The Nirav Modi Fraud Tells Us That the Business of Govt Should Not Be Business

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The government of India owns 21 public sector banks. We have been advocating over the years that the government doesn’t really need to own so many banks. It just adds to the economic mess.

In the aftermath of the Nirav Modi fraud, many other economists, businessmen and analysts, have been making this rather obvious point.

The finance minister Arun Jaitley ruled this out recently, when he said: “This (privatisation) involves a large political consensus. Also, that involves an amendment to the law (Banking Regulation Act). My impression is that Indian political opinion may not find favour with this idea itself. It’s a very challenging decision.”

The total bad loans of public sector banks as on September 30, 2017, were at Rs 6,89,806 crore. The bad loans rate was at 13.5% i.e. of every Rs 100 lent by public sector banks, Rs 13.5 had not been repaid by the borrowers.

The Nirav Modi fraud is pegged at $1.8 billion (or around Rs 11,400 crore). If the total Rs 11,400 crore is assumed as a bad loan, then the total bad loans of public sector banks will be a little over Rs 7,00,000 crore. Hence, the fraud is simply a drop in the ocean of bad loans of public sector banks.

This means that the problem is somewhere else. If we look at data as of March 31, 2017, the total bad loans of public sector banks were at Rs  6,19,265 crore. Of this around 69% or Rs 4,24,434 crore, was on account of lending to corporates. And this is where the problem lies.

One Nirav Modi and his companies are not the problem, it is the corporate sector as a whole which has been abusing the public sector banks in the country.

Of course, with such a huge amount of bad loans, the government has to constantly keep infusing capital into the public sector banks, in order to keep them going.

The hope is that with the government infusing money into these banks, they will gradually get back to full-fledged lending and in the process help the economy. Of course, there is nothing wrong with this hope but the economic incentive it creates for politicians, is totally different.

As Thomas Sowell writes in Basic Economics—A Common Sense Guide to the Economy: “Nothing is easier than to have good intentions but, without an understanding of how an economy works, good intentions can lead to counterproductive, or even disastrous, consequences for a whole nation. Many, if not most, economic disasters have been a result of policies intended to be beneficial—and these disasters could often have been avoided if those who originated and supported such policies had understood economics… [There is a] crucial importance of making a distinction between intentions and consequences. Economic policies need to be analysed in terms of the incentives they create, rather than the hopes that inspired them.”

Long story short—while implementing an economic policy, we need to be able to differentiate between what the policy hopes to achieve and the economic incentives it creates. It is ultimately, the economic incentives that are created which will decide how people react to the policy, making it effective or ineffective.

A major reason why politicians love the idea of owning public sector banks (or public sector enterprises for that matter), is that it allows them to bestow favours on their favourite industrialists (read crony capitalists).

In terms of public sector banks, this means forcing them to give out loans to businessmen, who either are not in a position or do not have any intention of repaying the loan. Hence, the government may be recapitalising banks with the hope of letting them operate at their full strength, but the real incentive for the politicians is somewhere else.

The only way of breaking this nexus between businessmen and politicians, is to privatise a bulk of the banking sector in India. If that is not possible due to regulatory hurdles (as Jaitley talked about), a bulk of public sector banks should not be lending to corporates. There activities should be limited to raising money as deposits and lending them out in the form of retail loans.

This “narrow banking” model is likely to work better simply because with a bulk of public sector banks not being allowed to give corporate loans, the politicians will not be in a position to direct lending towards their favourite corporates. With this taken out of the equation, public sector banks might just about manage to operate much more efficiently.

Also, with politicians having one lesser issue to deal with, they might just pay more attention to the other major problems that the country faces and get their heads together on tackling them.

The trouble is that the decision to get public sector banks out of lending to corporates, is to be made  by politicians. And as we saw in the column, they do not have an incentive to do anything like that. How do you deal with a problem like that?

The column originally appeared on Equitymaster on Equitymaster on Feb 26, 2018.

