The Daily Reckoning

Sovereign Gold Bonds are a great idea that won’t work in India

gold
On November 5, 2015, the Prime Minister Narendra Modi launched the sovereign gold bonds. On the occasion Modi said: “India has no reason to be described as a poor country, as it has 20,000 tonnes of gold. He said the gold available with the country should be put to productive use, and these schemes show us the way to achieve this goal.”

Our fascination for gold has led to a situation where we have managed to accumulate 20,000 tonnes of gold over the years. To understand how big this number is, consider the following point made by the World Gold Council. As it points out: “At the end of 2014, there were 183,600 tonnes of stocks in existence above ground. If every single ounce of this gold were placed next to each other, the resulting cube of pure gold would only measure 21 metres in any direction.”

What does this mean? India has 20,000 tonnes or around 10.9% of the 1,83,000 tonnes of gold in existence. The tragedy is that India doesn’t produce almost any gold. In fact, in 2013-2014, we produced 1.4 tonnes of gold.

And how much did we import? The minister of state for commerce Nirmala Sitharaman(independent charge) in a written reply in the Lok Sabha had pointed out that Indian import of gold in 2013-2014 had stood at 638 tonnes.

So India produced 1.4 tonnes of gold and imported 638 tonnes of gold. Interestingly, the import of gold in 2013-2014 fell by around 25% from 845 tonnes in 2011-2012. In 2011-2012, India had produced 1.59 tonnes of gold. Hence, we practically import all the gold that we consume.

And this creates major macroeconomic imbalances. Gold is sold internationally in dollars. When India imports gold it needs dollars, which need to be earned through exports. When India imports gold, it pushes up the demand for dollars in comparison to the rupee and the value of the rupee starts to fall. A depreciating rupee is good for the exporters because they earn more. But given that our imports are more than our exports it hurts.

Other than practically importing all the gold that it consumes, India also imports 80% of the oil that it consumes. A depreciating rupee means that the oil marketing companies which import oil have to pay more for oil in rupee terms. In the past, the government did not allow the oil marketing companies to pass on this increase in cost to the consumers totally.

Only recently diesel prices have been freed and are determined by the price at which oil marketing companies are able to buy oil internationally. Oil marketing companies still suffer under-recoveries every time they sell kerosene and domestic cooking gas.

The government has to compensate the oil marketing companies for these under-recoveries. Up until last year, the oil prices were very high. And when gold demand went up, the rupee depreciated and this pushed up the total amount of money oil marketing companies had to pay for oil. Since they were not allowed to totally pass on this increase in price to the end consumer on the oil products they sold, the government had to compensate them.

When the government compensated them, the expenditure of the government went up and so did its fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends. This meant higher borrowing by the government.  A higher borrowing led to crowding out, where the increased government borrowing did not leave enough on the table for the other borrowers. This, in turn, pushed up interest rates. And so the cycle worked.

Let’s look at this in another way. In 2013-2014, the gold and silver India imported, formed around 7.1% of the total commodity imports. In 2012-2013 and 2011-2012, the number was higher at 11.3% and 12.5%. For a commodity which is pretty much useless from an industrial point of view that is a huge proportion.

In 2013-2014, gold worth $28.7 billion had been imported. Now compare this to India’s IT and IT enabled services exports which during the same period stood at $86.4 billion. So, one way of looking at it is that one-third of dollars earned through IT and IT enabled services exports were used up to buy gold.

In fact, the situation was even worse in 2012-2013, when the gold imports were at $53.7 billion. The IT and IT enabled services exports were at $76.5 billion dollars. Hence, more than 70% of dollars earned through IT and IT enabled services exports were used up in buying gold. For 2011-2012, the proportion was even higher at 81%.

Once all these factors are taken into account the sovereign gold bonds sound like a fantastic idea. As a RBI notification dated October 30, 2015, points out: “The Bonds shall be denominated in units of one gram of gold and multiples thereof. Minimum investment in the Bonds shall be 2 grams with a maximum subscription of 500 grams per person per fiscal year (April – March).” The bonds shall also pay an interest of 2.75% per annum.

