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

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

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

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

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

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

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

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

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

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

As the Survey points out:

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Ratings shopping: Lessons from the Amtek Auto default

rupee
Amtek Auto was supposed to repay Rs 800 crore of its debt by Sunday (Sep 20, 2015). It has not been able to do so. Media reports suggest that the company has a total debt of Rs 18,000 crore, whereas the Amtek group has a debt of Rs 26,000 crore.

The interesting bit is that this debt that Amtek Auto has defaulted on will not be declared to be a bad loan immediately. As I have often written in the past in The Daily Reckoning, banks do not like to recognise bad loans immediately.

More often than not they kick the can down the road by restructuring the loan. When a loan is restructured a borrower is either allowed to repay the loan at a lower rate of interest or over a longer period of time or possibly both.

Deepak Shenoy makes this point on Capitalmind.in: “For a bank holding the bonds[on which Amtek Auto has defaulted on] this account is technically not an NPA [non-performing asset or a bad loan] until 90 days is over. So they can extend and pretend and hope that Amtek manages to salvage itself. Since the banking system has exposure to more than Rs 7,000 crore of loans to Amtek, you can bet your next salary that they will restructure the loan in some way and manage to not call it an NPA at all.”

And that is not the only disturbing bit. Amtek Auto is also a very clear case of rating agencies having been caught napping on their job. The agencies should have seen this default coming. But that did not turn out to be the case.

Care Ratings suspended the rating of the company on August 7, 2015. Before suspending the company Care had rated Amtek Auto at AA−. Care defines an AA rating as: “Instruments with this rating are considered to have high degree of safety regarding timely servicing of financial obligations. Such instruments carry very low credit risk.”  Over and above the rating, Care also uses plus or minus for a certain level of ratings. These signs “reflect the comparative standing within the category.”

From a rating of AA−, Care stopped rating Amtek Auto. Another rating agency Brickwork Ratings downgraded the debt of the company from a level of A+ to C−. This was a downgrade of 12 levels in a single shot.

Brickwork defines an A rating as: “Instruments with this rating are considered to have adequate degree of safety regarding timely servicing of financial obligations. Such instruments carry low credit risk.” It defines a C rating as: “Instruments with this rating are considered to have very high risk of default regarding timely servicing of financial obligations.”

It is worth asking here that how did a company go from being categorised as having an “adequate degree of safety” to a “very high risk of default,” all at once. The only possible explanation here is that the rating agency was caught napping or just chose to look the other way.

In fact, Amtek Auto is not an isolated case. There have been other such instances as well. As a recent news-report in the Mint newspaper points out: “In the past one year, there have been other instances where ratings have been cut sharply by three notches or more in one revision. In July, CARE Ratings downgraded Jaiprakash Associates Ltd by six notches from a rating of BB to D-, a rating that reflects a default in the debt security. Non-convertible debentures of Bhushan Steel Ltd also saw their rating drop by six notches following a revision by CARE Ratings in December 2014. Punj Lloyd Ltd faced a similar drop in ratings in July.”

Monet Ispat and Energy Ltd, Bhushan Power and Steel Ltd, Shree Renuka Sugars and 20 Microns Ltd, are examples of other companies that the Mint news-report points out.

There is a basic problem with the way rating agencies operate. The company which they are rating is the one which pays them as well. In this scenario one rating agency can be played against another, and a company can indulge in ratings shopping.

In fact, ratings shopping was a major reason behind the financial crisis. Banks and other financial institutions looking to rate their sub­prime bonds and other mortgage backed securities played off one rating agency against the other. If they did not get the AAA rating (which is the best rating on a financial security), they threatened to take their business elsewhere.

There was a huge ratings inflation that happened as well. As George Akerlof and Robert Shiller write in their new book Phishing for Phools—The Economics of Manipulation and Deception: “One ratings agency alone, Moody’s, gave 45,000 mortgage-related securities a triple-A rating(for the period 2000 to 2007); that generosity for the mortgage-backed securities contrasts with only six US companies that were similarly rated AAA(in 2010).”

This possibly explains that the rating agencies were giving high ratings to subprime and mortgaged backed securities in order to continue to get business from investment bank issuing subprime bonds and other mortgage backed securities.

As Akerlof and Shiller point out: “The originator of the packages [i.e. subprime bonds and the mortgage backed securities], typically an investment bank, was rewarded by high ratings on its offerings. And the ratings agency, in turn, would be shunned if it did not give the investment bank what it wanted. It was in the interest of neither the investment banks nor the ratings agencies to go back and do that extremely difficult—and perhaps impossible—task of opening up the packages and carefully examining their innards [the emphasis is mine].”

This is precisely what has happened in the Indian context as well. In their zeal to get business, the rating agencies awarded these companies higher ratings than what they deserved in the first place. If they hadn’t done that the companies would have taken their business elsewhere. Pretty soon shit hit the ceiling and they had to cut ratings by several notches all at once.

To conclude, it is worth repeating here, something that a managing director of Moody’s told his employees: “Why didn’t we envision that credit would tighten after being loose, and housing prices would fall after rising, after all most economic events are cyclical and bubbles inevitably burst. Combined, these errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue, or a little bit of both [the emphasis is mine].”

The Indian rating agencies did something similar as well.

