Category: Swarajya | Page 2

4 February, 2016

Bill Bonner: “It’s 100% impossible for the value of stocks to be divorced from the economy”

Dear Reader,

This is a Special Edition of the Diary. In this I speak to Bill Bonner, whose books and columns I have admired reading tremendously over the years. He founded Agora Inc. in 1979. With his friend and colleague Addison Wiggin, he co-wrote the New York Times best-selling books Financial Reckoning Day and Empire of Debt. His other works include Mobs, Messiahs and Markets (with Lila Rajiva), Dice Have No Memory, and most recently, Hormegeddon: How Too Much of a Good Thing Leads to Disaster.

Even though Bill writes largely on finance and economics, his writing style is close to literary fiction, and that is precisely what makes it so enjoyable to read him.

In this interview we talk about how the world of finance and economics has changed over the last few years. And how does Bill read the world that we live in. This paragraph summarises everything: “I just didn’t think it [i.e. the financial crisis] will go on this long but that’s also one of the realities that things that you think can’t last, actually do last longer than you expect and they get worse than you expect and then after they have gotten much worse and lasted much longer than you expect then you begin to think well maybe I don’t understand something about it and maybe there is something going on here that can last and then of course it blows up and you were right all along and then at that time of course you are not anticipating it.”

This is the first part of the interview. The second part will appear tomorrow.

Happy Reading!
Vivek Kaul

I guess the last time we spoke would probably have been sometime in 2011-2012. So how have things changed?

It was surprising to me that the authorities were more aggressive than I expected coming in with the QE1, QE2 and QE3 and then the twist. And those things as expected didn’t do anything for the economy.

In fact, it may have actually slowed down the real economy. But they did wonders for the stock market and the financial industry so they are very very popular and well those things were essentially reducing the cost of credit, making easy money even easier.

So naturally, there is more and more debt and it just seems to be a phenomenon or fact of life that when you make debt cheap, when you make it cheaper than it should be, you get people borrowing money for things they shouldn’t be doing and too much capacity, too many speculations, too many gambles, too many business expansions that don’t really make any sense.

And what did that lead to?

So we saw the effect of that in the commodity market, particularly the oil market which has been really laid low by this combination of cheap money which made it possible for American drillers to get out there all over the place and drill for oil and some marginal producers in Canada and otherwise in Brazil and everywhere to come up to increase the supply of oil. Meanwhile the actual demand for oil was going down because the world economy was actually not in a growth mode at all.

So we have those kinds of things happening and that’s all happening since the last time we talked and the huge expansion and explosion and implosion of the oil market, implosion of the commodity market and explosion in world debt which has gone up about 57 trillion dollars since 2008. So these things were really much bigger than I anticipated.

I just didn’t think it will go on this long but you that’s also one of the realities that things that you think can’t last, actually do last longer than you expect and they get worse than you expect and then after they have gotten much worse and lasted much longer than you expect, then you begin to think well may be I don’t understand something about it and maybe there is something going on here that can last and then of course it blows up and you were right all along and then at that time of course you are not anticipating it.

So why hasn’t all this debt lead to economic growth? Why hasn’t cheaper money led to economic growth because you know this was one of the beliefs that central bankers had and their actions in the last seven- eight years have been built on the belief that we will flood the markets with money, we will have low interest rates, people will buy, companies will do well and economic growth will return. Why hasn’t this happened?

Why doesn’t that happen? And the answer is hard. I don’t really know. There is a Swedish economist named Knut Wicksell and Knut Wicksell noticed, that whenever the cost of money was too low, he said there were two interest rates.

He said there was a natural rate which is to say the rate that money should cost in a real properly functioning market and then there is the actual rate and the actual rate is jigged up by the authorities in the banking industry. Whenever the actual rate is too low, people do not invest in the kinds of things that will increase real production.

He said what they do, and I never have really fully understood this, but he said what they do when money is too cheap, they tend to go for easy things. So the banks take the easy money which is too cheap and then they invest it in US Governments Securities, you know the 10-year treasury bonds and that way they get guaranteed return, a guaranteed positive carry.

What else did he say?

And then he says that when money is too cheap people make cheap investments, one because they don’t really know what is going on. You know the cheap money distorts the whole picture. The cost of money is the critical number in all of capitalism You have to know what it will cost you really to borrow money. And once you know what the money really costs then you should decide whether you should build a factory, whether you should invest in this, buy that.

