incentive to invest, no matter how great profits are or how low interest rates are on bank loans.” These are very important points that the mandarins who run the ministry of finance in this country need to understand.
So how good is the creditworthiness(or the ability to repay a loan) of Indian companies? The answer for this is provided in the recent Mid Year Economic Analysis released by the ministry of finance. As the report points out: “M
ore than one-third firms have an interest coverage ratio of less than one (borrowing is used to cover interest payments). Over-indebtedness in the corporate sector with median debt-equity ratios at 70 percent is amongst the highest in the world.”
Interest coverage ratio is the earnings before income and taxes of a company divided by the interest it needs to pay on its debt. If the ratio is less than one what it means is that the company is not earning enough to repay even the interest on it debt. The interest then needs to be repaid by taking on more debt. This works just like a Ponzi scheme, which keeps running as long as money being brought in by new investors is greater than the money that needs to be paid to the old investors.
In this situation it is not surprising that the bad loans of banks, particularly public sector banks have gone up dramatically. As the
latest financial stability report released by the RBI points out: “The gross non-performing advances (GNPAs) of scheduled commercial banks(SCBs) as a percentage of the total gross advances increased to 4.5 per cent in September 2014 from 4.1 per cent in March 2014.”
The stressed loans of banks also went up. “Stressed advances increased to 10.7 per cent of the total advances from 10.0 per cent between March and September 2014. PSBs continued to record the highest level of stressed advances at 12.9 per cent of their total advances in September 2014 followed by private sector banks at 4.4 per cent.”
The stressed asset ratio is the sum of gross non performing assets plus restructured loans divided by the total assets held by the Indian banking system. The borrower has either stopped to repay this loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan (which also entails some loss for the bank) by increasing the tenure of the loan or lowering the interest rate.
What this means in simple English is that for every Rs 100 given by Indian banks as a loan(a loan is an asset for a bank) nearly Rs 10.7 is in shaky territory. For public sector banks this number is even higher at Rs 12.9.
The question that crops up here is why is the stressed asset ratio of public sector banks three times that of private sector banks? The financial stability report has the answer for this as well. As the report points out: “Five sub-sectors: infrastructure, iron and steel, textiles, mining (including coal) and aviation, had significantly higher levels of stressed assets and thus these sub-sectors were identified as ‘stressed’ sectors in previous financial stability reports. These five sub-sectors had 52 per cent of total stressed advances of all SCBs as of June 2014, whereas in the case of PSBs it was at 54 per cent.”
As is well known that these sectors are full of crony capitalists who were close to the previous political dispensation. This forced the public sector banks to lend money to these companies and now these companies are either not in a position to repay or have simply fleeced the bank and not repaid.
The report further points out that the public sector banks have the highest exposure to the infrastructure sector: “Among bank groups, exposure of PSBs to infrastructure stood at 17.5 per cent of their gross advances as of September 2014. This was significantly higher than that of private sector banks (at 9.6 per cent) and foreign banks (at 12.1 per cent).”
Public sector banks haven’t been able to recover these loans from businessmen who have defaulted on them. Given this, if there is one assurance that Narendra Modi needs to give to public sector banks, it has to be this—he needs to assure them that there will be absolutely no pressure on them from his government to lend money to crony capitalists who are close to the current political dispensation.
This single measure, if followed, will go a long way in improving the situation of public sector banks in this country. It will be one solid move towards the promised
acche din.

The article originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 3, 2015