RBI

Mr Modi, Here’s What to Do Next in Fight Against Black Money

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Prime Minister Narendra Modi’s address to the nation on the New Year’s Eve turned out to be a damp squib. While people were looking for specific answers on demonetisation, what they got instead was a long list of generalities.

Sample this: “Over the last ten to twelve years, 500 and 1000 rupee currency notes were used less for legitimate transactions, and more for a parallel economy.” This is something that the ministry of finance press release accompanying the demonetisation decision had also pointed out.

As the press release said: “Use of high denomination notes for storage of unaccounted wealth has been evident from cash recoveries made by law enforcement agencies from time to time. High denomination notes are known to facilitate generation of black money.” The term unaccounted wealth essentially means black money. Black money is income which has been earned through legal or illegal means but on which tax has not been paid.

Both Modi and the ministry of finance were essentially saying the same thing. High denomination notes facilitate the black economy. Take the case of a real estate transaction. A home is sold. The buyer and the seller carry out a part of the transaction in cheque and the rest is carried out in cash.

There is no record of the transaction being carried out in cash. Hence, the buyer does not pay a stamp duty on that part of the transaction and the seller does not pay a capital gains tax. The cash that is paid, is in high denomination notes. Hence, high denomination notes facilitate a black economy transaction on which taxes are not paid.

Further, individuals keep a part of the black money they have earned, in the form of high denomination notes. Demonetisation was supposed to hurt them by rendering the Rs 500 and Rs 1,000 notes useless overnight. That hasn’t happened. But we will not get into that.

The idea that high denomination notes facilitate the black economy is well accepted internationally. Take the case of the United States. The highest denomination note is $100. In Britain, the highest denomination note is £ 50. Hence, the highest denomination note in United States is 100 times the lowest denomination note of $1. In Britain, it is 50 times. In India, up until demonetisation happened, the highest denomination note was Rs 1,000, which was 1,000 times in value the lowest denomination note of Re 1.

Given this, one would have appreciated the decision to demonetise Rs 500 and Rs 1,000 notes, if a new note of Rs 2,000 wouldn’t have been issued. If Rs 500 and Rs 1,000 were facilitating black market transactions, so will Rs 2,000.

As on November 8, 2016, 685.80 crore Rs 1,000 notes were in circulation. These notes have been replaced by the Rs 2,000 note. As on November 8, 2016, the RBI had printed and kept around 247 crore Rs 2,000 notes in its kitty. Since then it would have printed more. 247 crore Rs 2,000 notes can replace 494 crore Rs 1,000 notes. It is safe to say that more than 72 per cent of the Rs 1,000 notes have already been replaced by Rs 2,000 notes.

Now these notes can be used for facilitating the black economy transactions like Rs 1,000 notes were. So, what is the way out of this? Some economic commentators have suggested that in the time to come the Rs 2,000 note should be demonetised as well. As we have come to know by now demonetisation is very disruptive.

The best way to go about this is to phase out Rs 2,000 notes gradually. This idea has been suggested by the economist Kenneth Rogoff in his new book The Curse of Cash in a different context. Paper money has a limited shelf life. As Rs 2,000 notes run through their lifecycle, they need to be replaced by Rs 500 notes and not by new Rs 2,000 notes.

This won’t happen overnight and will take time. Meanwhile, the government, unlike this time around, can be ready for it, and print enough Rs 500 notes in advance. It will take four 500 rupee notes to replace a Rs 2,000 note. Over a period of few years, the Rs 2,000 notes can be replaced by Rs 500.

Of course, all this is subject to the condition that the government genuinely wants to attack black money and not just talk about it.

The column originally appeared in the Bangalore Mirror on January 4, 2017

Why the New Rs 500 Note is Missing from Your Pocket

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Yesterday, the Reserve Bank of India, put out an interesting set of numbers. Between November 10, 2016 and November 27, 2016, the banks reported deposits of Rs 8,11,033 crore. Over and above this, Rs 33,948 crore of exchange of notes was carried out.

The deposits and exchange became necessary in the aftermath of the Narendra Modi government deciding to demonetise notes of Rs 500 and Rs 1,000, respectively. People have time till December 30, 2016, to deposit these demonetised notes into their bank accounts or their post office accounts. Earlier a certain amount of money could also be exchanged for new notes or notes which continue to be legal tender, but that has since been stopped.