 

If PM Modi could sell Notebandi why not Bankbandi? Many banks do not deserve fresh capital

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One of the examples of Big Government I have in my book India’s Big Government is that of government owned public sector banks. (The good news is that the book is available at a huge discount on Amazon till Friday, 27th October. The Kindle version is going at Rs 199, against a maximum retail price of Rs 749, and the paperback is going at Rs 499, against a maximum retail price of Rs 999).

When I wrote the book, the Indian government owned 27 public sector banks. As of April 1, 2017, the Bhartiya Mahila Bank and the five associate banks of State Bank of India, were merged with the State Bank of India. Due to this merger, the number of government owned banks fell to 21. This merger has pulled down the overall performance of the State Bank of India and is just a way of sweeping problems under the carpet. Over the years, the government plans to use mergers to reduce the number of banks it owns to anywhere between ten to fifteen. This as I have said in the past is a bad idea.

Yesterday afternoon, the finance ministry announced a plan to invest more capital in public sector banks, which are saddled with a massive amount of bad loans and restructured loans. The government plans to put in Rs 2,11,000 crore over the next two years, “with maximum allocation in the current year”.

Where will this money come from? Rs 18,139 crore has been allocated from the current financial year’s budget. Banks are expected to raise capital by issuing new shares. This is expected to raise around Rs 58,000 crore.

This leaves us with around Rs 1,35,000 crore. Where will this money come from? This money is expected to come in through recapitalisation bonds. How will this work? The government hasn’t specified the details of how these bonds will be issued. (This makes me wonder as to why have a press conference in the first place, when the most important part of the plan, has not been decided on).

From what I could gather speaking to people who understand such things, this is how it is supposed to work. The banks have a lot of liquidity because of all the money that has come in because of demonetisation. A part of these deposits will be used by public sector banks to buy recapitalisation bonds issued by the government.

The money that the government thus gets will be used to buy fresh shares that the banks will issue. Thus, the banks will be recapitalised.

Now on the face of it, this sounds like a brilliant plan, where money is moved from one part of the balance sheet to another and a huge problem is solved. But is it as simple as that?

a) By issuing recapitalisation bonds the debt of the government will go up. Over and above this, interest will have to be paid on these bonds. Both the debt and the interest will add to the fiscal deficit of the government.

b) Given that the debt of the government will go up, this would mean that the taxpayers will ultimately pick up the tab because the debt will have to be repaid. It makes sense to always remember that there is no free lunch in economics. The corollary to this is that there is no free lunch especially when something feels like a free lunch. Of course, the taxpayers aren’t organised and hence, they are unlikely to protest. And given that they finance all bailouts.

c) It remains to be seen what the banks do with this extra capital. Will they use it to write off restructured loans of corporates? Will this dull their enthusiasm (not that they had enough of it in the first place) to recover bad loans? As the situation changes, so will the behaviour of bankers.

This will also bring to the fore the issue of moral hazard. And what is moral hazard? As Mohamed A El-Erian writes in The Only Game in Town: “[It] is the inclination to take more risk because of the perceived backing of an effective and decisive insurance mechanism.” If the government bails them around this time around, the banks know that they can count on the government bailing them out the next time around as well. And this means that they can follow fairly loose standards of lending, in order to lend money quickly.

d) As I keep saying, bank lending among other things is also a function of whether there is demand for such lending. The public sector banks have gone slow on lending to corporates (in fact they have contracted their loan book) because of a lack of capital. Or so we are told. But this lack of capital doesn’t seem to have hindered their lending to the retail segment. Now that they will have access to more capital, will this reluctance to lend to corporates go away? I am not so sure.

e) Also, some of the banks are in such a bad state, that they really don’t deserve this capital. They shouldn’t be in the business of banking in the first place. Take a look at Table 1. Table 1, lists out the bad loans ratio of all the public sector banks. Bad loans are essentially loans in which the repayment from a borrower has been due for 90 days or more.

