High Inflation In Times of Covid Will Hit Us Hard

In October 2020, inflation as measured by the consumer price index stood at 7.61%. This is the highest inflation experienced during the period Narendra Modi has been prime minister. The last time inflation or the rate of price rise, was higher than this, was in March 2014, when it had stood at 7.63%.

Let’s look at this issue pointwise.

1) A major reason for high inflation has been high food inflation which was at 11.07% in October. Food forms around 39% of the weight of the consumer price index. Within food, prices of egg, fish and meat, oils and fats, vegetables, pulses and spices, went up by more than 10%.

Interestingly, potato prices are 104.56% higher since last October. This is the highest inflation among all the items which are a part of the consumer price index. One reason offered for this has been a disruption in supply chains due to the spread of covid. But the economy has now more or less totally opened up, meaning disruption can’t continue to be a valid reason. Also, food inflation has been on the higher side since October last year, much before covid broke out.

2) The high inflation is not just because of high food inflation. If we look at core inflation, which leaves out food items and fuel and light items, the inflation is at 5.64%, the highest in thirty months. A major reason for this has been an increase in transport and communication costs which went up by 11.16% in October.

Fares of buses, taxies, auto-rickshaws and rickshaws, have gone up. This is because petrol and diesel are now more expensive than they were last year. The government has increased the excise duty on both the fuels, despite the fact oil prices have fallen internationally. The government’s dependence on fuel taxes has only gone up this year and which is now reflecting in a higher inflation as well. Petrol and diesel used for vehicles come under the transport and communication category of the consumer price index and not the fuel category.

3) Another reason for high core inflation is the higher inflation in the pan, intoxicants and tobacco segment. Interestingly, foreign liquor and beer cost 22.32% and 25.32% more this year than last year. This reflects the state governments increasing the tax on these products in order to shore up revenue.

Toddy prices have also risen 20.19%. Also, the personal care and effects segment saw an inflation of 12.07% in October. The cost of going to a barber/beautician went up by 7.04%. But the major increase here has been in the prices of gold, silver and other ornaments, which went up by 33.77%, 36.66% and 20.52%, respectively. For some reason, they are categorised under personal care and effects.

4) While inflation in the health category has been lower this year than the last year, in October it went up by 5.22%, the highest it has been this year.

5) Within the fuel category, the price of domestic cooking gas went up by 10.16% in October, while non-PDS kerosene was up 8.28%.

6) The high inflation is primarily in the areas of food, parts of fuel, communication and to some extent, health. These are areas which impact the common man. How do higher prices of gold, silver and other ornaments impact the common man? They play a very important role in Indian marriages.

All in all, high inflation has hit India at a time when the country has just gone through its first ever recession after independence. The Indian economy contracted by 23.9% during April to June. It is expected to contract between July and September as well. A recession is defined as a period when the economy contracts for two consecutive quarters.

In fact, as Nikhil Gupta and Yaswi Agarwal of the stock brokerage Motilal Oswal point out in a recent research note: “The rise in the core inflation in India is also the highest among the 21 major economies in the world.” Indeed, this is very worrying.

7) High inflation has hit us at a time when an economic contraction has led to a fall in incomes. Over and above this, people are also saving more to be ready for a rainy day. The total amount of bank savings have increased by Rs 6.32 lakh crore between March 27, around the time the country first started to realise how dangerous covid could be, and October 23. Last year, during a similar period, the deposits had gone up by Rs 3.29 lakh crore. The psychology of a recession is totally in place.

What does this mean?  A good segment of the population has been cutting down on their consumption, particularly non-essential consumption, thanks to lower incomes. A high rate of inflation, if it prevails, will only add to people cutting down on consumption further, making the job of the government and the Reserve Bank of India (RBI) to get the economy going even more difficult.

8) While deposits with banks have soared, the total amount of loans given by banks has actually contracted by a little over Rs 32,000 crore between March 27 and October 23. On the whole, banks haven’t given a single rupee of a new loan, since covid struck.

This has led to the RBI cutting the repo rate or the rate at which it lends to banks. Along with this, the central bank has printed and pumped a lot of money into the financial system, in the hope of driving down interest rates, in order to get both companies and individuals to borrow and spend more money.

That clearly hasn’t happened because of the lack of certainty of economic future. But all the money flooding around in the financial system has led to lower deposit rates making lives of senior citizens difficult, who have no other option but to cut down on their consumption. Even those who use fixed deposits to save for the future are caught in a jam.

To conclude, in this environment if inflation continues to remain stubbornly high, as it has through much of this year, the job of the government and the RBI to get consumption going will become even more difficult. It will also lead to the RBI finding it difficult to continue cutting the repo rate.

This column originally appeared in the Deccan Herald dated November 22, 2020.

