What’s the Logic Behind Govt’s मांडवली (compromise) on Interest on Interest with Supreme Court?

Three institutions, the Reserve Bank of India (RBI), the Supreme Court and the Department of Financial Services, have spent more than a few weeks in deciding on waiving off the interest on interest on all retail loans and MSME loans of up to Rs 2 crore.

Resources at three systematically important institutions have been used to arrive at something which is basically largely useless for the economy as a whole, is bad for banks and sets a bad precedent which can lead to a major headache for both the government as well as the Supreme Court, in the time to come.

This is India’s Big Government at work, spending precious time on things which it really shouldn’t be. Let’s take a look at this issue pointwise.

1) By waiving off interest on interest on all retail loans and MSME loans of up to Rs 2 crore, for a period of six months between March and August 2020 when many loans were under a moratorium, the government is essentially fiddling around with the contract that banks entered with borrowers. A government interfering with contracts is never a good idea. If at all, negotiations for any waiver should have happened directly between banks and their borrowers, under the overall supervision of the RBI.

2) Some media houses have equated this waiver with a Diwali gift and an additional stimulus to the economy etc. This is rubbish of the highest order. The government estimates that this waiver of interest on interest applicable on loans given by banks as well as non-banking finance companies (NBFCs) is going to cost it Rs 6,500 crore. Other estimates made by financial institutions are higher than this. The rating agency Crisil estimates that this waiver is going to cost Rs 7,500 crore. Another estimate made by Kotak Institutional Equities put the cost of this waiver at Rs 8,500 crore.

Whatever be the cost, it is worth remembering here that the money that will go towards the waiver, is money that the government could have spent somewhere else. In that sense, unless the government increases its overall expenditure because of this waiver, it cannot be considered as a stimulus. Even if it does increase its overall expenditure, it will have to look at earning this money through some other route. The chances are, we will end up paying for it in the form of some higher tax (most likely a higher excise duty on petrol and diesel).

3) Also, the question that is bothering me the most on this issue, is a question that no one seems to be asking. Who is this move going to benefit? Let’s take an extreme example here to understand this. Let’s say an individual took a home loan of Rs 2 crore to be repaid over 20 years at an interest rate of 8%. He or she took a loan in early March and immediately put it up for moratorium once it was offered.

The moratorium lasted six months. The simple interest on the loan of Rs 2 crore for a period of six months amounts to Rs 8 lakh (8% of Rs 2 crore divided by 2).

This is not how banks operate. They calculate interest on a monthly basis. At 8% per year, the monthly interest works out to 0.67% (8% divided by 12). The interest for the first month works out to Rs 1.33 lakh (0.67% of Rs 2 crore).

Since the loan is under a moratorium and is not being repaid, this interest is added to the loan amount outstanding of Rs 2 crore.

Hence, the loan amount outstanding at the end of the first month is Rs 2.013 crore (Rs 2 crore + Rs 1.33 lakh). In the second month, the interest is calculated on this amount and it works out to Rs 1.34 lakh (0.67% of Rs 2.013 crore).

In this case, we calculate interest on the original outstanding amount of Rs 2 crore. We also calculate the interest on Rs 1.33 lakh, the interest outstanding at the point of the first month, which has become a part of the loan outstanding. This is interest on interest.

At the end of the second month, the loan amount outstanding is Rs 2.027 crore (Rs 2.013 crore + Rs 1.34 lakh). This is how things continue month on month, with interest being charged on interest.

At the end of six months, we end up with a loan outstanding of Rs 2.081 crore. This is Rs 8.134 lakh more than the initial loan outstanding of Rs 2 crore. As mentioned initially, the simple interest on Rs 2 crore at 8% for a period of six months works out to Rs 8 lakh.

Hence, the interest on interest works out to Rs 13,452 (Rs 8.134 lakh minus Rs 8 lakh).

Why did I consider this extreme example? I did so in order to show the futility of what is on. An individual who has taken a home loan of Rs 2 crore is not in a position to pay a total interest on interest of Rs 13,452, is a question well worth asking? Who are we trying to fool here? Given that the moratorium was for a period of six months, the average interest on interest works out to Rs 2,242 per month.

Even at a higher interest rate of 12% (let’s say for MSMEs), the average interest on interest works out to a little over Rs 2,500 per month. Are MSMEs not in a position to pay even this?

So, who are we doing this for? No one seems to have bothered asking and answering this most important question.

4) I guess it’s not fair to blame the government, at least for this mess. The petitioners wanted interest on loans for the period during the moratorium waived off. The Judges entertained them and the government had to find a way out so that the Judges could feel that they had done something at the end of the day and not feel embarrassed about the entire situation.

Crisil estimates that an interest rate waiver of retail and MSME loans of up to Rs 2 crore (including interest on interest) would have cost the government a whopping Rs 1,50,000 crore. Both the government and the RBI wanted to avoid this situation and ended up doing what in Mumbai is called a मांडवली or a compromise. Hence, clearly things could have been worse. Thankfully, they aren’t.

5) The case has dragged on for too long. Currently, banks are not allowed to mark any account which was a standard account as of August 31, as a default. The longer the case goes on, the longer it will take the banking system to recognise the gravity of the bad loans problem post-covid. Bad loans are loans which haven’t been repaid for a period of 90 days or more.

Also, this isn’t good news for banks which had provisioned (or set money aside) to quickly deal with the losses they would face due to the post-covid defaults.

Even at the best possible rate, the gravity of the problem facing banks will come out in the public domain only by the middle of next year now. And that’s just too long. Instead of the government, this time around, the Supreme Court has helped kick the bad loans can down the road.

Ideally, banks should have started recognising post-covid bad loans by now and also, started to plan what to do about it.