You don’t know until you know the real cost of money and by distorting the real cost of money as Wicksell points out what it does is it drives out everybody away from real investment where they don’t really know what they should be doing. They don’t want to invest real money in a project where the returns are uncertain and the value of money is uncertain and everything is uncertain. So they go for these cheap investments. These easy investments such as US treasury bonds where they know they will get paid and so you get a big increase in these debt investments. Hence, just the quantity of debt goes up where everybody is just counting on being able to borrow cheap and lend a little less cheap in order to pocket the difference without any real risk.

Even though the economies as such haven’t recovered, the stock market and the real estate markets in parts of the world have done very very well. So how do you explain that dichotomy? Has the link between economic growth and stock market returns broken down?

Oh! It has totally broken down. We have a chart that we use. We go back to 1971, where we believe something fundamental happened when they changed the US money system. Since 1971 what you see if you look at US GDP growth, it looks more or less normal. I mean the growth rate was higher in the 70s and it gradually went down decade after decade, it got lower and lower.

But you are talking about going down from five to three to four to three to two and now probably about zero percent, but that growth is real…that’s the real economy…that’s Main Street…that’s where people work…that’s where they spend their money…that’s where they earn their money.

When you put that on to that chart, and you put a chart of what the value of America’s stocks and bonds are, then that chart just goes right up after about 1995.

Yes that’s what the chart shows…

And so there is something going on where the stocks and the value of assets is being cut off completely from the value of the real economy that supports them, which is impossible of course.

I mean it is impossible for that to continue because ultimately any asset is only valuable in as much as the economy gives it value. It’s not valuable in itself. If you have a blue jeans factory and you are producing five thousand pairs of blue jeans a day but that is not worth a penny unless you have got people who are willing to buy five thousand blue jeans a day and they can only do that if they are earning enough to buy five thousand blue jeans a day.

And you know that was Say’s principle which was that “Supply creates demand”, which is a funny thing. I mean it’s easy for people to misunderstand that. But what it really means is that it’s only because you have an economy that produces wealth that people have the money to buy what you are making.

So there is no way, it’s absolutely hundred percent impossible for the value of stocks and bonds to be divorced from the value of the economy itself. And what we have seen is a separation and we call it a divorce. But the two have been separated for a long time and my guess is that they are going to get back together.

In the book ‘The Age of Stagnation’ Satyajit Das makes a very interesting point about how lower interest rates have not led to increased consumption and he gives a very interesting reason for it. What he says is that when the return on fixed income investments comes down, people put their money in the stock market and when they do that the pressure on companies to keep increasing their earnings so that they can keep giving dividends increases.

You know people are looking at stocks as a mode of dividend [regular income] than a mode of capital gains because the money they used to earn through the fixed income investments has come down [dramatically]. So when there is pressure on companies to give dividends in a scenario where the sales are not really growing, they fire their employees. They [also] borrow money so that they can buy back their stocks and when they buy back their stocks the earnings per share goes up and the dividend per share [as there are fewer shares than before] also goes up. So that is why even with cheap money, easy money and low interest rates, consumer buying hasn’t picked up and hasn’t translated into economic growth. Does this makes sense?

Well I think it totally makes sense. I saw an example of that just in today’s press which unfortunately I can’t recall. The company announced simultaneously that it was laying off 10,000 employees and had a big [stock] buy-back program.

I think it’s just a shift that in America has been widely described as the ‘financialization’ where the money goes from Main Street to Wall Street. You can see that shift very clearly, if you look at the salaries paid on the Main Street, which have gone nowhere for decades and the salaries paid on Wall Street which have gone straight up and you could also look at the profit share of the economy.

The whole of the financial industry earned about 10% of the US profits in 1980 and by 2007 it was 40%. This is wealth that is going from Main Street economy where people work, live, eat, earn their lives, earn their retirements to Wall Street where its speculation, gambling, investing of sorts. And that change has transformed the entire economy and eventually that is what I keep saying—trees don’t grow to the sky. I feel this cannot go on forever and how much longer it can go on of course is a subject of great interest. But I really don’t know.

You know you talked about Wall Street, do you think Wall Street in 2015 -2016 has gone back to the way things were in 2006, 2005 and 2007. Would you say that?

Oh yes! I would say that that’s generally the case. You don’t want to pin point and you don’t want to be too tied to historical rhythms but it certainly looks that way. We don’t have a housing bubble of the same sort now in America.

But there is a bubble…

There is a bubble in housing but it is not the same sort. But the bigger bubbles in the US today are the bubbles in the student debt and auto debt. We have a heck of an auto debt bubble and the corporate debt bubble that we didn’t have before.

Corporate debt is huge because all the money that has been used to buy back shares…

It is mind boggling to think that a corporation would borrow money to buy some shares and you wonder what business is this corporation in.

Is the student bubble has big as the housing bubble?

