Why RBI is Doing Dhishum Dhishum With Bond Market

I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody. – James Carville.

The Reserve Bank of India (RBI) is unhappy with the bond market these days. Well, it hasn’t said so directly. A central bank rarely does. But a series of newsreports across the business media suggests so. (Oh yes, the RBI also leaks when it wants to).

The bond market wants the RBI to pay a higher yield on the government of India bonds it is currently issuing. The cost of the higher yield will have to be borne by the government of India, something that the RBI doesn’t want.

And this is where we have a problem (don’t worry I will explain this in simple English and not write like bond market reporters or experts tend to, for other bond market reporters and other bond market experts). Government bonds are financial securities which pay an interest and are issued by the government in order to borrow money.

Let’s try and understand this issue pointwise.

1) The government’s gross borrowings for 2020-21, the current financial year, had been budgeted at Rs 7.8 lakh crore. In May 2020, after the covid pandemic broke out and the tax collections crashed, the number was increased to Rs 12 lakh crore. The final borrowings are expected to be at Rs 12.8 lakh crore. In 2021-22, the gross borrowings of the government are expected to be at Rs 12.06 lakh crore.

Hence, over a period of two years, the government will end up borrowing close to Rs 25 lakh crore. It isn’t surprising that the bond market wants a higher rate of return or yield as it likes to call it, from government bonds, given that the financial savings in the country will not expand at the same rate as government borrowing is expected to. Also, there is no guarantee that the government will stick to borrowing what it is saying it will borrow. That’s a possibility the market is also discounting for.

2) Take a look at the following chart which plots the 10-year bond yield of the government of India. A 10-year bond is a bond which matures in ten years and the return on it on any given day is the per year return an investor will earn if he buys that bond on that day and holds on to it until maturity.

Source: www.investing.com

As can be seen from the above chart, the 10-year bond yield has largely seen a downward trend since January 2020, though since January 2021 it has gradually been rising. As of the time of writing this, it stood at 6.14%, having crossed 6.2% on February 22.

Media reports suggests that the RBI wants the yield to settle around 6%. The bond market clearly wants more. This explains why in the recent past bond auctions have failed with the bond market not buying bonds or the RBI refusing to sell them at yields the bond market wanted.

3) The question is why does the bond market now want a higher rate of return on bonds than it did in 2020. There are multiple reasons for it. Bank lending has largely collapsed during this financial year and has only improved since October. Between March 27, 2020 and January 29, 2021, the overall bank lending has grown by just Rs 3.34 lakh crore, with almost all of this lending carried out during the second half of the financial year.

This forms around 27% of the deposits of Rs 12.3 lakh crore that banks have managed to raise during the period. Clearly, the banks haven’t been able to lend out a large part of their fresh deposits.

Hence, it has hardly been surprising that a bulk of the bank deposits have been invested in government bonds. During the period Rs 6.94 lakh crore or 56% of the deposits have been invested in government bonds. Along with banks, other financial institutions have had few lending/investment opportunities, leading to a lot of money chasing government bonds, which has led to lower returns on them.

Over and above this, the RBI has flooded the financial system with money by cutting the cash reserve ratio (CRR) and by also printing money and buying bonds (something it refers to as open market operations), thereby driving down returns further.

4) What has changed now? The budget expects India to grow by 14.4% in nominal terms (not adjusted for inflation) in 2021-22. Even in real terms (adjusted for inflation), India is expected to grow by at least 10%. This basically means that bank and other lending will pick up. At the same time, the government borrowing will continue to remain high at Rs 12.06 lakh crore. Hence, there will be more competition for savings in 2021-22 than has been the case during this financial year, given that savings are not going to rise suddenly. Hence, yields or returns on government bonds need to go up accordingly. QED.

5) There is another point that needs to be made here. Thanks to the RBI wanting to drive bond yields and interest rates down, there is excess liquidity in the financial system right now. Lending to the government is deemed to be the safest form of lending. If lending to the government becomes cheaper, interest rates on everything else also tends to go down.

As of February 23, the excess liquidity in the financial system stood at Rs 5.7 lakh crore. This is money which banks have parked with the RBI.

On February 5, the RBI governor, Shaktikanta Das, had said: “A two phase normalisation of the cash reserve ratio (CRR) – which I am going to announce – needs to be seen in this context.”

The banks need to maintain a certain proportion of their deposits with the RBI. It currently stands at 3%. In April 2020, the RBI had cut the CRR by 100 basis points to 3%. One basis point is one hundredth of a percentage. With the banks having to maintain a lower proportion of their deposits with the RBI there was more liquidity in the financial system, which helped drive down yields and interest rates.

Now the RBI wants to increase the CRR in two phases. Assuming it wants to increase the CRR to 4%, this means that more than Rs 1.56 lakh crore (using data as of February 23) will be pulled out of the financial system by banks and be deposited with the RBI, in the months to come.