So anyone looking to buy gold instead of buying actual physical gold can buy these bonds. The value of these bonds will be linked to the price of gold. As the RBI notification points out: “The redemption price shall be fixed in Indian Rupees on the basis of the previous week’s (Monday – Friday) simple average closing price for gold of 999 purity, published by IBJA [Indian Bullion and Jewellers Association].” The bonds can be held on paper as well as demat form.

When an investor invests in these bonds he will not buy physical gold. This will help in reducing gold imports and the entire cycle, which I have explained above, will not play out or play out to a lesser extent. The RBI and the government will not get a macroeconomic headache because of our fascination for buying gold. At least, that’s the idea.

Of course I am assuming here that investors will move from buying physical gold to investing in sovereign gold bonds. Nevertheless, will that happen? Paper and demat gold has already around in the form of gold mutual funds and gold exchange traded funds(gold ETFs). Gold mutual funds invest the money that they collect into Gold ETFs.

These funds haven’t really taken off. This tells us that the Indian investor has an aversion to paper and demat gold and likes to hold real gold.

The advantage in case of sovereign gold bonds is that the investor along with getting gold returns also gets 2.75% as interest on the initial amount he invests. Is that lucrative enough to get him to move from physical gold to paper/demat gold? I don’t think so.

And that’s basically because there are other factors at play. Investing in gold is a lot about touch and feel. Indians are emotionally and culturally attached to the gold that they buy. Further, as I mentioned in the Friday edition of The Daily Reckoning, many Indians buy gold to store their black money. A lot of money can be held by buying a small amount of gold. These individuals are likely to continue to buy gold in physical form. The reason is straightforward. They are not going to buy paper/demat gold because it would be establish an audit trail and lead to problems for these individuals.

Also, those interested in getting gold jewellery made will get gold jewellery made and not buy sovereign gold bonds instead.

Due to all these reasons, I think the sovereign gold bonds are unlikely to take off. Indians will continue to buy gold in physical form. But that shouldn’t stop the government from trying.

The column originally appeared on The Daily Reckoning on November 10, 2015

Bihar elections: Why TV channels declared that Nitish Kumar had lost

220px-Nitish_Kumar
In Friday’s edition of The Daily Reckoning I had mentioned that on Monday I will be discussing the recently launched sovereign gold bonds. Nevertheless, there is something else that I wanted to share today, in the aftermath of the Bihar election results.

Given this, the column dealing with the sovereign gold bonds will now appear tomorrow (November 10). Today I want to discuss the Bihar election results. Or to put it more specifically, the analysis that happened on TV and the social media after the counting started and the first trends (and not results) started to come in.

The counting started at 8AM and within a period of 30 minutes the first trends stared to come in. Over the next hour and a half, the Bhartiya Janata Party (BJP) led National Democratic Alliance (NDA) was way ahead of the Nitish Kumar led Grand Alliance (comprising of Nitish Kumar’s Janata Dal(United), Lalu Prasad Yadav’s Rashtriya Janata Dal(RJD) and the Congress Party).

Experts on a whole host of TV channels and social media started offering reasons for this trend. Some experts and TV anchors more or less declared a BJP victory. One senior journalist surmised on an English news channel that Nitish Kumar’s arrogance during the second term had cost him this election. He also said that Nitish had misread the youth.

On a Hindi channel an expert said that the “annihilation of caste had started in Bihar,” as Dr Ambedkar and Dr Lohiya had predicted. A senior Muslim BJP politician belonging to Bihar also said the same thing: “humne jatiya ganit ko toda hai (we have broken the caste arithmetic).”

Within the Grand Alliance, initially Nitish Kumar’s Janata Dal (United) or JD(U), was leading in many more seats, in comparison to Lalu’s RJD. An expert on a Hindi news channel explained this in a very interesting way, which sounded quite convincing at that point of time.