No. It’s not that big. The housing bubble was worth $4 trillion or something and this is $ 1 trillion.

Which is big anyway. $1 trillion is not small.

It’s huge, but it’s not the same kind of huge. It’s an entirely different thing because the housing bubble was exposed to the value of the collateral. In the housing bubble there is something there and eventually it was obvious that what was there was not worth what they thought it was because at the end of it the typical house costs something like twice as much as the typical family could afford. So it didn’t take a genius to figure out that cannot go on for much longer and by the way salaries were not going up. There was no way that a person was going to catch up to that. But now what is the collateral on a student loan? It’s nothing.

There is some intellectual capital…

This student loan is interesting because the collateral is essentially worthless. They have done studies to show that if people borrow money, get educated they don’t earn more money and it’s a bit of a fraud. Its money that a bank lends, secured by the government, goes to the student, goes to the education industry, which is just lobbying Congress for the whole thing to continue.

How big is the auto bubble?

The auto bubble is big but I don’t remember the numbers. And there is a huge transformation of the auto sales system where it is all directed.

So essentially what we can say here is that low interest rates have had some impact on the auto industry, I mean people have been buying cars.

Big effect yes and without those low interest rates there wouldn’t be these car sales and the car sales like employment have been held up by the central bankers and the economists as evidence that the economy is healthy.

Why they are buying cars is because the interest rates are held down. This is the equivalent of those low interest loans in the housing industry in 2007. Now they have the auto industry that has loans that stretch out. The average loan goes more than four years. And yeah four years for cars is a long time.

To be continued…

The interview originally appeared in the Vivek Kaul’s Diary on February 4, 2016

3 February, 2016

India Is Still Facing The Ill-Effects Of The Congress Era Inflation

The devil, like beauty, always lies in the detail.

Sometime last week the Central Statistics Office(CSO) put out data which clearly shows that India is still facing the ill-effects of the inflationary era unleashed by the Congress led United Progressive Alliance (UPA) government.

Between 2008-2009 and 2013-2014, the average consumer price inflation was higher than 10%. Food inflation was higher than 11%. High inflation essentially forced people to spend more and in the process they had lesser money to save.

Take a look at the following table. The household savings fell from 23.39% of the nominal Gross Domestic Product (GDP) to 19.06%. Nominal GDP does not take inflation into account.

In Rs crore	2011-2012	2012-2013	2013-2014	2014-2015
Household Savings	2065453	2233950	2360936	2380488
As a % of total savings	68.20%	66.40%	63.40%	57.20%
As a % of nominal GDP	23.39%	22.36%	20.94%	19.06%
Net Financial Savings (Gross financial savings minus financial liabilities)	642609	733616	862873	961307
As a % of nominal GDP	7.28%	7.34%	7.65%	7.70%
Saving in physical assets	1389209	1463684	1460844	1379411
As a % of nominal GDP	15.73%	14.65%	12.96%	11.05%

The household savings primarily comprise of financial savings as well as savings in physical assets and savings in the form of gold and silver ornaments. The overall household savings have fallen from 23.39% of the GDP in 2011-2012 to 19.06% in 2014-2015.

The household financial savings (i.e. investments made in fixed deposits, provident funds, shares and debentures and life insurance) rose marginally from 7.28% to 7.70% of the GDP.

What the table does not tell you is that in 2007-2008, before the Congress led UPA government initiated an era of high-inflation, the household financial savings had stood at 11.45% of the GDP. Between 2007-2008 and 2011-2012, household financial savings fell dramatically. They haven’t really recovered since then despite lower inflation numbers.

In 2014-2015, the consumer price inflation was at an average of 5.83% during the course of the year. Food inflation was at 6.26%. The after-effects of the era of high inflation are still being felt. The low growth in household financial savings also explains why despite a massive fall in inflation, interest rates haven’t fallen at the same pace. If savings had risen at a much faster rate, the interest rates would have fallen more.

Savings in physical assets (homes, land, flats etc.) have fallen dramatically between 2011-2012 and 2014-2015 from 15.73% of the GDP to around 11.05%. This is again a reflection of the fact that people are not saving enough despite low inflation. One possible explanation for this is that incomes are not going up at a fast pace.

The other point that needs to be made here is that the real estate prices have gone way beyond what most people can afford. And that explains to some extent why household financial savings have risen between 2011-2012 and 2014-2015, but physical assets have not.

Now take a look at the following table. Companies (non-financial corporations) have been saving more over the years. Their savings have gone up from 9.59% of the GDP in 2011-2012 to 12.27% of the GDP in 2014-2015. What does this tell us?

