Vivek Kaul
The State Bank of India (SBI) cut its base rate by 5 basis points (i.e. 0.05%, one basis point is one hundredth of a percentage) to 9.7% in response to the Reserve Bank of India (RBI) cutting the repo rate by 25 basis points (i.e. 0.25%). Guess it was their idea of a ‘bad’ joke. Repo rate is the interest rate at which the RBI lends to banks.
While newspapers have gone to town trying to tell you and me that interest rates are falling nothing like that has happened. A few banks have cut their auto loan rates but no major bank(other than SBI) has cut its base rate. Base rate is the lowest rate of interest at which a bank can lend.
Why has that been the case? Numbers tell a really interesting story.
As on March 30, 2012, banks had invested 28.55% of their deposits in government bonds. This number has since gone up and as on January 11, 2013, banks had invested 30.23% of their deposits in government bonds.
This means that during the course of this financial year (i.e. the period between April 1, 2012 and March 31, 2013) the Indian banks have invested a greater proportion of the deposits they managed to raise into government bonds.
The government issues bonds to finance its fiscal deficit. Fiscal deficit is the difference between what the government earns and what it spends.
What is interesting is that banks have to maintain a statutory liquidity ratio of 23% i.e. invest Rs 23 of every Rs 100 raised as demand and time deposits compulsorily into government bonds. But as of January 11, 2013, for every Rs 100 collected as deposits, banks had Rs 30.23 invested in government securities. And this has gone up from Rs 28.55 as on March 30, 2012. This in a scenario where banks need to invest only Rs 23 out of every Rs 100 raised as deposits in government bonds.
This tells us that banks would rather lend more to the government than you and me. This excess money chasing government bonds has led to a situation where the return on government bonds has fallen. The return on a 10 year government bond as on March 30, 2012, stood at 8.54%. On January 11, 2013, it was at 7.87%.
This excess lending and lower returns on the government portfolio has meant that banks need to continue charging high interest rates on the loans they make to consumers, in order to continue maintaining their profit levels. And that explains to a large extent why they haven’t cut interest rates despite the Reserve Bank cutting the repo rate by 0.25%.
The question to ask here is why are banks happy lending to the government rather than you and me? Is it a lazy banking? Why bother lending to individual consumers when you can lend in bulk to the government? Or are banks facing more losses on their lending and hence are sticking to lending to the government? Lending to the government is deemed to be safe given that even in the worst possible scenario the government can always print and repay money. Or is it a case of the government forcing public sector banks to invest a greater amount of their deposits than is required as per the law of the land, in government bonds?
Whatever be the case this excess lending to the government has led to a situation where banks are unable to cut interest rates.
It has also helped the government, allowing it to easily raise money from banks to finance its massive fiscal deficit at lower rates of interest. The fiscal deficit targeted for this financial year (i.e. the period between April 1, 2012 and March 31, 2013) was Rs 5,13, 590 crore. For the period April to November the fiscal deficit stood at around Rs 4,13,000 crore. This means that during the first eight months of the year, the fiscal deficit crossed 80% of the budgeted estimate.
If we project the fiscal deficit number for the first eight months for the entire financial year it is likely to come to Rs 6,16,000 crore, which is Rs 1,00,000 crore more than the budgeted fiscal deficit. And if the banks continue to help the government as they have in this financial year, the government can keep running its huge fiscal deficit rather easily.
There had been great pressure on the RBI governor D Subbarao to cut the repo rate. He had resisted the idea for a while now despite repeated hints given by the government in general and the finance minister P Chidambaram in particular. Now that he has gone ahead and cut the repo rate, it is not translating into subsequent cut in interest rates by banks.
In an interview to The Economic Times former RBI governor YV Reddy explained the friction between a central bank and the government by saying “A central bank that is always in agreement with the government is superfluous, just as a central bank that is always in disagreement is obnoxious. The solution really is to have messy coordination.”
To conclude, there is not much that the RBI can do to bring down interest rates. That will only happen once the government is able to control its fiscal deficit. And that is not happening any time soon. So higher EMIs and interest rates are here to stay.