6) The banks will have to first pass on the waiver to the borrowers and will then get compensated by the government. As anyone who has ever dealt with the government when it comes to payments will assure you, it can be a real pain. Thankfully, the amount involved on the whole is not very large and the banks should be able to handle any delay on part of the government.

7) This is a point I have made before, but given the seriousness of the issue, it needs to be repeated. Interest is nothing but the price of money. By meddling with the price of money, the Supreme Court has opened a Pandora’s box for itself and the government. There is nothing that stops others from approaching the Courts now and asking for prices of other things, everything from real estate to medicines, to be reduced. Where will it stop?

To conclude, India’s Big Government only keeps getting bigger in its ambition to do much more than it can possibly do. The interest on interest issue is another excellent example of this.

Risk Hai Toh Ishq Hai: 20 Things You Can Learn About 1990s By Watching Scam 1992

Over the last weekend I saw Scam 1992—The Harshad Mehta Story. The OTT series is based on a book titled The Scam—From Harshad Mehta to Ketan Parekh written by Debashis Basu and Sucheta Dalal.

The 10-episode series is set around the Harshad Mehta scam where Mehta used banking funds illegally to drive up stock prices. Dalal, a journalist with The Times of India broke the story about Mehta’s shenanigans.

Basu who used to work for Business Today magazine at that point of time (not mentioned in the series) is shown to be helping her all along. The story is told from the point of view both Mehta’s and Dalal’s characters.

I enjoyed watching the series immensely and even tweeted saying that the brief Indian OTT era now needs to be divided into before and after Scam 1992.

Watching the series has also inspired me to write this fun piece where I highlight stuff which was very different in the 1990s vis a vis how things are now.

There might be some spoilers here as well (though very few). So, if you haven’t watched the series and plan to watch it, it’s best you stop reading this piece now. You have been warned 

Let’s take a look at this pointwise.

1) The word scam itself wasn’t very popular with the Indian media until Dalal broke the Harshad Mehta scam and weaved the word into the story she wrote for The Times of India (as shown in the series). The phrase used before this was the rather dull financial fraud.

2) A major part of the series is set in 1992, which was a pre-mobile phone era. Hence, all the action happens through landline phones (thankfully pushbutton landline phones had made an appearance by then and so had big cordless phones).

3) It was also the pre-internet era. You had to remember facts or have access to libraries or research departments. This also meant that if you had to verify a company’s address you had to go there physically and do it and couldn’t simply log onto the internet and do so.

4) Cable TV had just started making an appearance in late 1991. Hence, the government owned Doordarshan was the dominant TV channel. It was also the major source of news, which wasn’t a 24/7 business at that point of time. The newspapers came in the morning. All India Radio had news bulletins at fixed points of time during the day. Doordarshan had news in the evenings (and later even in the mornings).

5) You could just walk into the Bombay Stock Exchange, unlike now where you have to go through multiple levels of security and tell the security guys exactly who you are going to meet. So, for journalists to meet sources was easy. Also, unlike today, the sources could be more easily protected simply because there were no electronic /digital footprints being left anywhere.

6) The Bombay Stock Exchange had a trading ring where jobbers representing stockbrokers made the market by actually buying and selling stocks. This matching of the seller and the buyer happens electronically now. The circular trading ring still exists and is used as a hall for hire for events. The events of BSE as the Bombay Stock Exchange is now known as, also happen in what used to be the trading ring.

7) Unlike now, if you wanted to buy or sell a stock you had to call up your broker and ask him to buy or sell on your behalf. You couldn’t just simply login into your demat account and buy or sell whatever you wanted to.

8) India had 23 stock exchanges at that point of time. Bombay and Kolkata were the most important exchanges. Even Patna had one.

9) The drink offered to everyone visiting the Bombay Stock Exchange was masala tea and not machine coffee, as it is now.

10) The Securities and Exchange Board of India (Sebi), the stock market regulator, did exist, but it did not have statutory powers. Hence, even if they knew that financial shenanigans were happening, they weren’t in a position to do anything. That only happened once the Sebi Act came into being in April 1992.

11) The media newsrooms did not have many computers. The stories were still typed on a typewriter, which meant that one had to have the entire story written in one’s mind before one started typing it out on a typewriter. The way a story can be rewritten now on a computer was rather difficult at that point of time.

12) You could smoke inside a media office. (How journalists would love this).

13) You could smoke on an airplane.

14) You could smoke in restaurants and cafes.

15) The RBI Governor leaked news to the media directly.

16) Even short sellers were popular investors at that point of time. The short-seller Manu Manek was called the Black Cobra of the stock market. (In my two decades of following the stock market, I am yet to come across a short seller the market loves). Interestingly, the stock market’s current darling was also a short seller at that point of time. Short selling involves borrowing and selling stocks in the hope that the price will fall and the stock can then be bought later at a lower price, returned to whom it had been borrowed from, and a profit can be made in the process.

17) The BSE was controlled totally by the brokers in the 1990s. It could even open at midnight to change prices at which trades had happened to help certain brokers.

18) The cars on the road were primarily Premier Padmini, Ambassador and the Maruti. India hadn’t seen an explosion in a choice in car models.

19) Levis Jeans hadn’t made an appearance in India until then, though Debashis’s character is shown wearing them in the series. It was launched in India in 1995.

20) There is a scene in the second episode of the Scam 1992, in which a newsreader is seen saying that this year’s budget has a deficit of Rs 3,650 crore for which no arrangements have been made (or as the newsreader in the series said, jiske liye koi vyawastha nahi ki gayi hai). The reference was to the financial year 1986-87.

Given that the makers of the series have stuck to details of that era as closely as possible, I was left wondering if the Rs 3,650 crore number was correct or made up. I went looking for the budget speech of 1986-87 made by the then finance minister Vishwanath Pratap Singh, and found it.

