Rajan won’t cut interest rates before the budget

This is a column I should have written earlier this week. But given that I got busy explaining the 7.4% economic growth number, this took a backseat.

The Reserve Bank of India (RBI) presented the Fifth Monetary Policy Statement for this financial year, earlier this week on December 1, 2015. It maintained the repo rate at 6.75%. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

In the press conference that followed the declaration of the Monetary Policy Statement, Raghuram Rajan, the governor of the RBI, said: “We are still accommodative.” What this means in simple English is that the RBI is still looking to cut the repo rate rather than raise it, if the conditions are right.

Nevertheless, it is unlikely that Rajan and the RBI will cut the repo rate any further before Arun Jaitley presents the next budget in February 2016. Why do I say that? Almost towards the end of the Monetary Policy Statement Rajan says: “The implementation of the Pay Commission proposals, and its effect on wages and rents, will also be a factor in the Reserve Bank’s future deliberations, though its direct effect on aggregate demand is likely to be offset by appropriate budgetary tightening as the Government stays on the fiscal consolidation path.”

The Seventh Pay Commission has recommended a 23.6% overall increase in the salaries of central government employees as well as the pensions of the retired central government employees. The RBI will keep a lookout for the impact this jump in salary and pension will have on inflation in the days to come.

Over and above this, the RBI feels that the impact of the Seventh Pay Commission recommendations on inflation (or what it calls direct effect on aggregate demand) will be offset by the government cutting down on its expenditure in other areas. The fear is that the increased salaries and pensions will lead to higher spending and that will lead to higher inflation.

There are multiple reasons why this is unlikely to happen. The first being that factories are currently running around 30% below capacity. Typically as demand for products and services goes up, the supply side can’t keep pace if it is operating full throttle. That is clearly not the case here. If consumer demand picks up, the supply side can easily accommodate by ramping up production.

Further, the RBI feels that the government will carry out “appropriate budgetary tightening”
to stay on “the fiscal consolidation path”. The Seventh Pay Commission recommendations as and when they are accepted, will lead to a higher expenditure for the government, everything else remaining the same.

The RBI expects that the government will not let this happen by ensuring that it cuts its expenditure on other fronts and ensures that it keeps moving towards the fiscal deficit target of 3% of the gross domestic product for 2017-2018 that it has set for itself (or what the RBI calls the fiscal consolidation path in the monetary policy statement).

While expectation is one thing, the RBI needs to make sure that the government continues moving towards the fiscal consolidation path. And that will only be possible to figure out once the budget for the next financial year 2016-2017 is presented in February 2016.

Given this, the RBI is unlikely to do anything on the interest rate front before it gets a dekko at the next financial year’s budget document.

Another important point that the RBI made in the monetary policy statement was regarding the efficacy of monetary policy. As it pointed out: “Since the rate reduction cycle that commenced in January, less than half of the cumulative policy repo rate reduction of 125 basis points has been transmitted by banks. The median base lending rate has declined only by 60 basis points.” One basis point is one hundredth of a percentage.

What this means is that while the RBI has cut the repo rate by 125 basis points since the beginning of 2015. The banks in turn have managed to cut less than half at 60 basis points. Why is that? A major reason for this is that bad loans have been piling up at banks. The overall bad loans of banks as of September 2015 stood at Rs 3,36,685 crore. As a recent research note by CARE Ratings points out: “Gross NPAs [i.e. bad loans] stood at Rs 3,36,685 crore in Q2-FY16[as on September 30, 2015] increasing by Rs 71,129 crore over Q2-FY15[as on September 30, 2014]. This indicates growth of 26.8% in gross NPAs across 37 banks.”

The public sector banks are facing more bad loan problems than their private sector counterparts. Bad loans eat into profit. Hence, in order to maintain their profit at a certain level, the public sector banks need to maintain their interest rates at high levels. And they have not been able to cut interest rates by as much as the RBI has cut the repo rate.

Further, given that the public sector banks haven’t cut interest rates by as much as the RBI wants them to, the private sector banks haven’t needed to cut interest rates either at a rapid rate.