The article originally appeared on www.firstpost.com on January 31, 2013.
(Vivek Kaul is a writer. He can be reached at [email protected])
P Chidambaram
Chidambaram should realise that gold is useful because it is useless
Vivek Kaul
Gold bashing seems to have become the favourite pastime of finance minister P Chidambaram these days. He has repeatedly warned Indians to get over their fascination for gold.
But Mr Chidambaram does not know his history well enough. If he did he wouldn’t be saying the things that he has been.
Gold over the centuries became universal money and there were several reasons for the same. It is not fragile and is durable. It does not rot. It is chemically inert unlike copper, silver and iron, which means its radiance is timeless.
Given its chemically inert nature most of the gold mined since eternity is still around. Estimates suggest that the world has 1,65,000 tonnes of gold. The supply of gold rarely goes up suddenly.
A report released by Standard Chartered in 2011, expected the supply of gold to go up at the rate of 3.6% per year between 2011 and 2015, suggesting the stable supply of the yellow metal. In a bear case scenario the report said that the supply would grow at an even slower rate of 1.2% per year. The price of gold has rallied over the last 2 decades even then there has hardly been any significant growth in supply of gold, with production going up at the rate of minuscule 0.7% per year. During the period 1900 to 1990 the production of gold grew at the rate of 1.9% per year.
This has historically held good as well. Since 1492, the supply of gold has never gone up by more than 5% in any given year. In fact, during the normal course of things gold supplies have grown between 1 to 2% every year. The exception to this is when new gold discoveries happen and lead to a gold rush. These are the only occasions, as was the case with California and Australia in the 1850s or South Africa in the 1890s, when gold supplies went up faster than 4% per year. With the supply of gold being limited, what it means is that it has held its value much better than other forms of saving money over the centuries.
Gold is 20 times as dense as water and twice as dense as lead, which means a lot of it can be packed into a very small size. One cubic metre of gold would weigh around 19.3 metric tonnes (i.e. 19,300 kilograms). What this means is that very high value of money can be easily moved around if it’s in the form of gold.
When it came to rarity something like a diamond or a ruby was a better bet. But figuring out the quality of a diamond and other stones was difficult. Experts could easily haggle on it, with different experts having a different opinion. When it came to gold such problems did not exist.
As Aristotle, the Greek philosopher and teacher of Alexander the Great put it “It became necessary to think of certain commodities, easily manageable, safely transportable, and of which the uses are so general and so numerous, that they insured the certainty of always obtaining for them the articles wanted in exchange.” Gold had all these qualities.
And that’s how over the centuries gold emerged as money that everyone preferred to use. What also helped was the “uselessness” of gold. Despite the fact that it is highly malleable (can be beaten into sheets easily) and ductile(can be easily drawn into wires) and the best conductor of electricity, gold does not have many industrial uses like other metals like silver have primarily because there is very little of it going around.
Also when commodities are used as money they are taken away from their primary use. So if rice or wheat is used as money for daily transactions and to preserve wealth, it means a lesser amount of rice and wheat in the market. This in turn would mean higher prices of grains which are staple food in large parts of the world. Gold doesn’t have many practical uses. So if people hoard gold, it doesn’t hurt anyone.
As the blogger FOFOA put it, “Gold’s utility is that for thousands of years it has held its value relatively well. And because it is not used for many things other than mere hoarding, the act of hoarding gold is not an infringement on the natural rights of others to enjoy the utility value of “real world” things like BMW’s and oil and wheat… If one were to corner, say, the copper market or the chocolate market, there would likely be repercussions as those industries fought back through the power of the collective that likes to consume chocolate and copper. But with gold there is no such worry.”
Gold started giving away to simple paper money at the start of the First World War in 1914. While it did make a few comebacks as money over the years, the world moved onto a complete paper money system in the early 1970s.
What this did was that it allowed governments around the world to print as much money as they wanted to. And this has led to paper money rapidly losing its purchasing power over the years. Things have become particularly worse since the start of the financial crisis in September 2008. The government of Western nations have been printing more and more paper money and pumping it into their financial systems. This was been done in the hope that their citizens will spend that money, which will help revive their economies.