This is what Singh said on page 32 (and point 168) of the speech: “The proposed tax measures, taken together with reliefs, are estimated to yield net additional revenue of Rs 445 crores to the Centre. This will leave an uncovered deficit of Rs 3650 crores. In relation to the size of our economy and the stock of money, [the deficit is reasonable and non-inflationary.”

The number used in the series is absolutely correct. Hence, the makers of the Scam 1992, have gone into this level of detailing.

But the point here being that back then, the government monetised the fiscal deficit. It simply asked the Reserve Bank of India (RBI) to print money and hand it over to the government to spend. This was stopped in 1997.

To conclude, the key dialogue in the series, which keeps getting made over and over again is, risk hai to ishq hai. The inference being only if you take high risk in the stock market do you earn a high return. The trouble, as was the case in 1992 and as is now, just because you take high risk in the stock market (or anywhere else in life) doesn’t mean you will end up with a high return. Investors who hero worshipped Mehta in the 1990s learnt that the hard way.

Investors still continue to learn this basic principle of the stock market, the hard way.

Not everything has changed.

Why Govt of India Isn’t Acting Like a Spender of the Last Resort

It’s 2019, and you are out watching an international cricket match.

You didn’t book tickets quickly enough and are sitting in one of the upper stands, pretty far away from where the action is.

Instead of sitting and watching the match, you stand up to get a better view. Of course, by doing this, you end up blocking the person behind you. He also has to get up to get a better view of the cricket.

When he does this, he ends up blocking the view of the person behind him. And so, it goes. Pretty soon, everyone in the rows behind you has also stood up to get a better view.

Economists have a term for a situation like this. They call it the fallacy of composition or the assumption that what’s good for a part (that’s you in this case) is good for the whole (the people sitting behind you) as well.

As economist Thomas Sowell writes in Basic Economics-A Common Sense Guide to the Economy: “In a sports stadium, any given individual can see the game better by standing up but if everybody stands up, everybody will not see better.”

So, why are we talking about cricket and sports here? What’s true about watching sports in a stadium is also true for the economy as a whole.

John Maynard Keynes, the most famous and influential economist of the twentieth century (and perhaps even the twenty first), came up with a concept called the paradox of thrift, where thrift refers to the entire idea of using money carefully.

Keynes studied the Great Depression of 1929. He concluded that during tough economic times, when the going is difficult, people become careful with spending money and try and save more of it. While this makes perfect sense at the individual level, it doesn’t make much sense at the societal level because ultimately one man’s spending is another man’s income.

If a substantial portion of the society starts saving, the paradox of thrift strikes, incomes fall, jobs are lost, businesses shutdown and the governments face a pressure on the tax front. The government also faces the pressure to do something about the prevailing economic situation.

This is precisely the situation playing out in India currently. The paradox of thrift is at work. Bank deposits between March 27 and September 25, the latest data that is available, have gone up by 5.1% or Rs 6.9 lakh crore to Rs 142.6 lakh crore. This is twice more than the increase that happened during the same period last year.

As far as loans are concerned, outstanding loans of banks have shrunk during this financial year. On the whole they haven’t given a single rupee of a new loan  (loans are again meant to be spent).

Keynes had suggested that during tough economic times, when the private sector, both individuals and corporations are not spending much money, the government needs to step in and act as the spender of the last resort. In fact, Keynes rhetorically even suggested that if nothing, the government should get workers to dig holes and fill them up, and pay them for it.

When the workers spend this money, it would start reviving the economy. Economists refer to the situation of the government spending money in order to get economic growth going again as a fiscal expansion or a fiscal stimulus.

Since the start of this financial year, everyone who is remotely connected to economics in India in anyway, be it journalists, economists, analysts, corporates, fund managers and even politicians, have been demanding a bigger fiscal stimulus from the government to get economic growth going again.

The government has responded in fits and starts. Last week the central government came up with a few more steps including the LTC cash voucher scheme, special festival advance scheme, loans to states for capital expenditure and an additional capital expenditure of Rs 25,000 crore.

The fact that one week later one’s not hearing much about these moves, tells us they have already fizzled out. They didn’t have much legs to stand on in the first place. Let’s look at these moves pointwise before we get into greater fiscal stimulus as a strategy, in detail.

1) The government announced last week that in lieu of leave travel concession (LTC) and leave encashment, the central government employees can opt for a cash payment. This money has to be used to take make purchases.

LTC is a part of the salaries of central government employees. Instead of traveling in these difficult times in order to avail the LTC, the employees can opt for a cash payment. But this cash payment comes with certain terms and conditions.

Employees who opt for an encashment need to buy goods/services which are worth thrice the fare and one time the leave encashment. Only the actual fare of travelling can be claimed as a tax exemption. Tax has to be paid on the money spent on other expenses during travelling, like hotel and restaurant bills.

This money will have to be spent on buying stuff which attract a minimum 12% goods and services tax (GST), by paying through the digital route to a GST-registered vendor. It is expected that the scheme will cost the government Rs 5,675 crore. Over and above this, it will cost the public sector banks and public sector units another Rs 1,900 crore. This works out to a total of Rs 7,575 crore.

The question is will people opt for this scheme or not, given that they need to spend money out of their own pocket (i.e. their savings) in order to get a tax deduction. It needs to be mentioned here that the increase in dearness allowance of central government employees has been postponed until July 1, 2021. This will act against the idea of spending. Also, there is paperwork involved here (always a bad idea if you want people to spend money).

2) Over and above this, all central government employees can get an interest-free advance of Rs 10,000, in the form of a prepaid RuPay Card, to be spent by March 31, 2021. This is expected to cost the central government Rs 4,000 crore. It’s not clear from the reading of the press release accompanying this announcement, whether it’s compulsory for central government employees to take this card, given that this money will have to ultimately be repaid.

