Thomas Sowell

Explained: Why the Govt is Misleading Us on High Fuel Prices and Oil Bonds

The reason why doesn’t matter. The only thing that matters is controlling the narrative – Fabian Nicieza in Suburban Dicks.

Over the last few years, several government ministers have blamed the oil bonds issued during the era of the previous United Progressive Alliance (UPA) government, for the high petrol and diesel prices, which have prevailed for a while now.

The then oil minister Dharmendra Pradhan had tweeted in 2018 that: “The country and our OMCs [oil marketing companies} are also yet to recover from the shock of Oil Bonds worth Rs 1.4 Lakh Crores issued during the UPA regime.”

The finance minister Nirmala Sitharaman rblamed the oil bonds for the high prices of petrol and diesel, in a recent statement.  This is not true. I have explained this issue in great detail on earlier occasions. Nevertheless, I will try and offer a broader summary here, before getting on to the new points I want to make. 

Oil bonds were largely issued by the previous UPA government. This was done in order to compensate oil marketing companies, like Indian Oil, Bharat Petroleum and Hindustan Petroleum, for selling petrol, diesel, kerosene and domestic cooking gas, at a price which wasn’t monetarily feasible for them.

The argument offered by the National Democratic Alliance (NDA) government is that since interest has to be paid on these bonds and that these bonds have to be repaid, the government needs to charge a high excise duty on petrol and diesel. This leads to high petrol and diesel prices.

In that sense, the NDA government and you and me are paying for the sins of the UPA government. This argument is never made in as clear words as I am making it here. Things are left vague enough for people to fill in the gaps and make their own WhatsApp forwards.

As of March 2014, before the NDA government came to power, the total oil bonds outstanding stood at Rs 1,34,423 crore. By March 2015, this had come down to Rs 1,30,923 crore, which is where it has stayed up until March 2021.

This means that between end March 2015 and end March 2021, no oil bonds matured and hence, the NDA government didn’t need to repay a single rupee of oil bonds. Of course, interest had to be paid on these bonds. An interest of Rs 9,990 crore has to be paid on these bonds every year. This means, over a period of six years, between end March 2015 and end March 2021, the government has paid Rs 59,940 crore as interest on these bonds.

During the same period, it earned Rs 14,60,036 crore as excise duty on petroleum products. As the government told the Lok Sabha in early August this year: “Central excise duty is contributed largely by Petrol and Diesel.” So, excise duty earned on the sale of petrol and diesel makes up for a bulk of the excise duty earned on sale of petroleum products.

In total, during this period, 4.1% of the excise duty collected on petroleum products has gone towards paying interest on oil bonds. In 2020-21, this stood at just 2.7% (Rs 9,990 crore of interest against excise duty of Rs 3,71,726 crore earned on petroleum products).

In fact, if were to look at excise duty collected on just petrol and diesel, between end March 2015 and end March 2021, it amounts to around Rs 13.7 lakh crore. The interest paid on oil bonds amounts to 4.4% of this amount.

In 2021-22, the current financial year, Rs 10,000 crore worth of oil bonds are maturing and hence, need to be repaid. The interest that needs to be paid on the oil bonds during the year should amount to around Rs 9,500 crore. So, during 2020-21, around Rs 19,500 crore will be needed by the government to service these bonds.

In an answer provided to the Lok Sabha recently, the government had said that the total excise duty earned on petrol and diesel, between April and June this year, had stood at Rs 94,181 crore.

Given that, the second Covid wave was on during this period, and that it would have negatively impacted the consumption of petrol and diesel to some extent, it is safe to say that if excise duty on petrol and diesel continue to be where they are, the total collections this year can easily touch Rs 4 lakh crore. Of course, the collections on petroleum products will be even greater.

Rs 19,500 crore works to around 4.9% of Rs 4 lakh crore. So, the government is likely to spend one-twentieth of the excise duty earned on petrol and diesel, in servicing the oil bonds (both repaying maturing bonds and paying interest on the outstanding bonds).

The remaining bonds worth Rs 1,20,923 crore (Rs 1,30,923 crore minus Rs 10,000 crore worth of bonds maturing this year), will mature between November 2023 and March 2026.

The other argument that is being made is that the government needs to save money in order to repay these bonds in the years to come. It is worth clarifying here that the government meets the expenditure of a given year from the revenue earned during that year. Hence, bonds maturing in 2023, 2024, 2025 and 2026, will be repaid using taxes earned during that year. This nullifies the argument about the government having to save in order to repay these bonds.

Hence, the entire argument that the oil bonds have led to a situation where the government has had to charge a high excise duty on petrol and diesel, is totally wrong. In fact, as I have explained earlier, the reason for this lies in the fall of corporate tax collections.