In Rs crore	2011-2012	2012-2013	2013-2014	2014-2015
Savings of non-financial corporations	847134	990322	1218020	1532262
As a % of total savings	28.00%	29.40%	32.70%	37.20%
As a % of nominal GDP	9.59%	9.91%	10.80%	12.27%
Savings of financial corporations	272371	300599	294180	335679
As a % of total savings	9.00%	8.90%	7.90%	8.20%
As a % of nominal GDP	3.08%	3.01%	2.61%	2.69%
Savings of general government	-158234	-160048	-148089	-131729
As a % of total savings	-5.20%	-4.80%	-4.00%	3.20%
As a % of nominal GDP	-1.79%	-1.60%	-1.31%	-1.05%

It tells us that there are not enough investment opportunities going around and hence the profits that these companies are making are not being invested to expand but being saved. This is again a good indicator of the overall slow trend of the economy.

For sustainable economic growth to happen a country needs to produce things. As the Say’s Law states “A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value.”

The law essentially states that the production of goods ensures that the workers and suppliers of these goods are paid enough for them to be able to buy all the other goods that are being produced. Production of goods also creates new jobs.

A pithier version of this law is, “Supply creates its own demand.” And that is why industrial expansion is important for economic growth to happen. But currently that doesn’t seem to be happening.

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The column originally appeared on Swarajya on February 3, 2016

28 January, 2016

Why Indian E-commerce Is A Ponzi Scheme

It is that time of the year when the business media is publishing the financial results of Indian ecommerce companies for the financial year 2014-2015(i.e. the period between April 1, 2014 and March 31, 2015). The numbers are being taken from the filings that the ecommerce companies have made with the Registrar of Companies(RoC).

And the results make for a very interesting reading. As can be seen from the accompanying table compiled from various media reports, the losses of the major ecommerce companies have gone up multiple times during the course of the year.

It needs to be stated here upfront that it is difficult to estimate the exact numbers of the ecommerce companies given that they have complex holding structures as regulations in India currently do not allow foreign direct investment in online retail, but allow it in case of an online marketplace.

chart

The combined losses of the five companies in the table stood at Rs 5524 crore in 2014-2015. In 2013-2014, the losses had stood at Rs 1338.1 crore. This is a jump of a whopping 313%. How does their combined revenue number look? In this case a direct comparison cannot be made given that the revenue numbers of Snapdeal for 2014-2015 are not available.

As a recent news-report in the Mint newspaper points out: “Snapdeal reported a loss of Rs.1,328.01 crore for the same year, compared with Rs.264.6 crore in the previous year, RoC documents show. It didn’t disclose revenue numbers.”

Hence, we will have to adjust for Snapdeal numbers before we compare revenue earned by the companies with their accumulated losses. The revenue for 2014-2015 for four companies other than Snapdeal stood at Rs 11,827 crore. The revenue for 2013-2014 for these four companies had stood at Rs 3,445.8 crore. This is a jump of 243% over the course of one year.

In the normal scheme of things a jump of 243% in revenue in one year would have been deemed to be fantastic, but the losses of these companies have gone up at a much faster rate. In 2013-2014, the losses of the four companies other than Snapdeal stood at Rs 1073.5 crore. In 2014-2015, the losses had jumped by a whopping 291% to Rs 4,196 crore.

Hence, a 243% jump in revenues has been accompanied by a 291% jump in losses. This analysis is skewed to some extent given the huge size of Flipkart in the sample. If we had known Snapdeal revenue numbers for 2014-2015, the results would have been more robust.

Nevertheless, even the small companies in the sample, show the same trend as the broad trend is. Take the case of Paytm. In 2013-2014, the company made a profit of Rs 5 crore on a revenue of Rs 210 crore. In 2014-2015, the revenue jumped to Rs 336 crore and the losses jumped to Rs 372 crore. Shopclues also showed a similar trend. The revenue of the company went up by 155% between 2013-2014 and 2014-2015, whereas the losses went up by 163%.

What sort of a business model is this—where the losses of a company go up at a faster rate than its revenue? The answer lies in the fact that the Indian ecommerce companies have adopted a discount model in order to lure customers. This means selling products at a loss in order to build a customer base.

This strategy of acquiring customers has been directly copy-pasted from what many American ecommerce companies did during the dotcom boom towards the turn of the century. As Gary Smith writes in Standard Deviations—Flawed Assumptions, Tortured Data and Other Ways to Lie With Statistics: “A dotcom company proved it was a player not by making money, but by spending money, preferably other people’s money…One rationale was to be the first-mover by getting big fast…The idea was that once people believe that your web site is the place to go to buy something, sell something, or learn something, you have a monopoly that can crush competition and reap profits.”