Data from the Reserve Bank of India(RBI) shows that in 2015-2016 the total amount of paper notes in circulation amounted to Rs 16.4 lakh crore. Of this, the high denomination notes of Rs 500 and Rs 1,000 amounted to Rs 14.2 lakh crore. The Rs 500 notes amounted to Rs 7.9 lakh crore whereas Rs 1,000 notes amounted to Rs 6.3 lakh crore.

Between March 2016 and November 2016, the number of Rs 500 and Rs 1,000 notes would have gone up. Using “econometric model factoring in inter alia, real GDP growth prospects, rate of inflation and denomination-wise disposal rate of soiled notes,” the RBI places orders for new notes every year. But given that we don’t have exact numbers for the number of Rs 500 and Rs 1,000 notes printed between April 2016 and November 8, 2016, when these notes were demonetised, it is best to stick to the March end numbers.

Hence, Rs 500 and Rs 1,000 notes, forming 86 per cent of the total currency by value have been demonetised. Against the Rs 14.2 lakh crore worth notes that were demonetised, Rs 2,16,617 crore has made it back into the financial system between November 10, 2016 and November 27, 2016. People have withdrawn this money from their bank accounts as well as ATMs.

What this means that withdrawals of Rs 2,16,617 crore from banks and ATMs have replaced the Rs 14.2 lakh crore of currency that has been rendered useless due to demonetisation. Of course, some portion of the currency that has been demonetised may have been hoarded in the form of black money.

The estimates of this black money in the form of cash that I have seen, vary anywhere from 6-20 per cent. Hence, even at the upper end of 20 per cent, more than Rs 11 lakh crore of currency (Rs 11.36 lakh crore to be very precise. Rs 14.2 lakh crore minus 20 per cent of Rs 14.2 lakh crore) was out there in the economy, helping people carry out transactions.

Hence, around 19.1 per cent, or a little under one fifth, of the demonetised currency which was in circulation, has been replaced. This best explains why transactions across markets in the country have collapsed. People just don’t have enough currency going around.

It is easy to ask that why are they not moving towards wallets and netbanking. The point is that more than 80 per cent of the transactions in India by value are still carried in cash and that number cannot disappear overnight. This is an economic reality and needs to be taken into account in the political decision making process.

Assurances have been made about banks having enough new notes, both by politicians as well as the RBI. But that as we all know by now is really not true. The reason for that is straightforward. There aren’t enough new Rs 500 notes going around simply because they haven’t been printed. Some basic maths tells us that it will take at least another five to six months to print enough new Rs 500 notes and get them out there.

I had first discussed this issue in the November 25, 2016, edition of The Vivek Kaul Letter. But given the importance of this issue, the whole point is worth repeating here.

The question is why is the rate of currency replacement been so slow? The simple explanation for this lies in the fact that the government hasn’t printed enough new notes to replace the old ones. There is only so much printing capacity going around at the printing presses of the government.

In total, around 1571 crore 500 rupee notes have become useless due to the demonetisation. Media reports suggest that the capacity of the government is to churn out around 300 crore notes per month. It is interesting to see how they have arrived at this number. In the last three years, the printing presses have supplied around 2200 crore notes a year, on an average. This number can be arrived at by looking at data in the RBI annual report.

A Mint newsreport points out that the total capacity of the printing presses is around 2400 crore notes per year. This is achieved by running two shifts. Adding a third shift can increase production by 50 per cent to 3600 crore notes per year. This essentially means a production of 300 crore notes per month.

What if we work with the supply number of 2200 notes per year? A third shift would lead to a jump of 50 per cent to 3300 crore notes per year. This would mean a production of 275 crore notes per month.

To get back to the point, around 1571 crore 500 rupee notes need to be exchanged. At 300 crore notes per month, this will take around 5.2 months to print, the new Rs 500 notes to replace the old ones. At 275 crore per month, it will take around 5.7 months.

So, just to replace Rs 500 notes can take a period of up to five months. Over and above this, there is the Rs 1,000 note that also needs to be replaced. In total, around 633 crore, 1000 rupee notes have become useless due to the demonetisation.

Assuming the new Rs 2,000 notes directly replace the Rs 1,000 note, then that would mean printing 316.5 crore new notes of Rs 2,000 (633 crore divided by 2). At the rate of 275 crore or 300 crore notes a month, this would mean a little over a month. If all the currency is printed, it will take a little over six months to print it.

Also, we can clearly see that the problem is with the Rs 500 note and not the Rs 2,000 note. Further, media reports suggest that most of Rs 2,000 notes that need to be printed have already been printed. There are a reasonable number of Rs 2,000 notes going around but they are of no use because nobody has enough change to return. They become useful only if a purchase of more than Rs 1,500 is to be made. Only then is it possible to get change from the merchants.