The bond market is discounting for this possibility as well, even with Das saying: “systemic liquidity would, however, continue to remain comfortable over the ensuing year.” What this basically means is that the RBI will continue to carry out open market operations by buying bonds and pumping money into the financial system as and when it deems fit.

Having said that, the overall liquidity in the financial system will go down, simply because once the RBI withdraws more than Rs 1.56 lakh crore through raising the CRR, it isn’t going to pump in the same amount of money back into the system, through open market operations, simply because then there would have been no point in increasing the CRR.

6) If your head is not spinning by now, dear reader, then you are clearly a bond market veteran. (Now isn’t the stock market so much simpler). Basically, the RBI is trying to play two roles here. It is the government’s debt manager and banker. At the same time, it also has the mandate of maintaining the rate of consumer price inflation between 2-6%. And at some level these objectives go against each other.

As the government’s debt manager, the RBI needs to ensure that the government is able to borrow at lower rates. In order to do that the RBI now and then floods the system with more money and drives down rates.

The trouble with flooding the system with more money in an economy which is recovering from a huge economic shock, is higher inflation as there is the risk of more money chasing the same amount of goods and services. Of course, with the manufacturing sector having a low capacity utilisation, they can always start more machines and pump up more goods, and ensure that inflation doesn’t shoot up. But the risk of inflation is there, given that money supply (M3) as of January 29, had gone up by 12.1%, year on year.

Over the years, there has been a lot of debate around whether the RBI should continue being the debt manager to the government or should that function be split up from the central bank and another institution should be created specifically for it, with the RBI just concentrating on managing inflation. I guess, in times like the current one, this suddenly starts to make sense.

7) Okay, there is more. The yield on the 10-year US treasury bond has been rising and as I write it has touched 1.33% from around 0.92% at the end of 2020. A major reason for this lies in the fact that the bond market is already factoring in the plan of the newly elected American president Joe Biden to spend more money in order to drive up economic growth.

Of course, with bond yields rising in the US, there is bound to be an impact everywhere else, given that the American government bond is deemed to be the safest financial security in the world. This has added to further pressure on the yields on the Indian government bonds.

8) After the finance minister presented the budget, the bond market realised that the government has huge borrowing plans even in 2021-22 and that even this financial year it would borrow Rs 80,000 crore more than the Rs 12 lakh crore it had said it would.

Accordingly, the 10-year bond yield moved up from 5.95% on January 29 to 6.13% on February 2, a day after the budget was presented. The RBI carried out open market operations worth Rs 50,169 crore between February 8 and February 12, on each of the days, to increase the liquidity in the financial system and push the yield below 6% to 5.99% on February 12.

But the yields have gone back up again and stand at 6.14% at the point of writing this. Interestingly, the yields on state government bonds have almost touched 7.2%.

Clearly, the bond market has made up its mind as far as yields are concerned. The way out of this for RBI is to print more money and buy more government bonds and drive down yields. Of course, this needs to be done regularly and by following a certain routine.

That’s the trouble with printing money. A major lesson in economics since 2008 has been that printing money by central banks leads to printing of more money in the time to come, given that the market gets addicted to the easy money.

Let’s see how the RBI comes out of this predicament, given that it has promised an “accommodative stance of monetary policy as long as necessary – at least through the current financial year and into the next year”.

9) We aren’t done yet. Other than being the debt manager to the government and having to manage the consumer price inflation between 2-6%, the RBI also needs to keep a look out for the dollar rupee exchange rate.

During the course of this financial year, the foreign institutional investors have brought in $35.4 billion to invest in the stock market. When they bring money into India they need to sell their dollars and buy rupees. This increases the demand for the rupee and leads to the rupee appreciating against the dollar.

When the rupee is appreciating against the dollar, the RBI typically sells rupees and buys dollars, in order to ensure that there is enough supply of rupees going around. In the process, the RBI ends up building foreign exchange reserves and it also ends up pumping more rupees into the financial system, thereby increasing the money supply, and pushing up the risk of a higher inflation.

Over and above this, the open market operations of buying bonds and cutting the CRR, this is another way the RBI ends up pumping money into the financial system. All this goes against its other objective of maintaining inflation.

One dollar was worth Rs 74.9 sometime in mid-November 2020. It has been falling since then and as I write this, it stands at Rs 72.4. What this means is that in the last few months, the RBI has barely been intervening in the foreign exchange market.

This brings us back to the concept of trilemma in economics, which the RBI seems to have hit. Trilemma is a concept which was originally expounded by the Canadian economist Robert Mundell. Basically, a central bank cannot have free international movement of capital, a fixed exchange rate and an independent monetary policy, all at the same time. It can only choose two out of these three objectives. Monetary policy refers to the process of setting of interest rates in an economy, carried out by the central bank of the country.