Given that the global money supply has increased dramatically over the last few years, there is a grave danger that paper money will lose value rapidly in the years to come. And this has led to people buying gold all over the world which is seen as the ultimate store of value.
People in India have bought gold because of this reason as well. The other reason has been our high rate of inflation which has led to the purchasing power of the rupee going down dramatically, motivating people to buy gold which is seen as a commodity which holds its value relatively well.
And the good part is that people in India have been buying ‘hoarding’ gold to ensure that the value of their accumulated wealth does not fall.
Imagine if they had tried to hold wealth in the form of rice or wheat. In a world where nearly 79 million people are being added to the dinner table every year (and a lot of them in India), hoarding rice and wheat could have caused food riots. Imagine if all the Indians would have actively speculated on metals used across industries. There prices would have gone through the roof. (in fact with huge demand for industrial metals from China these metals had been rallying for the last few years. Imagine what would have happened to the price if Indians had started actively speculating in them?)
So its good that people are buying gold to hoard their wealth and not something which is actually useful. As FOFOA puts it “Thankfully we have a commodity that is mostly used for hoarding, and little else. Like Warren Buffet said, we dig it up and then bury it again in a vault. And all it does is one little thing: it maintains its value over thousands of years. That’s gold’s utility.”
And Mr Chidambaram should thank his stars for that.
References:
Chen,Y and others. 2011. In Gold We Trust. Standard Chartered
Bernstein, P. 2000. The Power of Gold – The History of an Obsession. John Wiley and Sons.
FOFOA. 2010. The Value of Gold. Available at www.fofoa.blogspot.com
Skousen, M. 2010. Economics of a Pure Gold Standard. Foundation for Economic Education
The article originally appeared on www.firstpost.com on January 10, 2013.
(Vivek Kaul is a writer. He can be reached at [email protected])
Deficit Crisis: Hope Chidamabaram is praying to goddess Lakshmi
One of the many Diwali traditions that have come up over the years is the idea of leaving the doors and the windows of the house open. This is done to facilitate the entry of Lakshmi, the goddess of wealth, into the house.
The Union Minister of Finance, P Chidambaram, hopefully is a believer, and had left the doors and windows to his house open yesterday, in the hope that Lakshmi will come into the coffers of the government he is a part of.
The way the finances of the government of India are placed, it’s time for Chidambaram to do what most Indians do when they are stretched and stressed. Pray to god. And hope for the best. So if he isn’t a believer it’s high time he becomes one and starts praying that Lakshmi doesn’t give the government a slip.
The fiscal deficit of the government of India for the year 2012-2013(i.e. the period between April 1, 2012 and March 31, 2013) has been targeted at Rs 5,13,590 crore or 5.1% of the gross domestic product. Fiscal deficit is the difference between what the government earns and what it spends.
Targets need to be met and it’s unlikely that the government of India will meet the fiscal deficit target it has set for itself. As the Kelkar committee on fiscal consolidation recently pointed out “A careful analysis of the trends in the current year, 2012-13, suggests a likely fiscal deficit of around 6.1 percent which is far higher than the budget estimate of 5.1 percent of GDP, if immediate mid-year corrective actions are not taken.” The committee estimated if the government continued to function as it currently is it will end up with a fiscal deficit of Rs 6,15,717 crore.
In order to control this burgeoning fiscal deficit the government can do two things, increase its income or control its expenditure. But some recent developments show that the government is more than faltering on both the fronts.
Take the case of the auction of the 2G telecom spectrum. The government expected to raise Rs 30,000 crore from this. But the actual number is nowhere near that. The other big entry into the revenue figure was supposed to come from the disinvestment of shares that the government holds in public sector enterprises. Not a single rupee has been raised on that front.
Also what does not help is the fact that the amount of tax collected seems to be slowing down. As economist Shankar Acharya recently wrote in the Business Standard “By end September the government’s tax receipts amounted to less than 40 per cent of the year’s Budget target.”