Of course, all this currency may not have to be printed given that all of it may not make it the banks, given that some of it is black money held in the form of cash. And some people may prefer letting their money become useless pieces of paper than generate an audit trail for the bank. That part of the detail will come clear only after December 30, 2016, the last date for depositing old notes to banks.

Current assumptions on black money held in the form of notes are in the range of 6-20 per cent. If, the total amount of black money held in the form notes is 20 per cent, then at least one-fifth of the demonetised notes will not make it to the banks. This would mean around a month less of printing new notes.

This one month less of printing new notes is nullified by the fact that we are considering Rs 500 notes in existence only until March 31, 2016. In 2016-2017, the RBI had asked the printing presses to print 572.5 crore of old Rs 500 notes to be printed, during the course of the year.

Assuming that half of the lot has already been printed, it would mean that close to 300 crore old Rs 500 notes would have been printed during the course of this financial year. These notes are over and above the 1,571 crore Rs 500 notes in existence as on March 31, 2016. They will also have to be replaced by the new Rs 500 notes and this would mean an extra one month of work, given the printing capacity of 300 crore notes per month. This would in effect neutralise the impact of around 20 per cent of the old Rs 500 notes not making it back to banks or post offices.

Taking these factors into account, it is likely to take at least five months for the situation to get back to normal, when there will be enough new notes going around in the financial system. And this with the assumption that all Rs 1,000 notes are replaced by Rs 2,000 notes.

If that is not the case, and Rs 500 notes also replace Rs 1,000 notes, then it will take even longer. Of course, all this comes with the assumption that during this period the low denomination notes of Rs 10, Rs 50 and Rs 100 are not printed at all. I don’t know how feasible that is.

Also, we are assuming here that the government printing presses are working full steam here. Now that as well know is an unrealistic assumption. A report in the Quint points out that only 1 crore Rs 500 notes have been printed up until now. That is less than 0.1 per cent of the total number of Rs 500 notes that need to be printed. Further, I don’t know whether the government printing presses are in a positon to run a third shift.

Other than printing the new notes, they should also reach the different parts of the country, quickly enough.

To cut a long story short, this mess will take some time to sort out.

(The column originally appeared on November 29,2016, on Vivek Kaul’s Diary)

The Biggest Challenge for the New RBI Governor Urjit Patel is…

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On Saturday, August 20, 2016, the Narendra Modi government appointed Urjit Patel, as the 24th governor of the Reserve Bank of India(RBI). He will take over fromRaghuram Rajan, on September 4, 2016.

Since Patel’s appointment two days back, a small cottage industry has emerged around trying to figure out what his thinking on various issues is. The trouble is that Patel has barely given any speeches, or interviews, for that matter, since he became the deputy governor of the RBI, in January 2013.

A check on the speeches page of the RBI tells me that he has given only one speech (you can read it here) and one interview (you can read it here) in the more than three and a half years, he has been the deputy governor of the RBI.

You can’t gauge much about his thinking from the speech which is two and a half pages long. As far as the interview goes, Patel has answered all of three questions. Some of his thinking can be gauged from the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework¸ of which he has the Chairman. The report was published in January 2014 and ultimately became the basis for the formation of the monetary policy committee, which will soon become a reality.

There are also a few research papers that he has authored over the years.

Given this, Patel’s thinking on various issues will become clearer as we go along and as he interacts more with the media in the days to come. While he may have managed to avoid the media in his role as the deputy governor that surely won’t be possible once he takes over as the RBI governor. He may not make as many speeches as his predecessor did (which is something that the Modi government probably already likes about him), but there is no way he can avoid interacting with the press, after every monetary policy statement, and giving interviews now and then.

Given this, the policy continuity argument being made across the media about Patel being appointed the RBI governor, is rather flaky. There isn’t enough evidence going around to say the same. The only thing that can perhaps be said from what Patel has written over the years is that his views on inflation seem to be in line with Rajan’s thinking. Also, some of the stuff that is being cited was written many years back. And people do change views over the years. There is no way of knowing if Patel has.

The Challenges for the new RBI governor

While, his thinking on various issues may not be very clear, it doesn’t take rocket science to figure out what his bigger challenges are. Take a look at the following chart. It maps the inflation as measured by the consumer price index since August 2014.

