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

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

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

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

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

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

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

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

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

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

As the Survey points out:

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

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

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

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

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

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

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

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

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

 

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

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

The banks are yet to face the negative impact of the covid led contraction primarily because of regulatory forbearance. The banking system should be facing the first blows of the economic contraction. But that hasn’t happened, thanks to the Supreme Court and regulatory forbearance. The Supreme Court, in an interim order dated September 3, 2020, had directed the banks that loan accounts which hadn’t been declared as a bad loan as of August 31, shall not be declared as one, until further orders. Hence, the balance sheets of banks as revealed by their latest quarterly results, seem to be too good to be true.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

 

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

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

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

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

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

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

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

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

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

Taxpayers will have to Pick-Up the Final Bill of the Mess in Govt Banks

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In a column I wrote last week I said that I was happy that the profit of the State Bank of India, the country’s largest bank, had fallen by 62%. Along the same lines I need to say that I am happy that the Bank of Baroda has made a loss of Rs 3342 crore, for the period October to December 2015. This is the biggest loss ever made by any Indian bank. In fact, the losses would have been higher if not for a Rs 1,118 crore tax write-back that the bank got.

Over the years, banks have not been recognising bad loans as bad loans. This process that has started now and is bringing out the real state of the Indian public sector banks and that is a good thing. In case of Bank of Baroda, the gross non-performing loans (or bad loans) of the bank jumped by 152% to Rs 38,934 crore, in comparison to as on December 2014. In percentage terms, the bad loans as of December 2015 stand at 9.68% of total lending in comparison to 3.85% in December 2014.

What this clearly tells us is that the Bank of Baroda, like the other public sector banks, had been under-declaring its bad loans up until now. This can be easily said from the fact the bad loans as a percentage of total loans, as on September 2015, had stood at 5.56%. By December 2015, this had jumped up by 412 basis points to 9.68%. One basis point is one hundredth of a percentage.

The situation could not have become so bad over a period of just three months. This clearly tells us that the bank had not been putting out the correct situation of its loans earlier. But now that it is, the stock market is clearly happy about it, with the stock rallying by 22% to Rs 139.55 as on February 15, 2016.

It needs to be pointed out here that the public sector banks are finally getting around to presenting the right set of accounts because the RBI led by Raghuram Rajan has pushed them to do so, by unleashing the asset quality review on to them.

As Rajan pointed out in a recent speech: “ With markets generally in decline, the decline in bank share prices has been more accentuated. However, part of the reason is that some bank results, mainly public sector banks, have not been, to put it mildly, pretty. Clearly, an important factor has been the Asset Quality Review (AQR) conducted by the Reserve Bank and its aftermath.”

This leads to the question as to what was the RBI doing all these years, especially in the pre-Rajan years given that such a huge build-up of bad loans couldn’t have happened overnight.

Also, it needs to be clarified here that a bad loan doesn’t mean that the bank has lost all the money. This seems to be the general understanding and is incorrect. A loan is typically declared to be a non-performing asset (or a bad loan), 90 days after the borrower starts defaulting on the interest and principal payments. When this happens a bank can no longer continue to accrue interest on the portion of the loan that remains unpaid. It has to start making provisions i.e. start keeping money aside.

This basically means that the bank starts keeping money aside so that if the loan is totally defaulted on or partially defaulted on or the bank cannot recover enough money from the assets that it has as a collateral, then enough money has been set aside to meet the losses.

Along these lines, the Bank of Baroda has increased its provisioning. For October to December 2015, the bank set aside Rs 6,165 crore. This is an increase of 389% in comparison to the money it had set aside for September to December 2014.

The question is even with this huge jump in provisioning, is the bank setting aside enough? The Reserve Bank of India(RBI) Master Circular on Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances: “Banks should build up provisioning and capital buffers in good times i.e. when the profits are good, which can be used for absorbing losses in a downturn. This will enhance the soundness of individual banks, as also the stability of the financial sector. It was, therefore, decided that banks should augment their provisioning cushions…and ensure that their total provisioning coverage ratio…is not less than 70 per cent.”

The provisioning coverage ratio is defined as the total provisions set aside by a bank as on a particular date divided by the total gross non-performing assets (bad loans) of the bank as on the same day.

The RBI wants banks to maintain a provision coverage ratio of 70%. But that doesn’t seem to have happened. In fact, as a recent news-report in The Indian Express points out: “An analysis of provisioning coverage ratio data of 20 public sector banks for March 2011 to March 2015 shows a steady fall in the coverage ratio. It has dropped from an average of 72 per cent for the group of 20 banks in the year-ended March 2011 to 57 per cent for the year-ended March 2015.”

In fact, for Bank of Baroda, the provisioning coverage ratio as on March 31, 2015, had stood at 64.99%. Since then, despite the absolute jump in provisioning, the provisioning coverage ratio of the bank has fallen to 52.70%. So, the bank clearly is not setting aside enough money against its bad loans, even though its setting aside more money in absolute terms, than it has done in the past.

How do things look for other banks? Let’s take the case of Punjab National Bank, the second largest public sector bank. The provisioning coverage ratio of the bank as on March 31, 2015, was at 58.21%, since then it has fallen to 53.85%. The same is the case with the State Bank of India. The ratio has fallen from 69.13% to 65.23%.

So none of the bigger public sector banks are fulfilling the provisioning coverage requirement of 70% as required by the RBI. What this tells us is that if the banks work towards achieving this ratio in the coming quarters, the losses of these banks will only go up. This would also mean eating into the capital of the bank.

Also, it is worth asking here what portion of the bad loans will the public sector banks be able to recover? The answer is not encouraging if we look at the numbers of the two biggest banks—the State Bank of India and the Punjab National Bank.

During the course of this financial year, the State Bank of India has managed to recover loans of Rs 2,761 crore. During the period its bad loans jumped up from Rs 56,725 crore to Rs 72,792 crore.

How do things look for Punjab National Bank? During the course of this financial year, the bank has managed to recover loans worth Rs 6,382 crore. During the same period, the bad loans of the bank have jumped from Rs 25,695 crore to Rs 34,338 crore. For both, State Bank of India as well as Punjab National Bank, there has been a huge jump in the loans recovered in comparison to April to December 2014. Nevertheless, the total amount of bad loans has gone up as well, in effect negating the recoveries. And this doesn’t augur well for the banks.

My guess is that public sector banks losses will eat into their capital in the months and years to come and the government (i.e. the taxpayer) will have to keep coming to their rescue by infusing fresh capital into these banks. Since 2010, the government has pumped in Rs 67,734 crore into public sector banks. It will have to put in a lot more money in the days to come.

As Michael Pettis writes in The Great Rebalancing: “Traditionally the cost of a banking crisis is borne directly or indirectly by households. Whether it is in the form of foregone deposits, government bailouts funded by household taxes…Households always foot the bill for banking crisis.”

The situation in India will be no different.

The column was originally published in the Vivek Kaul Diary on Equitymaster on February 16, 2016