How the American real estate bubble impacts you and your investments

What if I were to say that the home prices in the United States impact the value of your investments in India. You will probably turn around and ask me to go take a walk.

But the fact of the matter is that there is actually a link between the two and we have reached a stage where the link perhaps matters more than it ever did. Nonetheless, before we get into understanding this, it’s important to know how we got here in the first place.

In late 2019 and early 2020, rich world central banks led by the Federal Reserve of the United States, the American central bank, started to print a lot of money, first to take care of the economic slowdown and then the economic contraction because of the spread of the covid pandemic.

The idea was to drive down interest rates. At lower interest rates people were expected to borrow and spend money. Interest rates on thirty year home loans in the United States fell to as low as 2.65% in early January 2021, the lowest they had been since 1971, the year from which this data is available.

Naturally, with interest rates at such low levels, more people started borrowing and buying homes than was the case in the past. While the demand for homes went up quickly, their supply couldn’t go up as quickly to meet this extra demand. Hence, home prices went up, at a very past pace.

In April 2022, home prices in the US, as per the S&P Case-Shiller 20-City Composite Home Price Index, went up by 21.2% in comparison to April 2021. Home prices have been rising at more than 17% year on year from May 2021 onwards. This kind of price rise wasn’t even seen during the real estate bubble of the 2000s.

One straight impact of this has been rising home rents. As per Realtor.com, the median rent in the United States in May 2022 was 23.2% higher than in May 2020 and 15.5% higher than in May 2021. This rise in home rents feeds into retail inflation. As The Economist puts it, in May 2022, the “rising housing costs already accounted for 40% of the monthly increase in the consumer-price index [which measures retail inflation].”

In May 2022, the retail inflation in the United States stood at 8.6%, the highest since December 1981, when it was at 8.9%. People are now building in this high inflation into their monetary calculations; in the home-rents they demand and in the salaries and wages they ask for.

In May 2022, the median one-year ahead expected inflation rate in the United States was 6.6%, the highest that it has been in a while. As any economist would put it, once inflation expectations set in the minds of people it becomes very difficult for central banks to control inflation.

So, in this scenario, it has become very important for the Federal Reserve to control the fast pace at which housing prices have been going up, given that it can’t do much about the high energy prices, due to the war in Ukraine.

The Federal Reserve has decided to gradually withdraw some of the money that it had printed and pumped into the financial system. Between June 2021 and May 2022, it expects to suck out close to a trillion dollars, bringing an era of easy money to an end.

This is already pushing up home loan and other long-term interest rates in the United States. As of June 30, the median interest rate on a 30-year fixed interest rate home loan had risen to 5.7%, from a low of 2.65% in early January 2021.

As the Fed keeps sucking out money, the interest rate on home loans will keep going up and this will hopefully drive down the demand for fresh homes and the rate of price rise of homes. As home price inflation cools down, rental inflation will also cool down and in turn bring down retail inflation. That’s the theory.

Other than taking out the money it had printed, the Federal Reserve also plans to raise its key short interest rate, the federal funds rate. This is expected to drive up short term interest rates in the United States.

The end of the era of easy money and rising interest rates in the United States will have an impact on investments in India. In fact, this is already happening. The foreign institutional investors (FIIs) have already sold Indian stocks worth Rs 2.56 trillion between October 2021 and July 1, 2022. This has led to the value of investments in stocks, equity mutual funds and unit linked insurance plans, falling.

Further, as FIIs sell out of India, they convert their rupees into dollars, leading to a surge in the demand for the dollar and drop in the value of the rupee. One dollar is currently worth around Rs 79. It was worth around Rs 74.5 at the beginning of 2022. This makes life expensive for those looking to study abroad or to go for a foreign holiday.

As the Federal Reserve raises interest rates, the Reserve Bank of India will have to do the same. This will push up interest rates on loans as well as deposits in India. Hence, people with loans are likely to end up paying higher EMIs, whereas people with deposits are likely to earn a higher interest than was the case in the past. Again, this is already happening.

Of course, a big impact of the rise in interest rates in the United States has been on crypto prices, which have crashed by close to 80% from their all-time high-levels, leaving many zoomers poorer.

All in all, as the old cliché goes, when America sneezes, the whole world catches cold.

This piece originally appeared in the Deccan Herald on July 3, 2022, with a different headline.