Mr Subramanian, Lower Interest Rates Do Not Always Lead to More Bank Loans

Arvind_Subrahmaniyam

“Lower interest rates lead to higher lending,” is something that most economists firmly believe in. The beliefs of Arvind Subramanian, the chief economic adviser to the ministry of finance, are not an exception to this rule.

Hence, not surprisingly in a lecture a few days back he came out all guns blazing against the Reserve Bank of India(RBI) for not cutting the repo rate. 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 loan. We say sort of a benchmark here because there are other factors which go into deciding what rate of interest that banks charge on their loans.

Subramanian wants the RBI to cut the repo rate further from its current level of 6.25 per cent. As he said: “Inflation pressures are easing considerably… the inflation outlook is benign because of a number of economic developments… Against this background, most reasonable economists would say that the economy needs all the macroeconomic policy support it can get: instead, both fiscal policy and monetary policy remain tight.

The point here being that current inflation is under control and from the looks of it, future inflation should also be under control. And given this, the RBI must cut its repo rate. The RBI last cut the repo rate in October 2016. And as and when it cuts the rate further, the hope is that the banks will cut their lending rates. Only then will people and industries both borrow and spend more. This will give a flip to the economy. QED.
Subramanian’s point is well taken. Nevertheless, does it make sense? We will deviate a little here before we arrive at the answer.

The RBI Monetary Policy Report released in early April 2017 points out that the decline in the one-year marginal cost of funds based lending rates (MCLRs) of banks between April and October 2016 was just 15 basis points. This when the repo rate was cut by 50 basis points. Hence, even though the RBI cut its repo rate by 50 basis points, the banks cut their lending rates by just 15 basis points, a little under a one-third. One basis point is one hundredth of a percentage.

Post demonetisation “27 public sector banks have reduced their one-year median MCLR in the range of 50 to 105 bps, and 19 private sector banks have done so in the range of 25 to 148 bps.” This when the repo rate has not been cut at all. On an average the one year MCLRs of banks fell by 70 basis points to 8.6 per cent.

What has happened here? A cut in the repo rate barely makes any difference to the cost at which banks have already borrowed money to fund their loans. But demonetisation did. The share of the “low cost current account and savings account (CASA) deposits in aggregate deposits with the SCBs went up to 39.2 per cent (as on March 17, 2017) – an increase of 4.0 percentage points relative to the predemonetisation period”. This is because people deposited the demonetised notes into the banks and this money was credited against their accounts.

This basically meant that banks suddenly had access to cheaper deposits because of demonetisation. And this in turn led them to cut interest rates on their loans, despite no cut in the repo rate. The RBI’s repo rate continued to be at 6.25 per cent during the period.

A cut in lending rates is only one part of the equation. The bigger question has it led to higher borrowings? Are people and businesses borrowing more because lending rates are now lower than they were in the past? And this is where things become interesting.
The total deposits of banks between October 28, 2016 (before demonetisation) and December 30, 2016 (the last date to deposit demonetised currency into banks) went up by 6.41 per cent to Rs 10,568,17 crore. This was a huge jump during a period of two months. This sudden increase in liquidity led to banks cutting their deposit rates and then their lending rates.

Interestingly, the total deposits of banks have continued to remain stable and as of April 30, 2017, were at Rs 10,509,337 crore. This is a minor fall of 0.6 per cent since December 2016.

Between end October 2016 and end April 2017, only around 36 per cent of the incremental deposits raised by banks were loaned out. (We are looking at non-food credit here. The total bank loans that remain after we adjust for the loans that have been given to the Food Corporation of India and other state procurement agencies for the procurement of rice and wheat produced by farmers).

This means for every new deposit worth Rs 100, the bank loaned out just Rs 36, despite a cut in interest rates.

If we were to look the same ratio between end October 2015 and end April 2016, it projects a totally different picture. 116 per cent of the incremental deposits during the period were lent out. This means for every new deposit worth Rs 100, the bank loaned out Rs 116.  This means that deposits raised before the start of this period were also lent out.

Hence, a greater amount of lending happened at higher interest rates between October 2015 and April 2016. And this goes totally against Subramanian’s idea of the RBI needing to cut the repo rate. It also goes against the idea of banks lending more at lower interest rates.

Given this, low interest rates are only a part of the story. If that is not leading to higher lending, it doesn’t help in anyway. Lending isn’t happening due to various reasons, which we keep discussing. Demonetisation has only added to this issue.

Also, a fall in interest rates hurts those who depend on a regular income from fixed deposits to meet their expenditure. It also hurts those who are saving for their long-term goals. In both the cases, expenditure has to be cut down. In one case because enough regular income is not being generated and in another case in order to be able to save more to reach the investment goal. And this cut in spending hurts the overall economy. Interest rates are also about the saver and depositor.

