Demonetisation: How Black Money Has Become White


Yesterday in a press conference after the monetary policy, R Gandhi, one of the deputy governors of the Reserve Bank of India, said that Rs 11.55 lakh crore of demonetised notes had made it back to the banks.

This essentially amounts to close to 75 per cent of the total value of the demonetised notes. With this, it is safe to say that by December 30, 2016, the last date of submitting demonetised notes, most of the demonetised notes will make it back to the banks.

This goes against the initial logic that the black money would form a certain portion of the demonetised notes and that won’t make it back to the banks. Black money is essentially money which has been earned through legal and illegal means, but on which tax has not been paid.

People who had black money in the form of cash would not submit it to the banks for the fear of generation of an audit trail. And this is how black money would be destroyed.

But we Indians have turned out to be smarter than that. Various ways have been used to convert old demonetised notes into new ones. This is something that the brains beyond the current demonetisation process had not bargained for. Here are a few ways which I have come across, through which black money is being converted into white.

a) I have come across a number of stories where daily wage labourers are still being paid in old demonetised notes. It is a case of either take it or leave it, for them. They have no other option but to take these old notes and then go to a bank to submit these notes into their bank accounts. They then need to stand in another line to withdraw notes which continue to be legal tender.

b) Another story that I have come across is that merchants with black money are forcing their employees to deposit old demonetised notes in their bank accounts. So, the way this works is that the merchant hands Rs 50,000 to his employee and asks him to go and deposit the money into the bank account. He then tells the employee that this money will be deducted from the salary over the next few months. In the process, this becomes an interest free loan for the employee and the merchant’s black money gets converted into white.

c) Another interesting story that I have heard is of those with black money buying dollars with it, at a very good rate. This clearly is a play against the rupee. People buying dollars don’t want to take any further risk of holding their black wealth in the form of rupees.

It is then the responsibility of the person selling the dollars to go and deposit the money in the bank and ensure that it continues to have purchasing power. This is another way through which black money has been converted into white.

d) Then there have been cases of many households finding a lot of cash in their homes, which the women folk had saved up over the years. This money has been spread across various bank accounts that the household has and deposited into banks.

e) There have also been stories of black money being converted into white, by depositing it into Jan Dhan accounts.

Of course, the thing is that none of these methods are fool-proof. As revenue secretary Hasmukh Adhia told The Indian Express: “No black money hoarder will be spared. If someone has deposited Rs 50,000 in the accounts of 500 people each, he will also be caught.”

With information technology, things can easily be tracked. If someone suddenly deposits Rs 1 lakh into an account, in which he normally does not deposit more than Rs 10,000 every month, this can easily be flagged by the information technology system. The income tax department can then enquire into this.

Of course, people who are depositing money into bank accounts and converting black to white in various ways, understand this. What they are essentially backing on is, how many people can the income tax department go after? There is a limitation to that. Also, how easy will it be prove things, if things do end up in court? Further, the more notices that are sent out, the more unpopular the demonetisation decision is likely to get.

And all this is something worth thinking about.

The column originally appeared in The 5 Minute Wrapup on November 9, 2016

Buys High and Not Low: That’s the Indian Investor for You


“Buy Low, Sell High,” goes the old stock market wisdom.

But like most stock market wisdom, this is easy to mouth, but difficult to implement in real life. It is very difficult to buy when others are selling and vice versa.

The tendency is to go with the herd because there is safety in numbers. And if things don’t work out as intended, one has someone else to blame as well. “I only did what Mr Singh’s son recommended,” goes the argument.

The question is how do numbers look on this front? Do investors actually buy when market levels are low and sell when market levels are high. Or are they doing exactly the opposite?

Take a look the following chart. That is how the Sensex has looked between April 1, 2011 and March 31, 2016. As can be seen from the chart, the overall trend of the Sensex has been in the upward direction, though it did fall during the course of 2015-2016.


Now take a look at the following table.

YearShares and Debentures
(as a % of GNDI)

Source: Annual Report of the Reserve Bank of India

The table shows the portion of gross national disposable income (basically the GDP number adjusted for a few other things. For a detailed treatment click here) made up for by investments in shares and debentures, which are a part of the household financial savings. In 2011-2012, shares and debentures made up for 0.2 per cent of the gross national disposable income. By 2015-2016, this had jumped up to 0.7 per cent. The household financial savings comprise of currency, deposits, shares and debentures, insurance funds, pension and provident funds and something referred to as claims on government. The claims on government largely reflects of investments made in post office small savings schemes.