Also, this is not fiscal expansion in the strictest sense of the term given that LTC is already a part of the employee pay and has been budgeted for. As far as the Rs 10,000 being given as an advance is concerned, it is an interest free advance. The government will bear the interest cost on this, which will be an extremely small amount. The employees will have to repay the advance.

3) The central government is also ready to give state governments Rs 12,000 crore for capital expenditure. These loans will be interest free and need to be repaid over a period of 50 years. This money needs to be spent by March 31, 2021. A state government will be given an amount of 50% of what it is eligible for first. The second half will be given after the first half has been spent.

One can’t really question the logic behind this move. But the question that arises here is, are state governments in a position to spend this money in the next five and a half months?

4) Finally, the government has decided to spend an additional Rs 25,000 crore (over and above Rs 4.12 lakh crore allocated in the budget) on roads, defence, water supply, urban development and domestically produced capital equipment. Again, one can’t question the basic idea but one does need to ask here whether this is yet another attempt to manage the narrative.

The total capital expenditure that the government has budgeted for this financial year is Rs 4,12,009 crore. In the first five months of the financial year (April to August 2020), the government has managed to spend Rs 1,34,447 crore or around a third of what it has budgeted for. Last year, in the first five months, the government had spent around 40.6% of what it had budgeted for.

In this scenario, it is more than likely that the government will not get around to spending the extra Rs 25,000 crore. The government systems can only do a certain amount of work in a given period of time, their scale cannot be suddenly increased.

If one doesn’t nit-pick with the four above points, it needs to be said that the amounts involved are too small to even make a dent into the economic contraction expected this year. The economy is expected to contract by 10% this financial year. This means destruction of Rs 20 lakh crore of economic value, given that the nominal GDP in 2019-20, not adjusted for inflation, was Rs 203.4 lakh crore.

The government expects the moves announced last week to boost the expenditure in the economy by Rs 1 lakh crore. The mathematics of this Rs 1 lakh crore is similar to the mathematics of the Rs 20 lakh crore stimulus package (which actually added up to Rs 20.97 lakh crore) earlier in the year. As we saw earlier, the chances that the government ending up spending the Rs 4.12 lakh crore originally allocated for capital expenditure is difficult. Hence, how will it end up spending the newly allocated Rs 25,000 crore?

The government also expects the private sector spending to avail of the LTC tax benefit to be at least Rs 28,000 crore. What no one has talked about here is the fact that while there is an income tax benefit available, one also needs to pay a GST. Net net, there isn’t much benefit left after this. For someone in the marginal bracket of 20% income tax, after paying a GST of 18% to make these purchases, there isn’t much of a saving. Also, to spend three times the amount to avail of tax benefits, isn’t the smartest personal finance idea going around.

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In the recently released OTT series Scam 1992 – The Harshad Mehta Story, there is a scene in the second episode, in which a newsreader is seen saying that this year’s budget has a deficit of Rs 3,650 crore for which no arrangements have been made (or as the newsreader in the series said, jiske liye koi vyawastha nahi ki gayi hai).

Given that the makers of the series have stuck to details of that era as closely as possible, I was left wondering if the Rs 3,650 crore number was correct or made up. I went looking for the budget speech of 1986-87 made by the then finance minister Vishwanath Pratap Singh, and found it.

This is what Singh said on page 32 (and point 168) of the speech: “The proposed tax measures, taken together with reliefs, are estimated to yield net additional revenue of Rs 445 crores to the Centre. This will leave an uncovered deficit of Rs 3650 crores. In relation to the size of our economy and the stock of money, the deficit is reasonable and non-inflationary [emphasis added].”

The number used in the series is absolutely correct. Hence, the makers of the Scam 1992, have gone into this level of detailing.

Dear Reader, you must be wondering by now, why have I suddenly started talking about the budget speech of 1986-87. This random point in the OTT series made me realise something. At that point of time, the government could get the Reserve Bank of India to monetise away the fiscal deficit or the difference between what it earned and what it spent.

This meant that the RBI could simply print money and hand it over to the government to spend it. Of course, money printing could lead to a higher amount of money chasing a similar number of goods and services, and hence, higher inflation. This explains why Singh in his budget speech emphasises that the uncovered deficit of Rs 3,650 crore will be non-inflationary. Not that he knew this with any certainty, but there are somethings that need to be said as a politician and this was one of those things.

As a result of two agreements signed between the RBI and the government (in 1994 and 1997) and the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, the automatic monetisation of government deficit was stopped.

The government funds its deficit by selling bonds to raise debt. The FRBM Act prevented the RBI from subscribing to primary issuances of government bonds from April 1, 2006. In simple terms, this meant that it couldn’t print money and hand it over directly to the government by buying government bonds.

Now why I have gone into great detail in explaining this will soon become clear.

As I wrote at the beginning of this piece, many journalists, economists, analysts, corporates, fund managers and even politicians, have been demanding a greater fiscal stimulus from the government. In short, they have been wanting the government to spend more money than it currently does.

The International Monetary Fund  recently said that India needs a greater fiscal stimulus. Former Chief Statistician of India Pronab Sen has gone on record to say that India needs a fiscal stimulus of Rs 10 lakh crore. Business lobbies have demanded stimulus along similar levels.

The question is why is the government not going in for a bigger stimulus? The answer lies in the fact it simply doesn’t have the money to do so. The gross tax revenue of the government has fallen by 23.9% this year. Hence, it doesn’t even have enough money to finance the expenditure it has budgeted for. So, where is the question of spending more?

