Money printing

RBI to Print Rs 1 Lakh Crore to Keep Government Happy

After Lehman Brothers, the fourth largest investment bank on Wall Street went bust in September 2008, the Federal Reserve of the United States, the American central bank, came up with three rounds of large-scale asset purchases (LSAP). The LSAP was popularly referred to as quantitative easing or QE.

Yesterday, Shaktikanta Das, the governor of the Reserve Bank of India (RBI) announced a similar sounding GSAP or G-sec acquisition programme, where G-sec stands for government securities. India now has its own planned QE. (At the risk of deviation, it’s not just the Indian film industry which copies the Americans, our central bank also does.)

The government of India issues financial securities known as government securities or government bonds, in order to finance its fiscal deficit or the difference between what it earns and what it spends. Banks, insurance companies, non-banking finance companies, mutual funds and other financial institutions, buy these securities. Some are mandated to do so, others do it out of their own free will. 

What does GSAP entail? Like was the case with the Federal Reserve and the LSAP, the RBI will print money and buy government securities. For the first quarter of 2021-22 (April to June), the RBI has committed to buying government securities worth Rs 1 lakh crore. The first purchase under GSAP of Rs 25,000 crore will happen on April 15, later this month.

Why is this being done? Among other things, the RBI is also the debt manager for the central government. It manages government’s borrowing programme. After borrowing Rs 12.8 lakh crore in 2020-21, the government is expected to borrow another Rs 12.05 lakh crore in 2021-22. Due to the covid-pandemic and a general slowdown in tax revenues over the years, the government has had to borrow more in order to finance its expenditure and the fiscal deficit.

This information of the government having to borrow more than Rs 12 lakh crore again in 2021-22, came to light when the annual budget of the central government was presented on February 1. Due to this higher borrowing, the bond market immediately wanted a higher return from government securities.

The return (or yield to maturity as it is more popularly know) on 10-year government securities as of January 29, had stood at 5.95%. By February 22, the return had jumped to 6.2% or gone up by 25 basis points, in a matter of a few weeks. One basis point is one hundredth of a percentage. 

The yield to maturity on a security is the annual return an investor can expect when he buys a security at a particular price, on a particular day and holds on to it till its maturity.

As the latest monetary policy report of the RBI released yesterday points out: “Yields spiked following the announcement of government borrowings of  Rs12.05 lakh crore for 2021-22 and additional borrowing of Rs 80,000 crore for 2020-21.”

In May 2020, the government had announced that it would borrow a total of Rs 12 lakh crore in 2020-21. When the budget was presented, the government said that it would end up borrowing Rs 12.8 lakh crore or Rs 80,000 crore more. 

At any given point of time, the financial system can only lend a given amount of money. When the demand for money goes up, it is but natural that the return expected by the lenders will also go up. This led to the bond market demanding a higher rate of return on government securities, pushing up the yields or returns on government securities.

How did this become a bother for the government? When the returns on existing government securities go up, the RBI has to offer higher rates of interest on the fresh financial securities that it plans to issue on behalf of the government to fund the fiscal deficit. This pushes up the interest bill of the government, which the government is trying to minimise. 

Government securities are deemed to be the safest form of lending. Once returns on these securities go up, the interest rates in general across the economy tend to go up, which is not something that the RBI wants at this point of time. The hope is that lower interest rates will help the economy revive faster.

As the debt manager of the government, it’s the RBI’s job to offer the best possible deal to its main client. Hence, post the budget, the RBI got into the job quickly and to drive down returns on government securities launched an open market operation (OMO). As the monetary policy report points out: “Yields subsequently eased somewhat on the back of… the OMO purchases for an enhanced amount of Rs 20,000 crore on February 10, 2021.”

In an OMO, the RBI prints money and buys government securities from those institutions who are willing to sell them. The idea here is to pump more money into the financial system and in the process ensure that yields or returns on government securities go down.