So things are looking bad on the income front. The other big headache for the government has been the fall of the rupee against the dollar. As I write this one dollar is worth around Rs 55.
And this means increased expenditure on the oil front. Oil is sold internationally in dollars and when rupee loses value against the dollar that means Indian oil companies have to pay more in rupee terms to buy the same amount of oil. Currently the price of crude oil for the Indian basket is at $106.09 per barrel. At Rs 55 to a dollar this means Rs 5835 per barrel in rupee terms. Compare this to October 4 when the rupee touched a recent high against the dollar. On that day one dollar was worth Rs 51.5. At that price crude oil would have been at Rs 5464 per barrel in rupee terms, much lesser than what it is today.
Hence, as rupee loses value against the dollar, the oil bill goes up. This wouldn’t have been a reason for worry if products made out of oil i.e. petrol, diesel and kerosene, were sold at their market price. But they are not. The government subsidises the oil marketing companies (OMCs) for selling diesel and kerosene at a loss. It also subsidises the OMCs for selling cooking gas at a loss. As the rupee loses value against the dollar it means increased losses for the OMCs unless prices of the products they sell are raised. And in the process it also means increased expenditure for the government and hence a greater fiscal deficit.
Also recent numbers released by Controller General of Accounts project a worrisome picture. Fiscal deficit for the first six months of the year (i.e. between April 1 and September 30) was at Rs 3,36,00 crore. This means that for the first six months of the year the fiscal deficit stood at 65.6% of the estimated fiscal deficit of Rs 5,13,590 crore. This clearly is not a good sign. If the government continues at the same pace it will end up with a fiscal deficit of Rs 6,72,000 crore or 6.7% of the GDP.
A high fiscal deficit is worrying. As the Kelkar report points out “High fiscal deficits tend to heighten inflation, reduce room for monetary policy stimulus, increase the risk of external sector imbalances and dampen private investment, growth and employment.”
Over and above that a high fiscal deficit can also lead to a “likely…sovereign credit downgrade and flight of foreign capital.” As foreign money leaves India this would put further pressure on the rupee against the dollar, leading to a higher oil bill and in process a higher fiscal deficit. So a higher fiscal deficit will lead to an even higher fiscal deficit.
Hence, the government has to either increase its income in some way or control its expenditure. One way of doing that is controlling on subsidies which can be done by increasing prices of oil products as well as fertilizer. But that is unlikely to happen given that it is politically enviable.
So that leaves the government with only one way out and that is to get aggressive on the disinvestment front. Very little action has been seen on that front. But with the government getting a massive amount of bad press over the last few months for being involved in a variety of scams, whether investors pick up shares in public sector companies that the government decides to disinvest, remains to be seen.
In this scenario the government’s one and only hope is the Life Insurance Corporation (LIC) of India. The government can direct LIC to pick up shares of companies it decides to disinvest. When it comes to LIC it is best placed to carry out such operations in the last three months of the financial year (i.e. between January and March).
At that point of the year people start seriously thinking about their tax saving investments and in large parts of the country that means buying a new LIC policy or paying the premium for the existing ones. And that’s when the insurance behemoth has a lot of cash which can be used to rescue the government by picking up shares of companies that it decides to disinvest.
Till then Chidambaram can at best continue to pray to Lakshmi, the goddess of wealth and hope that it blesses the government.
The article originally appeared on www.firstpost.com on November 14, 2012.
(Vivek Kaul is a writer. He can be reached at [email protected])
Will Vadragate turn out to be Sonia’s Bofors?
Vivek Kaul
“Roti tawa par, janta party hawa main” was one of the slogans going around in the Lok Sabha elections that happened after the assassination of Indira Gandhi. Riding on the honest image of Rajiv Gandhi (Indira’s son and a former Indian Airlines pilot) and a sympathy wave due to the assassination of Indira Gandhi by her bodyguards, the Congress party won more than 400 seats in the lower house of Indian parliament.
This was an unprecedented majority for the Congress party, something it had not managed to achieve even under the leadership of Jawahar Lal Nehru, Rajiv’s grandfather and India’s first Prime Minister. Neither had it managed such a huge mandate from the people of India under the leadership of Indira Gandhi.