He said all of Lalu’s voters (i.e. primarily the Muslims and the Yadavs) had voted for Nitish (in constituencies where a JD(U) candidate had been put up by the Grand Alliance), but the vice versa has not happened (i.e the Kurmis and the Extremely Backward Classes, who are supposed to the supporters of Nitish, hadn’t voted for the RJD in constituencies where the RJD candidate had been put up).

An Indian American who is known to be a Modi bhakt (though in the recent past he has been very unhappy with the economic policies of the Modi government) tweeted saying: “Please don’t feel bad, JDU+RJD. At least you won the exit polls.”

After 10 AM the trend started to change and the Grand Alliance started to move ahead and ultimately overtook the NDA by a huge margin. The Hindi news channels caught on to this very quickly. The English channels took some time. And that’s how it stayed till the end. The NDA was washed out. The Grand Alliance got 178 seats and the NDA ended up with just 58 seats.

The RJD emerged as the largest party with 80 seats. The JD(U) came in second at 71 seats. And the BJP was third at 53 seats.

So that is the background to the issue I want to write about today.

Analysing on TV and the social media forces people to come up with instant analysis. There is no scope for nuance or words like possibly and maybe. The experts can’t wait either.

The instant analysis can be shaky given that many times it’s based on very small sample sizes. This leads to analysts and experts on TV and the social media, becoming victims of the law of small numbers. And this is precisely what happened in the first two hours after the counting of votes started yesterday.

As Leonard Mlodinow writes in The Drunkard’s Walk—How Randomness Rules Our Lives: “
The misconception—or the mistaken intuition—that a small sample accurately reflects underlying probabilities is so widespread that [Daniel] Kahneman and [Amos] Tversky gave it a name: the law of small numbers. The law of small number is not really a law. It is a sarcastic name describing the misguided attempt to apply the law of large numbers when the numbers aren’t large.”

And what is the law of large numbers? As Mlowdinow writes, the law of law large numbers essentially states that “a large enough sample will almost certainly reflect the underlying makeup of the population being sampled.”

How does this apply in the context of the Bihar elections? When the first trends started to come in, only a few votes had been counted. Hence, this sample of votes was a small portion of the total votes that had been polled. And it showed that the NDA was well ahead. Nevertheless, it did not reflect the underlying reality. As Daniel Kahneman writes in Thinking, Fast and Slow: “Large samples are more precise than small samples. Small samples yield extreme results more often than large samples do.”

The extreme result yielded in this case was that the NDA was ahead in many constituencies. This led analysts and TV anchors to declare an NDA win. But the votes that had been counted initially (the small sample) were not a correct representation of how the public had actually voted (the overall population).

A few hours after the counting started, when a large number of votes had been counted (a large sample), the Nitish led Grand Alliance emerged clearly ahead.

And all the analysts on TV and the social media predicting an NDA win, ended up with eggs on their faces.

In any election analysis, the experts need to wait till a decent number of votes have been counted, so that these votes are a good representation the way the overall voting has happened. But in the days of instant analysis on TV and the social media, waiting is simply not possible.

To conclude, as Kahneman puts it: “We pay more attention to the content of messages than to information about their reliability, and as a result end up with a view of the world around us that is simpler and more coherent than the data justify. Jumping to conclusions is a safer sport in the world of our imagination than our reality.”

In fact, the NDTV anchor Ravish Kumar summarised the situation the best when he said: “pal pal badalti khabron par, pal pal badalta vishleshan. Hum log chalak log hain (As the news changes second by second, so does our analysis. We are smart people).”

The column originally appeared on The Daily Reckoning on November 9, 2015
 

It doesn’t make any sense to hand over your gold to the govt

gold

The Prime Minister Narendra Modi launched the gold monetisation scheme as well as sovereign gold bonds, yesterday. The scheme and the bonds try to address India’s obsession with gold and the macroeconomic fall out of that obsession.