Table 1:

Name of the bankBad loans ratio (in per cent)
IDBI Bank24.11
Indian Overseas Bank23.6
UCO Bank19.87
Bank of Maharashtra18.59
Central Bank of India18.23
Dena Bank17.37
United Bank of India17.17
Corporation Bank15.49
Oriental Bank of Commerce14.83
Allahabad Bank13.85
Punjab National Bank13.66
Andhra Bank13.33
Bank of India13.05
Union Bank of India12.63
Bank of Baroda11.4
Punjab and Sind Bank11.33
Canara Bank10.56
State Bank of India9.97
Syndicate Bank9.96
Vijaya Bank7.3
Indian bank7.21

Source: www.careratings.com 

As can be seen from Table 1, only two public sector banks have a bad loans ratio significantly lower than 10 per cent (Actually its four, but State Bank of India and Syndicate Bank are very close to 10 per cent).

Eight out of the 21 banks have a bad loans ratio of greater than 15 per cent. This basically means that out of every Rs 100 of lending carried out by these banks, at least Rs 15 is no longer being repaid.

Some of these banks with extremely high bad loans are way too small to make any difference in the overall lending carried out by banks. Take a look at Table 2.

Table 2:

Name of the BankTotal advances as a percentage of gross advances of banks (as on March 31, 2017)Bad loans rate (as on June 30, 2017)
United Bank of India0.82%17.17%
Dena Bank0.90%17.37%
Bank of Maharashtra1.18%18.59%
UCO Bank1.48%19.87%
Central Bank of India1.73%18.23%
Indian Overseas Bank1.74%23.60%

Source: Author calculations on Indian Banks’ Association data and www.careratings.com 

These public sector banks have now reached a stage wherein there is no point in the government trying to spend time and money, in reviving them. It simply makes more sense to shut them down and sell their assets piece by piece or to sell them, lock, stock and barrel, if any of the bigger private banks or any other private firms, are willing to buy them. But what the government is doing instead is using taxpayer money to maintain its control over banks.

f) Also, recapitalising banks does not take care of the basic problem at the heart of public sector banks, which is that they are public sector banks. Allow me to explain. Let’s take the example of the State Bank of India, the largest public sector banks. As of June 30, 2017, the bad loans ratio of the bank when it came to retail lending was 1.56 per cent. At the same time, the bad loans ratio when it came to corporate lending was 18.61per cent.This basically means that State Bank of India, does a terrific job at retail lending but really screws up when it comes to lending to industry. What is happening here? Thomas Sowell, an American economist turned political philosopher, discusses the concept of separation of knowledge and power, in his book Wealth, Poverty and Politics.

How does it apply in this context? In public sector banks, managers who have the knowledge to take the right decisions may not always have the power to do so. Take the case of retail lending. The manager looks at the ability of the borrower to repay a loan, and then decides to commission or not commission one. This explains why the bad loans ratio in case of retail lending is as low as 1.56 per cent (in fact, it was just 0.55 per cent before the merger). A proper process to give a loan is being followed in this case.

But when it comes to lending to corporates, there are people out there (or at least used to be) who are trying to influence the manager’s decision; from bureaucrats to ministers to politicians. In this scenario, the manager ends up giving out loans even to those corporates who do not have the wherewithal to repay it.

The separation between knowledge and power has led to a situation where bank loans were given to many crony capitalists who have defaulted, and what we are seeing now is a fall out of that. In many cases, the corporates have simply siphoned off the loan amounts by over declaring the cost of the projects they borrowed against.

Of course, as long public sector banks continue to remain public sector banks, this risk will remain. But this government (and the ones before it) likes the idea of owning banks, and because it gives some relevance to ministers and bureaucrats.

Also, the employee unions of public sector banks have a huge nuisance value. No government has had the balls to take them on, in the past. Neither does this one. And this basically means that taxpayers will have to continue rescuing the public sector banks.

The column originally appeared on Equitymaster The column originally appeared on Equitymaster with  a different headline on October 25, 2017.

The Perils of Too Much News

In my early teens, there were only two sources of news in India, the daily newspaper and the late evening news on Doordarshan, the only channel in town. Hence, the news wasn’t a 24 by 7 affair like it is now, especially with the advent and the rise of the digital media over the last few years.