In 2018-19, the total corporate tax or the income tax paid by corporates had stood at Rs 6.64 lakh crore. This fell to Rs 5.57 lakh crore in 2019-20. It fell further to Rs 4.57 lakh crore in 2020-21.

This fall was on account of the base rate of corporate tax being cut from 30% to 22% in September 2019. It can also be argued that Covid must have led to lower profits for corporates in 2020-21 and hence, lower corporate tax collections for the government.  

Data from the Centre for Monitoring Indian Economy tells us that in 2020-21, the net profit of listed corporates (more than 5,000 companies) increased by 120.3% in comparison to 2019-20. So, Covid didn’t impact profits among the listed corporates. While net profit went up by 120.3%, the corporate tax paid by these companies went up just 13.9%. 

Covid has negatively impacted smaller businesses and that must have impacted corporate tax collections to a certain extent. But a bulk of the fall in corporate tax collections seems to have come from a lower rate of tax. This has been compensated through higher excise duty on petrol and diesel.

In 2018-19, excise duty earned on petroleum products by the central government brought in Rs 2.14 lakh crore. This jumped to Rs 3.72 lakh crore in 2020-21, thanks to a higher excise duty on petrol and diesel.

The corporate tax cut was supposed to boost consumption and lead to an increase in corporate investment. But that hasn’t really happened. Expecting consumption to increase thanks to lower corporate taxes was kite-flying at its very best.

Consumption increases when people see the prospect of earning more money, not when corporate taxes go down. Investment, for a whole host of reasons, has been down in the dumps for close to a decade now,. I shall not go into these reasons in detail here, having dealt with this issue on multiple occasions in the past.

This has created a communication problem around high petrol and diesel prices for a government obsessed with managing the narrative.

In their book Nudge—The Final Edition, Richard Thaler and Cass Sunstein talk about the publicity principle, originally elucidated by the philosopher John Rawls. As Thaler and Sunstein write: “If a firm or government adopts a policy that it could not easily defend publicly, it stands to face considerable embarrassment, and perhaps much worse, if the policy and its grounds are disclosed [emphasis added].”

This is precisely the problem with the entire messaging around the issue of high petrol and diesel prices. The only reason for this is the high excise duty on petrol and diesel, in order to compensate for lower corporate tax collections.

The excise duty on petrol has gone up from Rs 9.48 per litre in October 2014 to Rs 32.90 per litre currently, a jump of close to 250%. A bulk of this increase of around Rs 10 per litre has happened in the last one year. A similar story has played out with diesel, with excise duty going up from Rs 3.56 per litre in October 2014 to Rs 31.80 per litre currently, a jump of close to 800%. (I would like to thank Chintan Patel for providing this information by using the central government notifications on excise duty on petrol and diesel).

Of course, this is not something that a narrative obsessed government can admit to. This would mean telling the world at large that the common man is being made to pay for lower corporate taxes. This has led to the entire narrative around oil bonds and they having to be repaid and interest having to be paid on them, and that leading to a higher excise duty on petrol and diesel, and hence, higher pump prices of fuel.

This is a narrative that can be easily sold on WhatsApp, given that most people don’t have the time to check the facts of any argument and buy anything that is sent to them over the world’s newest and the most happening university.

As Thomas Sowell writes in Knowledge and Decisions: 

“To exhort the individual citizen to make investments in knowledge comparable to those of lobbyists and political crusaders (both of whom have much lower costs per unit of personal benefit) is to urge him to behaviour that is irrational, if not physically impossible in a twenty-four hour day.”

This is something that the current government is making use of and projecting a narrative that wrongly blames the past government for high fuel prices.

As Thaler and Sunstein write: “Organizations of all forms should respect people, and if they adopt policies that they could not and would not defend in public, they fail to show that respect. Instead, they treat citizens as tools for their own use or manipulation [emphasis added].”

This is precisely what is happening.

The interesting thing is that the government has given the more or less the right reason behind high fuel prices in an answer to a question raised in the Lok Sabha. As it said: “The excise duty rates on petroleum products are calibrated from time to time with the objective of generating resources for infrastructure and other developmental items of expenditure, taking into account all relevant factors and keeping in view the prevailing fiscal situation.”

Every government has the right to tax the citizens in different ways. This answer tells us precisely that. Of course, explaining the rationale behind the tax is not always that straightforward.

On WhatsApp University

Around fifteen days back, a friend of mine from school asked, whether repayment of oil bonds issued during the Congress-UPA regime was responsible for higher petrol and diesel prices. Given that, these bonds had to be repaid, the government had no option, but to charge higher taxes on petrol and diesel.