While nobody really knows how much gold is owned by Indian households, various estimates keep popping up. The estimates that I have seen in the recent past put India’s household gold hoard at 20,000-22,000 tonnes (Don’t ask me how these estimates are arrived at. I have no idea).

In this column I will just concentrate on the gold monetisation scheme and leave the analysis of the sovereign gold bonds for Monday’s column (November 9, 2015). I will also discuss the macroeconmic fall out of India’s obsession with gold on Monday.

The idea behind the gold monetisation scheme is to put India’s idle gold hoard to some use. Under this scheme, you can deposit gold with the bank and earn an interest on it. The Reserve Bank of India (RBI) issued a notification on November 3, 2015, which said that the banks would pay an interest of 2.25% if the gold is deposited for the medium term and 2.5%, if the gold is deposited for the long term. The medium term is a period of five to seven years whereas the long term is a period of 12 to 15 years. (For those interested in knowing the entire process of how to go about it, can click here).

Also, as the RBI notification issued on October 22, 2015, points out: “The designated banks will accept gold deposits under the Short Term (1-3 years) Bank Deposit (STBD) as well as Medium (5-7 years) and Long (12-15 years) Term Government Deposit Schemes. While the former will be accepted by banks on their own account, the latter will be on behalf of Government of India.”

What this means is that individual banks are free to decide on the interest that they will offer on the gold they collect in the short-term for a period of one to three years.

So, the question is will this scheme succeed in getting India’s hoard of gold out from homes and into the banks? The first thing we need to look at is the existing gold deposit scheme which was launched in 1999. The RBI notification issued in October 1999 states that “individual banks will be free to fix the interest rates in tune with their costing considerations. Interest will be payable in cash at fixed intervals or at maturity as decided by the bank.”

Under this scheme the State Bank of India allowed people to deposit gold for three, four or five years. The interest paid on gold was 0.75% for three years and 1% for four and five years, respectively. The minimum deposit had to be 500 hundred grams of gold.

The scheme did not manage to collect much gold. An article in The Financial Express points out: “The existing scheme, introduced 16 years ago, mobilised only 15 tonnes of gold—as the minimum deposit was 500 grams and the interest rate was a mere 0.75% for a three-year deposit.” There was no upper limit to the amount of gold that could be deposited.

As I pointed out earlier in this column, estimates suggest that India has around 20,000 tonnes of gold. When compared to that fifteen tonnes is not even a drop in the ocean.

Further, October 22, 2015 RBI notification on the new gold monetisation scheme clearly states that: “The minimum deposit at any one time shall be raw gold (bars, coins, jewellery excluding stones and other metals) equivalent to 30 grams of gold of 995 fineness. There is no maximum limit for deposit under the scheme.”

So the minimum amount of gold that can be deposited under the new scheme is just 30 grams in comparison to the earlier 500 grams. Over and above this, the gold can be deposited up to a period of 15 years in comparison to the earlier five. Further, the rate of interest on offer is either 2.25% or 2.5%, which is higher than the earlier 0.75-1%.

On all these counts the new gold monetisation scheme is a significant improvement on the gold deposit scheme. Given this, will gold move from Indian homes to banks (and indirectly to the government, given that banks are running a major part of the scheme on behalf of the government)?

Before answering this, it is worth asking here, why do Indians buy gold? It is a part of our tradition and culture is the simple answer. What does that basically mean? It means we buy gold because our ancestors used to buy gold as well. We also buy gold because it is easy to sell during times of emergency. We are emotionally attached to the gold we buy and like seeing it in the physical form. This makes it highly unlikely that the gold monetisation scheme will be a smashing success.

Any more reasons? Gold is a very easy way to hide black money (essentially money which has been earned and on which tax has not been paid). A lot of black money can be stored by buying just a few bars of gold. People who have invested their black money in gold are not going to come forward with it and deposit it in banks. That is really a no-brainer.

