[email protected],000 – How RBI Played a Part in Creating the Stock Market Bubble

The BSE Sensex, India’s premier stock market index, crossed 50,000 points today in intra day trading. It has risen by more than 80% from around the end of March, when it had fallen to 27,591 points, in the aftermath of the covid pandemic hitting India.

This astonishing rise has now got the Reserve Bank of India (RBI) worried. The RBI Governor Shaktikanta Das, writing in the foreword to the latest Financial Stability Report, pointed out:

“The disconnect between certain segments of financial markets and the real economy has been accentuating in recent times, both globally and in India.”

People who run central banks are not always known to talk in simple English. Das is only following tradition here. The statement basically refers to stock prices. Das feels they have risen too fast in the recent past and have become disconnected from the overall economy.

While the overall Indian economy is expected to contract this year, the stock market has rallied by more than 80%. How is this possible? Or as you often get to hear these days, if the economy is doing badly, why is the stock market doing so well.

Theoretically, a possible explanation is that the stock market discounts the future and the stock market investors think that the future of the Indian economy is bright. Another explanation offered often by the stock market investors is that corporate profits this year have been at never seen before levels.

But even after taking these reasons into account, the current high level is really not justified. As Das put it in his foreword: “Stretched valuations of financial assets pose risks to financial stability.” One way to figure out whether valuations are stretched is to look at the price to earnings ratio of the stocks that constitute the Sensex index.

In January 2021, the price to earnings ratio has been at around 34. This means that investors are ready to pay Rs 34 as price, for every rupee of earning of the companies that make up for the Sensex. Such a high level of the price to earnings ratio has never been seen before. Not even in late 2007 and early 2008, when stock prices rallied big time or the first half of 2000, when the dotcom bubble was on.

Clearly, stock prices are in extremely bubbly territory. The current jump in corporate earnings isn’t sustainable for the simple reason that corporates have pushed up earnings by cutting employee costs as well as raw material costs. This means the incomes of those dealing with corporates from employees to suppliers and contractors, have fallen.

This fall in income has limited the ability of these individuals to spend money. This will lead to lower private consumption in the months to come, which, in turn, will impact corporate revenues and eventually profits. A sustainable increase in profits can only happen when people keep buying things and corporate revenues keep going up.

This brings us back to the question as to why stock prices are going up, when the overall economy is not doing well. A part of the reason is the RBI, though the central bank, rather expectedly, glosses over this totally in the latest edition of the Financial Stability Report.

Since February 2020, the RBI has pumped in a massive amount of money into the financial system through various measures, some of which involve the printing of money. By flooding the financial system with money, or what central banks refer to as liquidity, the RBI has ensured that interest rates in general and bank deposits in particular, have fallen.

The idea here is threefold. A drop in interest rates allows the government to borrow at lower interest rates. This became necessary because thanks to the pandemic, the tax collections of the government have dropped during this financial year. Between April and November 2020, the gross tax revenue stood at Rs 10.26 lakh crore, a drop of 12.6% in comparison to the same period in 2019.

Secondly, lower interest rates ensured that the interest costs of corporates on their outstanding loans, came down. Also, the hope was that at lower interest rates, corporates will borrow and expand.

Thirdly, at lower interest rates, the hope always is that people will borrow and spend more, and all these factors will lead to a faster economic recovery.

But there is a flip side to all this as well. A fall in interest rates has got people looking for a higher return. This has led to many individuals buying stocks, in the hope of a higher return and thus driving up prices to astonishingly high levels.

This can be gauged from the fact that in 2020, the number of demat accounts, which are necessary to buy and sell stocks, went up by nearly a fourth to 4.86 crore accounts. One of the reasons for this is the rise of Robinhood investing in India. This term comes from the American stock brokerage firm Robinhood which offers free online trading in stocks. India has seen the rise of similar stock brokerages offering free trading.

What has added to this is the fact that many unemployed individuals have turned to stock trading to make a quick buck. All it needs is a smartphone, a cheap internet connection and a low-cost brokerage account.

Of course, this search for a higher return isn’t local, it’s global. Hence, foreign institutional investors have invested a whopping $31.6 billion in Indian stocks during this financial year, the highest ever. This stems from the fact that Western central banks, like the RBI, have printed a huge amount of money to drive down interest rates.

This has pushed more and more investors into buying stocks despite the fact that the global economy isn’t doing well either.

A slightly different version of this column appeared in the Deccan Herald on January 17, 2021. It was updated after the Sensex first crossed 50,000 points during intra day trading on January 21, 2021.

Indian Banks Will Have Rs 17-18 Lakh Crore Bad Loans By September

The Reserve Bank of India (RBI) publishes the Financial Stability Report (FSR) twice a year, in June and in December. This year the report wasn’t published in December but only yesterday (January 11, 2021).