Inflation as measured by the consumer price index

The chart tells us very clearly that the inflation as measured by the consumer price index is at its highest level since August 2014. In August 2014, the inflation was at 7.03 per cent. In July 2016, it came in at 6.07 per cent.

Why has the rate of inflation as measured by the consumer price index, spiked up? The answer lies in the following chart which shows the rate of food inflation since August 2014.

 

Food Inflation

 

Like the inflation as measured by the consumer price index, the rate of food inflation is also at its highest level since August 2014. In August 2014, the food inflation was at 8.93 per cent. In July 2014, the food inflation was at 8.35 per cent. Food products make for a greater chunk of the consumer price index.

What this tells us is that the inflation as measured by the consumer price index spikes up when the food inflation spikes up. And that is the first order effect of high food inflation. This becomes clear from the following chart.

Inflation

But what can the RBI do about food inflation?

There is not much that the RBI can do about food inflation. And this is often offered as a reason, especially by the corporate chieftains and those close to the government (not specifically the Modi government but any government), for the RBI to cut the repo rate. The repo rate is the rate of interest that the RBI charges commercial banks when they borrow overnight from it. It communicates the policy stance of the RBI and tells the financial system at large, which way the central bank expects interest rates to go in the days to come.

The trouble is that things are not as simplistic as the corporate chieftains make them out to be. While, the RBI has no control over food inflation (and not that the government does either), it can control the second-order effects of food inflation.

As D Subbarao, former governor of the RBI, writes in his new book Who Moved My Interest Rate?-Leading the Reserve Bank of India Through Five Turbulent Years: “What about the criticism that monetary policy is an ineffective tool against supply shocks? This is an ageless and timeless issue. I was not the first governor to have had to respond to this, and I know I won’t be the last. My response should come as no surprise. In a $1500 per capita economy-where food is a large fraction of the expenditure basket-food inflation quickly spills into wage inflation and therefore into core inflation…When food has such a dominant share in the expenditure basket, sustained food inflation is bound to ignite inflationary expectations.”

Given this, the entire logic of the RBI cutting the repo rate because it cannot manage food inflation is basicallybunkum. Food inflation inevitably translates into overall inflation and that is something that the RBI has some control over, through the repo rate. If this is not addressed, second order effects of food inflation can lead to an even higher inflation as measured by the consumer price index. And this will hurt a large section of the population.

As Subbarao writes: “The Reserve Bank of India cannot afford to forget that there is a much larger group that prioritizes lower inflation over a faster growth. This is the large majority of public comprising of several millions of low-and-middle-income households who are hurt by rising prices and want the Reserve Bank to maintain stable prices. Inflation, we must note, is a regressive tax; the poorer you are, the more you are hurt by rising prices.”

But one cannot expect corporate chieftains who have taken on a huge amount of debt over the years, in order to further their ambitions, to understand this rather basic point. Given this, this hasn’t stopped them from demanding a repo rate cut from the new RBI governor. (You can read more about it here). The government has also made it clear over and over again that it wants the RBI to cut the repo rate. Given that, it is the biggest borrower, this is not surprising. Since January 2015, the RBI has cut the repo rate by 150 basis points to 6.5 per cent. One basis point is one hundredth of a percentage.

As Subbarao writes: “The narrative of our growth-inflation debate is also shaped by what I call the ‘decibel capacity’. The trade and the industry sector, typically a borrower of money, prioritizes growth over inflation, and lobbies for a softer interest-rate regime.”

The people who invest in deposits unlike the corporate chieftains are not in a position to lobby. But it is important that the RBI does not forget about them.

Hence, it is important that people are offered a positive real rate of interest on their fixed deposits. The real rate of interest is essentially the difference between the nominal rate of interest offered on fixed deposits and the prevailing rate of inflation. A positive real rate of interest is important in order to encourage people to save and build the domestic savings of India, which have been falling over the last few years.

This was one of the bigger mistakes made during the second-term of the Manmohan Singh government.

As outgoing governor Raghuram Rajan told NDTV in an interview sometime back “When inflation was 9 per cent they [i.e. depositors] were getting 9 per cent. This meant earning nothing in real terms and losing everything in inflation.”

This wasn’t the case for many years. As Rajan explained in a June 2016 speech: “In the last decade, savers have experienced negative real rates over extended periods as CPI has exceeded deposit interest rates. This means that whatever interest they get has been more than wiped out by the erosion in their principal’s purchasing power due to inflation. Savers intuitively understand this, and had been shifting to investing in real assets like gold and real estate, and away from financial assets like deposits.”