What the table clearly tells us very clearly is that a very small portion of Indian retail investors invests in shares and debentures. In fact, these numbers also include the mutual fund numbers.

What do we learn from the chart and the table? As the Sensex went up, so did the investments in shares and debentures.

The trouble is that for some reason, which actually makes no sense, the RBI puts out the data for shares and debentures together. A breakdown of the total amount of money held in the form of shares (or debentures for that matter) is not available. But with the help of some other data we can prove that the Indian investor basically follows the policy of buying once the stock markets have rallied.

As on March 31, 2011, the total amount of money held in equity mutual funds in India had stood at Rs 1,69,754 crore. By March 31, 2016, this number had stood at Rs 3,44,707 crore. The assets under management increase in two ways. The first is because the value of the shares held by the mutual funds goes up. And the second is because of the fresh money being invested into the mutual funds.

As we can see the assets under management have more than doubled in the five-year period. On the other hand, the Sensex returns during the period stood at 30.5 per cent. Hence, it is safe to say that the major part of the increase in assets under management was because of new money coming into the mutual fund schemes.

And this new money kept coming in as the Sensex kept going up. Take the case of what happened between March 31, 2015 and March 31, 2016. The Sensex fell by 9.3 per cent during the course of the year. The assets under management of equity mutual funds on the other hand, went up by 12.8 per cent.

In fact, during the period, the Sensex achieved its highest level on January 29, 2015, when it closed at 29,681.77 points. Between then and March 31, 2016, the Sensex fell by 14.6 per cent. At the same time, the assets under management of equity mutual funds went up by 14 per cent.

This is a clear indication of the fact that investors actually invest in equity mutual funds only after the markets have rallied. Once the market has rallied, the investors probably assume that it will continue to rally.

Hence, I guess, it is safe to say that a similar behaviour is on when it comes to direct investing in stocks as well. And that (along with increase in mutual fund investments) explains why the share of shares and debentures has increased from 0.2 per cent of gross national disposable income in 2011-2012 to 0.7 per cent in 2015-2016.

Of course, one would be able to say this with much greater confidence if the RBI gave an exact breakdown of shares and debentures. I hope that this anomaly is corrected in the days to come.

The column originally appeared in The Five Minute Wrapup on September 7, 2016

Why Deposit Growth is at a Twenty-Five Year Low


The Reserve Bank of India releases the aggregate deposits with scheduled commercial bank data every week.

Data released on April 22, 2016, suggests that for the year 2015-2016, the aggregate deposits with scheduled commercial banks grew by 9.72%. This is the lowest in more than 25 years and the second lowest in more than 50 years.

Only in 1990-1991, the year before economic reforms were introduced, had the growth been slower at 9.65%. Also, this is the second lowest deposit growth since 1963-1964. Further, it is only the second time that deposit growth has been in single digits since 1963-1964.

And this is a worrying trend.

Why is this happening? One reason is that household savings as a whole have fallen over the years primarily because of the high rate of inflation that prevailed between 2008 and 2013. The household savings fell from 22.2% of gross national disposable income in 2011-2012 to 17.8% in 2013-2014. More recent data points are not available.

The household financial savings was at 7.5% of gross national disposable income in 2014-2015. As the RBI annual report for 2014-2015 points out: “Growth in aggregate deposits, which forms a major component of money supply, has generally been declining over the years in line with a decrease in the saving rate of the economy. In addition, slowdown in credit growth led to lower deposit mobilisation by banks.”

Raghuram Rajan, the governor of the Reserve Bank of India (RBI), has also offered another reason, whenever this question has been put to him. When deposit growth was faster inflation was also higher, he has explained. In 2010-2011, the aggregate deposits with scheduled commercial banks grew by 15.3%. The consumer price inflation during the year was at 10.45%. In 2012-2013, the deposits grew by 13.8% and the inflation was at 10.44%.

In 2015-2016, the consumer price inflation was 4.83% and the deposit growth was at 9.72%. Once we look the growth from this angle, suddenly it doesn’t look as bad.

In fact, there is another important reason for the fall in the aggregate deposits growth and this reason is not so obvious.

The loan growth of banks (i.e. non-food credit) has been slow over the last few years and this has led to slower deposit growth as well.

In 2015-2016, the total amount of loans given by scheduled commercial banks grew by 10.3%. This was better than the 9.3% growth seen in 2014-2015, but low nonetheless. In fact, the loan growth in the last two years has been the slowest since 1993-1994.