The major Indian ecommerce companies seem to be following a similar strategy of trying to build a monopoly by offering products on substantial discounts. The trouble with this strategy is that it needs a lot of money. Up until now, the Indian ecommerce companies have managed to survive because international hedge funds and private equity investors have made a beeline for investing in them.

With returns from financial securities all over the world drying up over the last few years, Indian ecommerce companies have offered an iota of hope. The trouble is that every reasonably big Indian ecommerce company with access to funding seems to be following the same strategy of offering discounts and wanting to build a monopoly. And once they are there, they hope to cash in.

Having said that, the current structure of the Indian ecommerce companies is akin to a Ponzi scheme. A Ponzi scheme is essentially a financial fraud in which investment is solicited by offering very high returns. The investment of the first lot of investors is redeemed by using the money brought in by the second lot.

The investment of the second lot of investors is redeemed by using the money brought in by the third lot and so on.

The scheme continues up until the money being brought in by the new investors is greater than the money being redeemed to the old investors. The moment the money that needs to be redeemed becomes greater than the fresh money coming in, the scheme collapses.

How does this apply in case of Indian ecommerce companies? Up until now the companies have managed to survive because of investors bringing in fresh money into the scheme at regular intervals. It is worth mentioning here that every time investors bring in more money, they bring it in at a higher valuation.

This essentially means that the price at which shares of the company are sold to the investors are higher than they were the last time around. This increases the market capitalization of the company.

This increase in market capitalization comes about because the company has managed to increase its revenue. But as we have seen earlier in this column, this increase in revenue typically comes at the losses increasing at a much faster rate. I wonder why all these fancy investors do not take something as basic as this into account?

Having said that, as long as this money keeps coming in and is greater than the losses being accumulated by the ecommerce firms, these firms will keep running.

The moment this changes, the firms will start to shut-down. The structure of the Indian ecommerce companies is that of a classic Ponzi scheme. In fact, a news-report in The Economic Times suggests that FabFurnish, a furniture retailer, is likely to shutdown given that its German investor does not want to burn any more money to finance its losses.

The trouble is that everyone wants to be build a monopoly. But everyone cannot be a monopoly. As Smith writes in the context of the American dotcom bubble: “The problem is that, even if it is possible to monopolize something, there were thousands of dotcom companies and there isn’t room for thousands of monopolies. Of the thousands of companies trying to get big fast, very few can ever be monopolies.” While the word thousands does not really apply in the Indian case, the overall logic still remains the same i.e. everyone cannot be a monopoly.

This means that many of today’s fledging ecommerce companies will shutdown in the years to come as investors pull the plug. In fact, the companies with the deepest pockets are likely to survive. Meanwhile, dear reader, enjoy the discounts until they last.

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The column originally appeared on SwarajyaMag on January 28, 2016

7 January, 2016

Mr Jaitely, Where Will The Money For Public Investment Come From?

On the last page of his magnum opus The General Theory of Employment, Interest and Money, the British economist John Maynard Keynes wrote: “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

One of the ideas of Keynes that has never become ‘defunct’ so to say, is that of governments needing to spend more when the economy is in trouble. In The General Theory, Keynes went to the extent of saying: “If the Treasury[i.e. the government] were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again … there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.”

How would this help in reviving the economy during bad times? Raj Patel explains this in The Value of Nothing as follows: “Keynes suggested, rhetorically, that if they lacked the imagination for anything more creative, governments could simply bury bottles of money under tons of trash, and that this would help get the economy going. It may sound bizarre, but it would certainly be worth someone’s while to dig up free money. To find these banknotes would require workers. Those workers would need to pay for food and shelter and everything else they needed to survive while they dug. The grocers who fed them and the landlords who rented to the workers would then have cash to spend, which they would use to buy other goods, and so on. This is called the “multiplier effect,” and it’s the added return that a government gets from spending its money in the economy.”

Keynes’ The General Theory was first published in 1936 and since then politicians all over the world have latched on to the idea of the government having to increase public spending when times are tough.

The finance minister Arun Jaitley is not different on this front. As he recently said: “Public investment has been stepped up in the last year and it will continue to remain stepped up… When you fight a global slowdown, public investment has to lead the way.”

In an environment where corporate balance sheets are stressed and public sector banks are in a mess, this might seem like the best way forward. But that is a very simplistic way of looking at things. The question is where will the money to pay for this public investment come from? And how will the government meet this expenditure and at the same time ensure that the fiscal deficit does not go up? Fiscal deficit is the difference between what a government earns and what it spends.