Media reports suggest that the report was delayed because the government wanted to consult the RBI on the stance of the report. For a government so obsessed with controlling the narrative this doesn’t sound surprising at all.

Let’s take a look at the important points that the FSR makes on the bad loans of banks and what does that really mean. Bad loans are largely loans which haven’t been repaid for a period of 90 days or more.

1) The bad loans of banks are expected to touch 13.5% of the total advances in a baseline scenario. Under a severe stress scenario they are expected to touch 14.8%. These are big numbers given that the total bad loans as of September 2020 stood at 7.5% of the total advances. Hence, the RBI is talking of a scenario where bad loans are expected to more or less double from where they are currently.

2) Under the severe stress scenario, the bad loans of public sector banks and private banks are expected to touch 17.6% and 8.8%, respectively. This means that public sector banks are in major trouble again.

3) In the past, the RBI has done a very bad job of predicting the bad loans rate under the baseline scenario, when the bad loans of the banking system were going up.

Source: Financial Stability Reports of the RBI.
*The actual forecast of the baseline scenario was between 4-4.1%

If we look at the above chart, between March 2014 and March 2018, the actual bad loans rate turned out to be much higher than the one predicted by the RBI under the baseline scenario. This was an era when the bad loans of the banking system were going up year on year and the RBI constantly underestimated them.

4) How has the actual bad loans rate turned out in comparison to the bad loans under severe stress scenario predicted by the RBI?

Source: Financial Stability Reports of the RBI.
*The actual forecast of the baseline scenario was between 4-4.1%

In four out of the five cases between March 31, 2014 and March 31, 2018, the actual bad loans rate turned out higher than the one predicted by the RBI under a severe stress scenario. As Arvind Subramanian, the former chief economic advisor to the ministry of finance, writes in Of Counsel:

“In March 2015, the RBI was forecasting that even under a “severe stress” scenario— where to put it colourfully, all hell breaks loose, with growth collapsing and interest rates shooting up—NPAs [bad loans] would at most reach about Rs 4.5 lakh crore.”

By March 2018, the total NPAs of banks had stood at Rs 10.36 lakh crore.

One possible reason can be offered in the RBI’s defence. Let’s assume that the central bank in March 2015 had some inkling of the bad loans of banks ending up at around Rs 10 lakh crore. Would it have made sense for it, as the country’s banking regulator, to put out such a huge number? Putting out numbers like that could have spooked the banking system in the country. It could even have possibly led to bank runs, something that the RBI wouldn’t want.

In this scenario, it perhaps made sense for the regulator to gradually up the bad loans rate prediction as the situation worsened, than predict it in just one go. Of course, I have no insider information on this and am offering this logic just to give the country’s banking regulator the benefit of doubt.

5) So, if the past is anything to go by, the actual bad loans of banks when they are going up, turn out to be much more than that forecast by the RBI even under a severe stress scenario. Hence, it is safe to say that by September 2021, the bad loans of banks will be close to 15% of advances, a little more than actually estimated under a severe stress scenario.

This will be double from 7.5% as of September 2020. Let’s try and quantify this number for the simple reason that a 15% figure doesn’t tell us about the gravity of the problem. The total advances of Indian banks as of March 2020 had stood at around Rs 109.2 lakh crore.

If this grows by 10% over a period of 18 months up to September 2021, the total advances of Indian banks will stand at around Rs 120 lakh crore. If bad loans amount to 15% of this we are looking at bad loans of Rs 18 lakh crore. The total bad loans as of March 2020 stood at around Rs 9 lakh crore, so, the chances are that bad loans will double even in absolute terms. If the total advances grow by 5% to around Rs 114.7 lakh crore, then we are looking at bad loans of around Rs 17.2 lakh crore.

6) The question is if this is the level of pain that lies up ahead for the banking system, why hasn’t it started to show as yet in the balance sheet of banks. As of March 2021, the RBI expects the bad loans of banks to touch 12.5% under a baseline scenario and 14.2% under a severe stress scenario. But this stress is yet to show up in the banking system.

This is primarily because the bad loans of banks are currently frozen as of August 31, 2020. 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.

As the FSR points out:

“In view of the regulatory forbearances such as the moratorium, the standstill on asset classification and restructuring allowed in the context of the COVID-19 pandemic, the data on fresh loan impairments reported by banks may not be reflective of the true underlying state of banks’ portfolios.”

The Supreme Court clearly needs to hurry up on this and not keep this hanging.

7) Delayed recognition of bad loans is a problem that the country has been dealing with over the last decade. The bad loans which banks accumulated due to the frenzied lending between 2004 and 2011, were not recognised as bad loans quickly enough and the recognition started only in mid 2015, when the RBI launched an asset quality review.