This explains why the RBI is letting the rupee appreciate, in order to ensure free movement of capital (at least for foreign investors) and an independent monetary policy. Let’s say the RBI kept intervening in the foreign exchange market in order to ensure that the rupee doesn’t appreciate against the dollar. In this situation, it would have ended up pumping more rupees into the financial system and thereby risking higher inflation in the process.

A higher inflation would have forced the RBI to start raising interest rates in an environment where the economy is recovering from a huge shock and the government is looking to borrow a lot of money. This would have led to the RBI losing control over its monetary policy. Clearly, it didn’t want that. (For everyone wanting to know about the trilemma in detail, you can read this piece, I wrote in September last year).

10) Finally, an appreciating rupee has multiple repercussions. People like me who make some amount of money in dollars, get hit in the process. (I would request my foreign supporters to keep this in mind while supporting me. Okay, that was a joke!)

Further, it makes imports cheaper, going against the entire narrative of atmabnirbharta being promoted right now. If imports become cheaper, the local products will find it even more difficult to compete. Of course, cheaper imports is good news for the consumers, given that the main aim of all economics is consumption at the end of the day.

An appreciating rupee also hurts the exporters as they earn a lower amount in rupee terms, making it more difficult for them to compete globally. And all this goes against the idea of promoting Indian exports and exporters to become a valuable part of global value chains and boosting Indian exports.

To conclude, and I know I sound like a broken record (millennials and gen Xers please Google the term) here, there is no free lunch in economics. That’s the long and short of it. All the liquidity created in the financial system to drive down yields on government bonds to help the government borrow at lower rates, is having other repercussions now. And there isn’t much the RBI can do about it.

Of course, if the bond market keeps demanding higher yields, the RBI’s dhishum dhishum with it will get even more intense in the days to come . If you are the kind who gets a high out of these things, well, continue watching this space then!

10 Things You Need to Know About Indian Real Estate in 2021

If you are the kind who follows the business media closely, you would probably be thinking that for the last few months all people have done across India is buy homes to live in. But is that really true? The short answer is no, though sales did pick up during October to December 2020, in comparison to the three month period before that. But whether that was pent up demand or genuine demand coming back, only time will tell.

A thriving real estate sector really helps the overall economy grow at a fast pace. But given the mess that the Indian real estate sector has been in for many years, and the fact that the deep state of Indian real estate won’t allow market forces to work to help clean it up, that isn’t really going to happen.

Let’s look at the issue in more detail.

1) As per the annual roundup of residential real estate published by PropTiger Research, sales in 2020 contracted by 47% to 1.83 lakhs across eight large cities (Delhi NCR, Mumbai, Pune, Ahmedabad, Chennai, Bengaluru, Hyderabad, Kolkata).

In short, 2020 was a bad year for real estate. Having said that, sales during October to December 2020 picked up and 58,914 units were sold, which was 68% more in comparison to the number of units sold during July to September 2020. In comparison to October to December 2019, sales were down 27%, during the period.

Of course, the real estate sector wants us to believe that demand is back and all is well with the sector. Nevertheless, this jump in sales can be because of pent up demand. Whether it sustains in the months to come remains to be seen. This is an important caveat to keep in mind.

2) More than half of these sales have happened in Mumbai and Pune. The reason offered for this is the cut in stamp duty carried out by the state government. The Maharashtra government cut the stamp duty applicable on real estate transactions from 5% to 2%. This was applicable until December 31, 2020.

The stamp duty cut driving up builder sales, is true to some extent. Given that the price of an apartment in a city like Mumbai runs into crores, even a 3% saving on the price runs into a decent amount of money. But more than the stamp duty cut, a substantial drop in prices, especially for homes priced at more than Rs 2 crore, is the main reason for the sales in the city picking up.

Independent real estate expert Vishal Bhargava has pointed this out in the past in his columns (Those who like to follow Mumbai’s real estate scene, should seriously read all that Vishal writes).

Of course, you haven’t read about this in the mainstream media simply because the mainstream media depends on advertisements from real estate companies and needs to keep driving the notion that real estate prices don’t fall, over and over again. (Another reason you need to support my work).

One reason for a fall in prices is the fact that businessmen who run small and medium enterprises have been facing a tough time since covid broke out. And they are looking at alternate avenues to raise money to keep their businesses going. This includes selling the real estate assets they have accumulated in the past. There is some distress sale as well.

Also, other than Mumbai and Pune, the other six cities account for less than half the sales. This tells us clearly that real estate sales in these cities are at best sluggish.

3) The clearest trend in the PropTiger data is that 48% of the sales have been for apartments selling at a price of less than Rs 45 lakh. What this tells us is that high prices remain the biggest challenge of owning a home in India. It also tells us that while home prices haven’t really fallen, on the whole across India, despite the lower demand, the demand that remains is primarily at the lower end of the price spectrum. Hence, the market has corrected itself in its own way, despite home prices not coming down in absolute terms. This is an important lesson that the real estate industry needs to learn.