The rise of the digital media has ensured that news gets to people faster. One doesn’t have to wait for the morning newspaper or the evening news to know what has happened. Also, with more and more news sources hitting the market, censoring the media isn’t as easy as it was in the past. Hence, to that extent it is a good thing.

Nevertheless, the rise of 24 by 7 news media brings with itself other sets of problems. As Alain de Botton writes in The News—A User’s Manual: “The modern world is teaching us that there are dynamics far more insidious and cynical still than censorship in draining people of political will; these involve confusing, boring and distracting the majority away from politics by presenting events in such disorganized, fractured and intermittent way that a majority of the audience is unable to hold on to the thread of the most important issues for any length of time.”

The point being that proliferation of the media and the rise of the social media has essentially ensured that the audience keeps getting bored and needs more and more new issues to agitate or at least feel agitated about. In the process, the most important issues of the day, actually get lost.

Take the Indian case. One of the most important issues which barely gets discussed in India is the fact that close to one million individuals are entering the workforce every month. This means around 1.2 crore individuals are entering the workforce every year. This is likely to continue at least for the next decade and a half. Further, the number can turn out to be an underestimate if more women enter the workforce.

While, 1.2 crore Indians are entering the workforce every year, there aren’t enough jobs going around for them. Many of these individuals are educated i.e. at least they have gone to school. Nevertheless, they don’t have any employable skills. There are economic and social repercussions that this is going to have.

As Thomas Sowell writes in Wealth, Poverty and Politics: “People who have acquired academic degrees, without acquiring many economically meaningful skills, not only face personal disappointment and disaffection with society, but also have often become negative factors in the economy and even sources of danger… In many poorer countries, especially, the “educated unemployed” are often numerous enough to be not only a major disappointment but a social and political danger.”

Also, what happens is that the only institution ready to employ them is the government. As Sowell writes: “Even many of those with academic credentials, but no economically meaningful skills, who are in fact employed are often employed in government bureaucracies, since they are unlikely to be much in demand in competitive markets where employers are spending their own money, rather than spending the taxpayers’ money.” This is what explains a whole host of engineers, MBAs and PhDs applying for government jobs of sweepers and peons.

The question is, when was the last time you saw anything in the media analysing this issue. We were busy arguing whether a film star couple should have named their son what they did. Until we moved on to something else.

The point, as Botton writes, is that “news organisations broadcast a flow of random-sounding bulletins, in great numbers but with little explanation of context, within an agenda” that keeps changing, and “without giving any sense of the ongoing relevance of an issue that had seemed pressing only a short while before.” This is interspersed with constant antics of film stars.

And this, as Botton writes, “would be quite enough to undermine most people’s capacity to grasp political reality – as well as any resolve they might have summoned to alter it.”

Indeed, this is something that we should worry about.

The column was originally published in the Bangalore Mirror on March 22, 2017

Trump’s Plan to Make America Great Again Will Fail Because of Dollar

In the early 16th century the Spaniards captured large parts of what is now known as South America. The area had large deposits of silver and gold. As I write in my book Easy Money: Evolution of Money from Robinson Crusoe to the First World War: “The precious metals were melted and made into ingots so that they could be easily transported to Spain. Between 1500 and 1540, nearly 1,500 kg of gold came to Spain every year on an average from the New World.” i

Gold wasn’t the only precious metal coming in. A lot of silver came in as well. As I write in Easy Money: “One of the biggest silver mines was found in Potosi, which is now in Bolivia, in 1545. Potosi is one of the highest cities in the world and is situated at a height of 4,090 m. Given the height it sits on, it took Spaniards sometime to get there. Here a mountain of silver of six miles around its base was discovered.ii The mountain or the rich hill, as it came to be called, generated nearly 45,000 tonnes of silver between 1556 and 1783. iii

Most of this new found silver was shipped to Seville in Spain where the mint was. In the best years some 300 tonnes of silver came in from silver mines in various parts of South America.iv

Once the gold and silver started to land on their shores, the Spaniards became proficient at spending it rather than engaging themselves in productive activities. Easy money had spoiled them and they produced very little of their own. Once this happened everything had to be imported. Weapons came from the Dutch, woolens from the British, glassware from the Italians, and so on.v It also led to Spaniards buying goods like bangles, cheap glassware, and playing cards from foreigners for the sheer pleasure of buying them.