Further, the customer agreeing to deposit the gold the bank will “have to fill-up a Bank/KYC form and give his consent for melting the gold.” The gold will be melted in order to test its purity. Also, the “the gold ornament will then be cleaned of its dirt, studs, meena etc.”

The question is how many women would like to see their gold jewellery melted so that they can earn a return of a little more than 2% per year on it? I don’t think I need to answer that question.

These reasons best explain why the gold deposit scheme launched in 1999 has been a huge failure. And they also explain why the current gold monetisation scheme is unlikely to lead to any major shift of gold from homes to the government.

This brings me to the question whether you should be depositing your gold with the banks (and essentially the government)? One reason why people buy gold is because they believe that it acts as a hedge against inflation. The evidence on whether gold acts as a hedge against inflation is not so straightforward.

As John Plender writes in Capitalism—Money, Morals and Markets: “In real terms, the price of gold in 2012 was similar to the prevailing price in 1265.” So doesn’t that mean that gold has acted as a store of value over the last 1000 years? Not really. As Plender writes: “Over much of that time, though, the yellow metal failed to live up to its reputation as a solid store of value.”

Why does Plender say that? Dylan Grice, who used to work for Societe Generale explains this. As Grice writes: “A fifteenth-century gold bug who’d stored all his wealth in bullion, bequeathed it to his children and required them to do the same would be more than a little miffed when gazing down from his celestial place of rest to see the real wealth of his lineage decline by nearly 90 per cent over the next 500 years.”

In fact, even those who had bought gold at the peak of the 1971-1981 bull market in gold would have lost around 80% of their investment in real terms, over the next two decades.

Nevertheless, if you believe that gold acts as a hedge against inflation, should you hand over your gold to the government? Inflation more often than not is due to the “easy money” policies run by the government. This could mean inflation created through money printing or keeping interest rates too low for too long.

When gold and silver were money, the governments destroyed money by debasing it, i.e., lowering the content of precious met­als in the coins they issued.

When paper money replaced precious metals as money, the governments destroyed it by simply printing more and more of it. Now they create money digitally.

So the last thing you should do is hand over gold to the government. The reason you are holding gold is because you don’t trust the government to do a good job of managing the value of money. And given that, it’s best that the hedge (i.e. gold) be with you. If that means losing out on interest of 2.25-2.5% per year, then so be it.

Postscript: On Monday (Nov 9, 2015) I will be analysing the sovereign gold bonds which have been launched as well. Look out for that.

The column originally appeared on The Daily Reckoning on Nov 6, 2015

One last time: The govt shouldn’t be running 27 banks

rupee
In yesterday’s edition of The Daily Reckoning I explained why the privatisation of IDBI Bank is a test case for the Narendra Modi government.

The other important point that I made in the column (and have made in the past) and will make again today is that there is no reason the Modi government (or for that matter any other) should be running 27 public sector banks.

Let me first explain why I am making this point again today. Yesterday’s edition of The Times of India had a news-report headlined “Govt looks at 3 options to reduce stake in IDBI Bank“. This news-report talks about the three options the government is looking at in order bring down its stake in IDBI Bank.

While a decision on how the shares of IDBI Bank will be disinvested hasn’t been made, the three ways the government is looking at are: a) to sell the shares in small lots to the public through the stock exchanges. The trouble with this option is that the government may not be able to sell the shares at the best possible price.

b)The second option being considered is to sell the IDBI Bank shares to the likes of Life Insurance Corporation (LIC) of India, other government owned insurance companies and pension and provident funds, at a premium to the current market price. This option, as has often been the case in the past, is taking the easy way out.

c) The third option (which is very similar to the second option) being considered is to sell shares to public sector banks and financial institutions. This was tried in the case of Maruti Suzuki in 2005-2006. A PTI news-report published on January 12, 2006 points out: “The government today sold 8% shares in MarutiUdyog for Rs 1,567.60 crore with Life Insurance Corporation (LIC) picking up more than 50% of the 2,31,12,804 shares sold by the government. LIC successfully bid for 1,68,00,000 shares at Rs 682 per share. Eight public financial institutions have picked up Maruti shares. SBI would be getting 39,27,074 shares at Rs 660 per share.”