This led to a slowdown in lending in particular by public sector banks and negatively impacted the economy. Hence, it is important that the problem be handled quickly this time around to limit the negative impact on the economy.

8) Public sector banks are again at the heart of the problem. Under the severe stress scenario their bad loans are expected to touch 17.6% of their advances. The sooner these bad loans are recognised as bad loans, accompanied with an adequate recapitalisation of these banks and adequate loan recovery efforts, the better it will be for an Indian economy.

9) At an individual level, it makes sense to have accounts in three to four banks to diversify savings, so that even if there is trouble at one bank, a bulk of the savings remain accessible. Of course, at the risk of repetition, please stay away from banks with a bad loans rate of 10% or more.

To conclude, from the looks of it, the process of kicking the bad loans can down the road seems to have started. There is already a lot of talk about the definition of bad loans being changed and loans which have been in default for 120 days or more, being categorised as bad loans, against the current 90 days.

And nothing works better in the Indian system like a bad idea whose time has come. This is bad idea whose time has come.

 

Why Large Corporates/Industrial Houses Owning Banks is a Bad Idea

 

An internal working group (IWG) of the Reserve Bank of India (RBI) has suggested that large corporate/industrial houses may be allowed to promote banks. Does this huge leap of faith being made by the Indian central bank, given their current extremely cautious and conservative approach, make sense? Let’s try and understand.

Why should large corporates be allowed into banking?

The IWG feels that allowing large corporates to promote banks can be an important source of capital. In a capital starved country like India this makes sense. Further, these corporates can bring “experience, management expertise, and strategic direction to banking”.

The group also noted that internationally “there are very few jurisdictions which explicitly disallow large corporate houses”. All these reasons make sense, but there are major reasons as to why the RBI in the last five decades hasn’t let large corporates enter the banking sector in India. At the heart of all this is the conflict of interest it would create.

Why have large corporates not been allowed into banking?

The IWG spoke to experts on the issue: “All the experts except one [said] that large corporate/industrial houses should not be allowed to promote a bank.”  The corporate governance in Indian companies isn’t up to international standards and “it will be difficult to ring fence the non-financial activities of the promoters.”

There will be a risk of promoters giving loans to themselves. Before bank nationalisation in 1969, some of the private banks were owned by large corporates. As Professor Amol Agrawal of Ahmedabad University puts it: “Since the private banks were run by big industrialists, they gave loans to themselves.”

What does history have to say in this regard?

As Pai Panandikar, an Advisor in the Finance Ministry, wrote in August 1967, regarding these banks : “Internal procedures… vest large discretionary powers in the Boards of Directors who have often acted as sources of patronage in deciding credit matters.”

A survey showed that 188 individuals served as directors on boards of 20 leading banks and held 1452 directorships of other companies. These individuals had directorships in 1100 companies.

What did these large discretionary powers lead to?

In an October 1967 report commissioned by politician Chandrashekhar, then the Secretary of the Congress Party, it was found that of the total bank loans of Rs 2,432 crore in 1966, Rs 292 crores was the debt due from the bank directors and their companies.

In fact, if indirect loans and advances were included, the actual debt-linked to directors was Rs 600-700 crore. There is a danger of something similar happening even now given the weak corporate governance structures.

*As of March 31, 2018.
Source: Rajya Sabha Unstarred Question No: 1492, Answered on 18 July 2018.

What does this mean in the current scheme of things?

As of March 2018, the domestic bad loans of Indian banks peaked at Rs 9.62 lakh crore. Of this, around 73.2% or Rs 7.04 lakh crore, were defaults made by industry.

The corporates have been responsible for a bulk of the mess in the Indian banking sector. Given that, handing over banking licenses to them is not a sensible idea, especially when the ability of banks to recover bad loans is limited.

High Inflation In Times of Covid Will Hit Us Hard

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

Let’s look at this issue pointwise.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Why No One is Worried About Savers

Economists are like sheep. They like to move in a herd.

If one of them says that the Reserve Bank of India (RBI) and banks need to cut interest rates in order to revive the economy, largely everyone else follows.

This basically stems from the fact that the practitioners of economics like to think of the subject as a science, having built in all that maths into it over the decades.

In science, controlled experiments can be run and results can be arrived at. If these experiments are run again, the same results can be arrived at again.

The economists like to think of economics along similar lines. But then economics is not a science.

Take the case of the idea of a central bank and banks cutting interest rates when the economy of a country is not doing well. Why do economists offer this advise? The idea is that as banks cut interest rates, people will borrow and spend more.