Inflation up, savings down

Take a look at the following chart clearly shows that between 2008 and 2013, the real rate of return on deposits was negative. In fact, it was close to 4 per cent in the negative territory in 2010.

 

Inflation as measured by the consumer price index

 

High inflation essentially ensured that India’s gross domestic savings have been falling over the last decade. Between 2007-2008 and 2013-2014, the rate of inflation as measured by the consumer price index, averaged at around 9.5 per cent per year. In 2007-2008, the gross domestic savings peaked at 36.8 per cent of the GDP. Since then they have been falling and in 2013-2014, the gross domestic savings were at 30.5 per cent of the GDP, having improved from a low of 30.1 per cent of GDP in 2012-2013.

This fall in gross domestic savings has come about because of a dramatic fall in household financial savings. Household financial savings is essentially a term used to refer to the money invested by individuals in fixed deposits, small savings schemes of India Post, mutual funds, shares, insurance, provident and pension funds, etc. A major part of household financial savings in India is held in the form of bank fixed deposits and post office small savings schemes.

Between 2005-2006 and 2007-2008, the average rate of household financial savings stood at 11.6 per cent of the GDP. In 2009-2010, it rose to 12 per cent of GDP. By 2011-2012, it had fallen to 7 per cent of the GDP. The household financial savings in 2014-2015, stood at 7.5 per cent of GDP. Chances of this figure having improved in 2015-2016 are pretty good given that a real rate of return on deposits is on offer for savers, after many years.

If a programme like Make in India has to take off, India’s household financial savings in particular and overall gross domestic savings in general, need to be on solid ground. And that is only going to happen if people are encouraged to save by ensuring that they make a real rate of return on their deposits. In fact, if India needs to grow at 10 per cent per year, an estimate made in Vijay Joshi’s book India’s Long Road suggests that the savings rate will have to be around 41 per cent of the GDP.

As Rakesh Mohan and Munish Kapoor of the International Monetary Fund write in a research paper titledPressing the Indian Growth Accelerator: Policy Imperatives: “In the near future, we expect financial savings to be restored to the earlier 10 per cent level, as inflation subsides, monetary conditions stabilize and households begin to obtain positive real interest rates on their deposits and other financial savings. Financial savings are then projected to increase gradually to around 13 per cent by 2027-32.”

And how is this going to happen? As Mohan and Kapoor point out: “A sustained reduction in inflation that leads to the maintenance of low nominal interest rates, but positive real interest rates, will help in restoring corporate profitability, while encouraging household savings towards financial instruments.”

The point is that a scenario where a positive real rate of return is available to depositors is very important. But is that how things will continue to be? Take a look at the following chart, which plots the repo rate and the consumer price inflation.

Inflation as measured by the consumer price index

As can be seen from the graph, the difference between the repo rate (the orange line) and overall inflation (i.e. inflation as measured by the consumer price index) has narrowed considerably and is at its lowest level in the last two years. This effectively means that the real rate of return on fixed deposits offered by banks has been falling as the rate of inflation has been going up. (Ideally, I should have taken the average rate of return on fixed deposits instead of the repo rate, but that sort of data is not so easily available. Hence, I have taken the repo rate as a proxy).

This is not a good sign on several counts. In a country like India where deposits are a major way through which people save, high inflation leading to lower real rates of interest which effectively means that they are not saving as much as they should. This is something that most people do not seem to understand.

The economist Michael Pettis makes a very interesting point about the relationship between interest rate and consumption in case of China. As he writes in The Great Rebalancing: “Most Chinese savings, at least until recently, have been in the form of bank deposits…Chinese households, in other words, should feel richer when the deposit rate rises and poorer when it declines, in which case rising rates should be associated with rising, not declining, consumption.”

Now replace China with India in the above paragraph and the logic remains exactly the same. Given that a large portion of the Indian household financial savings are invested in bank deposits, any fall in interest rates (as the corporate chieftains regularly demand) should make people feel poorer and in the process negatively impact consumption, at least from the point of savers.

Given this, the biggest challenge for Urjit Patel will be to not taken in by all these demands for lower interest rates and ensure that the deposit holders get a real rate of interest on their fixed deposits.

Further, it is unlikely that he will cut the repo rate given that as the monetary policy committee comes in place, the RBI needs to maintain a rate of inflation between 2 to 6 per cent. In July 2016, the rate of inflation was over 6 per cent.