None of these methods will lead to genuine privatisation. If the government sells shares to the general public through the stock exchanges, it will continue to remain the majority owner of shares in the bank. And that is the basic problem. As I had pointed out in yesterday’s column, the private sector banks are much better run and more profitable than their public sector counterparts.

Currently, the government owns 76.5% of the IDBI Bank. Even if it were to reduce its shareholding to 49%, it will still continue to be the biggest shareholder in the bank. With government ownership comes political corruption, crony capitalism and bad lending, which leads to bad loans. This story has played out over the last few years.

In fact, the net non-performing assets of public sector banks, for the financial year ending on March 31, 2015, stood at 2.92% of their total advances (i.e. loans). It was at 2.01% for the financial year ended March 31, 2013. In comparison, the private sector banks are extremely well placed with their net non-performing assets being at 0.89% of their total advances. For financial year ending on March 31, 2013, the net non-performing assets of these banks stood at 0.52%.

What this clearly tells us is that the private sector banks are better at lending money given that they don’t have to deal with political corruption and crony capitalism. In a poor country like India it is important that any money that is being lent is utilized properly as far as possible and is not siphoned off by greedy businessmen. It has become clear over the last few years that businessmen find it easy to siphon off money they have borrowed from public sector banks in comparison to private sector banks.

The second option being considered by the government is to sell shares to LIC. The interesting thing is that LIC already owns 8.59% of the bank. Does it make sense to allow LIC’s investment in any stock to go beyond 10%? The Securities and Exchange Board of India does not allow mutual funds to own more than 10% of a company. This is to prevent concentration of risk on the overall investment portfolio. But this does not apply to LIC, given that it is an insurance company.

The question is why is the government allowing this concentration of risk in LIC’s investment portfolio to happen? Ultimately like mutual funds, LIC is also basically managing money.

Further, it is also important to state here that the money that LIC has is not government’s money. LIC manages the hard earned savings of the people of India and given that these savings need to be treated with a little more respect.

Also, selling shares to LIC or the State Bank of India, for that matter, means that the ownership stays with the government. And that as I have stated earlier, is the basic problem. For IDBI Bank to do well, it needs genuine privatisation with a private owner, with the government being a minority shareholder at best.

As I had mentioned in yesterday’s column, IDBI Bank is saddled with a huge amount of bad loans. And given this it is not surprising that the government owned financial institutions are not keen on picking up any stake in the bank.

The Times of India news-report cited at the beginning points out: “State-run entities are, however, not very keen on buying the government stake. “Given the distress in the banking sector, IDBI Bank may not be the best bet since its retail as set base is weak and it has legacy issues,” said a top official.”

IDBI Bank was a major lender to Kingfisher. It also lent to Deccan Chronicle Holdings, Bhushan Steel and Jaypee Associaties, companies which are in a financial mess.

Also, if the government follows any of these three methods to sell shares in IDBI Bank, as the majority shareholder it will have to continue to keep pumping money into the bank. In fact, the government holding in the bank has gone up “from 65.14% in July 2010 to 76.5% in December 2013 by total equity infusion amounting to Rs 5,300 crore”.

Any increase in holding will bring us back to square one.

In May 2014, the Committee to Review Governance of Boards of Banks in India (better known as the PJ Nayak Committee) had submitted a detailed report on reforming the public sector banks in India.

The Nayak committee estimated that between January 2014 and March 2018 “public sector banks would need Rs. 5.87 lakh crores of tier-I capital.” The committee further said that: “assuming that the Government puts in 60 per cent (though it will be challenging to raise the remaining 40 per cent from the capital markets), the Government would need to invest over Rs. 3.50 lakh crores.”