Also, 74% of the sales have happened for home prices of less than Rs 75 lakh.

4) As far as prices are concerned, the PropTiger report points out: “Weighted average prices for new launched projects across the top-eight cities remained stagnant in the past few quarters, with prices moving in close ranges.”

This is something that is also reflected in Reserve Bank of India’s 10 city house index, though the cities tracked by this index are not the same as the cities tracked by PropTiger.

Source: Centre for Monitoring Indian Economy.

The cities tracked by the RBI’s 10-city house index are Mumbai, Delhi, Chennai, Kolkata, Bengaluru, Ahmedabad, Lucknow, Kanpur, Jaipur and Kochi. The index tells us that the average one-year return of owning real estate in India during the period July to September 2020, stood at 1.13%. This is the lowest since the index came into existence. The index also tells us that the return on real estate during 2020 has been marginally negative.

What this means is, and as I have often said in the past, Indian real estate is going through a time correction and not a price correction. The inflation seen over the last two years has been around 6% per year on an average. This means in real terms, the prices have already corrected by more than 12%, over a two year period.

5) This trend is likely to continue given the huge amount of inventory that remains piled up with builders. The overall inventory stock is at 7.18 lakh units across eight cities as per PropTiger. It has come down from 7.91 lakh units in 2019, simply because builders aren’t launching as many new projects as they used to.

Having said that, with the sales slowing down, at the current sales pace it will take around 47 months to clear the remaining inventory. Even though all this inventory is not ready to move in, a significant portion is. Also, it is worth remembering that the prospective buyers have a choice when it comes to buying a home. Over the years, investors across the country have ended up buying a huge number of homes in the hope of a price appreciation. Many of these homes have remained locked and are available for sale.

As Bhargava wrote in a recent column: “Resale transactions are traditionally 2/3rd of the market.” Even if this proportion were to come down, resale transactions of locked homes will continue to form a significant chunk of the market, making it difficult for builders to cut down their inventory quickly. Also, even if builders don’t offer ready to move in homes, there is a significant supply that will keep coming in from individuals who have bought real estate as an investment over the years.

6) Homes priced below Rs 45 lakh form 48% of the inventory. What does this tell us? It tells us that the real demand for homes is at a price even below Rs 45 lakh, probably below Rs 25 lakh. This is something that the builders need to keep in mind. It may not work in a city like Mumbai, where land available is limited and expensive, but it will definitely work for the other seven cities that PropTiger tracks and other parts of India, where cities can expand in all directions and land is really not an issue.


7) It is worth remembering here that builders have benefitted because of the Reserve Bank of India allowing banks and non-banking finance companies, to restructure commercial real estate loans.

As former RBI governor Urjit Patel writes in Overdraft—Saving the Indian Saver:

“In February 2020, ‘living dead’ borrowers in the commercial real-estate sector – under a familiar guise (‘a ghost from the past’, if you will) viz., ad hoc ‘restructuring’ – have been given a lifeline. It is estimated that over one-third of loans to builders are under moratorium.”

Patel does know a thing or two about banks and lending and hence, needs to be taken seriously. It remains to be seen for how long will the RBI continue supporting the builders. The longer, the RBI supports the builders, the longer they can hold on to a significant price cut. This also means that inventory will take longer to clear and home prices will continue to stagnate. It is all linked.

8) At a macro level this means that the ability of real estate to create jobs for the unskilled and the semi-skilled, will continue to remain limited. It is also worth remembering that real estate as a sector can have a huge multiplier effect on the overall economy.

The real estate sector has forward and backward linkages with 250 ancillary industries. This basically means that when the real estate sector does well, many other sectors, right from steel and cement to furnishings, paints, etc., do well.

If this were to happen, the Indian economy would really benefit in the post-covid times. But sadly it won’t, given that the deep state of Indian real estate which includes, builders, banks and politicians, will make sure that the sector is continued to be treated with kids gloves and any problems which could lead to a price cut, are kicked down the road. Trying to maintain the status quo in the sector is not helping the Indian economy.

9) Dear reader, some of you by now must be like all this gyan is fine, but tell me one simple thing, should I buy home or should I hold on to my money. The answer as always is, it depends. It is worth remembering here, that what we can possibly do with our money is a very individual thing.

If you are looking to buy a home to live in and have the capacity to pay an EMI and arrange for a down-payment, then this is a good time as any to buy a home. Owning a house has its own set of advantages. Parents and in-laws feel you have settled in life. There is no danger of the landlord acting cranky. And once you have children it gives them some kind of stability with friends, activities as well as the school they go to. Of course, address proofs don’t need to change, every time you move house.