In the budget speech Jaitley made in February 2015, he had said: “I will complete the journey to a fiscal deficit of 3% in 3 years, rather than the two years envisaged previously. Thus, for the next three years, my targets are: 3.9%, for 2015-16; 3.5% for 2016-17; and, 3.0% for 2017-18.”

From what it looks like, Jaitley is unlikely to meet the fiscal deficit target of 3.5% of the gross domestic product (GDP) in 2016-2017, the next financial year. In fact, the Mid-Year Economic Analysis released by the ministry of finance in December 2015 has hinted at this very clearly.
As the Economic Analysis points out: “If the government sticks to the path for fiscal consolidation, that would further detract from demand…[Fiscal] consolidation of the magnitude contemplated by the government… could weaken a softening economy”. Fiscal consolidation is essentially the reduction of fiscal deficit, along the lines Jaitley had talked about in his budget speech.

What this clearly tells us is that the government is more serious about public investment than meeting the fiscal deficit target. The question is where will the money to finance public investment come from? As I explain here, the total cost of implementing the recommendations of the Seventh Pay Commission and One Rank One Pension will come close to Rs 1,40,000 crore, if the Railways is not bailed out by the government. Over and above this, food and fertilizer subsidies of more than Rs 1,00,000 crore, continue to remain unpaid. This doesn’t leave much scope for public expenditure, unless the government leaves the subsidy bills unpaid.

Further, there are other things that need to be looked at. Take a look at the following table and the debt servicing ratio of the government.

Debt servicing is defined as the amount of money a government spends towards repaying the debt as well as paying interest on the outstanding debt. The debt servicing ratio is obtained by dividing the money spent towards debt servicing by the revenue receipts i.e. the income of the government. What the table clearly tells us is that the debt servicing ratio of the government has worsened over the years.

In 2015-2016, the government is expected to spend close to 60% of what it earns in servicing its debt. And this is clearly not healthy. Any further worsening of the fiscal deficit will only mean a greater amount of government revenues going towards servicing its past debt in the years to come. This will leave a lower amount of money for other more important things, in the years to come. Debt servicing is defined as the amount of money a government spends towards repaying the debt as well as paying interest on the outstanding debt. The debt servicing ratio is obtained by dividing the money spent towards debt servicing by the revenue receipts i.e. the income of the government. What the table clearly tells us is that the debt servicing ratio of the government has worsened over the years.

Also, most analysts and experts tend to just look at the fiscal deficit of the central government, without taking into account the fiscal deficits of the state governments as well. As economist M Govinda Rao wrote in a recent column in The Financial Express: “This year, the Union government’s deficit is set at 3.9%, and with the states together having a deficit of about 2.2%, the aggregate fiscal deficit of the government works out to 6.1%. It is reported that 21 distribution companies are likely to join the UDAY scheme and the deficit on that account could be about 1%.”

If we were to add all this the real fiscal deficit of the government would come at 7.1% of the GDP. The household financial savings in 2014-2015 stood at 7.5% of GDP. What this tells us very clearly is that the government captures most of the household financial savings. Any further increase in fiscal deficit leading to increased borrowing by the government will only push up interest rates. Also, Rao estimates that public sector enterprises claim around 2% of the GDP. Hence, as he asks “where can financial institutions find the money to lend for private investment?”

Over and above all these numbers the credibility of Arun Jaitley is at stake as well. In his maiden budget speech in July 2014 he had said: “We need to introduce fiscal prudence that will lead to fiscal consolidation and discipline. Fiscal prudence to me is of paramount importance because of considerations of inter-generational equity. We cannot leave behind a legacy of debt for our future generations. We cannot go on spending today which would be financed by taxation at a future date.”

In his February 2015 speech Jaitley went against what he had said earlier and loosened the fiscal strings a little. If he does that again this year, how much credibility would what he says, continue to have? Also, is Jaitley still worried about inter-generational equity? Or was what he said in July 2014 innocent murmurs of a new finance minister, which should not have been taken seriously?

Further, there has been very little effort on part of the government to take tough decisions on the expenditure front. It continues to fund loss making entities like MTNL, Air India etc. The finance ministry had set up the Expenditure Management Commission in 2014. The reports of the Commission have not been made public up until today. This clearly tells us how serious the government is about cutting wasteful expenditure.

Also, there has been very little new thinking on part of the government in order to increase its income. Even low hanging fruit like the stake the government holds in companies like ITC, L&T and Axis Bank, through the Specified Undertaking of Unit Trust of India (SUUTI)., hasn’t been cashed in on. All the government seems to be doing to increase its revenue is to increase the excise duty on petrol and diesel.