As Thomas Sowell writes in Wealth, Poverty and Politics: “The vast wealth pouring into Spain [in the form of gold and silver from South America]… allowed the Spanish elite to live in luxury and leisure, enjoying the products of other countries, purchased with the windfall gain of gold and silver. At one point, Spain’s imports were nearly twice as large as its exports, with the difference being covered by payments in gold and silver… It was a source of pride, however, that “all the world” served Spain, while Spain “serves nobody”.”

Dear Reader, you must be wondering, why have I chosen to point out all this history so many centuries later. The point I am trying to make is that there is an equivalent to what happened in Spain in the 16th century in this day and age. It is the United States of America.

Like Spain, the total amount of good and services that the United States imports is much more than what it exports. The ratio of the imports of the United States to its exports was around 1.23 in 2016. The difference between the imports and the exports stood at $503 billion. In fact, if we look at the imports and the exports of goods, the ratio comes to around 1.51.

The point being that like Spain, the United States imports much more than it exports. Spain had an unlimited access to money in the form of gold and silver mines of South America. This gold and silver over a period of time was mined and shipped to Spain and in turn used by Spaniards to buy stuff from other parts of the world.

What is the equivalent in case of the United States of America? The dollar. The US dollar is the international reserve currency. It is also the international trading currency. As George Gilder writes in The Scandal of Money-Why Wall Street Recovers But the Economy Never Does: “Today it [i.e. the dollar] handles more than 60 percent of world trade, denominates more than half the market capitalization of world stocks, and partakes in 87 percent of global currency trades.”

Spain had almost unlimited access to the gold and silver from South America. Along similar lines, the United States has unlimited access to the dollar. Other countries need to earn these dollars by exporting goods and services. The United States needs to simply print the dollars (or digitally create them these days) and hand it over for whatever it needs to pay for.

While the unlimited access to gold and silver was Spain’s easy money, the dollar is United States’ easy money. And given this, it isn’t surprising that like Spain, the United States imports much more than it exports. This basically means that the country consumes much more than it produces. Also, while the Spaniards had to face the risk of gold and silver ultimately running out, the United States does not face a similar risk because dollar is a fiat currency unlike gold, and can be created in unlimited amounts. As long as dollar remains the global reserve currency and trading currency, the United States can keep creating it out of thin air. Of course, the role of the United States in global politics will be to ensure that the dollar continues to remain the reserve and trading currency. Having the biggest defence budget and military in the world, will help.

The supply of silver in Spain peaked around 1600 and started to fall after that. But the spending habits of people did not change immediately, leading to Spain getting into debt to the foreigners. The government defaulted on its loans in 1557, 1575, 1607, 1627, and 1647.vi

One impact of access to the easy money in the form of gold and silver, was a huge drop in human capital in Spain. As Sowell writes: “What this meant economically was that other countries developed the human capital that produced what Spain consumed, without Spain’s having to develop its human capital… Even the maritime trade that brought products from other parts of Europe to Spain was largely in the hands of foreigners and European businessmen flocked to Spain to carry out economic functions there. The historical social consequence was that the Spanish culture’s disdain for commerce, industry and skilled labour would be a lasting economic handicap bequeathed to its descendants, not only in Spain itself but also in Latin America.”

So, what is human capital? Economist Gary Becker writes: “Economists regard expenditures on education, training, medical care, and so on as investments in human capital. They are called human capital because people cannot be separated from their knowledge, skills, health, or values in the way they can be separated from their financial and physical assets.”

What is happening on this front, in case of the United States? As Michael S Christian writes in a research paper titled Net Investment and Stocks of Human Capital in the United States, 1975-2013, published in January 2016: “The stock of human capital rose at an annual rate of 1.0 percent between 1977 and 2013, with population growth as the primary driver of human capital growth. Per capita human capital remained much the same over this period.”