With the GSAP, the RBI has just taken this idea forward. While the GSAP is not very different from the OMOs that the RBI carries out, it is more of an upfront commitment and clear communication from the RBI that it will do whatever it takes to ensure that yields on government securities don’t go up. Like between April and June, the RBI plans to print and pump Rs 1 lakh crore into the financial system. 

Let me make a slight deviation here. In this case, the RBI is also indirectly financing the government’s fiscal deficit. As the debt manager for the government, the RBI sells fresh securities to raise money in order to help the government finance its fiscal deficit.

These securities are bought by various financial institutions. When they do this, they have handed over money to the RBI, which credits the government’s account with it. In the process, the financial institutions as a whole have that much lesser money to lend for the long-term.

By printing money and pumping it into the financial system, the RBI ensures that the money that financial institutions have available for lending for the long-term, doesn’t really go down or doesn’t go down as much,

Hence, in that sense, the RBI is actually indirectly financing the government borrowing. (It’s just buying older bonds and not newer ones directly). A reading of business press tells me that the bond market expects more money printing by the RBI during the course of the year. One particular estimate going around is that of more than Rs 3 lakh crore. In that sense, even if the RBI prints Rs 3 lakh crore, it will indirectly finance around a fourth of the government borrowing given that it is scheduled to borrow Rs 12.05 lakh crore in 2021-22. 

Now getting back to the topic. Like in any OMO, while carrying out a GSAP operation, the RBI will print money and buy government securities. In the process, it will put money into the financial system. This will ensure that returns on government securities don’t go up. In the process, the government will end up borrowing at lower rates.

This is how the RBI plans to keeps its main customer happy. It needs to be mentioned here that with the second wave of covid spreading across the country, chances are economic recovery will take a backseat and the government will have trouble raising tax revenues like it did in 2020-21, the last financial year.

This might lead to increased borrowing on the government front. Increased borrowing without the RBI interfering will definitely lead to the bond market demanding higher returns from government securities. With the GSAP, the hope is that yields or returns on government securities will continue to remain low.

It is worth remembering that Shaktikanta Das’ three year term as the RBI Governor comes to an end later this year. Hence, at least until then, it makes sense for Das to keep Delhi happy.

Of course, the money printing leading to lower return on government securities, will also ensure that the interest you, dear reader, earn on your fixed deposits, will continue to remain low, and the real rate of interest after adjusting for the prevailing inflation, will largely be in negative territory. 

As mentioned earlier, lending to the government is deemed to be the safest form of lending. And if that lending can be carried out at low rates, the other rates will also remain low. This is the cost of the RBI trying to help the government, the corporates and the individual borrowers. It comes at the cost of savers. This is interest that the savers would have otherwise earned.

It is as if the RBI is telling the savers, don’t have your money lying around in deposits. Chase a higher return. Buy stocks. Buy bitcoin. 

If the RBI had let the interest rates find their own level, with the government borrowing more, the interest rates would have gone up and helped the savers earn a higher return on their deposits. This would have also encouraged consumption, especially among those individuals whose expenditure depends on interest income. The argument offered by economists over and over again is that lower interest rates lead to higher borrowing and faster economic recovery.

Let’s take a look at this in the case of bank lending to industry. As of February 2021, the total bank lending to industry stood Rs 27.86 lakh crore. As of February 2016, five years back, the total bank lending to industry had stood at Rs 27.45 lakh crore.

Over a period of five years, the net bank lending to industry has gone up by a minuscule Rs 40,731 crore or just 1.5%. Meanwhile, the interest rate on fresh rupee loans given by banks during the same period has fallen from 10.54% to 8.19%, a fall of 235 basis points.

So much for corporates borrowing more at lower interest rates. This is their revealed preference; the actions that they are taking and not the bullshit that they keep mouthing on TV and in the business media. Currently, the Indian corporate simply isn’t confident enough about the country’s economic future and that’s the reason for not borrowing and expanding, irrespective of the public posturing. 