Having said that do keep in mind that we live in tough times and the negative economic impact of covid is yet to go away. Also, there can be further cycles of the spread of the virus. Before taking on a home loan, ensure that you have some money in the bank to be able to continue paying the EMI in case you lose your source of income.

When it comes to investing in a house, it continues to remain a bad idea on the whole. Of course, there will always be some good opportunities and some distress sales happening.

10) Finally, everyone who makes a living out of selling real estate will spend 2021 trying to tell us that demand is coming back, people are buying homes, new trends are springing up and all is well.

As PropTiger points out:

“By making bare the limitations involved in other investment assets, the pandemic has forced people to rethink their investment strategies, tilting it in favour of home ownership.”

This is basically rubbish which has been written well. Why would anyone in their right mind during tough economic times, invest a large part of their savings and/or take on a large loan to buy an illiquid asset?

Some people who can afford it, may have definitely bought new homes in order to adjust to the new reality of work from home, but beyond that the proposition that PropTiger is making, remains a difficult one to buy.

If it were true, some of the massive amount of easy money that is currently floating around in the financial system, would have gone into real estate as well. But given that sales have crashed 47% during 2020 tells us that it clearly hasn’t.

In fact, the outstanding home loans of banks between March 2020 and November 2020 have gone up by just Rs 44,463 crore. This is around two-fifths of the increase (38.7% to be precise) in outstanding home loans of Rs 1,14,636 crore seen between March 2019 and November 2019. This is despite the fact that home loan interest rates have come down to as low as 7%.

So, people are generally being careful when it comes to buying a home by taking on a loan and that is the right strategy to follow at this point of time.

High Inflation In Times of Covid Will Hit Us Hard

In October 2020, inflation as measured by the consumer price index stood at 7.61%. This is the highest inflation experienced during the period Narendra Modi has been prime minister. The last time inflation or the rate of price rise, was higher than this, was in March 2014, when it had stood at 7.63%.

Let’s look at this issue pointwise.

1) A major reason for high inflation has been high food inflation which was at 11.07% in October. Food forms around 39% of the weight of the consumer price index. Within food, prices of egg, fish and meat, oils and fats, vegetables, pulses and spices, went up by more than 10%.

Interestingly, potato prices are 104.56% higher since last October. This is the highest inflation among all the items which are a part of the consumer price index. One reason offered for this has been a disruption in supply chains due to the spread of covid. But the economy has now more or less totally opened up, meaning disruption can’t continue to be a valid reason. Also, food inflation has been on the higher side since October last year, much before covid broke out.

2) The high inflation is not just because of high food inflation. If we look at core inflation, which leaves out food items and fuel and light items, the inflation is at 5.64%, the highest in thirty months. A major reason for this has been an increase in transport and communication costs which went up by 11.16% in October.

Fares of buses, taxies, auto-rickshaws and rickshaws, have gone up. This is because petrol and diesel are now more expensive than they were last year. The government has increased the excise duty on both the fuels, despite the fact oil prices have fallen internationally. The government’s dependence on fuel taxes has only gone up this year and which is now reflecting in a higher inflation as well. Petrol and diesel used for vehicles come under the transport and communication category of the consumer price index and not the fuel category.

3) Another reason for high core inflation is the higher inflation in the pan, intoxicants and tobacco segment. Interestingly, foreign liquor and beer cost 22.32% and 25.32% more this year than last year. This reflects the state governments increasing the tax on these products in order to shore up revenue.

Toddy prices have also risen 20.19%. Also, the personal care and effects segment saw an inflation of 12.07% in October. The cost of going to a barber/beautician went up by 7.04%. But the major increase here has been in the prices of gold, silver and other ornaments, which went up by 33.77%, 36.66% and 20.52%, respectively. For some reason, they are categorised under personal care and effects.

4) While inflation in the health category has been lower this year than the last year, in October it went up by 5.22%, the highest it has been this year.

5) Within the fuel category, the price of domestic cooking gas went up by 10.16% in October, while non-PDS kerosene was up 8.28%.

6) The high inflation is primarily in the areas of food, parts of fuel, communication and to some extent, health. These are areas which impact the common man. How do higher prices of gold, silver and other ornaments impact the common man? They play a very important role in Indian marriages.

All in all, high inflation has hit India at a time when the country has just gone through its first ever recession after independence. The Indian economy contracted by 23.9% during April to June. It is expected to contract between July and September as well. A recession is defined as a period when the economy contracts for two consecutive quarters.

In fact, as Nikhil Gupta and Yaswi Agarwal of the stock brokerage Motilal Oswal point out in a recent research note: “The rise in the core inflation in India is also the highest among the 21 major economies in the world.” Indeed, this is very worrying.