This has had an impact on deposit growth. And how is that? As Michael McLeay, Amar Radia and Ryland Thomas of the Bank of England write in a note titled Money Creation in the Modern Economy: “The vast majority of money held by the public takes the form of bank deposits. But where the stock of bank deposits comes from is often misunderstood. One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.”

As it turns out, things are not as straightforward as that. As the Bank of England authors write: “Commercial banks create money, in the form of bank deposits, by making new loans.”

How is that possible? Let’s say an individual deposits money in a bank. The bank uses that money to make a car loan (assuming that the deposit is large enough). The money is deposited into the account of the borrower. The borrower of the car loan uses that money to buy a car and pays the car dealer. The money is deposited in the account of the car dealer. The car dealer in turn uses that money to pay his employees.

The employees when they are paid, money is deposited into their savings bank accounts. Hence, a loan creates more deposits. The employees then withdraw a part of that money to meet their monthly expenditure. They may also transfer a part of their deposit from a savings bank account into a fixed deposit.

A part of the money that the employees withdraw goes towards paying their local kirana wallah(or the mom and pop shop) from where their monthly grocery is bought. A part of this spend again finds its way back into the bank as a deposit.

This multiplier effect essentially ensures that new loans create more deposits. And given that loan growth of banks has been slow, it is not surprising that deposit growth is slow as well. Hence, for deposit growth to pick up loan growth will have to pick up.

And what needs to happen for loan growth to pick up? The simplistic answer is that lower interest rates will lead to higher loan growth. But things are not as simple as that. Interest rates also need to be maintained over the prevailing rate of inflation in order to encourage people to save. Further, lower interest rates do not always encourage people to borrow, as is more than obvious across large parts of the Western world, currently.

What needs to improve is the promoter interest in doing new business for which they need to borrow.

As Mahesh Vyas of Centre for Monitoring Indian Economy wrote in a recent piece: “Why do a significantly large number of projects continue to be stalled when most important reasons for phenomenon have already played themselves out? The most prominent reason turns out to be lack of promoter interest. One third of the total investments whose implementation was stalled in 2015-16 was because of lack of promoter interest. Another 15 per cent of the promoters who stalled implementation stated that the current market conditions were unfavourable to pursue their projects further. The two reasons are essentially the same – that these are not very good times to invest.”

The column originally appeared on The 5 Minute Wrapup on April 29, 2016

Finally, an Economist Explains Why the Indian GDP Growth Number Is Wrong



I was just joking to a friend the other day that if economists started writing their stuff in simple English, which everybody can understand, guys like me who make a living out of translating what economists think and write, into simple English, would be driven out of the business very quickly.

The question is why do economists write the way they do? As John Lanchester writes in How to Speak Money: “As your vocabulary becomes more specific, more useful, more effective, it also becomes more exclusive. You are talking to a smaller audience…There are a lot of things like that in the world of money, where the explanation is hard to hold on to because it compresses a whole sequence of explanations into a phrase, or even just into a single word.” This is precisely what happens when economists write, or talk for that matter.

Nevertheless, given the chances of economists writing in simple English are low, I guess I am likely to continue to be in business.

Moving forward, in this piece I wanted to look at a column which was recently published in the Mint newspaper. The column is titled Real GDP is growing at 5%, not 7.1% and has been written by economist Rajeswari Sengupta.

I think the column makes a very important point. Nevertheless, my only quibble with it is that it has not been written in simple English. An idea as important as this column communicates needs to reach a wider audience and not just other economists.

So what is the core idea of the Mint column? As Sengupta writes: “Are our gross domestic product (GDP) numbers credible? Many commentators have expressed their doubts. But no one has yet identified problems with the Central Statistical Organisation’s (CSO) methodology. This is because they have been looking in the wrong place.”

Sengupta essentially goes on to explain what is wrong with the Indian GDP growth numbers.

In January 2015, the CSO moved to a new way of calculating the GDP. The GDP is a measure of all goods and services produced within a country. It is a measure of the economic size of any country. And GDP growth is essentially a measure of economic growth.

After the CSO last January unveiled the new way of calculating the GDP, the Indian GDP numbers suddenly started to look better. The GDP growth as per the old method had stood at around 5%. With the new method, the GDP growth suddenly crossed 7%.