Anyway, the point is not that higher interest rates are required. But the point is that if the RBI did not intervene like it has been doing, by printing money and buying bonds, slightly higher interest rates which would put the real interest rate in positive territory, would have been the order of the day. And that would have been better than the prevailing situation. A little better for the savers about whom neither the RBI nor the government seems to be bothered about.

But then as I said earlier, the government is the RBI’s main customer these days. And that’s the long and the short of it.

Bitcoin Without Monetary Ambition is Just Another Ponzi Scheme

There has been a lot of talk around the government banning bitcoin and other cryptocurrencies.

In fact, as the finance minister Nirmala Sitharaman recently told the Rajya Sabha: “”A high-level Inter-Ministerial Committee (IMC) constituted under the Chairmanship of Secretary (Economic Affairs) to study the issues related to virtual currencies and propose specific actions to be taken in the matter recommended in its report that all private cryptocurrencies, except any virtual currencies issued by state, will be prohibited in India.”

There is no scope for confusion in this statement. It’s saying that the government is gearing up to ban all cryptocurrencies including bitcoin. The only cryptocurrencies it will allow are those issued by it. (A government issuing a cryptocurrency is a joke, but then let me not go there for the time being. We will tackle it as and when it happens).

If bitcoin and other cryptocurrencies are banned by the government then all the bitcoin brokers through which investors trade, will need to shut down. Hopefully, the government will allow investors some sort of an exit option.

Of course, if you are trading bitcoin through a broker then you are speculating and do not really believe in the philosophy with which bitcoin was designed and launched (even if you think you do).

Satoshi Nakamoto, the creator (or creators for that matter, given that we don’t know), didn’t like the ability of the government and the central banks to create paper money out of thin air by printing it (or creating it digitally for that matter).

As he wrote on a message board in February 2009: “The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve.”

This happened in the aftermath of the financial crisis that broke out in September 2008, after which the Western central banks started printing massive amounts of money to drive down interest rates, in the hope of people and businesses, borrowing and spending money, in order to revive their respective economies.

Nakamoto looked at a central bank’s ability to debase paper money (by creating it out of thin air), as an abuse of the trust people had in it. And Bitcoin was supposed to be a solution for this breach of trust; a cryptocurrency which did not use banks or any third party as a medium and the code for which has been written in such a way that only 21 million units can be created.

The moment you are using a broker to buy bitcoin, you become a part of the conventional financial system and you really don’t remain anonymous anymore as was the idea originally.

A few bitcoin believers who have interacted (a fairly euphemistic word) with me on the social media have told me that there are ways of continuing to buy and sell bitcoin, even if the government bans them. So, they are really not perturbed by the idea of the government banning bitcoin.

The trouble with this argument is that if you continue to trade bitcoin after the ban, you are breaking the law. You might feel that the law isn’t fair, but a law is a law. One way of continuing to trade bitcoin is to legally move money abroad (up to a limit of $2,50,000) and use that money to trade bitcoin.

While this is possible, at some point of time the need to bring money back to India might arise, so, under what head of income will one declare it? If the gains are substantial, won’t the taxman come calling in these days of big data? (Or even if you regularly keep moving a good amount abroad every year).

Believers might still figure out ways to get around the system, but for most normal souls this is not worth the trouble. This is something that the bitcoin believers haven’t gotten their heads around to (yes, yes, yes, have fun stay poor).  Like one individual told me that he can simply bribe the taxman (I mean, yes, you can also do hawala and get your money in cash).

Another factor that needs to be kept in mind here is that the government in the next few years is going to be desperate for tax revenues. I guess I will leave this point here.

The bitcoin brokers in India are desperately trying to spin the usefulness of bitcoin in many interviews in the mainstream media. In fact, in one interview, Sumit Gupta, CEO & Co-Founder of CoinDCX, pointed out that there are 75 lakh bitcoin investors in India. A report in The Times of India puts the number at 1 crore. No source has been provided for these numbers.