The column originally appeared in Vivek Kaul’s Diary on August 22, 2016

 

The Clean Up of Public Sector Banks is On, but the Basic Problem Still Remains

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Earlier this week, the Reserve Bank of India(RBI) released the biannual Financial Stability Report. And this is how the most important paragraph of the report reads: “The gross non-performing advances (GNPAs) of SCBs sharply increased to 7.6 per cent of gross advances from 5.1 per cent between September 2015 and March 2016 after the asset quality review (AQR). A simultaneous sharp reduction in restructured standard advances ratio from 6.2 per cent to 3.9 per cent during the same period resulted in the overall stressed advances ratio rising marginally to 11.5 per cent from 11.3 per cent during the period. PSBs continued to hold the highest level of stressed advances ratio at 14.5 per cent, whereas, both private sector banks (PVBs) and foreign banks (FBs), recorded stressed advances ratio at 4.5 per cent.”

What does this mean? As on March 31, 2016, the gross non-performing advances (or bad loans) of banks stood at 7.6% of the loans that they have given out. This figure had stood at 5.1% as on September 30, 2016. It had stood at 4.6% as on March 31, 2015.

This basically means that between March last year and March this year, the bad loans of banks have gone up by 300 basis points. One basis point is one hundredth of a percentage. Between September 2015 and March 2016, the bad loans of banks have gone by 250 basis points.

Nevertheless, this is good news. But how can bad loans of banks going up be good news?  It is good news because the banks (particularly public sector banks) are finally getting around to recognising bad loans as bad loans. Up until now, they were basically postponing the recognition of bad loans as bad loans by passing them as restructured loans.

A restructured loan essentially implies that the borrower has been given a moratorium during which he does not have to repay the principal amount. In some cases, even the interest need not be paid. In some other cases, the tenure of the loan has been increased.

This is how banks had been helping many borrowers who were no longer in a position to repay the loans they had taken on. In many cases, restructuring was just an exercise to postpone the recognition of bad loans. Even after the loans were restructured many borrowers, were not in a position to repay their loans.

This becomes clear from looking at the stressed advances ratio of the banks. The stressed advances figure is obtained by adding the total bad loans to the restructured assets. Over the last few years, the stressed advances ratio of banks has gone up at a rapid rate, as banks restructured loans at a rapid pace.

This has now stopped. The restructured asset of banks as on March 31, 2016, fell to 3.9% of loans. In September 2015, it had stood at 6.2% of total advances. This basically means that the strategy of banks to postpone recognition of bank loans by passing them off as restructured assets has come to an end. Given this, the overall stressed assets ratio of banks as on March 31, 2016, stood at 11.5%, against 11.3% as on September 30, 2015.

A stressed asset ratio of 11.5% was basically obtained by adding bad loans of 7.6% to restructured assets of 3.9%. In September 2015, the restructured assets had stood at 6.2% whereas the bad loans had stood at 5.1%, leading to a stressed assets ratio of 11.3%.

What this tells us is that between September 2015 and March 2016, the stressed assets ratio has gone up by just 20 basis points from 11.3% to 11.5%. Indeed, this is good news for the simple reason that banks are now being forced to recognise bad loans as bad loans and not pass them of as restructured assets like they were doing earlier.

This is a huge feather in the cap of both the Reserve Bank of India as well as the Narendra Modi government. The basic problem is with public sector banks which gave out loans in the past primarily to many crony capitalists, which these borrowers are now not in a position to repay.

The stressed asset ratio of public sector banks as on March 31, 2016, stood at 14.5%. As on September 30, 2015, the ratio had stood at 14.1%. The stressed asset ratio of public sector banks is now going up at a slower rate than it was in the past, as can be seen from the accompanying table.

 

DateRatio
March 31, 201614.50%
September 30, 201514.10%
March 31, 201513.50%
September 30, 201412.90%
March 31, 201411.70%
September 30, 201312.30%
March 31, 201310.90%
  

 

What this means is that public sector banks are cleaning up their act by recognising more and more bad loans. This wasn’t happening in the past. Now it is important that they go after the borrowers (especially the larger ones) and recover as much of the loans as they can. The more the loans they can recover, the lesser will be the capital that the government will have to put into these banks, to get them up and running again.

Also, it is important to point out that this cleaning up has been possible because of the asset quality review initiated by the Rajan led RBI. The RBI asset quality review covered 36 banks (including all public sector banks). This review accounted for 93% of the total lending carried out by the scheduled commercial banks.