We are yet to see a professional economist talk from this angle. To them it is always a case of garbage in garbage out i.e. lower interest rates lead to increased lending. This is simply because most professional economists these days get trained in the United States where the system is totally different and lower interest rates do lead to a higher borrowing by businesses and people.

But that doesn’t necessarily work in India. It is a totally different proposition here.

The column originally appeared in Equitymaster on May 15, 2017.

Demonetisation: Can Indian Banks Handle Low Interest Rates?

RBI-Logo_8

One of the benefits of demonetisation that is being bandied around is lower interest rates. Suddenly, banks are flush with a huge amount of deposits. The demonetised Rs 500 and Rs 1,000 notes need to be handed over to banks as well as post offices by December 30, 2016. The total value of demonetised currency is Rs 15.44 lakh crore.

Between November 10, 2016 and December 10, 2016, Rs 12.44 lakh crore has made it back to the banks. Banks have issued new notes as well as notes which continue to be legal tender of Rs 4.61 lakh crore to the public over their counters and through their ATMs.

What this means that the deposits with the banks have gone up at a very rapid pace. Between November 11 and November 25, 2016, the aggregate deposits with banks went up by 4 per cent. This increase was within a span of just 15 days. (This is the latest figure that is available.)

Given this, huge and sudden jump in deposits, it is but natural that the banks will cut the interest rates that they offer on their deposits. At the same time, the overall lending by banks (non-food credit) during the 15-day period fell by 0.9 per cent.

Hence, a rise in deposits and a fall in loans will lead to banks cutting interest rates on their deposits and then on their loans. At lower interest rates both businesses as well as consumers will borrow and spend more. And this will help economic growth. Or so we are being now told.

This, as I have often argued in the past, is a very simplistic argument. (You can read one such argument here in the Letter that I write every Friday). Lower interest rates for borrowers are just one side of the equation. We also need to consider lower interest rates for savers, who form the other side of the equation. There can’t be any borrowers without savers. Look at Table 1.

Table 1: Financial Saving of the Household Sector.As can be seen from Table 1. Deposits form a bulk of the household financial savings. Between 2011-2012 and 2015-2016, the share of deposits in the household financial savings has come down. Nevertheless, it remains a major part of how people save. If interest rates on deposits come down, people need to save more to meet their savings goal. This means lesser consumption, which has an impact on economic growth. There is also a possibility of not saving enough and not meeting their savings goal, which again is not a good thing. This could mean not having an adequate amount of money for the education of children, among other things.

Further, in a country with very little social security, the senior citizens use fixed deposits to generate regular monthly income. A sudden fall in interest rates hurts them the most. This is another thing that needs to be kept in mind. Hence, fixed deposit interest rates at any point of time should be at least 150 to 200 basis points higher than the prevailing rate of inflation as measured by consumer price index. This is not a perfect formula, given that each one of us has our own rate of inflation, but then something is better than nothing.

Given that it is the largest borrower, it is understandable that the government keeps batting for lower interest rates. But lower interest rates are not necessarily good for everyone and mindlessly advocating lower interest rates as many experts and industrialists tend to do, is not good for anyone.

Take the case of banks. How responsibly can we expect them to lend? If we look at the recent record of the banks, they don’t inspire enough confidence. In fact, this is precisely the point made by Pallavi Chavan and Leonardo Gambacorta in the RBI Working Paper titled Bank Lending and Loan Quality: The Case of India. The paper was published on the RBI website on December 14, 2016.

The major point that Chavan and Gambacorta make is as follows: “We find that a one-percentage point increase (decrease) in loan growth is associated with an increase (decrease) of NPLs over total advances (NPL ratio) by 4.3 per cent in the long run.” What does this mean in simple English? It essentially means that for every one per cent increase in loans the bad loans ratio goes up by 4.3 per cent.

This basically means that when the times are good, Indian banks go easy on the lending and end up giving loans to even those who don’t deserve a loan. As Chavan and Gambacorta point out: “Banks tend to take on more risks during an upturn in credit growth and be more cautious whenever there is a downturn.”

So why do banks go overboard while lending while times are good? The simple reason is that when times are good there is far greater competition to lend and in this scenario, the lending conditions tend to get relaxed.

But there is another reason as well-crony capitalists. As Chavan and Gambacorta point out: “Well-capitalised banks tend to take on less credit risk”. What does this mean? It means that banks which have more capital tend to take less risk when it comes to giving out loans. Hence, banks which have less capital tend to take more risk while giving out loans. The question is which banks have less capital? Public sector banks.

The new generation private sector banks, which form a bulk of the private sector banking in India, are much better capitalised than the public sector banks. So, what is it that leads to public sector banks going easy on the lending? While Chavan and Gambacorta don’t say so, the answer perhaps lies in crony capitalism.