The interesting thing is that Gupta feels that “there is a lot of confusion in calling bitcoin as cryptocurrency and not calling it an asset.” He wants bitcoin in India to be considered as an asset and be regulated. He doesn’t want it to be considered as money.

If something like this where to happen, it changes quite a few things.

When an investor buys a company’s stock, he is buying a share in the future earnings of the company. When he buys mutual funds, he is indirectly buying stocks or other financial securities issued by companies or even something like gold. When he buys gold, he buys gold.

When he buys derivatives, he is either hedging against price fluctuation or speculating on the price of a certain commodity. When he buys real estate he buys a home to live in or as a physical asset to profit from in the years to come. I mean one can go on and on here.

(Charles Ponzi on whom the Ponzi scheme is named). 

What does one buy, when one buys bitcoin as an investment asset? Nothing. It would be fair to say that if you take out bitcoin’s or for that matter any other cryptocurrency’s ambition to emerge as a parallel form of money out of the equation, it simply becomes a Ponzi scheme. (Don’t think Gupta realised this while making the point that he did). (You can read why I think bitcoin will never be money, here and here).

A Ponzi scheme is a financial scheme, where a fraudulent promoter promises very high return in a very short period of time to investors. He has no business model to earn this money in order to deliver returns.

The money being brought in by the second set of investors is used to pay off the first set. Or they are encouraged to roll over. As the news of high return spreads, more and more investors get sucked into the scheme, with the greed of earning potentially very high returns driving their investment.

This continues until the money being brought in by the new set of investors is less than the money being redeemed to the older set. Then the scheme collapses. Of course, most promoters disappear with the money before reaching such a stage.

Bitcoin without monetary ambitions is exactly like that. Money being brought in by newer investors pushes the price up, given the limited supply and prices go up very quickly, allowing existing investors to benefit.

As long as money being brought in by fresh investors is higher than money being taken out by existing ones, bitcoin keeps going up. When the equation changes, just like in a Ponzi scheme, bitcoin price crashes.

It’s basically the Ponzi scheme structure of bitcoin which explains its huge volatility on the price front. On February 21, the price of bitcoin was $57,434. Six days later on February 27, it was down by nearly a fifth to $46,345. Or take the period of six days between February 15 and February 21, when the price of bitcoin rose by a fifth (or 20%) to $57,434.

Of course, unlike normal Ponzi schemes, there is technology and thinking behind bitcoin and other cryptocurrencies. But that doesn’t make them any less a Ponzi scheme.

Given this, it’s time that the government steps into ban bitcoin and other cryptocurrencies. India has enough Ponzi schemes to deal with already. There is no point in adding more to the list.

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!

Mr Chief Economic Advisor, Printing Money is Always a Bad Idea.

The Economic Survey for 2020-21 was published yesterday. I wrote a summary of the survey titled 10 major points made by the Economic Survey.

It wasn’t possible to even speed-read the whole Survey quickly, hence, I missed out on a few points, and am writing about them here. This piece is a follow up and I strongly recommend that you read the first piece before reading this one.

Let’s look at some important points made in the Survey.

1) The spread of corona has led to a massive economic contraction this year. While the growth is expected to bounce back over the next few years, the impact of this year’s contraction isn’t going to go away in a hurry.

As per the Survey, if India grows by 12% in 2021-22 and 6.5% and 7%, in 2022-23 and 2023-24, respectively, the Indian economy will be at around 91.5% of where it would have possibly been if there would have been no covid and no economic contraction, and India would have continued to grow at 6.7% per year on an average, as it has in the five years before 2020-21.

At 10% growth in 2021-22, and 6.5% and 7% growth in 2022-23 and 2023-24, respectively, the Indian economy will be at around 90% of where it could have possibly been, the Survey points out.

This is an important point that we need to understand. While, 2021-22 might see a double digit growth, covid has put us back by more than half a decade, if we look at trend growth.