Given this, unless the bad loans problem of public sector banks is solved, interest rates are unlikely to keep coming down at the rate the RBI wants them to. As the RBI acknowledged: “The on-going clean-up of bank balance sheets will help create room for fresh lending.”

The other issue here is that of small savings schemes which tend to offer slightly higher interest rates than bank fixed deposits. Given this, unless the interest rates on small savings schemes come down to the level of fixed deposits, banks can’t rapidly cut the interest rates on their fixed deposits. If they do this, they are likely to see money deposited with them moving to small savings schemes.

If banks can’t cut their fixed deposit rates, they won’t be able to cut their lending rates. The RBI was hopeful that “The Government is examining linking small savings interest rates to market interest rates. These moves should further help transmission of policy rates into lending rates.”

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

What the media did not tell you about the economic growth number

In yesterday’s column I had explained why the gross domestic product (GDP) growth number of 7.4% is more of a statistical quirk. The GDP is essentially the measure of the size of an economy.

The coverage of the GDP news in the media talked about the 7.4% economic growth, without really getting into the details of how that number was arrived at. The GDP growth of 7.4% that everyone from the politicians to the media seem to be talking about is essentially the real GDP growth.

Neither the media nor the economists and the politicians talked about the nominal GDP, which came in at 6%. The nominal GDP is calculated at the current price levels. Once this is adjusted for the prevailing inflation, we arrive at the real GDP.

Hence, nominal GDP growth minus inflation equals the real GDP growth. In this case, the nominal GDP growth came in at 6% and was lower than the real GDP growth of 7.4%. This meant that the inflation was negative. The inflation in this case is referred to as GDP deflator and came in at – 1.4%.

This as I had explained yesterday is because the GDP deflator is a sort of a combination of inflation as measured by the consumer price index and inflation as measured by the wholesale price index. The wholesale price index has been in negative territory for some time now. And this has led the GDP deflator into negative territory as well. Hence, the deflator instead of deflating the nominal GDP number is inflating it.

This is a point that the experts and the media missed out on. There was another important point that the media missed out on and was brought to my notice by Anindya Banerjee, Analyst, Kotak Securities, FX and interest rate desk.

Nominal GDP Growth

Earlier this year, the ministry of statistics and programme implementation moved to a new way of measuring the gross domestic product. They also produced some backdated data for the last few years. The red curve shows the nominal GDP growth rate as per the new method of calculating the GDP. The blue curve, on the other hand, shows the GDP growth as per the old method of calculating the GDP.

What the table clearly tells us is that the nominal GDP growth has collapsed. In fact, as the table clearly shows the nominal GDP growth has never been as low as it is now, in the last ten years. I know I am committing a sin here by mixing data from two different GDP series but the trend has been clearly downward. And this is a reason to worry.

As I had mentioned in yesterday’s column, negative wholesale price inflation has had a huge role to play in inflating the economic growth number. India is seeing a negative wholesale price inflation because of several reasons. Commodity prices have crashed and that is the good bit, because we import a huge amount of important commodities like oil.

On the flip side, negative wholesale price inflation is also a reflection of weak industrial and consumer demand, low capacity utilisation by factories as well as low private investment and falling exports.

These factors are a negative for the economy. But they have ended up adding to the calculation of the GDP in a positive way. The negative wholesale price inflation has led to a negative GDP deflator which has in turn inflated the real GDP growth number. And this has meant that even though the real GDP growth number is strong, the economic growth doesn’t really seem strong.

What all this tells us is that for economic growth to really recover, the nominal GDP number needs to start to move up. Also, it is worth highlighting here that nominal growth really matters.

Corporate earnings are not adjusted for inflation through the GDP deflator. Neither are wages given by companies both private and government, as well as entrepreneurs. And this has an impact on the psychology of private consumption. The corporate earnings for the period of three months between July and September 2015 grew by less than 1%. In this scenario wage increments will be low.

Let’s say the companies are generous and give around 3% wage increments to their employees in the coming year. The employee will look at it as a 3% increment in wages, which is not huge. He will not look at it as a 7.5% ‘real’ increase in wages (3% nominal wages minus the wholesale price inflation of around – 4.5%). This tendency to look at money in nominal rather than real terms is referred to as the money illusion. Given this, higher wages will not lead to a higher consumption.