It is also worth asking why does the fastest going large economy in the world need a fiscal stimulus from the government?

To conclude, since I started this column with Keynes it is only fair that I end it with him as well. One of the misconceptions that people have is that Keynes was an advocate of the government running high fiscal deficits all the time. It needs to be clarified that his stated position was far from that.

Keynes believed that, on an average, the government budget should be balanced. This meant that during years of prosperity, governments should run budget surpluses. But when the economic environment is weak, governments should spend more than what they earn, and even run high fiscal deficits.

But over the decades, politicians have only taken one part of Keynes’ argument and run with it. The idea of running deficits during bad times has become permanently etched in their minds. However, they have forgotten that Keynes had also wanted them to run surpluses during good times as well.

Jaitley is a politician, he is no different from others of his ilk.

(The column originally appeared on SwarajyaMag on January 7, 2016)

24 December, 2015

Did RBI just hint that Indian corporates have reached Ponzi stage of finance?

The Reserve Bank of India(RBI) releases the Financial Stability Report twice a year. The second report for this year was released yesterday (i.e. December 23, 2015). Buried in this report is a very interesting box titled In Search of Some Old Wisdom. In this box, the RBI has resurrected the economist Hyman Minsky. Minsky has been rediscovered by the financial world in the years that have followed the financial crisis which started with the investment bank Lehman Brothers going bust in September 2008.

So what does the RBI say in this box? “When current wisdom does not offer solutions to extant problems, old wisdom can sometimes be helpful. For instance, the global financial crisis compelled us to take a look at the Minsky’s financial stability hypothesis which posited the debt accumulation by non-government sector as the key to economic crisis.”

And what is Minsky’s financial stability hypothesis? Actually Minsky put forward the financial instability hypothesis and not the financial stability hypothesis as the RBI points out. I know I am nit-picking here but one expects the country’s central bank to get the name of an economic theory right. I guess given that the name of the report is the Financial Stability Report, someone mixed the words “stability” and “instability”.

The basic premise of this hypothesis is that when times are good, there is a greater appetite for risk and banks are willing to extend riskier loans than usual. Businessmen and entrepreneurs want to expand their businesses, which leads to increased investment and corporate profits.

Initially, banks only lend to businesses that are expected to generate enough cash to repay their loans. But as time progresses, the competition between lenders increases and caution is thrown to winds. Money is doled out left, right, and centre and normally it doesn’t end well.

This is the basic premise of the financial instability hypothesis. In this column I will explain that the Indian corporates have reached what Minsky called the Ponzi stage of finance. Minsky essentially theorised that there are three stages of borrowings. The RBI’s box in the Financial Stability Report explains these three stages. Nevertheless, a better explanation can be found in L Randall Wray’s new book, Why Minsky Matters—An Introduction to the Work of a Maverick Economist.

As Wray writes: “Minsky developed a famous classification for fragility of financing positions. The safest is called “hedge” finance (note that this term is not related to so-called hedge funds). In a hedge position, expected income is sufficient to make all payments as they come due, including both interest and principal.” Hence, in the hedge position the company taking on loans is making enough money to pay interest on the debt as well as repay it.

What is the second stage? As Wray writes: “A “speculative” position is one in which expected income is sufficient to make interest payments, but principal must be rolled over. It is “speculative” in the sense that income must increase, continued access to refinancing must be expected, or an asset must be sold to cover principal payments.”

Hence, in a speculative position, a company is making enough money to keep paying interest on the loan that it has taken on, but it has no money to repay the principal amount of the loan. In order to repay the principal, the income of the company has to go up. Or banks need to agree to refinance the loan i.e. give a fresh loan so that the current loan can be repaid. The third option is for the company to start selling its assets in order to repay the principal amount of the loan.

And what is the third stage? As Wray writes: “Finally, a “Ponzi” position (named after a famous fraudster, Charles Ponzi, who ran a pyramid scheme—much like Bernie Madoff’s more recent fraud”) is one in which even interest payments cannot be met, so that the debtor must borrow to pay interest (the outstanding loan balance grows by the interest due).”

Hence, in the Ponzi position, the company is not making enough money to be able to pay the interest that is due on its loans. In order to pay the interest, it has to take on more loans. This is why Minsky called it a Ponzi position.

Charles Ponzi was a fraudster who ran a financial scheme in Boston, United States, in 1919. He promised to double the investors’ money in 90 days. This was later shortened to 45 days. There was no business model in place to generate returns. All Ponzi did was to take money from new investors and handed it over to old investors whose investments had to be redeemed. His game got over once the money leaving the scheme became higher than the money being invested in it.