The CSO estimates that in 2015-2016 (the current financial year) the Indian economy is likely to grow at the rate of 7.6%. It is important to understand that the GDP is a theoretical construct. There are many high frequency economic data indicators which tell us very clearly that there is no way that the country is growing at the rate at which the CSO wants us to believe it is.

Exports are down. Two wheeler sales growth has been fairly insipid. Railway freight growth has been very slow. Bad loans of banks are rising at a fairly rapid rate and their lending growth has been very slow. Corporate earnings growth has been terrible.

Given these reasons, how can the GDP possibly grow at 7.6% during this financial year, is a question worth asking.

Sengupta in her column explains what is wrong with the GDP growth number of 7.6%. As she writes: “The problem is not, as many have suspected, in the nominal numbers. It lies in the system for constructing the deflators. This methodology is flawed, yielding exaggerated estimates of the speed at which the economy is growing.

Let me explain this mumbo jumbo in simple English. The GDP growth number of 7.6% is essentially what economists call the real GDP growth. The real GDP growth is essentially GDP growth which has been adjusted for inflation. The nominal GDP is the GDP growth which hasn’t been adjusted for inflation.

Hence, real GDP growth is essentially nominal GDP growth minus the prevailing rate of inflation. So far so good.

Now Sengupta talks about something known as a deflator in her column. What is a deflator? Lanchester defines a deflator in his book as “the number you use when working out the value of money minus the effect of inflation.”

In Sengupta’s case, she is talking about what economists refer to as the GDP deflator, which is nothing but the rate of inflation used to come up with the real GDP growth number from the nominal GDP growth number.

The real GDP growth number is essentially the nominal GDP growth number minus the GDP deflator. Let’s understand this through an example. Let’s say the nominal GDP growth is 10%. The GDP deflator is at 3%. Then the real GDP growth is 7% (10% minus 3%). If the GDP deflator is 1%, then the real GDP growth is 9% (10% minus 1%). That is how it works

What is the problem with the GDP growth number? As Sengupta puts it: “The real numbers are derived by taking nominal data on the economy and deflating them by price indices. So, if inflation is understated, then real growth is going to be overstated. And this is what has been happening.”

Hence, the CSO seems to be using a lower GDP deflator to arrive at the real GDP growth number. This has led to a higher real GDP growth number, which seems unreal.

And this is precisely where the problem lies. If we look at the nominal growth number for the period October to December 2015, it stands at 7.9%. A deflator of 0.7% meant that the real growth came in at 7.1%. (The number should be 7.2% if we follow what I explained earlier, but there must be some rounding off errors here).

Sengupta’s contention is that the CSO is understating the GDP deflator at 0.7% and the number should be higher than this. As she writes: “Could India’s inflation be so low? In effect, the CSO is saying that despite India’s booming economy, producer inflation is lower than that of the recession-wracked economies of the West, or even that of Japan, which has been wrestling with deflation since the 1990s.

This underestimation is happening primarily because the calculation of the GDP deflator closely tracks the inflation as measured by the wholesale price index, which has been in negative territory for some time now (16 months to be precise).

This explains why CSO feels that the Indian economic growth in 2015-2016 will be at 7.6%, even though the high speed economic indicators indicate otherwise. Sengupta shows that by using the right GDP deflator, the real GDP growth cannot be possibly more than 5%. And that is precisely the point I have been making over the last few months.

The column originally appeared on The 5 Minute Wrapup on Equitymaster on March 18, 2016

Govt Fixing Steel Prices: Is Make in India Just a Slogan?

make in india
On February 5, 2016, the directorate general of foreign trade imposed a minimum import price(MIP) on 173 steel products. The prices range from $352 per tonne to $752 per tonne of steel.

The MIP has been imposed in order to counter the dumping of cheap Chinese steel and should help the Indian steel companies. Also, the move should help public sector banks as well.

Why do I say that? As the RBI Financial Stability Report released in December 2015 points out: “A risk profile of select industries as at end September 2015 showed that iron and steel, construction and power industries had relatively high leverage as well as interest burden.”

The report further pointed out: “Five sub-sectors viz. mining, iron & steel, textiles,  infrastructure and aviation, which together constituted 24.2 per cent of the total advances of scheduled commercial banks as of June 2015, contributed to 53.0 per cent of the total stressed advances.”

What does this tell us? Steel companies have borrowed a lot of money from banks which they are now finding difficult to repay. The only way they can repay these loans is by ensuring that their sales and profits continue to grow. And that is not possible if cheap steel from China keeps hitting the Indian shores.