The government revenue and the fiscal deficit are not adjusted for inflation either. Also, the fiscal deficit of the government is expressed as a percentage of nominal GDP and not real GDP. Fiscal deficit is the difference between what a government earns and what it spends. Let’s take a closer look at the fiscal deficit number projected by the government for the current financial year, 2015-2016. The fiscal deficit has been projected at Rs 5,55,649 crore or 3.9% of the GDP.

The GDP has been assumed to be at Rs 14,108,945 crore for 2015-2016. The GDP under consideration is nominal GDP. The nominal GDP number for 2015-2016 was arrived at by assuming a growth of 11.5% over the nominal GDP number for 2014-2015.

The nominal GDP growth number between April and June 2015 had stood at 8.8%. Between July and September 2015 it came in at 6%. Hence, for the six months of this financial year, the nominal GDP growth has been nowhere near the assumed 11.5%.

Let’s assume that the nominal GDP growth improves during the second half of the year, and the final nominal GDP growth number comes in at 9%. What happens to the fiscal deficit? Assuming the absolute fiscal deficit stays the same, the fiscal deficit as a proportion of the GDP will cross 4%, against the targeted 3.9%. In order to ensure that this does not happen, the government will have to cut down on its expenditure. In an economy where private expenditure and investment is slow that is not the best thing that can happen.

Further, the government wants to reduce the fiscal deficit to 3% of the GDP by 2017-2018. For that to happen, the nominal GDP has to start to go up at a higher rate. It also needs to be pointed out here that the Raghuram Rajan, the governor of the Reserve Bank of India, in the latest monetary policy statement said that he expects the government to continue maintaining the fiscal deficit in the years to come, despite the increased expenditure due to the implantation of the recommendations of the Seventh Pay Commission.

The column was originally published on December 3, 2015 on The Daily Reckoning

YV Reddy is right: The govt borrowing on its own won’t work

yv reddy
In the budget speech he made on February 28, 2015, the finance minister Arun Jaitley had said: “I intend to begin this process this year by setting up a Public Debt Management Agency (PDMA) which will bring both India’s external borrowings and domestic debt under one roof.”

The government of India, like most governments spends more than it earns. The difference it makes up through borrowing. This borrowing is currently managed by the Reserve Bank of India (RBI). Jaitley now wants to take away this responsibility from the RBI and set up an independent public debt management agency.
On the face of it this sounds like a simple move-one institution was taking care of the government borrowings needs, now the government wants to takeover the responsibility. But it is not as simple as that.
Before I explain why, it is important to understand something known as the statutory liquidity ratio (SLR), which currently stands at 21.5%. What this means is that for every Rs 100 that banks raise as a deposit, Rs 21.5 needs to be invested in government bonds.
This number was at higher levels earlier and has constantly been brought down by the RBI over the years. This provision helps the government raise money at lower interest rates than it would otherwise be able to.
This is something that the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (better known as the Urjit Patel committee) released in January 2014 pointed out: “Large government market borrowing has been supported by regulatory prescriptions under which most financial institutions in India, including banks, are statutorily required to invest a certain portion of their specified liabilities in government securities and/or maintain a statutory liquidity ratio (SLR).”
This statutory requirement essentially ensures that there is a constant demand for government bonds. This helps the government get away by offering a lower rate of interest on its bonds.
The SLR prescription provides a captive market for government securities and helps to artificially suppress the cost of borrowing for the Government, dampening the transmission of interest rate changes across the term structure,” the Expert Committee report points out.
Take a look at the following chart. Between 2007-2008 and 2013-2014, the government was able to borrow money at a much lower rate of interest than the prevailing inflation. The red line which represent the estimated average cost of public debt (i.e. Interest paid on government borrowings) has been below the green line which represents the consumer price inflation, since around 2007-2008. 