2) The Economic Survey recommends money printing to finance higher government expenditure. Call me old school, but I always feel uncomfortable when economists recommend outright money printing to fund government expenditure. Of course, there is always a theoretical argument on offer.

The Survey refers to a speech made by Patrick Bolton, a professor of business at Columbia University in New York, to make the money printing argument and why money printing, where an excess amount of money chases a similar amount of goods and services, doesn’t always lead to inflation.

As the Survey points out:

“Printing more money can result in inflation and loss of purchasing power for domestic residents if the increase in money supply is larger than the increase in output….Printing more money does not necessarily lead to inflation and a debasement of the currency. In fact, if the increased money supply creates a disproportionate increase in output because the money is invested to finance investment projects with positive net present value.”

What does this mean in simple English? The Survey is essentially saying that if the printed money is well utilised and put into projects which are beneficial for the society, it benefits everyone, and doesn’t lead to inflation.

The trouble is a lot of things sound good in theory. One of the major things that the bad loans crisis of Indian banks teaches us is that the Indian system cannot take a sudden increase in investments. There is only so much that it can handle and that’s primarily because there is too much red tapism and bureaucracy involved in getting any investment project going. We are still dealing with the fallout of this a decade later.

Also, how do the government and bureaucrats ensure that the amount of money being printed is just enough and will not lead to inflation. (Central planning keeps coming back in different forms).

The government can print money and spend it. This can ensure one round of spending and the money will land up in the hands of people. Also, as men spend money, this money will land up with shopkeepers and businesses all over the country. The shopkeepers may hold back some of the cash that they earn depending on their needs.

The chances are that most of this money will be deposited back into bank accounts. In the normal scheme of things, the banks would lend this money out. In difficult times, banks are reluctant to lend. Hence, they end up depositing this money with the RBI. The RBI pays interest on this money. As of yesterday, banks had deposited Rs 5.6 lakh crore with the RBI. This is money they have no use for, or to put it in technical terms, this is the excess liquidity in the system.

Money printing will only add to this excess liquidity. Ultimately, for the economy to do well, people and corporates need to be in a state of mind to borrow and banks in the mood to lend. Printing money cannot ensure that.

Over and above this, money printing can and has led to massive financial and real estate bubbles, in the past few decades. This is asset price inflation. While this inflation doesn’t reflect in the normal everyday consumer price inflation, it is a form of inflation at the end of the day. And whenever such bubbles burst, which they eventually do, it creates its own set of problems.

Given these reasons, the chief economic advisor Krishnamurthy Subramanian’s recommendation of money printing by the government is a lazy idea which hasn’t been thought through. (For a detailed argument against money printing, please read this).

 

3) During the course of this financial year, banks have gone easy on borrowers who haven’t been in a position to repay.

Technically, this is referred to as regulatory forbearance. In this case, the central bank, comes up with rules and regulations which basically allows banks to treat borrowers in trouble with kids gloves. One of the learnings from the bad loans crisis of banks has been that regulatory forbearance of the Reserve Bank of India, India’s central bank, went on for too long.

The banks are yet to face the negative impact of the covid led contraction primarily because of regulatory forbearance. The banking system should be facing the first blows of the economic contraction. But that hasn’t happened, thanks to the Supreme Court and regulatory forbearance. 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. Hence, the balance sheets of banks as revealed by their latest quarterly results, seem to be too good to be true.

The Survey suggests that an asset quality review of the balance sheets of banks may be in order. As it points out: “A clean-up of bank balance sheets is necessary when the forbearance is discontinued… An asset quality review exercise must be conducted immediately after the forbearance is withdrawn.”

This is one of the few good suggestions in the Survey this year and needs to be acted on quickly, so as to reveal the correct state of balance sheets of banks. The Survey further points out: “The asset quality review must account for all the creative ways in which banks can evergreen their loans.” Evergreening involves giving a new loan to the borrower so that he can pay the interest on the original loan or even repay it. And then everyone can just pretend that all is well.

