Demonetisation: Can Indian Banks Handle Low Interest Rates?


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


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

Are banks finally pulling the plug on real estate?

The Reserve Bank of India (RBI) puts out the sectoral deployment of credit data every month.  These numbers tell us how much banks have lent to different sectors.

The latest set of numbers released by the RBI point out that lending to commercial real estate grew by just Rs 7,153 crore or 4.5% between August 22, 2014 and August 21, 2015. Commercial real estate includes loans to builders.

This, when the overall lending by banks grew by Rs 4,67,509 crore or 8.2%. Hence, the lending to real estate by banks grew at a much slower rate than the overall lending carried out by banks, over the last one year.

How did things stand in August 2014? Between August 23, 2013 and August 22, 2014, the overall lending of banks had grown by Rs 5,28,173 crore or 10.2%. In comparison the lending to commercial real estate by banks had grown by 17.3% or Rs 23,318 crore during the period. Hence, the lending to real estate banks between August 2013 and August 2014 had grown at a much faster rate than the overall lending by banks. That is clearly not the case now.

In fact, between August 2013 and August 2014, banks lent Rs 23,318 crore or nearly 3.3 times the Rs 7,153 crore that they have lent between August 2014 and August 2015. Hence, new lending to commercial real estate by banks has slowed down considerably.

What is interesting is that during the course of this financial year the overall lending to commercial real estate by banks has actually gone down. Between March 20, 2015 and August 21, 2015, the lending to commercial real estate has fallen by Rs 975 crore or 0.6%.

This should put further pressure on builders as far as their finances are concerned and push them more towards lowering prices of unsold homes.

In the recent past a spate of private equity/venture capital funds have invested in real estate companies as well as projects. This is now being offered as one of the reasons as to why the real estate prices won’t fall in the time to come. It is being said that money from private equity/venture capital funds will keep real estate companies going for a while.

There are multiple questions that needs to be answered here. The first question is, why are these funds investing in Indian real estate? John Kay explains this in his book Other People’s Money—Masters of the Universe or Servants of the People?

In the aftermath of the financial crisis, the central banks of the Western world have printed a huge amount of money. Some of this money has been diverted into asset markets and financial markets all around the world, driving up their values. At the same time, the markets have been going up and down in the same direction at the same time. They have become highly correlated in comparison to the past.

As Kay writes: “The resulting common volatility of security prices has provoked a search for ‘alternative assets’ which would not be correlated with existing portfolios. Traditionally ‘alternatives’ were investments such as gold, art, vintage cars and fine wines: but these exist only in limited quantities. And as investor interest in them grew, their prices became increasingly correlated with those of mainstream assets.”

This, perhaps explains why private equity and venture capital funds are interested in investing in Indian real estate. They believe that returns are not highly correlated to other asset classes.

The next question is how many real estate companies have got money from these funds? The answer is not many. It is worth remembering here that thousands of companies operate in the Indian real estate space all over the country. And once this is taken into account, the number of companies getting venture capital/private equity funding is essentially insignificant.

Further, at what prices are these funds buying into real estate companies or real estate projects. There is not much clarity on this front. It is safe saying here that the prices at which they are buying projects must be at a significant discount to the so called “market price” of real estate. So, in that sense there has been a price correction. The question is at what price will these companies sell these homes?

Meanwhile, the simplistic belief that a cut in home loan interest rates will revive the sector continues. As Sumeet Abrol of Grant Thorton India told The New Indian Express: “High interest rates and inflated prices were the major problems. Now one is resolved.” Really? The RBI cut the repo rate or the rate at which it lends to banks by 50 basis points (one basis point is one hundredth of a percentage) to 6.75%. In response the country’s largest bank, the State Bank of India, cut its base rate or the minimum interest rate a bank charges its customers, by 40 basis points to 9.3%.

This meant that the interest rate on home loans should have fallen by 40 basis points as well. Nevertheless, the interest rate on an SBI home loan will fall by only 20 basis points. Why is that? Earlier, the bank gave out home loans to men at five basis points above its base rate. To women, it gave out home loans at the base rate. Now it has decided to give out home loans to men at 25 basis points above the base rate. In case of women it is 20 basis points.

Hence, interest rate on a man taking an SBI home loan will be now be 9.55% (9.3% base rate plus 25 basis points). Earlier, the interest rate was 9.75%. This means a fall in interest rate of 20 basis points.