The  column originally appeared on The Daily Reckoning on Sep 24, 2015

Can Modi govt afford to run a higher fiscal deficit?

narendra_modiIn his maiden budget speech finance minister Arun Jaitley had talked about the government working towards lower fiscal deficits in the years to come. “ 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,” Jaitley had said in July 2014, when he presented the first annual budget of the Narendra Modi government. Fiscal deficit is the difference between what a government earns and what it spends.
A lot has changed since then. The mainstream view that now seems to be emerging is that the government needs to spend more in the days to come, given that the private sector is not spending as much as it should.
One of the first to advocate this view was Arvind Subramanian, the Chief Economic Adviser to the ministry of finance. In the Mid Year Economic Analysis Subramanian wrote: “Over-indebtedness in the corporate sector with median debt-equity ratios at 70 percent is amongst the highest in the world. The ripples from the corporate sector have extended to the banking sector where restructured assets are estimated at about 11-12 percent of total assets. Displaying risk aversion, the banking sector is increasingly unable and unwilling to lend to the real sector.”
This has led to a situation where banks aren’t interested in lending and corporates aren’t interesting in investing. In order to get around this problem Subramanian suggested that: “it seems imperative to consider the case for reviving public investment as one of the key engines of growth going forward, not to replace private investment but to revive and complement it.”
On the face of it, this make perfect sense. It is being suggested that finance minister Jaitley should give up on the fiscal deficit target of 3.6% of the GDP for 2015-2016 and look to work with a higher fiscal deficit number. The logic offered is straightforward. The public liabilities of the central government(which includes the public debt and other liabilities like external debt reported at current exchange rates and liabilities of the national small savings fund) have been falling over the years.
The public liability in 2008-2009 stood at 48.9% of the GDP. Since then the number has fallen to 45.7% of the GDP in 2014-2015 (estimated). The biggest fall has come under other liabilities which include national small savings fund and the state provident funds. These liabilities have fallen from 9.7% of the GDP to 5.8% of the GDP. The public debt has risen marginally from 39.1% of the GDP in 2008-2009 of the GDP to 39.9% of the GDP in 2014-2015.
On the face of it, the public debt and liability numbers of the central government are in a comfortable range. All in all the simple point is that the government can spend more, run a higher fiscal deficit and look to finance that through higher borrowing.
But these numbers do not take into account the public liabilities and debt of the state governments. How do there numbers look? Article 293(1) of the Indian Constitution empowers the state governments to borrow domestically. The public liabilities of the state governments stood at 26.1% of the GDP in 2008-2009. This has since fallen to 21.4% in 2013-2014. The public debt of the state governments has also fallen from 19.1% of the GDP to 16.1% of the GDP.
The number that one needs to look at is the general government liabilities and not just the central government liabilities. As the latest
Government Debt Status Paper points out: “General government [liabilities] represents the indebtedness of the Government sector (Central and State Governments). This is arrived at by consolidating the debt of the Central Government and the State governments, netting out intergovernmental transactions viz., (i) investment in Treasury Bills by States which represent lending by states to the Centre; and (ii) Centre’s loans to States.”
As can be seen from the accompanying table the general government liabilities were at 70.6% of the GDP in 2008-2009 and have fallen to 65.3% of the GDP in 2013-2014. This fall has primarily come about due to a fall in liabilities of the state governments.


So does this mean that the government can borrow and spend more and in the process run a higher fiscal deficit? The answer is not so straightforward. The latest government debt status paper provides several reasons in favour of India’s debt being sustainable. As it points out: “Government debt portfolio is characterized by favourable sustainability indicators and right profile. Share of short-term debt is within safe limits, although it has risen in recent years. Most of the debt is at fixed interest rates which minimizes volatility on the budget.”
Over and above this most of government debt is domestic in nature and hence, there is no currency risk. “Conventional indicators of debt sustainability, level and cost of debt, indicate that debt profile of government is within sustainable limits, and consistently improving,” the status paper points out.
But does this mean that the government can borrow and spend more without attracting the ire of the international rating agencies which have been following India’s fiscal deficit levels rather closely over the last few years? The thing is that India’s public liabilities and debt cannot be looked at in isolation.
We live in a highly globalized world where economic numbers are constantly being compared. As economist Sajjad Chinoy wrote
in a recent column in the Business Standard: “India’s consolidated fiscal deficit is currently close to 6.5 per cent of GDP, while countries with the same sovereign rating as us have a median and mean deficit of 2.5 per cent of GDP – 400 bps lower! The inflation tax has been chipping away at India’s debt/GDP ratio, but at 65 per cent – it is substantially higher than the 40 per cent debt/GDP ratio of the median country amongst our sovereign ratings peers.”
This is a very important point which most mainstream views on the subject seem to be ignoring. Jaitley in his maiden budget speech had promised a path of fiscal consolidation. If he chooses to abandon it midway this is not likely to go down well with foreign investors as well rating agencies.
Further, it is worth remembering that the Federal Reserve of the United States plans to start raising interest rates sometime this year. This means that a lot of easy money that has come into India and other emerging markets might leave the country.
The last time this happened in May 2013 was when Ben Bernanke, the then Chairman of the Federal Reserve merely hinted at interest rates going up in the future. Back then, a lot of easy money left India (particularly the debt market) and the rupee fell to 69 to a dollar in the process. I am sure the finance minister does not want anything of that sort to happen all over again.
Given this, he should be very careful about how he goes about financing any big public investment programme. In tomorrow’s column I will discuss how Jaitley can look to finance a public investment programme.

The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 28, 2015