But Rajiv would soon squander away these gains. As Aarthi Ramachandran writes in Decoding Rahul Gandhi “The Rajiv Gandhi government was bogged down by allegations of kickbacks to the tune of Rs 64 crore paid to middlemen in the purchase of Swedish Bofors guns. The government’s ‘stonewalling’ of demands to bring guilty to book in the Bofors case and other corruption scandals destroyed Rajiv’s image as Mr Clean. Ramchandra Guha in India After Gandhi says the ‘stonewalling prompted speculation that the middlemen were somehow linked to the prime minister himself’.”
The impact of this on the Congress party was huge. It lost the 1989 election to an alliance of Janata Dal and the Bhartiya Janta Party (BJP). Rajiv Gandhi had to become the leader of the opposition. A party which had more than three fourths of the seats in the Lok Sabha was thrown out of power.
It is often said that ‘perception is reality’. Rajiv Gandhi losing the 1989 Lok Sabha election because people ‘thought’ he was involved in the Bofors scandal and may have received a part of the kickbacks. And this perception was formed after his government stonewalled all attempts of bringing the guilty to book.
A similar situation seems to be now brewing up in the Robert Vadra-DLF case. A string of lawyer ministers from the Congress have jumped into the ring in order to defend Robert Vadra and would like the world at large to believe that there is no truth in accusations being hurled at Vadra (and indirectly Sonia Gandhi) by Arvind Kejriwal and his associates.
Let us sample some of the statements that have been made by these lawyer ministers. Kapil Sibal, one the country’s top practicing lawyers before he became a full time politician and currently the Minister of Human Resource Development and Minister of Communications and Information Technology recently came to the defence of Vadra. “Allegations are happening 24×7. It is a daily phenomena just like 24×7 television news channels,” he said.
On television Vadra has been defended by Jayanthi Natrajan who other than being the Union Minister for Environment and Forests also happens to be a lawyer having got her law degree from the Madras Law College. Vadra has also been defended by Manish Tewari, a Congress spokesperson, and a lawyer. Tewari felt that prima facie the charges made by Kejriwal and company were found to be ‘untruth, innuendos and lies’.
HR Bhardwaj, currently the governor of Karnataka, and a former law minister also came to the indirect defence of Robert Vadra. “Many allegations were levelled against the Gandhi family even in the past. Indira Gandhi was also attacked. But she had a towering personality and fought back. Morarji Bhai (late Prime Minister Morarji Desai) made so many cases against her but they fell like nine pins,” he told reporters,” he recently told the media. And I thought governors were meant to be above politics and political parties.
Rashid Alvi, one of the spokespersons of the Congress Party on one occasion brushed aside the accusations hurdled at Vadra by Arvind Kejriwal and company as a “part of a well-planned conspiracy not against an individual but against the Congress and its leadership.”
On another occasion on live television he dubbed Kejriwal’s accusation as a publicity stunt and questioned the veracity of the documents put out by Kejriwal by saying “who will decide that the documents shown by Kejriwal are genuine or fake.”The website of the Parliament of India lists his profession as an advocate in the Supreme Court.
P Chidambaram, the Union Finance Minister who also happens to be a lawyer said “All I can say is at this moment these allegations pertain to transactions between two private persons or entities…. The individual (Vadra, son-in-law of Sonia Gandhi) has disclosed all these transactions in his income tax and other returns, and perhaps in the returns of the company.”
Veerapa Moily, another Lawyer and who is the Union Minister for Corporate Affairs as well as Power, jumped to Vadra’s defence by saying “ I have already verified these allegations and no wrongdoings have been found in any of the six Robert Vadra-owned companies.”
What is surprising is that so many Congress lawyers have jumped to the defence of a “supposedly” private individual, Robert Vadra, and ruled out any wrong doing on the part of Sonia Gandhi’s son in law. The only thing that this ‘stonewalling’ has done is that it has built the perception among people that something must be wrong otherwise why are so many lawyer ministers and Congressmen jumping to Vadra’s defence.