In fact, even while making a suggestion for an asset quality review, the Survey takes potshots at Raghuram Rajan and the asset quality review he had initiated as the RBI governor in mid 2015.

4) Another point made in the Survey is to ignore the credit ratings agencies and their Indian ratings. As the Survey points out: “The Survey questioned whether India’s sovereign credit ratings reflect its fundamentals, and found evidence of a systemic under-assessment of India’s fundamentals as reflected in its low ratings over a period of at least two decades.”

This leads the Survey to conclude: “India’s fiscal policy must, therefore, not remain beholden to such a noisy/biased measure of India’s fundamentals and should instead reflect Gurudev Rabindranath Thakur’s sentiment of a mind without fear.”

While invoking Tagore, the Survey basically recommends that India’s government borrows more money to spend, taking into account “considerations of growth and development rather than be restrained by biased and subjective sovereign credit ratings”. (On a slightly different note, who would have thought that one day an economist would invoke Rabindranath Thakur’s name to market higher government borrowing).

Whether, the ratings agencies correctly rate India based on its fundamentals is one issue, whereas, whether it makes sense for India to ignore these ratings and borrow more, is another.

As the Survey points out: “While sovereign credit ratings do not reflect the Indian economy’s fundamentals, noisy, opaque and biased credit ratings damage FPI flows.” (FPI = foreign portfolio inflows).

What this means is that any further cut in credit rating can impact the amount of money being brought in by the foreign investors into India’s stock and bond market. In particular, it can impact the long-term money being brought in by pension funds.

While, the Survey doesn’t say so, it can possibly impact even foreign direct investment.

So, the point is, why take unnecessary panga, for the lack of a better word, with the rating agencies, at a point where the economy is anyway going through a tough time.

In another part, the Survey points out: “Debt levels have reached historic highs, making the global economy particularly vulnerable to financial market stress.”

5) Given that, tax revenues have collapsed, government borrowing money to finance expenditure has gone up dramatically during the course of this year. As the Survey points out:

“As on January 8, 2021, the central government gross market borrowing for FY2020-21 reached Rs 10.72 lakh crore, while State Governments have raised Rs 5.71 lakh crore. While Centre’s borrowings are 65 per cent higher than the amount raised in the corresponding period of the previous year, state governments have seen a step up of 41 per cent. Since the COVID-19 outbreak depressed growth and revenues, a significant scale up of borrowings amply demonstrates the government’s commitment to provide sustained fiscal stimulus [emphasis added] by maintaining high public expenditure levels in the economy.”

Fiscal stimulus is when the government spends more money in order to pump up the economy in a scenario where individuals and corporates are going slow on spending. The total government spending during April to November 2020 stood at Rs 19.1 lakh crore. It has risen by just 4.9% in comparison to April to November 2019. Given that inflation has stood at more than 6% this year, this can hardly be called a fiscal stimulus.

To conclude, economic surveys in the past, other than offering a detailed assessment on the current state of the Indian economy, also used to do some solid thinking about the future or stuff that needs to be done on the economic front.

Over the past few years, a detailed reading of these Surveys suggests that they have become yet another policy document which feeds into government’s massive propaganda machinery, albeit in a slightly sophisticated way.

Sensex@50,000 – How RBI Played a Part in Creating the Stock Market Bubble

The BSE Sensex, India’s premier stock market index, crossed 50,000 points today in intra day trading. It has risen by more than 80% from around the end of March, when it had fallen to 27,591 points, in the aftermath of the covid pandemic hitting India.

This astonishing rise has now got the Reserve Bank of India (RBI) worried. The RBI Governor Shaktikanta Das, writing in the foreword to the latest Financial Stability Report, pointed out:

“The disconnect between certain segments of financial markets and the real economy has been accentuating in recent times, both globally and in India.”