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.

Where are the jobs?

jobs

One million Indians are entering the workforce every month. This makes it around 1.2 crore a year, which is around half the total population of Australia.

This is India’s demographic dividend, which is supposed to find a job, earn and spend, pull India’s crores out of poverty. At least, that is the story that we have been sold over the years. But the theory is not translating into practice.

The land-owning communities across large parts of the country have been on the streets, protesting. This includes the Marathas of Maharashtra, the Jats of Haryana, the Kapus of Andhra Pradesh and the Patidar Patels of Gujarat.

The average size of the land farmed by the Indian farmer has fallen over the decades and in 2010-2011, the last time the agriculture census was carried out, stood at 1.16 hectares. In 1970-1971 it had stood at 2.82 hectares.

This has happened because of the division of land across generations. Further, this fall in farm size has made farming in many parts of the country, an unviable activity. And this explains why the land-owning castes across the country have been protesting and want a reservation in government jobs.

The trouble is that the government does not create jobs any more. In fact, between January 2006 and January 2014, the number of central government employees went up by just 30,000. The total number of people working for the public-sector enterprises has fallen over the years.

Only three out of five individuals who are looking for a job all through the year, are able to find one. In rural India, only one out of two individuals who are looking for a job all through the year, are able to find one. This has been the state of things since 2013-2014.
In fact, as far as Indian industry is concerned it favours expansion through capital (i.e. buying more machines and equipment) than recruiting more people.

Nikhil Gupta and Madhurima Chowdhury analysts at Motilal Oswal, use data up to 2014-2015, from the Annual Survey of Industries, and based on it conclude that over a period of 35 years up to 2014-2015, the rate of employment in the Indian industry has increased at 1.9 per cent per year on an average. In comparison, the capital employed by industry has grown at the rate of 14 per cent per year.

Clearly, capital has won the race hands down. Or if I were to put it in simple words, when it comes to Indian industry, machine has won over man for a while now. The Indian corporates like the idea of expanding their production and in the process their business, by installing new machines and equipment, rather than employing more people.

One of the reasons for this is the huge number of labour laws that Indian firms need to follow. As Jagdish Bhagwati and Arvind Panagariya write in India’s Tryst with Destiny: “The costs due to labour legislations rise progressively in discrete steps at seven, ten, twenty, fifty and 100 workers. As the firm size rises from six regular workers towards 100, at no point between the two thresholds is the saving in manufacturing costs sufficiently large to pay for the extra costs of satisfying these laws.”

The National Manufacturing Policy of 2011 estimates that, on an average, a manufacturing unit needs to comply with nearly 70 laws and regulations.  At the same time, these units sometimes need to file as many as 100 returns a year.

This basically ensures that an average Indian firm starts small and continues to remain small. In the process, jobs aren’t created. This is reflected in the fact that close to 85 per cent of Indian apparel firms employ less than eight people. As per an Economic Survey estimate, close to 24 jobs are created in this sector per lakh of investment. Despite, this firms in this sector continue to remain small.

The points discussed up until now are essentially big structural issues, which have been around for a while. In the recent past, demonetisation which overnight made 86.4 per cent of the currency in circulation, useless, ended up destroying many firms operating in the informal sector. The Goods and Services Tax has added to this.

These days the presence of informal sector is seen as a bad thing because it doesn’t pay its fair share of taxes to the government. This isn’t totally true. People who work for these firms do spend the money that they earn and pay their share of indirect taxes. Also, as the Economic Survey of 2015-2016 points out: “The informal sector should… be credited with creating jobs and keeping unemployment low.”

As economist Jim Walker of Asianomics wrote in a research note sometime back: “There is nothing intrinsic that says that the informal economy is a less effective or beneficial source of activity than the formal economy.” This is something that the Modi government needs to understand.

In its quest for more taxes, it is working towards destroying large parts of the informal economy, which is a huge part of Indian economy. Ritika Mankar Mukherjee and Sumit Shekhar of Ambit Capital wrote in a research note: “India’s informal sector is large and labour-intensive. The informal sector accounts for ~40% of India’s GDP and employs close to ~75% of the Indian labour force.” 

And this is something that the government needs to remember in its bid to forcibly formalise the Indian economy.

The column originally appeared in the Deccan Herald on October 15, 2017.