Of course, people who have been recommending a larger fiscal stimulus understand this. They simply want the RBI to print money and finance the government expenditure. Well, the RBI has been indirectly doing so. Take a look at the following table.

RBI –The Rupee Machine.

Source: Monetary Policy Report, October 2020.

What does the table tell us? It tells us that between early February and end September, the RBI has pumped in Rs 11.1 lakh crore into the financial system. How has it done so? Simply, by printing money in most cases. This does not apply to the cash reserve ratio cut, which meant banks having to maintain a lower amount of money with the RBI and hence, leading to an increase in the money available in the financial system to be lent out.

Here is the thing. The RBI prints money and buys bonds to introduce money into the financial system. Of course, it does not buy these bonds directly from the government. Nevertheless, even this indirect buying ends up financing  the government  fiscal deficit.

How? Let’s say the government sells bonds to finance its fiscal deficit. The financial institutions (banks, insurance companies, provident funds, mutual funds etc.) buy these bonds directly from the government (actually through primary dealers, but let’s keep this simple because the concept is more important here).

When they do this, they have handed over money to the government and have that much lesser money to lend. By printing money and pumping it into the financial system, the RBI ensures that the money that banks have available for lending doesn’t really go down or doesn’t go down as much, because of lending to the government.

Hence, in that sense, the RBI is actually indirectly financing the government. (It’s just buying older bonds and not newer ones).

The point being that despite the 1994 and 1997 agreements and the FRBM Act of 2003, the RBI is already financing the government fiscal deficit, albeit in an indirect way.

Of course, this financing is only enough to meet the current budgeted expenditure of the government. The thing is that the journalists, economists, analysts, corporates, fund managers and even politicians, want the government to spend more.

In fact, people in favour of a larger fiscal stimulus are okay with the RBI financing the government directly instead of this roundabout way. It seems that might be possible as well. As Viral Acharya, a former deputy governor of the RBI, writes in Quest for Restoring Financial Stability in India, published in July earlier this year:

“A recent amendment of the RBI Act allows the central bank to re-enter the primary market for government debt under certain conditions, annulling the reform of 2003 and recreating investor expectations of deficit monetization.”

Hence, the RBI can directly finance the government fiscal stimulus by printing money, buying government bonds and giving the government the money required to spend.

The question is why has the government not gone down this route? The fear of an even higher inflation seems to  be the answer. If there is one thing in economics that the current government is bothered about, it is inflation, in particular food inflation. The food inflation in September 2020 stood at 10.7%. During this financial year, it has been at a very high level of 9.8%.

The money supply in the economy (as measured by M3) has gone up at a pace greater than 12% since June, thanks to the RBI printing and pumping money into the financial system. For fiscal expansion more money will have to be printed and pumped into the financial system, hence, there is the risk of inflation rising even further.

A few experts have said that in a situation like this growth is more important than inflation. Some others have said that inflation is not a real danger currently.

A government focussed on narrative and perception 24 x 7 would not want to take the risk of inflation at any point of time, especially when food inflation is already close to 11% and there is grave danger of it seeping into overall retail inflation (as measured by the consumer price index).

There are other risks to printing money directly and the country’s public debt going up. Foreign investors can leave India. The rating agencies can cut the ratings. (You can read about it here). This stems from the fact that investors are not as comfortable holding investment assets in a currency like the Indian rupee vis a vis a currency like the American dollar or the British pound or the currency of any other developed country.

As L Randall Wray writes in Modern Monetary Theory: “There is little doubt that US dollar-denominated assets are highly desirable around the globe… To a lesser degree, the financial assets denominated in UK pounds, Japanese yen, European euros, and Canadian and Australian dollars are also highly desired.” This allows these countries to print money in a way that India cannot even dream of.

Also, if the government wanted to go the fiscal stimulus route, it should have done so at the very beginning. But instead it chose monetary expansion, with the RBI printing money and pumping it into the financial system, cutting the repo rate or the interest rate at which it lends to banks and getting banks to lend to certain sectors.

All this, in particular money printing by the RBI to drive down interest rates, has already led to the money supply going up. A larger fiscal stimulus will lead to the money supply going up even further increasing the possibility of a higher inflation.

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There is a new theory going around especially among the stock market wallahs who think they understand economics.

The foreign currency reserves with the RBI have gone up from $440 billion towards the end of March to around $509 billion as of October 9. What if a part of this can be converted into rupees and the money can be handed over to the government to spend, is the crux of the new theory going around.

Only someone who does not understand how these foreign currency reserves ended up with the RBI in the first place, would suggest something like this. The RBI buys foreign currency (particularly the American dollar) in order to intervene in the foreign exchange market.

Let’s say a lot of foreign money is coming into India. This increases the demand for the rupee and it leads to the appreciation of the rupee. The appreciation of the rupee makes imports more competitive, hurting domestic producers (not good for atmanirbharta). It also makes exports uncompetitive. In this scenario, the RBI intervenes. It sells rupees and buys dollars (Of course, these rupees have to be printed or rather created digitally these days).

The point being that the dollars end up on the balance sheet of the RBI, only after it has introduced rupees against them into the financial system. So, where is the question of printing and introducing more rupees against the same set of dollars?  (Which is why I keep saying that stock market wallahs should stick to earnings growth and not make a fool of themselves by coming up with such silly theories).

One way of raising money against these foreign exchange reserves is to borrow against them. But that would make India look very desperate and weak on the international as well as the domestic front. Do we really want to do that?

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Does all this mean that the government can’t do anything? Not really. I had written about lots of solutions a few weeks back.

One thing that the government needs to pursue seriously is an asset monetisation programme. This involves selling its stake in public sector units which are in a position to be sold. Even public sector units that cannot be sold have a lot of land lying idle.