Along similar lines once companies are not in a position to pay interest on their loans they need to borrow more. This new money coming in helps them repay the loans as well as pay interest on it. And until they can keep borrowing more they can keep paying interest and repaying their loans. Hence, the entire situation is akin to a Ponzi scheme.

By now, dear reader, you must be wondering, why have I been rambling on about a single box in the RBI’s Financial Stability Report and an economist called Hyman Minsky.

In RBI’s Financial Stability Report the box stands on its own. But is the RBI dropping hints here? Of course, you don’t expect the central bank of a country to directly say that a large section of its corporates have reached the Ponzi stage of finance. And there are many others operating in the speculative stage of finance. Even without the RBI saying it directly, there is enough evidence to establish the same.

In the report RBI points out that as on September 30, 2015, the bad loans (gross non-performing advances) of banks were at 5.1% of total advances of scheduled commercial banks operating in India. The number was at 4.6% as on March 31, 2015. This is a huge jump of 50 basis points in a period of just six months.

The restructured loans of banks fell to 6.2% of total advances from 6.4% in March 2015. A restructured loan is a loan on which the interest rate charged by the bank to the borrower has been lowered. Or the borrower has been given more time to repay the loan i.e. the tenure of the loan has been increased. In both cases the bank has to bear a loss.

The stressed loans of banks, obtained by adding the bad loans and the restructured loans, came in at 11.3% of total advances. They were at 11.1% in March 2015.
The numbers for the government owned public sector banks were much worse. The stressed loans of public sector banks stood at 14.1%. In March 2015, this number was at 13.2%. This is a significant jump in a period of just six months. The stressed loans of private sector banks stood at a very low 4.6% of total advances.

Let’s look at the stressed loans of public sector banks over a period of time. In March 2011, the number was at 6.6% of total advances. By March 2012, it had jumped to 8.8% of total advances. Now it is at 14.1%.

What is happening here? Banks are clearly kicking the can down the road by restructuring more loans, because many corporates are clearly not in a position to repay their bank loans. Why do I say that? As the Mid-Year Economic Review published by the Ministry of Finance last week points out: “Corporate balance sheets remain highly stressed. According to analysis done by Credit Suisse, for non – financial corporate sector (based on ~ 11000 companies in the CMIE database as of FY2014 and projections done for FY2015 based on a sample of 3700 companies), the number of companies whose interest cover is less than 1 has not declined significantly (this number was 1003 in September 2014 and is 994 in September 2015 quarter).”

Interest coverage ratio is essentially obtained by dividing the earnings before interest and taxes(operating profit) of a company during a given period, by the interest that it needs to pay on the loans that it has taken on.

In the Indian case, a significant section of the corporates have an interest coverage ratio of less than 1. This means that they are not earning enough to even pay the interest on their outstanding loans.

Further, the weighted average interest coverage ratio of all companies in the sample as on September 2015 was at 2.3. It was at 2.5 in September 2014. As the Mid-Year Economic Review points out: “Research indicates that an interest cover of below 2.5 for larger companies and below 4 for smaller companies is considered below investment grade.”

What this means that many corporates now are not in a position to even pay interest on their loans. They need newer loans to repay interest on their loans. They have reached the Ponzi stage of finance, as Minsky had decreed. Still others are in the speculative stage.

The RBI Financial Stability Report again hints at this without stating it directly. As the report points out: “Bank credit to the industrial sector accounts for a major share of their overall credit portfolio as well as stressed loans. This aspect of asset quality is related to the issue of increasing leverage of Indian corporates. While capital expenditure (capex) in the private sector is a desirable proposition for a fast growing economy like India, it is observed that the capex which had gone up sharply has been coming down despite rising debt. During this period, profitability and as a consequence, the debt-servicing capacity of companies has, seen a decline. These trends may be indicative of halted projects, rising debt levels per unit of capex, overall rise in debt burden with poor recoveries on resources employed.”

What the central bank does not say is that rising debt without a rising capital expenditure may also be indicative of the fact that newer loans are being taken on in order to pay off older loans as well as pay interest on the outstanding loans. The public sector banks are issuing newer loans because if they don’t corporates will start defaulting and the total amount of bad loans will go up even further.

In such a scenario, the public sector banks have also been helping corporates by restructuring more and more loans. By doing this they are essentially postponing the problem. A restructured loan is not a bad loan. Further, around 40% of restructured loans between 2011 and 2014 have turned into bad loans.

All this hints towards a large section of Indian corporates operating in what Minsky referred to as a Ponzi stage of finance. Many corporates are also in the speculative stage. And given that, it’s not going to end well.

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

The column originally appeared on SwarajyaMag on December 24, 2015