As the RBI Financial Stability Report points out: “The exercise sought to validate objective compliance of banks with applicable income recognition, asset classification and provisioning (IRACP) norms and exceptions were reported by the supervisors as divergences in asset classification / provisioning.” This basically means that RBI was checking for whether banks are recognising bad loans as bad loans.

Indeed, the fact that the bad loans ratio has jumped to 7.6%, tells us that many banks were not recognising bad loans as bad loans, and that anomaly has been corrected. The first step in tackling a problem is to recognise that it exists. The Indian banks, in particular, the public sector banks have now started to do that.

The Financial Stability Report suggests that “under the baseline scenario, the gross non-performing assets ratio [bad loans ratio] may rise to 8.5 per cent by March 2017 from 7.6 per cent in March 2016. If the macro scenarios deteriorate in the future, the gross non-performing assets ratio may further increase to 9.3 per cent.” The point is that the worst is still not over for India’s banks.

Also, this basically means that banks need to be aggressive about recovering their loans. Further, it’s time that the government as the owner of public sector banks, starts forcing the defaulting promoters to give up on their equity.

Nevertheless, the bigger problem still remains. The bigger problem is the fact that the public sector banks continue to remain government owned. As Ruchir Sharma writes in The Rise and Fall of Nations—Ten Rules of Change in the Post Crisis World: “Spend a lot of time in field, and it is all too easy to find evidence that the state is not a competent banker.”

The Indian public sector banks have ended up in trouble more than a few times before. One of the reasons for this is the politicians forcing these banks to lend to crony capitalists. And as long as these banks continue to remain government owned, that risk remains, especially given that it is crony capitalists who ultimately finance the electoral ambitions of India’s politicians.

The column was originally published in Vivek Kaul’s Diary on June 30, 2016

It’s Not the Interest Rate, Stupid

ARTS RAJAN

This week there has been an overdose on Raghuram Rajan, the governor of the Reserve Bank of India(RBI) and his decision to not take on a second term. I guess some readers haven’t liked that. Nonetheless, it is important to discuss his ideas and thoughts, given that this is an opportunity to explain some basic economics, which many people don’t seem to understand.

I don’t blame them given the surfeit of reading material that is generated these days. I get many WhatsApp forwards with spectacularly illogical conclusions and many people seem to believe in them. One of the theories going around these days is that Rajan did not cut interest rates fast enough, and this impacted both businesses as well as consumers.

I have tried to counter this argument over the last one week in different ways. But given that I have limited access to data, some questions still remained unanswered. Governor Rajan though does not have these limitations. In his latest speech, made in Bangalore, yesterday, he explained in his usual simple style, as to why interest rates weren’t slowing down bank lending.

But before we get down to that, I would like to discuss something else.

In one of the many columns written to justify Rajan’s decision of not taking on a second term, BJP member and newspaper editor Chandan Mitra, wrote: “Rajan’s emphasis on increasing savings fell on deaf ears because the middle class was by now impatient to spend, not save.”

The insinuation here is that if Rajan had cut interest rates fast enough, the middle class would have borrowed and spent. This would have reinvigorated the Indian economy. But then the Indian economy grew by 7.6% in 2015-2016. It is fastest growing major economy in the world. So, I really don’t what Mitra was cribbing about. Also, Rajan has cut the repo rate by 150 basis points since January 2015.

Rajan in his speech made it clear through data that interest rates hadn’t held back bank lending. As he said:“The slowdown in credit growth has been largely because of stress in the public sector banking and not because of high interest rate.” Take a look at the following chart.

Chart 1 : Non food credit growthChart1 Non Food credit growth 

The yellow line shows the overall lending growth of the new generation private sector banks (Axis, HDFC, ICICI, and IndusInd) over the last two years. What this shows very clearly is that the lending growth of new generationprivate sectors banks has had an upward trend with a few small blips in between.

In contrast the lending growth of public sector banks (the blue line) has slowed down considerably over the last two years. Let’s look at the bank lending growth in a little more detail. The following chart shows the bank lending growth to industry over the last two years.

Chart 2 : Credit to industryChart 2 Credit to Industry 

As can be seen from the above chart, the lending to industry, carried out by the new generation private sector banks has been robust. In fact, in the last one year, it has grown by close to 20%. Hence, the new generation private sector banks have been lending to industry at a very steady pace.

When it comes to public sector banks, the same cannot be said. The lending growth has been falling over the last two years. Now it is in negative territory. In fact, due to this, the overall lending by banks to industry in the last one year was at just 0.1%. The figure was at 5.9% between April 2014 and April 2015. A similar trend can be seen from the following chart when it comes to lending to micro and small enterprises.