This land needs to be monetised. This will take time. Nevertheless, the thing is that the Indian economy will need massive government support even in 2022-23. And if the government starts the monetising process now, it will be prepared in 2022-23 to help the economy.

10 Things You Need to Know About India’s High-Inflation

In September, inflation as measured by the consumer price index continued to remain in elevated territory at 7.34%. Inflation is the rate of price rise in comparison to the same period last year.

Let’s take a look at this relatively high inflation of 7.34%, pointwise.

1) Only twice in the last five years has the monthly inflation figure been higher than that in September 2020. This was in January 2020 and December 2019, at 7.59% and 7.35%, respectively. The December 2019 inflation figure was more or less similar to the September 2020 number.

2) Interestingly, eight out of the ten highest inflation months in the last five years have been in 2020. What this clearly tells us is that 2020 has been a year of high inflation. Alongside this consumer demand has collapsed and there is stagnation in the economy. Hence, 2020 has been the year of stagflation (stagnation + inflation) as well. While, this wasn’t clear at the beginning of 2020 when covid hadn’t made an appearance (and I had said so), it is very clear by now (and I am saying so).

3) In an environment where consumer demand has collapsed, prices should be falling and not going up. What’s the logic here? When consumer demand collapses, firms in order to get people to consume, cut prices. This leads to lower inflation or even deflation (in worst cases, when prices fall).

But that hasn’t happened in the Indian context. The question is why? The following chart plots food inflation (using data from the consumer price index) over the last five years and possibly has the answer.

High food inflation

Source: Centre for Monitoring Indian Economy.

 Food inflation in India has been rising since early 2019 and it has continued to remain high in the post-covid environment. The inflation of vegetables, pulses, oils and fats and egg, meat and fish, was in double digits in September. Vegetable prices led the way and rose at the rate of 20.73% during the course of the month, with potato prices rising 101.98%.

4) Food carries a weight of 39.06% in the overall consumer price index. In the rural part, it carries a weight of 47.25%. Hence, elevated food inflation pushes up overall inflation. Also, the thing to notice here is that food prices were high even before the covid-pandemic struck. This was due to weather disruptions among other things. The trend of high food prices has continued post-covid.

5) Take a look at the following chart. It plots the difference in food inflation as measured by the consumer price index and as measured by the wholesale price index.

The Farmer Doesn’t Benefit 

 Source: Author calculations on data from Centre for Monitoring Indian Economy.

What does this chart tell us? It tells us that post-covid, the food prices at the consumer level have been growing at a much faster rate than food prices at the wholesale level. The average difference between April and August was 610 basis points. One basis point is one hundredth of a percentage. The wholesale price index data for September is yet to come in (It will be published tomorrow).

What this means is that, despite the end consumers of food paying a higher price, the farmers are largely not benefitting from this rise in food prices, given that they sell their produce at the wholesale level.
This difference can be because of a few reasons.

a) A collapse in supply chains has led to what is being sold at the wholesale level not reaching the consumers at the retail level, thus, leading to higher prices for the consumer.

b) This could also mean those running the supply chains hoarding stuff, in order to increase their profit.

Having said that, the former reason makes more sense given that stuff like vegetables, egg, fish and meat, etc., cannot really be hoarded. Also, hoarding stuff like pulses, needs a specialized storage environment which India largely lacks.

6) The difference in food inflation as measured by the consumer price index and as measured by the wholesale price index peaked in April at 790 basis points. This makes complete sense given the lockdown was at its peak during the month. As the economy has opened up, the difference has come down.

Nevertheless, in August the difference was at 521 basis points. This is still high given that the average of the difference over the last five years is 38 basis points. Also, with the food inflation as measured by the consumer price index going up by 163 basis points to 10.68% in September 2020, in comparison to August 2020, chances are that the difference in food inflation as measured by the consumer price index and as measured by the wholesale price index, might go up in September.

7) So, what does this mean for food inflation in the second half of this financial year? The monetary policy committee of the RBI projects that the inflation will be between 4.5-5.4% during the second half of this financial year. This can only be if food inflation comes down and also, it does not seep into overall inflation.

In the past, high food inflation has seeped into wage inflation and overall food inflation. It remains to be seen whether this happens this time around as well. The monetary policy committee doesn’t think so, but then it has as much control over food prices as it has over the finance ministry.

Interestingly, in the monetary policy report released a few days back, the RBI says in this context:

“Food inflation has remained elevated in recent months driven by price pressures in vegetables, cereals and protein items such as pulses, eggs and meat. The normal south-west monsoon, increased sowing of kharif crops, moderate MSP hikes, and high reservoir storage are expected to soften food inflation going forward.”

It goes on to say:

“However, a delayed normalisation of supply chains, heavy rains and floods in some states and demand-supply imbalances in key items such as pulses could exert further upward pressure on the headline inflation and keep it higher by around 50 basis points. On the other hand, an accelerated softening of food inflation due to an early restoration of supply chains, ample buffer stocks and efficient food stock management by the Government could bring headline inflation below the baseline by up to 50 basis points.”

So, the RBI in the monetary policy report is basically saying it could go either ways. In the process, it has hedged itself well, either ways.

8) Until the dynamic of whether food inflation is seeping into overall inflation becomes clear, it will be very difficult for the RBI to cut the repo rate any further than 4%, where it currently stands. The repo rate is the interest rate at which the RBI lends to banks.

Also, if the food inflation starts seeping into the overall inflation, the easy money policy of the RBI, where it has been printing and pumping money into the economy to drive down the interest rates, will have to take a backseat.

The RBI has pumped a lot of money into the financial system since February. Some of it has been done by buying bonds from financial institutions. But a lot of it has been done by defending the rupee.  When a lot of foreign money comes into India, the demand for rupee increases and it tends to appreciate against the dollar. This hurts exporters as well as domestic producers.