This means a fall in EMI of a little over Rs 13 per lakh of a home loan. Data from the National Housing Bank shows that in 2013-14, the average home loan size in India was Rs 18-19 lakh. I couldn’t find more recent data. Hence, we can assume that the average home loan size for banks would be around Rs 20 lakh now.

The housing finance company, HDFC, gives out average home loan size data every three months, along with its quarterly results. As on June 30, 2015, the average home loan size of HDFC stood at Rs 23.4 lakh.

Given this, an average home loan of Rs 20 lakh for the Indian banking system is a good number to work with. This means that the EMI on an average Indian home loan would fall by Rs 260 (Rs 13 multiplied by 20). So, will that lead to more people buying homes? Or was that stopping people from buying homes in the first place? I don’t think I need to answer that.

As Abrol of Grant Thorton India put it: “Real growth will be triggered only when builders are ready to cut property prices. If a revival is to happen in the sector, prices which were artificially moved up in the recent past in some areas, should come down to realistic levels.”


(The column originally appeared on The Daily Reckoning on October 6, 2015)

Dear PM Modi, ache din won’t come just by meeting corporates

As I write this on the morning of September 8, 2015, Prime Minister Narendra Modi and his team are meeting the top businessmen of this country along with the governor of the Reserve Bank of India (RBI), Raghuram Rajan.

The press release put out by the Prime Minister’s office pointed out that “a wide-ranging discussion is expected on the impact of recent economic events, and how best India can take advantage of them.” For a meeting which is expected to last over two hours, this is as general an agenda as it can get. Since it chooses to address everything, it will end up addressing nothing.

As far as representatives of Indian business are concerned they have constantly blamed high interest rates for investment as well as economic growth not picking up. But the point is who is responsible for high interest rates? The conventional wisdom on this matter is that the Reserve Bank of India has not been reducing the repo rate, or the rate at which it lends to banks.

Only if it was as simple as that. The repo rate is at best an indicator of which way the interest rates are headed. At the end of the day banks need to decide the interest rates they charge on their loans. A major reason that has been stopping them from lowering interest rates is the massive amount of bad loans that have been accumulated over the years.

Take the case of the State Bank of India, it has a bad loan ratio of greater than 10%, when lending to corporates. This means for every Rs 100 that the bank lends to corporates, more than Rs 10 has turned into a bad loan.

A standard explanation for these defaults is that businesses have got hit during what are bad economic times and hence, are unable to repay the loans they had taken on. While that may be true in a large number of cases, it is not totally true.

As a recent report brought out by Ernst and Young and titled Unmasking India’s NPA issues – can the banking sector overcome this phase? points out: “While corporate borrower have repeatedly blamed the economic slowdown as the primary factor behind it[i.e. defaulting on bank loans], periodic independent audits on borrowers have revealed diversion of funds or wilful default leading to stress situations.”

The question is will Modi and his team crack the whip on these defaulters and ask them to pay up? From past evidence the answer is no. If they had to, they would have already done so by now. Hence, calling the corporates for a meeting and listening to the same old things all over again, is basically a sheer of waste of time.

Further, as far Modi is concerned he has a lot of explaining to do on the economic reform front, something he had promised during the course of the election campaign last year. During the course of the last year he has come up with slogans like Make in India, Digital India etc., with very little changing on the ground.

For businesses to make in India, different things like the ease of land acquisition and electric supply, need to improve. Many state electricity boards all over the country, continue to remain in a mess.  Further, the inspector raj that small businesses face, needs to be unshackled. Labour laws which stop favouring the incumbents (i.e. the labour in the  organised sector) need to be brought in. Very little seems to have happened on this front.

Further, the government hasn’t been able to push through a goods and services tax either, despite making a lot of noise on that front.

The basic point is that what was Modi’s strength has now become his weakness. During the course of the election campaign last year, Modi came across as a man of action—a man who got things done. The bar was set very high with slogans like “acche din aane waale hain”.

For acche din to come Modi needs to create jobs for the 13 million Indians who are entering the workforce every year. And for that to happen he needs to unshackle many things that are holding back the economy.

The ease of doing business has to improve, if India wants to take advantage of the current economic scenario where the Chinese economy is in doldrums. Just coming up with new slogans and meeting corporates regularly won’t help on that front.

The column appeared on Firstpost on Sep 8, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)