People who run central banks are not always known to talk in simple English. Das is only following tradition here. The statement basically refers to stock prices. Das feels they have risen too fast in the recent past and have become disconnected from the overall economy.

While the overall Indian economy is expected to contract this year, the stock market has rallied by more than 80%. How is this possible? Or as you often get to hear these days, if the economy is doing badly, why is the stock market doing so well.

Theoretically, a possible explanation is that the stock market discounts the future and the stock market investors think that the future of the Indian economy is bright. Another explanation offered often by the stock market investors is that corporate profits this year have been at never seen before levels.

But even after taking these reasons into account, the current high level is really not justified. As Das put it in his foreword: “Stretched valuations of financial assets pose risks to financial stability.” One way to figure out whether valuations are stretched is to look at the price to earnings ratio of the stocks that constitute the Sensex index.

In January 2021, the price to earnings ratio has been at around 34. This means that investors are ready to pay Rs 34 as price, for every rupee of earning of the companies that make up for the Sensex. Such a high level of the price to earnings ratio has never been seen before. Not even in late 2007 and early 2008, when stock prices rallied big time or the first half of 2000, when the dotcom bubble was on.

Clearly, stock prices are in extremely bubbly territory. The current jump in corporate earnings isn’t sustainable for the simple reason that corporates have pushed up earnings by cutting employee costs as well as raw material costs. This means the incomes of those dealing with corporates from employees to suppliers and contractors, have fallen.

This fall in income has limited the ability of these individuals to spend money. This will lead to lower private consumption in the months to come, which, in turn, will impact corporate revenues and eventually profits. A sustainable increase in profits can only happen when people keep buying things and corporate revenues keep going up.

This brings us back to the question as to why stock prices are going up, when the overall economy is not doing well. A part of the reason is the RBI, though the central bank, rather expectedly, glosses over this totally in the latest edition of the Financial Stability Report.

Since February 2020, the RBI has pumped in a massive amount of money into the financial system through various measures, some of which involve the printing of money. By flooding the financial system with money, or what central banks refer to as liquidity, the RBI has ensured that interest rates in general and bank deposits in particular, have fallen.

The idea here is threefold. A drop in interest rates allows the government to borrow at lower interest rates. This became necessary because thanks to the pandemic, the tax collections of the government have dropped during this financial year. Between April and November 2020, the gross tax revenue stood at Rs 10.26 lakh crore, a drop of 12.6% in comparison to the same period in 2019.

Secondly, lower interest rates ensured that the interest costs of corporates on their outstanding loans, came down. Also, the hope was that at lower interest rates, corporates will borrow and expand.

Thirdly, at lower interest rates, the hope always is that people will borrow and spend more, and all these factors will lead to a faster economic recovery.

But there is a flip side to all this as well. A fall in interest rates has got people looking for a higher return. This has led to many individuals buying stocks, in the hope of a higher return and thus driving up prices to astonishingly high levels.

This can be gauged from the fact that in 2020, the number of demat accounts, which are necessary to buy and sell stocks, went up by nearly a fourth to 4.86 crore accounts. One of the reasons for this is the rise of Robinhood investing in India. This term comes from the American stock brokerage firm Robinhood which offers free online trading in stocks. India has seen the rise of similar stock brokerages offering free trading.

What has added to this is the fact that many unemployed individuals have turned to stock trading to make a quick buck. All it needs is a smartphone, a cheap internet connection and a low-cost brokerage account.

Of course, this search for a higher return isn’t local, it’s global. Hence, foreign institutional investors have invested a whopping $31.6 billion in Indian stocks during this financial year, the highest ever. This stems from the fact that Western central banks, like the RBI, have printed a huge amount of money to drive down interest rates.

This has pushed more and more investors into buying stocks despite the fact that the global economy isn’t doing well either.

A slightly different version of this column appeared in the Deccan Herald on January 17, 2021. It was updated after the Sensex first crossed 50,000 points during intra day trading on January 21, 2021.