So, over a period of more than 35 years, the per capita American human capital has remained the same. And this is clearly not a good sign.

Further, unlike Spain which ultimately ran out of gold and silver, given that there was only so much of it going around in South America, the United States does not face any such risks given that dollar is a fiat currency and can be printed or simply created digitally.

But like Spain, the access to this easy money will ensure that in the years to come, the United States will continue to import more than it exports. This will go against the new President Donald Trump’s plan to make America great again. His basic plan envisages increasing American exports and bringing down its imports. But as long as America has access to easy money in the form of the dollar, the chances of that happening are pretty low because it will always be easier to import stuff by paying in dollars that can be created from thin air, than manufacture it locally.

The column was originally published on Equitymaster on March 14, 2017

America First?

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Moments after taking over as the 45th President of the United States on January 20th, Donald Trump said: “From this day forward, a new vision will govern our land. From this day forward, it’s going to be only America first, America first.”

The irony is that this insular approach comes from the President of a country which was built primarily by outsiders. Countries and civilizations which do well, never do so in isolation is a basic point that Trump seems to have forgotten.

Take the case of the British and how they managed to cross the Atlantic Ocean in order to reach North America. As Thomas Sowell writes in Wealth, Poverty and Politics: “When the British first confronted the Iroquois [a group of tribes] on the east coast of North America, the mental and material resources at the disposal of these two races were by no means confined to what they had developed themselves.”

So, what did British have access to, which they hadn’t produced themselves? As Sowell writes: “The British had been able to navigate across the Atlantic, in the first place, by using the compass invented in China, doing mathematical calculations with a numbering system from India, steering with rudders invented in China, writing on paper invented in China, using letters created by the Romans, and ultimately prevailing in combat using gunpowder, also invented in China. The Iroquois had no comparably wide cultural universe.”

The point being that Britain would not have managed to capture large parts of the world, including North America from the native tribes, without having access to all the foreign technology and the ideas that it had. And this was possible because Great Britain had always been a very open economy.

This ensured that many things that originated in Asia over the centuries became a part of the British and the European cultures. As Sowell points out, among the many things that originated in Asia and became a part of the European culture included, papers, bells, printing, gunpowder, the compass, rudders, spaghetti, chess, playing cards and so called Arabic numerals, which actually originated in India.

Without many of these things, the British wouldn’t have been able to crossover to North America. And if they hadn’t been able to do that, there would have been no United States of America. Hence, technologies and ideas from outside contributed a lot in Great Britain ruling large parts of the world, including North America. The founding fathers of the United States and the leaders that followed did not forget this, and their openness to ideas and individuals from outside, continued.

Donald Trump now wants to undo much of this. The question is can the United States afford this? As far as it comes to making things, the United States can’t compete with much of the world. This is clearly visible in the fact that it imports significantly more than what it exports. And this has led to a severely disgruntled workforce.

Nevertheless, one area where the United States clearly rules, is in the world of ideas and technology. As Ruchir Sharma writes in Breakout Nations—In Pursuit of the Next Economic Miracles: “US strength in technology looks overwhelming in comparison with even the fastest-rising emerging markets, and in comparison with Japan and Taiwan, nations that also spend heavily on tech research and development but generate a lot less growth out of it.”

Also, unlike Japan’s insular technology culture, the United States has a very open culture. As Sharma writes: “Silicon Valley is so rich in immigrant Indian and Chinese talent that it’s little surprise Google has travelled so well. The broader ecosystem that nurtures tech-start-ups, including the venture capital industry, the top-notch university system and the strong legal protection for intellectual property , is also arguably stronger in the United States than anywhere else in the world.”

America’s lead in technology is its best chance to pull the country out of the rut that it currently is. And the tech industry cannot continue to thrive, if only America and Americans come first. The sooner Donald Trump understands this, the better it is going for US long term growth.

The column originally appeared in the Bangalore Mirror on March 1, 2017