To prevent this from happening the RBI intervenes in the foreign exchange market by selling rupees and buying dollars. When the RBI sells rupees the money supply in the economy goes up. The RBI has an option of sterilising this rupee inflow by selling government bonds and sucking out the excess money. But it has chosen not to do this, which is in line with its easy money policy.

In the recent past, the RBI has allowed the rupee to appreciate against the dollar, by not buying dollars, and not adding rupees to the money supply through this route. This is primarily because there is already too much easy money floating around in the financial system.

This easy money hasn’t led to inflation because banks are going slow on lending and borrowers are being very careful before borrowing. This has ensured that the dynamic of too much money following the same amount of goods and services hasn’t played out and hasn’t created an even higher inflation.

Nevertheless, as the economy continues to recover there is a chance of this happening. Hence, the RBI needs to be careful with its easy money policy, especially if food inflation starts seeping into the overall inflation.

In the latest monetary policy, the monetary policy committee had said: “The MPC also decided to continue with the accommodative stance as long as necessary – at least during the current financial year and into the next financial year – to revive growth on a durable basis and mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target going forward [italics added].”

In simple English, this means that the RBI will keep driving lower interest rates to create growth. Up until now it doesn’t seem to be worried about its inflation mandate (to maintain the inflation as measured by the consumer price index between the range of 2-6%). But if food inflation remains high and seeps into overall inflation, the RBI will have a major problem at its hand, with all the liquidity it has pumped into the financial system.

9) Even if inflation falls to 4.5-5.4% as the RBI expects it to, the real return on fixed deposits after adjusting for inflation and taxes paid on the interest earned, will continue to remain in negative territory. And that’s not good news for savers as their savings will lose purchasing power. It’s great news for borrowers because inflation means they are repaying their loans in money which is worth less than it was at the time it was borrowed.

10) As much as economists might want us to believe, economics is no science. There are too many ifs and buts and maybes to the predictions that are made. And this is something that every reader needs to be aware of. This is true as much of this situation as it is of others.

Lower Interest Rates Good for Govt, Banks and Corporates, Not for Average Indian

The new monetary policy committee which met for the first time over the last two days has decided to keep the repo rate unmoved at 4%. Monetary policy committee is a committee which decides on the repo rate of the Reserve Bank of India (RBI). Repo rate is the interest rate at which RBI lends to banks and is expected to set the broad direction for interest rates in the overall economy.

The RBI has been trying to drive down the interest rates in the economy since January 2019. In January 2019, the repo rate was at 6.5%. Since then it has been cut by 250 basis points and is now at 4%. One basis point is one hundredth of a percentage.
This has had some impact in driving down fixed deposit interest rates of banks. Take a look at the following chart.

The Crash


Source: ICICI Securities, October 3, 2020.

From the peak they achieved between March and June 2019, fixed deposit interest rates have fallen by 170 to 220 basis points.
This in an environment where the inflation has been going up. In March 2019, inflation as measured by the consumer price index was at 2.9%. It had jumped slightly to 3.2% by June 2019. In August 2020, the latest data available for inflation as measured by the consumer price index, had jumped to 6.6%. Meanwhile, fixed deposit rates which were around 7-8%, are largely in the range of 4-6% now (of course, there are outliers to this).

Hence, inflation is greater than interest rates on fixed deposits, meaning the purchasing power of the money invested in fixed deposits is actually coming down.

In fact, interest rate on savings bank accounts, which in some cases was as high as 6-7%, has also come down. Take a look at the following chart.

Another crash


Source: ICICI Securities, October 3, 2020.

Savings bank accounts now offer anywhere between 2.5-3%.

The fall in interest rates is not just because of the RBI cutting the repo rate. A bulk of this fall has happened post the covid breakout. Banks haven’t lent money post covid.

Between March 27 and September 25, the outstanding non-food credit of banks has fallen by 1.1% or Rs 1.1 lakh crore to Rs 102 lakh crore. This means that people and firms have been repaying their loans and net-net in the first six months of this financial year, banks haven’t given a single rupee of a fresh loan.

Banks give loans to Food Corporation of India and other state procurement agencies to buy rice and wheat directly from the farmers. Once these loans are subtracted from overall lending by banks, what remains is non-food credit.

During the same period, the deposits of banks have risen by 5.1% or Rs 6.97 lakh crore to Rs 142.6 lakh crore. With people saving more, it clearly shows that the psychology of a recession is in place.

Banks have not been lending while their deposit base has been expanding at a rapid pace. The point being that banks are able to pay an interest on their deposits because they give out loans and charge a higher rate of interest on the loans than they pay on their deposits.

When this mechanism breaks down to some extent, as it has currently, banks need to cut interest rates on their deposits, given that they are not earning much on the newer deposits. This is bound to happen and accordingly, interest rates on fixed deposits have fallen.

While the supply of deposits has gone up, the demand for them in the form of loans, hasn’t. This has led to the price of deposits, which is the interest paid on them, falling.

But there is one more reason why interest rates have fallen. There is excess money floating around in the financial system. The RBI has printed money and pumped it into the financial system by buying bonds from financial institutions.

This excess money has also helped in driving down interest rates. While banks haven’t been able to lend at all in the first six months of the year, the government borrowing has gone through the roof. As the debt manager of the government, the RBI has printed and pumped money into the financial system to drive down the returns on government bond, in the process allowing the government to borrow at lower interest rates. Take a look at the following chart, which plots the returns (or yields) on 10-year bonds of the Indian government.

Going down

Source: Investing.com

The yield on a government bond is the return an investor can earn if he continues to own the bond until maturity. The above chart clearly shows that as the government has borrowed more and more through the year, the interest rate at which it has been able to borrow money has come down, thanks to the RBI and its money printing.