Politicians force public sector banks to lend to their businessman friends or crony capitalists. The projects are poorly financed with the businessmen putting very little of their own money at risk. As Raghuram Rajan said in a November 2014 speech: “The reason so many projects are in trouble today is because they were structured up front with too little equity, sometimes borrowed by the promoter from elsewhere. And some promoters find ways to take out the equity as soon as the project gets going, so there really is no cushion when bad times hit.”

To conclude, those talking about lower interest rates leading to higher lending to businesses, should also keep this in mind. Public sector banks are not adept at lending, at least not as long as they remain public sector banks, which allows politicians in power to interfere

(The column originally appeared on Equitymaster on December 16, 2016)

Interest rates are also about savers, not just about borrowers

ARTS RAJAN

One of the points that I have made in the past is that interest rates are not just about borrowers; they are also about savers.

Raghuram Rajan, the governor of the Reserve Bank of India(RBI) explained this beautifully in a recent interview to NDTV. At a talk somewhere, one gentleman got up and told the governor that he should bring down the interest rates to 4%.

A point that most people fail to understand is that an RBI governor can decide only on the repo rate. 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.

The RBI governor does not decide on the interest rate that a bank charges on its loans. Neither does he decide the interest rate a bank pays on its deposits for that matter. That is a decision individual banks make.

Hence, Rajan cutting the repo rate is not enough. Banks need to pass on the cut to the end consumers. Since January 2015, Rajan has cut the repo rate by 150 basis points. Banks have passed on around half of that cut to the end consumers due to various reasons. The public sector banks have been accumulating a huge amount of bad loans and this has limited their ability to cut interest rates on their loans.

Rajan asked this gentleman that the rate of inflation was still 5.5% and if he brought down the interest rate to 4%, would he still deposit his money at the bank? The gentleman said no. So he was not willing to deposit his money at a low interest rate, but wanted banks to lower their lending rates.

To this Rajan said: “say a bank pays 6% on deposits and lends at 4%, who is going to make up for the difference”. “The idea is that somebody is going to pick up the tab. We are used to somebody picking up the tab. Who is going to pick up this tab?

The point here is very simple. A bank can only lend at a rate of interest which is higher than the rate at which it borrows. Further, it needs to offer a certain rate of interest on its deposits, so that people deposit money with it and do not invest it in other avenues which offer a higher rate of return. Currently, the rate of interest offered on small savings schemes are significantly higher than those of fixed deposits.

Rajan also said that it takes some time for depositors to get used to the fact that inflation has actually come down over the last few years. “The real interest rate they [i.e. depositors] are getting now is much higher than the real interest rate they were getting earlier,” Rajan said.

The real interest rate is essentially the nominal interest rate offered by a bank on its fixed deposit subtracted by the prevailing rate of inflation. “When inflation was 9% they [i.e. depositors] were getting 9%. This meant earning nothing in real terms and losing everything in inflation,” Rajan explained. “Today they are getting 7% on their deposits and inflation is 5.5%. They are earning 1.5%. It is a real difference,” he added.

This is something that will take time to sink in because money illusion is at work. What is money illusion? As Gary Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes: “[Money illusion] involves a confusion between ‘”nominal” changes in money and “real” changes that reflect inflation…Accounting for inflation requires the application of a little arithmetic, which…is often an annoyance and downright impossible for many people…Most people we know routinely fail to consider the effects of inflation in their finance decision making.”

So, the point is that even though people are earning a better real rate of interest they don’t realise it. What they see is that nominal rate of interest has fallen and given this they are not happy with banks offering a lower rate of interest on their fixed deposits.

As Rajan said in the NDTV interview: “Depositors are already complaining that they are not getting enough. That is why banks are reluctant to cut [deposit] rates.” And unless banks can cut deposit rates there is no way they can cut lending rates, irrespective of what the RBI chooses to do with the repo rate.

This is how bank interest rates work. As Rajan asked: “For somebody to say that I have a God given right to get a loan at low interest rate but I won’t deposit at that rate, where is the money going to come from them?” This basically means that banks lend money they essentially get as deposits. And without deposits there is going to be no lending.

One of the most difficult things in economics to understand is general equilibrium. You do one thing it has other effects as well,” Rajan said. If interest rate on lending is cut where is the money going to come for savings, Rajan asked.

This is something that people who keep demanding lower interest rate at a drop of a hat don’t seem to understand. There are two sides to bank interest rates. The interest rate banks charge on their loans and the interest rate they pay on their deposits. And if interest rates on deposits can’t fall beyond a point, then the interest rate on loans can’t fall as well.

This is a basic point that people don’t seem to understand. And it’s not rocket science.

The column was originally published in the Vivek Kaul Diary on June 10, 2016