In some cases the defence has looked very shaky. Let’s look at Alvi’s insinuation that the documents might be fake. And this comes from a man whose profession is listed as a Supreme Court lawyer. It is very easy to download balance sheets of even unlisted companies these days. This writer spent the whole of last week doing that by logging on to www.mca.gov.in and paying a Rs 50 charge for every Vadra company for which details were needed. So all one needs to know is the name of the company and it’s possible to get the details of that company. And in Vadra’s case it was pretty well known that he operated through Sky Light Hospitality Private Ltd a company in which he owned 99.8%.
Also Alvi should remember that Kejriwal is being advised by Shanti and Prashant Bhushan, two of the best lawyers in the country. Shanti Bhushan was even the law minister of the country at a certain point of time. Other than this Kejriwal himself must understand a thing or two about balance sheets having been an Indian Revenue Service officer till a few years back. He is also an IIT Kharagpur passout from the pre coaching schools era and that definitely means he is smart. And more than anything else why would anyone who is raising a serious banner of revolt against the incumbent government choose to do so on “fake” documents?
P Chidambaram wanted us to believe that the dealings were between a private company and a private individual. If that is the case why are so many lawyer ministers coming to the defence of Vadra?
Veerapa Moily jumped to Vadra’s defence by saying that there was nothing wrong in any of Vadra’s six companies. If he had read through the memorandum of association of Vadra’s Sky Light Hospitality carefully enough he would have realised that the company claims that it will carry out business as hotels, restaurants, lodges, ice-cream merchants, sweet meat merchants, milk manufactures, bakers, wine and spirit merchants etc.
But instead of doing all that Sky Light Hospitality primarily seems to be in the business of real estate having accumulated a slew of properties on the basis of a so called Rs 50 crore advance it got from a plot of land from DLF. As has been repeatedly pointed out Firstpost and other places in the media the dealings between DLF and Vadra appear murky. (You can read about it completely here, here and here). Sky Light Hospitality owns a 50% stake in Saket Courtyard Hospitality Ltd through which it runs one hotel in Saket, New Delhi, in parternship with DLF.
Vadra’s Sky Light Hospitality bought 3.5acres of land sometime in 2008-2009 (period between April 1, 2008 and March 31, 2009) at Rs 15.38 crore. In the same period DLF bought this land from Vadra for Rs 58 crore. The question is how did the value of the land go up nearly 3.7 times in such a short period of time?
Against this sale DLF gave Vadra an advance of Rs 50 crore. An advance is typically given for the short term and needs to be returned within a year. But this advance was sitting on Vadra’s balance sheet even as on March 31, 2011. So the advance given by DLF to Vadra was with Vadra for a period of greater than two years. This doesn’t sound like an advance at all. It seems more like an interest free loan being passed off as an advance.
DLF also said in its 6 October statement that “we wish to categorically state that DLF has given no unsecured loans to Mr Vadra or any of his companies.” The balance-sheet (dated 31 March 2010) of Real Earth Estates Pvt Ltd, another company owned by Vadra, shows a clear entry of Rs 5 crore as a loan from DLF.
Vadra used all these loans from Vadra to go on a property buying spree. Estimates made now suggest that the value of this property now runs into hundreds of crores. He also benefitted from parking this largely interest free money in fixed deposits and earning an interest from them.
Congress Party’s over defence of Vadra has not helped it at all. It has built the perception among people that there must be some hanky panky involved in the entire business. That being the case no other response could have been expected from a party that doesn’t really stand for anything except the Nehru-Gandhi family. Kejriwal has hit the Congress party where it hurts the most.
As Ramachandran writes “the Nehru-Gandhi family remained relevant within the Congress. In fact, it became more powerful as it was only the centre around which the entire Congress edifice could hold together. It was now an amalgam of pressure groups which were interested in power, and their one-way ticket to it was through proximity to the Nehru-Gandhi family.”