The government on the other hand estimates that “the capital requirement of extra capital for the next four years up to FY 2019 is likely to be about Rs.1,80,000 crore.” Of this amount it proposes to invest Rs 70,000 crore. It has not explained from where will it get the remaining Rs 1,10,000 crore.

These are not small amounts that we are talking about. The tendency is to look at the government ownership in many public sector enterprises as family silver and hence, be careful while selling it. But in case of many public sector banks that cannot be really said. If the government continues to own public sector banks in the years to come it will have to keep pumping money into them in order to keep them going.

Take a look at the accompanying table. I have picked up five banks which are of a similar size. There are two private sector banks (HDFC Bank and ICICI Bank) and three public sector banks (Bank of India, Punjab National Bank and Canara Bank) in the table. The profit of the private sector banks is many times the profit made by the public sector banks. Their bad loans are also significantly lower. In fact, HDFC Bank makes more money than Bank of India, Punjab National Bank and Canara Bank put together. So does ICICI Bank.

Name of the bankTotal assets (in Rs crore)Net profit (in Rs crore)Bad loans (Net NPAs to Net Advances)
HDFC Bank5,90,50310,215.920.20%
ICICI Bank6,46,12911,175.351.61%
Bank of India6,18,6981,709.003.36%
Punjab National Bank6,03,3343,062.003.55%
Canara Bank5,48,0012,703.002.65%

Source: Indian Banks’ Association. As on March 31, 2015
To conclude, people keep reminding me that comparing the performance of public sectors banks with private sector banks is like comparing apples and oranges. The public sector banks have social obligations which private sector banks don’t. This is true. Nevertheless, the question is does the government need to own 27 banks in order to fulfil its social obligations?

I think, the government can easily go about fulfilling social-sector obligations by owning the State Bank of India and 4-5 other banks which are strong in different regions of the country.

Finally, a government should not be running so many banks. There are so many other things that it should be concentrating on, but it doesn’t.

(The column originally appeared on The Daily Reckoning on Nov 5, 2015)

IDBI Bank’s privatisation will be a test case for Modi govt

IDBI-Bank-Careers-Mumbai-3

Several news items in the last few days seem to suggest that the Narendra Modi government has plans of privatising IDBI Bank. A newsreport in The Economic Times talks about a “high-level committee headed by the cabinet secretary that will oversee strategic divestments”. The report also said that the “the first proposal likely to be examined by the panel will be the sale of the government’s stake in IDBI Bank to convert it to a private bank.”

The minister of state for finance Jayant Sinha had hinted at something similar last week when he told the media that “we’ll consider transforming IDBI Bank in a manner similar to the way Axis Bank was done.”

IDBI Bank is among the bigger public sector banks. It is the fifth biggest public sector bank in terms of market capitalisation. It is the seventh biggest in terms of total assets. But it’s the tenth biggest in terms of net profit.

The gross non-performing assets (bad loans) of the bank have been going up over the years. As of March 31, 2009, they stood at 1.38%. By March 31, 2015, they had jumped to 5.9% of total assets. Over and above this, the bank also had restructured assets (where the tenure of the loan or the interest on the loan has been changed in favour of the borrower) worth Rs 20,900 crore as on March 31, 2015.   The number had stood at Rs 3,100 crore as on March 31, 2009.

The restructured assets as well as bad loans of the bank have grown at a fairly rapid rate. This clearly tells us is that the restructured assets are turning into bad loans in the time to come. The bank, like many others, has used the restructured assets route to kick the ‘bad loans can’ down the road.

The accumulation of bad loans has essentially led to a situation where the net profit of the bank has gone nowhere over the last six years. The net profit for the financial year ending March 31, 2009, was at Rs 859 crore. Six years later, the net profit for the financial year ending March 31, 2015, stood at a similar Rs 873 crore.