At the same time corporates will borrow and expand, by setting up more factories and offices. This will create jobs. People will earn and spend more. Businesses will benefit. The economy will do better than it did in the past. And everyone will live happily ever after.

Okay, the economists don’t say the last line. I just added it for effect. But they do believe in everything else. Hence, they keep hammering the point of banks having to cut interest rates to get the economy going, over and over again. The corporates who pay these economists also like this point being made.

The trouble is that what the economists believe in doesn’t always turn out to be true. Or to put in a more nuanced way, there is a flip side to what they recommend. And I have seen very few professional economists talk about it till date. In fact, low interest rates hurt a large section of the population especially during an economic recession and contraction.

In India, a section of the population, is dependent on the level of interest rate on bank deposits (especially fixed deposits). Currently, the average interest rate on a fixed deposit is around 5.5% per year.

The inflation as measured by the consumer price index in September stood at 7.34%. Hence, the actual return on a fixed deposit is in negative territory. It has been in negative territory through much of this year. This doesn’t even take into account the fact that interest earned on fixed deposits is taxable at the marginal rate. After taking that into account the real return turns further negative.

This hurts people living off interest income, in particular senior citizens. Senior citizens whose fixed deposits have matured in the recent past have seen their interest income fall from around 8% per year to around 5.5% per year, in an environment where food inflation is higher than 10%.

The only way to keep going for them is to cut monthly expenses or start using their capital (or the money invested in fixed deposits) for regular expenses. It is worth remembering that India has very little social security and health facilities for senior citizens, as is common in developed nations.

Lower interest rates also impacts a large section of the population which saves for the future through bank fixed deposits. It is worth remembering that it is this section of the population which actually drives the private consumption in the country. When returns on their savings fall, the logical thing is to cut consumption and save more. If this is not done, then the future gets compromised on.

Lower interest rates hurt institutions like non-government organisations, charitable trusts etc., which save through the fixed deposit route.

The stock market wallahs love lower interest rates because a section of the population continues to bet on stocks despite the lack of company earnings. The price to earnings ratio of the stocks that constitute the Nifty 50, one of India’s premier stock market indices, is currently at more than 34.

Such high levels have never been seen before. It’s not the chances of future high earnings which have driven up stock prices but the current low interest rates, leading to more and more people trying to make a quick buck on the stock market. The government likes this because it feeds into their all is well narrative.

At the same time, given that the government is cash-starved this year, the stock market needs to continue to be at these levels for it to be able to sell its stakes in various public sector enterprises to raise cash.

Between March 27 and October 9, the deposits of banks (savings, current, fixed, recurring etc.) have increased by a whopping Rs 7.4 lakh crore or 5.4%. In the same time, the total loans of banks have shrunk by Rs 38,552 crore or 0.4%. This basically means people are repaying loans instead of taking on fresh ones, despite lower interest rates.

In this environment, with banks unable to lend out most of their fresh deposits, it is but natural that they will cut interest rates on their fixed deposits. You can’t hold that against them. That is how the system is adjusting to the new reality. But what has not helped is the fact that the RBI has been trying to drive down interest rates further by printing money and pumping it into the financial system.

Between early February and September end, the central bank has pumped more than Rs 11 lakh crore into the financial system.

Not all of it is freshly printed money, but a lot of it is. This has apparently been done to encourage corporates to borrow. The bank lending to industry peaked at 22.43% of the gross domestic product (GDP) in 2012-13. Since then it has been falling and in 2019-20, it stood at 14.28% of the GDP. Clearly, Indian industry hasn’t been in a mood to borrow and expand for a while. Hence, the so-called high interest rates, cannot be the only reason for it.

The real reason for the RBI pumping in money into the financial system and driving down interest rates has been to help the government borrow money at low interest rates. As tax collections have fallen the government needs to borrow significantly more this year than it did last year.

All this has hurt the saver. But clearly unlike the corporates and the government, the savers are not organised. Hence, almost no one is talking about them. In the latest monetary policy committee meeting, there was just one mention of them.

One of the members had this to say: “With retail fixed deposit rates currently ranging between 4.90-5.50 per cent for tenors of 1-year or more and the headline inflation prevailing above that for some months now, there has been a negative carry for savers.”

We already know that no economist talks about this phenomenon or more specifically the fact that low interest rates and high inflation should have led to a cut down in consumption. How big and significant is that cutdown? How is it hurting the Indian economy?

Is this cutdown in consumption more than the loans given by banks because of low interest rates?

These are questions that need answers. But the problem is that to a man with a hammer everything appears like a nail. For economists interest rates are precisely that hammer which they like using everywhere. This situation is no different.

The trouble is their hammer doesn’t necessarily work all the time.

A shorter version of this column appeared in the Deccan Chronicle on October 25, 2020.