The major reason for the same is the fact that there is an inbuilt demand for government securities. The Economic Survey of 2014-2015 has some interesting data which buttresses the point that I am trying to make. The total internal liabilities of the government of India have gone up by 1.9 times between 2009-10 and 2014-2015. Nevertheless, the average cost of borrowing has gone up only from 7.5% to 8.41%.

average cost of borrowing
This financial repression of forcing banks, insurance companies as well as provident funds to buy government bonds, allows the government to raise money at low interest rates, than they would be able to do if they allowed the market to operate.
Now the government wants to take away the debt management function from the RBI and raise money independently. In this scenario the question is can the SLR continue? Dr YV Reddy, former governor of the RBI, made this point in an interview to the The Economic Times. As he said: “If the government is having an independent debt office then how can the statutory liquidity ratio of a high order continue. Once it is an independent debt office, basically, it should independently be able to raise money.”
Fair point, I guess. “So, if the government want to raise money then indirectly the regulator cannot go on supporting through a cell. So the pre-condition will be SLR has to be removed. Because it would be inappropriate to say that you are independent but I will help you do something. So, in all probability the RBI will have no choice except to reduce SLR to zero as a precondition for an independent debt office,” Reddy told The Economic Times. 
The question that crops up here is whether the government is ready to take on this risk given that it is likely to lead to higher interest rates. With banks no longer having to compulsorily buy government bonds, they may not buy government bonds all the time, like is the case currently. This will lead to a situation where the government will have to offer a higher interest rate to get the banks interested. While this sounds good on the face of it, given that if the government offers higher interest rates on its bonds, that higher interest rate will become the benchmark.
Given this, banks will have to offer higher interest rates on their fixed deposits. This means that the chances of savers getting a higher rate of interest (which is greater than the rate of inflation) also goes up.
But if banks offer a higher rate of interest on fixed deposits, they will also have to charge a higher rate of interest on their loans. And this is something that the government won’t like, given that it is currently trying to push down interest rates in the hope of getting the investment cycle and the consumption cycle going all over again. It needs to be pointed out that savers are not the ones either governments or politicians are really bothered about.
Nevertheless, the government might force the RBI to keep the SLR at its current level. But then there would be no independent public debt office. It would be a farce. As Reddy put it: “If the government is pressurising the RBI to not reduce the SLR that is inappropriate. That is not an independent debt office. And it would be inappropriate for RBI even to appear to support the government debt programme. It cannot appear to be.”
Long story short-we haven’t heard the last of this issue. There will be more to come in the time to come. Stay tuned.

The column originally appeared on The Daily Reckoning on Mar 14, 2015

The mess in public sector banks will not be easy to sort out

The finance minister Arun Jaitley met the chiefs of public sector banks yesterday for a quarterly review of performance. Media reports suggest that among other things the banks were also asked to cut interest rates on their loans.
The Reserve Bank of India (RBI) has cut the repo rate by 50 basis points to 7.5% during the course of this year. Repo rate is the rate at which the RBI lends to banks. But banks haven’t passed on this cut to their end consumers.
There are multiple reasons for the same. Typically when the RBI increases the repo rate, the banks match the increase very quickly. But the same thing is not seen when it comes to a scenario where the RBI cuts the repo rate. Banks are normally very slow to pass on cuts to consumers.
Crisil Research points out in a research note: “Lending rates show upward flexibility during monetary tightening but downward rigidity during easing. Between 2002 and 2004, while the policy rate declined by 200 basis points, lending rates dropped by just 90-100 basis points. Conversely, in 2011-12, when the policy rate rose by 170 basis points, lending rates surged 150 basis points.”
But there is a little more to it than just this. The balance sheets of public sector banks are in a big mess. As thelatest financial stability report released by the RBI 
in December 2014 points out: “PSBs [public sector banks] continued to record the highest level of stressed advances at 12.9 per cent of their total advances in September 2014 followed by private sector banks at 4.4 per cent.”
What this clearly shows is that public sector banks are not in great shape. The stressed asset ratio is the sum of gross non performing assets plus restructured loans divided by the total assets held by the Indian banking system. The borrower has either stopped to repay this loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan (which also entails some loss for the bank) by increasing the tenure of the loan or lowering the interest rate.
What this means in simple English is that for every Rs 100 given by Indian banks as a loan (a loan is an asset for a bank) nearly Rs 10.7 is in shaky territory. For public sector banks this number is even higher at Rs 12.9.
Also, as the following table from 
Credit Suisse shows, 46% of public sector banks have a tier I capital of less than 8% and un-provided problem loans greater than 100% of their networth. 