Of course, with banks not lending on the whole, they are happy lending to the government. In fact, in his speech today, the RBI governor Shaktikanta Das said that the central bank planned to print and pump another Rs 1 lakh crore into the financial system in the days to come.

With more money expected to enter the financial system the 10-year government bond yield fell from 6.02% yesterday (October 8) to 5.94% today (October 9), a fall of 8 basis points during the course of the day.

The monetary policy committee also decided to keep the “accommodative stance as long as necessary”, with only one member opposing it. In simple English this means that the RBI will keep driving down interest rates as long as necessary “at least during the current financial year and into the next financial year – to revive growth on a durable basis and mitigate the impact of COVID-19 on the economy.”

The assumption here is that as interest rates fall people will borrow and spend more and corporations will borrow and expand more. This will help the economy grow, jobs will be created and incomes will grow. While, this sounds good in theory, it doesn’t really play out exactly like that, at least not in an Indian context.

Let’s take a look at this pointwise.

1) A bulk of deposits in Indian banks are deposited by individuals. In 2017-18, the latest data for which a breakdown is available, individuals held around 55% of deposits in banks by value. This had stood at 45% in 2009-10 and has been constantly rising. Hence, it is safe to say that in 2020-21, the proportion of bank deposits held by individuals will clearly be more than 55%.

When interest rates on deposits (both savings and fixed deposits) go down individuals get hurt the most. There are senior citizens whose regular expenditure is met through interest on these deposits. When a deposit paying 8% matures and has to be reinvested at 5.5%, it creates a problem. Either the family has to cut down on consumption or start spending some of their capital (the money invested in the fixed deposit).

This also disturbs many people who use fixed deposits as a form of long-term saving. The vagaries of the stock market are not meant for everyone. Also, in the last decade returns from investing in stocks haven’t really been great.

2) When interest rates go down, the families referred to above cut down on consumption and do not increase it, as is expected with lower interest rates. This may not sound right to many people who are just used to economists, analysts, bureaucrats, corporates and fund managers, mouthing, lower interest rates leading to an increase in consumption all the time. But there is a significant section of people whose consumption does get hurt by lower interest rates.

3) It’s not just about bank interest rates going down. Returns on provident fund/pension funds which hold government bonds for long time periods until maturity and post office schemes (despite being higher than banks), also come down in the process.

4) Also, no corporate is going to invest just because interest rates are low right now. Corporates invest and expand when they see a future consumption potential. This is currently missing. Also, banks lending to industry peaked at 22.43% of the GDP in 2012-13. It fell to 14.28% of the GDP in 2019-20. During the period, interest rates have gone up and down, but corporate lending as a proportion of the GDP has continued to fall. So clearly increased borrowing by corporates is not just about interest rates.

But corporates love to constantly talk about high interest rates as a reason not to invest. This is just a way of driving down interest on their current debt.

As former RBI governor Urjit Patel writes in Overdraft:

“Sowing disorder by confusing issues is a tried-and-trusted, distressingly often successful routine by which stakeholders, official and private, plant the seeds of policy/regulation reversal in India.”

One can understand interest rates going down in an environment like the current one, but there is a flip side to it as well, which one doesn’t hear the experts talk about at all. Also, anyone has barely mentioned the excess liquidity in the financial system, which currently stands at Rs 3.9 lakh crore. Why is that? Let’s look at this pointwise.

1)  The equity fund managers love it because with interest rates going down further, many investors will end up investing money in stocks despite very high price to earnings ratio that currently prevails. The price to earnings ratio of the Nifty 50 index currently is at 34.7. This is a kind of level that has never been seen before.

But with post tax real returns from fixed deposits (after adjusting for inflation) in negative territory, many investors continue to bet on stocks, despite the lack of earnings growth.

2) The debt fund managers love it because interest rates and bond prices are negatively related. When interest rates come down, bond yields come down and this leads to bond prices going up. This means that the debt funds managed by these fund managers see capital gains and their overall returns go up. Hence, debt fund managers love lower interest rates.

3) Banks invest a large proportion of the deposits they gather into government bonds. When bond yields fall, bond prices go up. This leads to a higher profit for banks. This in an environment where banks aren’t lending. Hence, bankers love lower interest rates.

4) Corporates love lower interest rates at all points of time, irrespective of whether they want to borrow or not. I don’t think this needs to be explained.

5) The government loves low interest rates because it can borrow at lower rates. Second, with the stock market going up, it can sell a positive narrative. If the economy is doing so badly, why is the stock market doing well?

6) This leaves economists. Economists love lower interest rates because the textbooks they read, said so.

The question is do lower interest rates or interest rates make a difference when it comes to borrowing by an average Indian? Let’s take a look at non-housing retail borrowing from banks over the years. In 2007-08 it stood at 5.34% of the gross domestic product (GDP). In 2019-2020, it stood at an all-time high of 5.97% of GDP.

In a period of 12 years, non-housing retail borrowing from banks, has barely moved. What it tells us to some extent is that the idea of taking on a loan to buy something (other than a house), is still alien to many Indians.

So, the idea that interest rates falling leading to increased retail borrowing is a little shaky in the Indian context.

To conclude, today the RBI governor Shaktikanta Das gave a speech which was more than 4,000 words long. In this speech, the phrase fixed deposit interest rate did not appear even once.

A whole generation of savers is getting screwed (for the lack of a better word) and the RBI Governor doesn’t even bother mentioning it in his speech. The RBI seems to be constantly worried about the interest rate at which the government borrows.

A central bank which only bats for the government, corporates and bond market investors, is always and anywhere a bad idea.

Shaktikanta Das’ RBI is at the top of this bad idea.