And it’s in times like these Congress leaders have to go through their agni parkiskha and show their loyalty to the Nehru Gandhi family. That’s precisely what they are doing. Their reactions are a clear case of Catch 22. They are dammed if they try to come to the defence of Vadra and they are dammed if they don’t. However, in the process Vadragate may turn out to be Sonia Gandhi’s Bofors.
The article originally appeared on www.firstpost.com on October 16, 2012. http://www.firstpost.com/india/will-vadragate-turn-out-to-be-sonias-bofors-492019.html
(Vivek Kaul is a writer. He can be reached at [email protected])
Why Chiddu wants insurance agents to mis-sell
Vivek Kaul
There’s nothing more thrilling than nailing an insurance company – Deck Shifflet (played by Danny DeVito) in The Rainmaker
Around three years back I suddenly got a call from my bank. “I am your relationship manager Sir,” the female voice at the other end said. “Since when did journalists start to have relationship managers,” was the first thought that came to my mind. It turned out she wanted to help me plan my finances.
Fair enough. But why did the bank have a sudden interest to plan my finances? I had been banking with them for close to four years and they hadn’t shown any such interest earlier. I checked my bank account and realised that there was a fair amount of cash lying around in my savings bank account. A friend had just repaid some money back and a fixed maturity plan which I had invested in had matured.
So the reason behind the bank’s sudden interest in planning my finances became clear to me. I asked my new relationship manager to come and meet me immediately. I was curious to see what financial plan she had in mind.
What she did not know was that my area of specialisation as a journalist was personal finance. The relationship manage soon turned up and within ten minutes she offered me the solution to all my financial problems in life, which as expected, turned out to be a unit linked insurance plan (Ulip).
The bank she worked for also has an insurance company and this particular Ulip was from that insurance company. I just checked the brochure she had brought along and was not surprised to find that the premium allocation charge for this Ulip for the first year was a whopping 60%. What this meant was that if I were to pay a premium of Rs 1 lakh, only Rs 40,000 would be actually invested. The remaining Rs 60,000 would be deducted as an expense.
A major part of the Rs 60,000 deducted as expense would be given to the insurance agent (in my case the bank) as commission. And it would help my relationship manager meet her rather stiff targets.
I pointed this out to my relationship manager and she realised that the game was over. I wouldn’t fall for her sales pitch. Then we got talking about other things and realised that we grew up in the same town. Before leaving she apologised for trying to sell me such a plan. She also told me that in the pressure to meet her target last year she had sold the same policy to her brother.
He had taken a policy with a premium of Rs 1 lakh of which Rs 40,000 had been invested. The stock markets had taken a beating since then and the value of the investment had fallen to Rs 32,000. “He doesn’t talk to me properly anymore,” she said, as she left with a tinge of regret in her voice.
Those were the heady days of mis-selling in insurance when even sisters sold Ulips to brothers so that they could earn a high commission and meet their targets. Since then commissions have been reduced and as a result the mis-selling has come down.
But if the finance minister P Chidambaram has his way with things,mis-selling is all set to return in the days to come. But before I get to that let me just share some numbers that the Insurance Regulatory and Development Authority, the insurance regulator, has released in its September 2012 journal.
For the period April 1 to June 30, 2012, the insurance companies in India collected Rs 12015.5 crore as first year’s premium by selling around 67.9 lakh new policies. Given this the average premium per policy works out to around Rs 17,690 (Rs 12015.5 crore divided by 67.9 lakh).
The total sum assured (or what is in general terms referred to as a life cover i.e. essentially the money the nominee will get if the policyholder dies) on these policies was Rs 1,50.902.8 crore. So the average life cover per policy works out to around Rs 2.22 lakh (Rs 1,50,902.8crore divided by 67.9lakh).
Hence, for the first quarter of 2012, the average premium on a life insurance policy was Rs 17,690 and it had an average life cover of Rs 2.22 lakh. If a 35 year old were to just buy a pure life cover of Rs 2.22 lakh, the premium works out to around Rs 500-700 per year on a 25 year policy. Assuming that a pure life cover of Rs 2.22 lakh can be bought for a premium of Rs 700 per year that would mean a premium of Rs 17,000 is left over.