62% of PSU banks have Tier-I < 9% and
Un-provided problem loans > 100%

Source: Company data, Credit Suisse estimates

What this clearly tells you is that banks many public sector banks do not have enough money to cover their losses. The public sector banks are hoping to recover some of these losses by cutting their deposit rates but staying put on their lending rates. And this leads to a situation where even though the RBI has cut the repo rate once, it hasn’t had much impact on the lending rates of banks.
Further, banks do not have enough capital going around. Take the case of Tier I capital mentioned
earlier. It is essentially sort of permanent capital that the bank has access to andincludes equity capital and disclosed reserves.As the RBI master circular on this points out: “Tier I capital consists mainly of share capital and disclosed reserves and it is a bank’s highest quality capital because it is fully available to cover losses.”

As the following table shows the average tier I capital of public sector banks is less than 8%. While this is the more than 6% tier I capital that banks are required to maintain under current norms, it is very close to the 7% tier I capital that banks will have to maintain under the Basel III norms, which need to be fully implemented by March 31, 2018.

Average Tier-I for PSU banks is less than 8%

This lack of capital has and will continue to constrain the ability of the public sector banks to lend and keep growing. The PJ Nayak committee report released in May 2014, estimated that between January 2014 and March 2018 “public sector banks would need Rs. 5.87 lakh crores of tier-I capital.”
The report further points out 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.” In the next financial year’s budget the finance minister Arun Jaitley has committed just Rs 7,940 crore towards this. 
As analysts Ashish Gupta, Prashant Kumar and Kush Shah of Credit Suisse point out in a recent research note: “The amount allocated is almost the same as our estimate of total dividend likely to be paid by all PSU banks to the government in FY16. This indicates that government capital infusion going forward could be a function of only the profit generation ability of PSU banks.”
Also, by allocating a very small amount to towards public sector banks recapitalization, the message that the government seems to be giving the banks is that they are on their own. This in a way is good, given that the government clearly is not in a position to commit the kind of money required to recapitalize the public sector banks.
Nevertheless, many public sector banks are not in a position to raise money on their own, given the mess their balance sheet is in. As the Credit Suisse analysts point out: “Smaller/weaker PSU banks with limited ability to raise capital from markets will be worst affected as there is very little likelihood of getting capital next year as well.”
So what is the way out? The only way out for the government is to sell off the weaker banks. There is no reason that the government of India should be running more than 20 banks. It simply doesn’t make any sense. Mergers of the weaker banks with the stronger ones is not a feasible option for the simple reason that it will tend to pull down the well performing banks as well. 
Of course politically this will be difficult to implement. But that is the kind of strong governance that Narendra Modi promised the people of this country. It is now time to deliver.

The column originally appeared on The Daily Reckoning on Mar 12, 2015

The great Indian govt Ponzi scheme is here to stay


Vivek Kaul

In the budget speech that he gave in July 2014, while presenting his first budget, the finance minister Arun Jaitley had said: “My Road map for fiscal consolidation is a fiscal deficit of 3.6 per cent for 2015-16 and 3 per cent for 2016-17.” Fiscal deficit is the difference between what a government earns and what it spends. It finances the deficit through borrowing.
In the budget speech that Jaitley gave on February 28, 2015, he put fiscal consolidation on the back burner, when he said: “I will complete the journey to a fiscal deficit of 3% in 3 years, rather than the two years envisaged previously. Thus, for the next three years, my targets are: 3.9%, for 2015-16; 3.5% for 2016-17; and, 3.0% for 2017-18.”
This is a worrying trend. Finance ministers want to increase government expenditure but they do not have much of an idea about how to increase its income. In the process, they end up running higher fiscal deficits, which leads to the government borrowing more.
As can be seen from the table that follows the Ponzi ratio of the Indian government has gone up over the years. In 2009-2010, it was at 0.70, and in 2015-2016, it will be at 1.23. Before I go about explaining what this means, it is important to go back in history and talk about a certain Charles Ponzi.