7) High inflation has hit us at a time when an economic contraction has led to a fall in incomes. Over and above this, people are also saving more to be ready for a rainy day. The total amount of bank savings have increased by Rs 6.32 lakh crore between March 27, around the time the country first started to realise how dangerous covid could be, and October 23. Last year, during a similar period, the deposits had gone up by Rs 3.29 lakh crore. The psychology of a recession is totally in place.

What does this mean?  A good segment of the population has been cutting down on their consumption, particularly non-essential consumption, thanks to lower incomes. A high rate of inflation, if it prevails, will only add to people cutting down on consumption further, making the job of the government and the Reserve Bank of India (RBI) to get the economy going even more difficult.

8) While deposits with banks have soared, the total amount of loans given by banks has actually contracted by a little over Rs 32,000 crore between March 27 and October 23. On the whole, banks haven’t given a single rupee of a new loan, since covid struck.

This has led to the RBI cutting the repo rate or the rate at which it lends to banks. Along with this, the central bank has printed and pumped a lot of money into the financial system, in the hope of driving down interest rates, in order to get both companies and individuals to borrow and spend more money.

That clearly hasn’t happened because of the lack of certainty of economic future. But all the money flooding around in the financial system has led to lower deposit rates making lives of senior citizens difficult, who have no other option but to cut down on their consumption. Even those who use fixed deposits to save for the future are caught in a jam.

To conclude, in this environment if inflation continues to remain stubbornly high, as it has through much of this year, the job of the government and the RBI to get consumption going will become even more difficult. It will also lead to the RBI finding it difficult to continue cutting the repo rate.

This column originally appeared in the Deccan Herald dated November 22, 2020.

Why Mis-selling By Banks ‘May’ Have Gone Up Post-Covid

The basic idea for almost everything I write emanates from some data point that tells me something. But this piece is slightly different and comes from the experiences of people around me and what I have been seeing on the social media.

I think with this limited anecdotal evidence and some data that I shall share later in the piece, it might be safe to say that mis-selling by banks post-covid may have gone up. Mis-selling can be defined as a situation where an individual goes to a bank wanting to do one thing, and ends up doing something else, thanks to the relationship/wealth manager’s advice.

The simplest and the most common example of this phenomenon is an individual going to a bank with the intention of putting his money in a fixed deposit and ends up buying some sort of an insurance policy or a pension plan.

Let me offer some evidence in favour of why I think the tendency to mis-sell post covid may have gone up.

1) Between March 27, around the time when the seriousness of the covid pandemic was first recognized in India, and October 9, the latest data available, the deposits of Indian banks have gone up by Rs 7.36 lakh crore or 5.4%.

Clearly, there has been a huge jump in bank deposits this year. To give a sense of proportion, the deposits between October 2016 and December 2016, when demonetisation happened, went up by Rs 6.37 lakh crore or 6.4%.

The increase in deposits post covid has been similar to the increase post demonetisation. Of course, the post-covid time frame has been longer.

What does this tell us? It tells us that people haven’t been spending. This is due to multiple reasons.

The spread of covid has prevented people from stepping out and there is only so much money that can be spent sitting at home (even with all the ecommerce). This has led to an accumulation of deposits. Further, people have lost jobs and seen their incomes crash. This has prevented spending or led to a cutdown. And most importantly, many people have seen their friends and family lose jobs. This has automatically led them to curtail their spending. All this has led to an increase in bank deposits.

2) Why do banks raise deposits? They raise deposits in order to be able to give them out as loans. Between March 27 and October 9, the total non-food credit given by banks contracted by Rs 38,552 crore or 0.4%. Banks give loans to the Food Corporation of India and other state procurement agencies to help them primarily buy rice and wheat directly from farmers. Once this lending is subtracted from the overall lending of banks what remains is the non-food credit.

What does this contraction in lending mean? It means that people and firms have been repaying their loans and not taking on fresh loans. On the whole, between March end and early October, banks haven’t given a single rupee of a new loan. This explains why interest rates on deposits have come down dramatically. Interest rates have also come down because of the Reserve Bank of India printing and pumping money into the financial system to drive down interest rates.

3) Using these data points, we can come to the conclusion that banks currently have an incentive to mis-sell more than in the past. Why? Banks currently have enough deposits. They don’t need more deposits, simply because on the whole, people and firms are not in the mood to borrow.

All this money that is not lent ends up getting invested primarily in government securities, where the returns aren’t very high. As of October 9, around 31.2% of total deposits were invested in government securities. This is the highest since July 2018.

The trouble is that banks cannot stop taking deposits even though they are unable to currently lend them. They can only disincentivise people through lower interest rates.

Or they can set the targets of relationship managers/wealth managers in a way where they need to channelise savings into products other than fixed deposits.

While banks have to pay an interest on fixed deposits, irrespective of whether they are able to lend them or not, they earn a commission on the sale of products like unit linked insurance plans, pension plans, mutual funds, portfolio management services, etc. This commission directly adds to the other income of the banks.