Flat profits due to an increase in bad loans essentially explains why the bank is seventh largest public sector bank when it comes to total assets but tenth largest when it comes to profit. In fact, flat profits have essentially led to a situation where the return on assets as well as return on equity of the bank have fallen dramatically over the years. The return on assets has halved from 0.6% as of March 2009 to 0.3% as of March 2015. The return on equity has totally collapsed from 12.1% to 3.9% during the same period.

Currently, the government owns 76.5% in IDBI Bank and any serious plan of privatisation would mean the government bringing down its stake in the bank majorly in the time to come. In fact, the government holding in the bank has gone up “from 65.14% in July 2010 to 76.5% in December 2013 by total equity infusion amounting to Rs 5,300 crore”.

There are several reasons why the government should privatise IDBI Bank. First and foremost as I have said in the past, there is no reason that a government should be running 27 public sector banks. There are other more important areas that need its attention.

Second, the return on equity on the government’s investment in the bank has fallen dramatically over the years. At 3.9%, it is lower than even the 4% interest that banks pay on their savings bank account. Hence, the government is not being adequately compensated for the investment risk.

How will privatisation help? As TN Ninan writes in The Turn of the Tortoise—The Challenge and Promise of India’s Future: “The last quarter century’s experience has shown that when the private sector is asked to provide telecom services, run airlines and airports, build and run ports, undertake banking, distribute electricity and even undertake water supply, the result is usually (though not always, for there is no shortage of private banks and airlines that have failed) a substantial improvement on what, the government was doing until then.”

This becomes clear from the fact that in the last financial year (April 1, 2014 to March 31, 2015) the private sector banks operating in India made a total profit of Rs 38,219.35 crore. In comparison, the public sector banks made a profit of Rs 37,820 crore.

This despite the fact that the total assets of private sector banks form only around 29.2% of the total assets of public sector banks. Assets owned by private sector banks in India form only 22.6% of the total assets owned by banks in India. Despite this, they are more profitable than public sector banks.

Interestingly, the total profit of public sector banks for the financial year ending March 31, 2013(April 1, 2012 to March 31, 2013), had stood at Rs 50,583 crore. Since then it has fallen by 25.2% to Rs 37,820 crore. The profit of private sector banks has jumped by 31.8% (from Rs 28,995.43 crore) to Rs 38,219.35 crore.

Between 2013 and 2015 as the economic scenario has gotten worse, the public sector banks have faltered big time. Meanwhile, the private banks have continued to increase their profits.

IDBI Bank as on March 31, 2015, had Rs 3,56,031 crore worth of total assets. As pointed out earlier it made a net profit of Rs 873 crore during the course of the financial year. Now compare this to Kotak Mahindra Bank which had total assets worth Rs 1,06,012 crore as on March 31, 2015. It made a net profit of Rs 1,866 crore, which was much more than that of IDBI Bank. Similar numbers can be put forward for other private sector banks like IndusInd Bank and Yes Bank as well, in comparison to those of IDBI Bank. These banks are significantly smaller than IDBI Bank but make much more money. [Data sourced from Indian Banks’ Association]

The government’s 76.5% stake in IDBI Bank is currently worth Rs 10,380.6 crore. If it privatises the bank, chances are whatever equity that it chooses to retain in the bank will end up being worth much more than it currently is, in the days to come.

The question is will the government get around to privatising IDBI Bank? The employees of IDBI Bank have called strike on November 27, later this month, to oppose the government’s move to privatise the bank. This shouldn’t stop the government from privatising the bank. The good part is that unlike a systematically important institution like Coal India, the employees of IDBI Bank have a limited nuisance value. Hence, a strike by IDBI Bank is not going to hurt many others. And this should help push through the decision.

Further, the government shouldn’t stop at IDBI Bank. This will be a test case for it on whether it will be able to continue privatising other public sector enterprises in the years to come.

There are many public sector enterprises which the government has no reason to own.

Like Mahangar Telephone Nigam Ltd.

Like Air India.

The column originally appeared on The Daily Reckoning on Nov 4, 2015