The government has tried to correct this by slapping an MIP on steel, in the process making imported steel more expensive. The idea is that anyone who needs steel within India, buys from Indian companies, instead of importing cheaper steel.

The question is does this make sense? It does for the steel companies. But not for the overall Indian economy as a whole. Before I get into explaining this, allow me to discuss what is known as the broken window fallacy. The French economist Frédéric Bastiat discusses this concept in his 1874 book That Which is Seen, and That Which is Not Seen.

Bastiat talks about a shopkeeper whose rather careless son has broken a glass window of his shop. As Basitat writes: “If you have been present at such a scene, you will most assuredly bear witness to the fact, that every one of the spectators, were there even thirty of them, by common consent apparently, offered the unfortunate owner this invariable consolation—“It is an ill wind that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken?

The point being if window glasses were never broken what would glaziers ever do? As Basitat writes: “Suppose it cost six francs to repair the damage, and you say that the accident brings six francs to the glazier’s trade—that it encourages that trade to the amount of six francs—I grant it, I have not a word to say against it; you reason justly. The glazier comes, performs his task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this is that which is seen.

But what about that which is not seen? “It is not seen that as our shopkeeper has spent six francs upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library. In short, he would have employed his six francs in some way which this accident has prevented,” writes Bastiat.

What is Bastiat trying to tell us here? When we are analysing economic issues, we tend to look at that which is seen and tend to ignore that which is unseen. In the case of minimum import price being fixed on steel imports, it means looking only at the benefits that this would bring to the Indian steel companies.

Stock analysts have labelled this move of the government as a “gamechanger” for the steel companies and have recommended that investors buy these stocks.  Now that is the ‘seen’ part of it, if we were to apply Bastiat’s broken window fallacy to this situation. But what about the unseen?

As Henry Hazlitt writes in Economics in one Lesson: “The tariff has been described as a means of benefitting the producer at the expense of the consumer. In a sense this is correct. Those who favour it only think of the interests of the producers immediately benefited by the particular duties involved. They forget the interests of the consumers who are immediately injured by being forced to pay these duties.”

A tariff is essentially a tax or a duty that is paid on imports of exports. In the case of the minimum import price on steel imports, no duty has been fixed or tax has to be paid. But given that the minimum import price will force consumers of steel to buy steel at a higher price from Indian steel companies, it basically means that the companies are being forced to pay more than they would have, if this move had not been made. In that scenario they could have simply imported cheaper steel, which they cannot do now. Hence, to that extent even an MIP is basically a tariff.

Steel is an input into many different sectors from automobiles to real estate to engineering to construction and infrastructure. Hence, if the price of steel goes up, companies operating in these sectors need to pay more when they buy steel. And this in turn will impact the prices of the consumer goods that these companies produce and the physical infrastructure that they create. This is the unseen negative that people are not talking about.

Take the case of engineering goods, which is as of now, India’s number one export. As TS Bhasin, Chairman of EEPC India, an engineering goods exporters’ body, told The Hindu: “The MIP will raise the cost of raw materials for engineering products by about 6-10 per cent. This will severely hurt engineering exports that have already declined by 15 per cent in the first nine months of this fiscal.” How will Indian engineering companies compete globally in an environment of slow global economic growth, if steel is made expensive?

Further, this also leads to the question as to how serious is the government about “Make in India”. Is it just a slogan? Or is it more than a slogan? If it is more than a slogan then there is no way that the government should be fixing steel prices and in the process increasing the price the consumers of steel pay.

Also, why is the government just trying to protect steel producers. How about retail companies which have been bearing the onslaught of ecommerce companies selling goods at significantly lower prices, backed by foreign venture capital and private equity money?

As Anindya Banerjee, analyst at Kotak Securities puts it: “The offline retailers have been long complaining how ecommerce companies, funded by cheap dollars/euros/yen of yield hungry bubble vision private investors, is undercutting them in every consumer product. They claim that these ecommerce companies are destroying hard working mom and pop stores and their employees, by resorting to unsustainable discounts. So why is the government not imposing a minimum retail price(MRP) for all products sold online. This MRP should be set at a price which is above the offline retail price. I presume my fellow citizens won’t mind paying more for their stuff they buy. After all they are supporting the economy, aren’t they?

Now that is something worth thinking about. And if something like that were to happen, we would be finally back to the eighties. My growing up years will  be back again.

The column originally appeared in The Five Minute Wraupup on Equitymaster on February 10, 2016