Basically, the way this incentive plays out explains why mis-seling by banks may have gone up post covid. Also, the risk of repaying a fixed deposit lies with the bank. The same is not true about the other products where the bank is just a seller and the risk is passed on.

What to do?

So, what should individuals do in a situation like this, is a question well worth asking? Let’s say you go to a bank to invest your money in a fixed deposit. As explained above, the bank really does not want your money in fixed deposit form.

The wealth managers/relationship managers will resort to the contrast effect while trying to persuade you to not put your money in fixed deposits. The interest rates on fixed deposits are very low currently. An average fixed deposit pays an interest of 5-5.5%. Clearly, once we take inflation and taxes on the interest on these deposits into account, the returns are in negative territory.

The relationship/wealth manager will contrast these low/negative returns with the possible returns from other products. His or her pitch will be that the returns will be higher in other cases. In the pitch, he or she will tell you that the returns from the other products are as good as guaranteed. A tax saving angle might also be sneaked in (for insurance products). (Of course, he or she will not present this in such a dull way. Typically, relationship/wealth managers tend to be MBAs, who can phaff at the speed of thought and leave you totally impressed despite their lack of understanding of things).

What’s the trouble with this? The returns in these other products are not fixed. In case of a fixed deposit the interest rate is fixed (which is why the word fixed is used in the first place). Now you might end up with a higher return on other products, but there is no guarantee to that. Also, sometimes the aim of investment is different. If you are putting your money in a fixed deposit, the aim might simply be return of capital than return on capital.

Further, the investment in these other products might be locked in for a long period of time, while you can break a fixed deposit at any point of time (of course you end up with lower returns). This is especially true for a tax saving investment.

To conclude, the next time you go to a bank, stick to what you want to do with your money and don’t fall prey to what the wealth/relationship manager wants you to do. Clearly, his and your incentives are not aligned. Also, if you can use internet banking to manage your money, that is do fixed deposits online, that’s the best way to go about it.

10 Things You Need to Know About India’s High-Inflation

In September, inflation as measured by the consumer price index continued to remain in elevated territory at 7.34%. Inflation is the rate of price rise in comparison to the same period last year.

Let’s take a look at this relatively high inflation of 7.34%, pointwise.

1) Only twice in the last five years has the monthly inflation figure been higher than that in September 2020. This was in January 2020 and December 2019, at 7.59% and 7.35%, respectively. The December 2019 inflation figure was more or less similar to the September 2020 number.

2) Interestingly, eight out of the ten highest inflation months in the last five years have been in 2020. What this clearly tells us is that 2020 has been a year of high inflation. Alongside this consumer demand has collapsed and there is stagnation in the economy. Hence, 2020 has been the year of stagflation (stagnation + inflation) as well. While, this wasn’t clear at the beginning of 2020 when covid hadn’t made an appearance (and I had said so), it is very clear by now (and I am saying so).

3) In an environment where consumer demand has collapsed, prices should be falling and not going up. What’s the logic here? When consumer demand collapses, firms in order to get people to consume, cut prices. This leads to lower inflation or even deflation (in worst cases, when prices fall).

But that hasn’t happened in the Indian context. The question is why? The following chart plots food inflation (using data from the consumer price index) over the last five years and possibly has the answer.

High food inflation

Source: Centre for Monitoring Indian Economy.

 Food inflation in India has been rising since early 2019 and it has continued to remain high in the post-covid environment. The inflation of vegetables, pulses, oils and fats and egg, meat and fish, was in double digits in September. Vegetable prices led the way and rose at the rate of 20.73% during the course of the month, with potato prices rising 101.98%.

4) Food carries a weight of 39.06% in the overall consumer price index. In the rural part, it carries a weight of 47.25%. Hence, elevated food inflation pushes up overall inflation. Also, the thing to notice here is that food prices were high even before the covid-pandemic struck. This was due to weather disruptions among other things. The trend of high food prices has continued post-covid.

5) Take a look at the following chart. It plots the difference in food inflation as measured by the consumer price index and as measured by the wholesale price index.

The Farmer Doesn’t Benefit 

 Source: Author calculations on data from Centre for Monitoring Indian Economy.

What does this chart tell us? It tells us that post-covid, the food prices at the consumer level have been growing at a much faster rate than food prices at the wholesale level. The average difference between April and August was 610 basis points. One basis point is one hundredth of a percentage. The wholesale price index data for September is yet to come in (It will be published tomorrow).

What this means is that, despite the end consumers of food paying a higher price, the farmers are largely not benefitting from this rise in food prices, given that they sell their produce at the wholesale level.
This difference can be because of a few reasons.

a) A collapse in supply chains has led to what is being sold at the wholesale level not reaching the consumers at the retail level, thus, leading to higher prices for the consumer.

b) This could also mean those running the supply chains hoarding stuff, in order to increase their profit.