And this is the amount that is invested by insurance companies after deducting the commission paid. In the year 2010-2011(i.e. between April 1, 2010 and March 31, 2011), the average commission paid on the first year premium was 8.89%. This is the latest data that is available.
Assuming this to be rate of commission, the commission on a premium of Rs 17,690 works out to Rs 1573 (8.89% of Rs 17,690). Deducting this from Rs 17,000, around Rs 15,417 is left over. This is the amount that is invested depending upon the mandate chosen by the policyholder which could vary from 100% stocks to 100% debt.
So what this basically tells us is that Indian insurance companies do not sell life insurance, they sell high commission paying mutual funds. As my calculations show less than 4% (Rs 700 expressed as a % of Rs 17,690) of the total premium goes towards actual insurance. Around 9% is paid as commission and the remaining amount is invested depending on the mandate given by the policy holder.
The finance minister P Chidambaram now wants to encourage the sales of these high cost mutual funds masquerading as insurance policies. He is in the process of offering a series of sops to insurance companies so that they can sell more. Among the proposed sops are greater tax deductions on insurance premiums, banks being allowed to sell insurance policies of more than one insurance company etc.
This is being done so that insurance companies are able to sell more policies and in the process more money from the domestic investors is channelised into the stock market. Since the beginning of the year domestic institutional investors have sold stocks worth around Rs 38,475 crore. The government wants to turn this tide in order to ensure that the stock market continues to go up.
This is very important if the government hopes to divest its stake in a lot of public sector companies. The disinvestment target for the year is Rs 30,000 crore. But a lot more shares will have to be sold if the government wants to control the burgeoning fiscal deficit. (you can read a detailed argument on this here).
So the higher the stock market goes the more the number of shares that the government will be able to sell. And for that happen more and money from domestic investors needs to come into the stock market. And that will only happen if the insurance companies are able to sell more policies.
As anybody who does not make money selling insurance policies or is honest enough, will tell you that mutual funds remain a better investment option. So the question that crops up here is why does Chidambaram want to encourage only insurance companies to sell more and not mutual funds?
Mutual funds are much more transparent. There performance when it comes to generating returns is much better than insurance companies. They don’t pay 9% commissions to their agents. And it is very easy to figure out which are the best mutual funds going around in the market. I haven’t seen anybody who makes a living out of selling insurance talk about returns generated by insurance policies till date.
There are a couple of reasons for Chidambaram encouraging insurance companies and not mutual funds. One is that commission offered by mutual funds is very low compared to the commission offered by insurance companies. Hence, agents of all kinds prefer to sell insurance rather than mutual funds. Chidambaram needs a lot of money to enter the stock market and he needs it to come quickly. That being the case, it’s easier for insurance companies to do this than mutual funds.
The second and more important reason is the fact that Life Insurance Corporation(LIC) of India which is India’s biggest insurance company, is government run. Between April and July of this financial year LIC collected 76.5% of the total first year’s premium. So three fourths of insurance in India is basically LIC.
The money collected by LIC can be directed by the government into specific stocks. If the stock market does not how enough interest in shares of a company being divested by the government, LIC can be instructed to pick up those shares.
If Chidambaram had encouraged mutual funds instead of insurance companies he wouldn’t have had this flexibility. So once these measures to help insurance companies are pushed through, insurance companies and agents will be back to doing what they do best i.e. mis-sell. Don’t be surprised if in the days to come you run into insurance agents promising you the moon, from your investment doubling in three years to you having to pay premiums only for five years.
And in this case this renewed attempt at mis-selling will be a result of the Finance Minister P Chidambaram encouraging insurance at the cost of mutual funds. The more insurance agents mis-sell, the greater will be the money invested in the stock market which will lead to the stock markets rallying and thus help the government sell more shares than it had originally planned.
The article originally appeared on www.firstpost.com on October 5, 2012. http://www.firstpost.com/economy/why-chiddu-wants-insurance-agents-to-mis-sell-480473.html
(Vivek Kaul is a writer. He can be reached at [email protected])