YearInterest paymentRepayment of principalTotal debt servicingFiscal DeficitPonzi ratio

Sometime in 1919, Charles Ponzi, an Italian immigrant into the United States, promised investors in the city of Boston that he would double their money (i.e. give them a 100% return on their investment) in 90 days.
Ponzi had hoped that to make this money through a huge arbitrage opportunity that he had spotted among the international postal reply coupons being sold across different countries. But due to various reasons both bureaucratic as well as practical, he could never get around to executing the scheme he had come up with.
But by the time Ponzi realised this, big money was coming into his scheme and he had got used to a good lifestyle. At its peak, the scheme had 40,000 investors who had invested around $ 15 million in the scheme.
Ponzi kept his investors happy by using money brought in by the new investors to pay off the old investors who wanted to redeem their investment. And that is how the scheme operated up to a point. On July 26, 1920, the
Boston Post ran a story questioning the legitimacy of the scheme.
Within a few hours, angry depositors lined up at Ponzi’s door, demanding their money back. Ponzi asked his staff to settle their obligations. The anger subsided, but not for long. On Aug 10
th, 1920, the scheme collapsed. The auditors, the newspapers and the banks declared that Ponzi was definitely bankrupt.
Ponzi was not the first individual to run a Ponzi scheme, just that his name stuck to it. A Ponzi scheme is essentially a fraudulent investment scheme in which
 money brought in by new investors is used to redeem the payment that is due to existing investors.
Governments also degenerate into Ponzi schemes over the years, though there is no intention of fraud. This happens when governments do not earn enough and issue new debt to repay old debt as well as pay interest on it.
Take a look at the table shared above. In 2009-2010, the interest payment on the total debt of government of India stood at Rs 2,13,093 crore. Over and above this, the government had to repay around Rs 81,764 crore of debt that was maturing. The total debt servicing cost came to Rs 2,94,857 crore. This amount divided by the fiscal deficit of Rs 4,18,842 crore was around 0.70. This ratio I refer to as the Ponzi ratio.
In 2015-2016, the interest payment on government debt will be at Rs 4,56,145 crore. The maturing debt that needs to be repaid is at Rs 2,25,574 crore. This leads to a total debt servicing cost of Rs 6,81,719 crore. The fiscal deficit for the year has been projected to be at Rs 5,55,649 crore. This means a Ponzi ratio of 1.23.
Hence, the entire fiscal deficit or the difference between what a government earns and what it spends, and which is financed through borrowing, is being used to pay interest on existing debt as well as repay the debt that is maturing. In fact, this is eating into the government revenues as well. Hence, because of the burgeoning debt the Indian government is spending more and more of its money on servicing debt. This is clearly not a good sign as it leaves a lesser amount of money to be spent on other things.
In the July 2014 budget speech, Jaitley had said: “The Government will constitute an Expenditure Management Commission, which will look into various aspects of expenditure reforms to be undertaken by the Government. The Commission will give its interim report within this financial year.” The Commission led by former Reserve Bank of India governor Dr Bimal Jalan, submitted its
report in January earlier this year. Nevertheless, the recommendations of the Commission do not seem to have made it into the budget.
The one big-ticket expenditure item that Jaitley had to deal with in this budget were the recommendations of the 14th
Finance Commission which increased the states’ share of central taxes from 32% to 42%. The other big-ticket item that Jaitley should have done something about, he chose to more or less ignore.
The public sector banks need a huge amount of capital in the years to come. The PJ Nayak committee report released in May 2014, estimated that between January 2014 and March 2018 “public sector banks would need Rs. 5.87 lakh crores of tier-I capital.”
The report further points out 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.” In the next financial year’s budget Jaitley has committed just Rs 7,940 crore towards this.
Further, as Jaitley said in his speech: “uncertainties that implementation of GST will create; and the likely burden from the report of the 7th Pay Commission.” This will make expenditure management even more difficult in the years to come. This means that the government Ponzi scheme will only get bigger than it currently is. Let’s see how this goes.

The column appeared on The Daily Reckoning on Mar 4, 2015