Having said that, the former reason makes more sense given that stuff like vegetables, egg, fish and meat, etc., cannot really be hoarded. Also, hoarding stuff like pulses, needs a specialized storage environment which India largely lacks.

6) The difference in food inflation as measured by the consumer price index and as measured by the wholesale price index peaked in April at 790 basis points. This makes complete sense given the lockdown was at its peak during the month. As the economy has opened up, the difference has come down.

Nevertheless, in August the difference was at 521 basis points. This is still high given that the average of the difference over the last five years is 38 basis points. Also, with the food inflation as measured by the consumer price index going up by 163 basis points to 10.68% in September 2020, in comparison to August 2020, chances are that the difference in food inflation as measured by the consumer price index and as measured by the wholesale price index, might go up in September.

7) So, what does this mean for food inflation in the second half of this financial year? The monetary policy committee of the RBI projects that the inflation will be between 4.5-5.4% during the second half of this financial year. This can only be if food inflation comes down and also, it does not seep into overall inflation.

In the past, high food inflation has seeped into wage inflation and overall food inflation. It remains to be seen whether this happens this time around as well. The monetary policy committee doesn’t think so, but then it has as much control over food prices as it has over the finance ministry.

Interestingly, in the monetary policy report released a few days back, the RBI says in this context:

“Food inflation has remained elevated in recent months driven by price pressures in vegetables, cereals and protein items such as pulses, eggs and meat. The normal south-west monsoon, increased sowing of kharif crops, moderate MSP hikes, and high reservoir storage are expected to soften food inflation going forward.”

It goes on to say:

“However, a delayed normalisation of supply chains, heavy rains and floods in some states and demand-supply imbalances in key items such as pulses could exert further upward pressure on the headline inflation and keep it higher by around 50 basis points. On the other hand, an accelerated softening of food inflation due to an early restoration of supply chains, ample buffer stocks and efficient food stock management by the Government could bring headline inflation below the baseline by up to 50 basis points.”

So, the RBI in the monetary policy report is basically saying it could go either ways. In the process, it has hedged itself well, either ways.

8) Until the dynamic of whether food inflation is seeping into overall inflation becomes clear, it will be very difficult for the RBI to cut the repo rate any further than 4%, where it currently stands. The repo rate is the interest rate at which the RBI lends to banks.

Also, if the food inflation starts seeping into the overall inflation, the easy money policy of the RBI, where it has been printing and pumping money into the economy to drive down the interest rates, will have to take a backseat.

The RBI has pumped a lot of money into the financial system since February. Some of it has been done by buying bonds from financial institutions. But a lot of it has been done by defending the rupee.  When a lot of foreign money comes into India, the demand for rupee increases and it tends to appreciate against the dollar. This hurts exporters as well as domestic producers.

To prevent this from happening the RBI intervenes in the foreign exchange market by selling rupees and buying dollars. When the RBI sells rupees the money supply in the economy goes up. The RBI has an option of sterilising this rupee inflow by selling government bonds and sucking out the excess money. But it has chosen not to do this, which is in line with its easy money policy.

In the recent past, the RBI has allowed the rupee to appreciate against the dollar, by not buying dollars, and not adding rupees to the money supply through this route. This is primarily because there is already too much easy money floating around in the financial system.

This easy money hasn’t led to inflation because banks are going slow on lending and borrowers are being very careful before borrowing. This has ensured that the dynamic of too much money following the same amount of goods and services hasn’t played out and hasn’t created an even higher inflation.

Nevertheless, as the economy continues to recover there is a chance of this happening. Hence, the RBI needs to be careful with its easy money policy, especially if food inflation starts seeping into the overall inflation.

In the latest monetary policy, the monetary policy committee had said: “The MPC also decided to continue with the accommodative stance as long as necessary – at least during the current financial year and into the next financial year – to revive growth on a durable basis and mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target going forward [italics added].”

In simple English, this means that the RBI will keep driving lower interest rates to create growth. Up until now it doesn’t seem to be worried about its inflation mandate (to maintain the inflation as measured by the consumer price index between the range of 2-6%). But if food inflation remains high and seeps into overall inflation, the RBI will have a major problem at its hand, with all the liquidity it has pumped into the financial system.

9) Even if inflation falls to 4.5-5.4% as the RBI expects it to, the real return on fixed deposits after adjusting for inflation and taxes paid on the interest earned, will continue to remain in negative territory. And that’s not good news for savers as their savings will lose purchasing power. It’s great news for borrowers because inflation means they are repaying their loans in money which is worth less than it was at the time it was borrowed.

10) As much as economists might want us to believe, economics is no science. There are too many ifs and buts and maybes to the predictions that are made. And this is something that every reader needs to be aware of. This is true as much of this situation as it is of others.