Chart 3 : Credit to Micro and Small EnterpriseChart 3 Credit to Micro & Small Enterprices 

This has led many people to believe that high interest rates have slowed down bank lending. As Rajan put it:“The immediate conclusion one should draw is that this is something affecting credit supply from the public sector banks specifically, perhaps it is the lack of bank capital.”

But as I have mentioned in the past, both public sector banks as well as private banks, have been happy to lend to the retail sector or what RBI calls personal loans.

These include home loans, vehicle loans, credit card outstanding, consumer durable loans, loans against shares, bonds and fixed deposits, and what we call personal loans. As I have mentioned in the past, retail loans have grown at a pretty good rate in the last one year.

The retail loans of banks have grown by 19.7% in the last one year. Between April 2014 and April 2015(between April 18, 2014 and April 17, 2015), these loans had grown by 15.7%. Hence, the retail loan growth has clearly picked up over the last one year. What is interesting is that in the last one-year retail loans have formed around 45.6% of the total loans given by banks (i.e. non-food credit). Interestingly, between April 2014 and April 2015, retail loans had formed 32.4% of the total lending.

This is precisely the point that Rajan made in his speech. Take a look at the following chart:

Chart 5 : Personal LoansChart 5 Personal Loans 

In this graph, the retail ending growth of public sector banks and new generation private sector banks has been plotted. As can be seen, the two curves are almost about to meet. What this tells us is that when it comes to lending to the retail sector, the public sector lending growth is almost as fast as the new generation private sector bank. And given that the public sector banks are lending on a bigger base, they are carrying out a greater amount of absolute lending.

As Rajan put it in his speech: “If we look at personal loan growth (Chart 5), and specifically housing loans (Chart 6), public sector bank loan growth approaches private sector bank growth. The lack of capital therefore cannot be the culprit. Rather than an across-the-board shrinkage of public sector lending, there seems to be a shrinkage in certain areas of high credit exposure, specifically in loans to industry and to small enterprises. The more appropriate conclusion then is that public sector banks were shrinking exposure to infrastructure and industry risk right from early 2014 because of mounting distress on their past loan.”

This isn’t surprising given that banks are carrying a huge amount of bad loans on lending to industry. As the old Hindi proverb goes: “Doodh ka jala chaach bhi phook-phook kar peeta hai – Once bitten twice shy.”

As I have mentioned in the past, in case of the State Bank of India, the gross non-performing ratio (or the bad loans ratio) of retail loans for 2015-2016 was at 0.75% of the total loans given to the retail sector. This came down from 0.93% in 2014-2015.

The bad loans ratio of large corporates has jumped from 0.54% to 6.27%. The bad loans ratio of mid-level corporates has jumped from 9.76% to 17.12%. And the bad loan ratio of small and medium enterprises has remained more or less stable and increased marginally from 7.78% to 7.82%. This is a trend seen across public sector banks. Hence, it isn’t surprising that public sector banks do not want to lend to the industry, at this point of time.

Take a look at the following chart, which plots the home loan lending growth of public sector banks and new generation private sector banks.

Chart 6 : Housing LoansChart 6 Housing Loans 

In this case, the lending growth of public sector banks is as fast as the lending growth of new generation private sector banks.

What all this tells us very clearly is that when it comes to the retail segment, public sector banks are lending as much as they can. This refutes Mitra’s point where he said that the middle class isn’t borrowing and spending because of high interest rates. If middle class wasn’t borrowing and spending, retail lending wouldn’t have grown by close to 20%, in the last one year.

In fact, credit card outstanding of banks has grown by 31.2% in the last one year, after growing by 22.9% between April 2014 and April 2015. So, I have really no clue as to what is Mitra talking about. Vehicle loans have grown by 19.7% against 15.4% earlier. Guess, it’s time he opened a few excel sheets before just mindlessly commenting on things.

Rajan summarised it the best when he said: “These charts refute another argument made by those who do not look at the evidence – that stress in the corporate world is because of high interest rates. Interest rates set by private banks are usually equal or higher than rates set by public sector banks. Yet their credit growth does not seem to have suffered. The logical conclusion therefore must be that it is not the level of interest rates that is the problem. Instead, stress is because of the loans already on public sector banks balance sheets, and their unwillingness to lend more to those sectors to which they have high exposure.”

To conclude, and with due apologies to Bill Clinton, “It’s not the interest rate, stupid!”

The column originally appeared on the Vivek Kaul’s Diary on June 23, 2016