I said no. He then asked, why are forwards going around on WhatsApp saying so. I wrote a piece explaining why there was no link between repayment of oil bonds and the high prices of petrol and diesel.

This set me thinking and led to the question. Why do people believe things sent on WhatsApp so easily? And here are a few answers that I could come up with.

1) Social media, cyberspace, WhatsApp or whatever else one might want to call it, in a way is an extension of the old village square or simply the park in the housing complex you live in or the little space in front of your building, where you meet your neighbours and friends, and talk and gossip with them. Like was the case earlier, WhatsApp is also a space where people meet, talk, discuss and have views on things they don’t understand, like was and is the case, when they meet physically.

The discussions that happened (or still happen) in a village square kind of space were not recorded anywhere. A version of the discussion existed only in the minds of people who happened to be there. No one remembers their past exactly. We all remember a version of it. And as days went by people forgot about what they had discussed at the village square and moved on.

This is not true about WhatsApp or other forms of social media. If a wrong explanation about a particular issue is offered there is an evidence that it exists. Of course, unlike a village square or a park in the housing complex, WhatsApp is not a physical space. But it is still a space where people meet and interact. So, to that extent things haven’t really changed.

Hence, what was happening earlier is also happening now. Even in the pre-WhatsApp/social media era, people believed in conspiracy theories or offered explanations on topics they had very little idea of and believed in many things without doing some basic research. It’s just that there was no record of such things happening.

But in a digital space, some sort of record of the discussion having happened, remains. Hence, this phenomenon is more obvious now than it was in the past. And to that extent, the fact that most people in general are ignorant about most things, comes out much more clearly now. Of course, their ignorance continues to be directly proportional to their confidence.

2) When I use the word ignorant here, I am not being judgmental, I am only trying to state the obvious. Most of us have extremely limited expertise in extremely limited areas (I suggest that you read another piece titled On Advice that I wrote a while back).

This is primarily because most of us are busy in our own little worlds, trying to make the best of what we have. So, unless something really matters to us, we don’t want to spend time understanding it. This explains why people spend so much time planning holidays but have next to no idea about what the gross domestic product (GDP) of a country really means.

As Thomas Sowell writes in Knowledge and Decisions: 

“To exhort the individual citizen to make investments in knowledge comparable to those of lobbyists and political crusaders (both of whom have much lower costs per unit of personal benefit) is to urge him to behaviour that is irrational, if not physically impossible in a twenty-four hour day.”

Nevertheless, this doesn’t stop us from having views on things that we don’t understand.

This is a weakness, which people with an agenda make use of. Take the case of the high petrol and diesel prices. They are high primarily because corporate tax collections have fallen since September 2019, when the government decided to cut the peak corporate rate from 30% to 22%. In order to make up for this deficit, the central government is charging higher taxes on every litre of petrol and diesel sold, than they did in the past.

This is a politically suicidal explanation when it comes to explaining why petrol prices in many parts of the country have crossed Rs 100 per litre. How can the common man pay more, when the corporates are not paying their fair share of taxes?

Hence, the politicians and many others have come with the story of oil bonds issued by the previous government having to be repaid, as an explanation for high petrol and diesel prices. Of course, a basic Google search can negate this explanation. But once people have read this on WhatsApp their minds are satiated, as an anomaly has been explained away in a way that sounds reasonably true.

Given the fact that people are learning what they are from WhatsApp, it’s even referred to as WhatsApp University in zest. 

3) The question is, why all this possible now, and wasn’t possible earlier. The answer lies in the fact that in the earlier era any large propaganda had to be carried out openly either through newspapers, magazines, TV or radio, for that matter. And given that it came with its own set of limitations.

One, there was a price attached to it. Two, most propaganda came with a face.

So, let’s say petrol prices had crossed Rs 100 per litre in the early 2000s, when smart phones were not around. Anyone writing a piece in a newspaper offering a reason for it, had to do it in his own name. In that situation, it would be very difficult to offer the wrong reasons in the hope of people buying it and the writer getting away with it. Once a piece had been published, others could easily call out the writer’s bluff leaving his or her reputation in tatters.

In today’s era, with a significant proportion of the population owning smartphones and the availability of cheap internet leading to the rise of social media like WhatsApp, such problems no longer exist. Producing fake news is cheap. All it requires is a literate person, who has a mobile phone with an internet connection. This has made things significantly easy for people who want to spread propaganda or run an agenda or just want to have some fun.

Take the case of vaccine deniers. Social media has made their life very easy. They can propagate any nonsense that they want to. This is not to say that this did not happen earlier. It did. It’s just that now it can be done anonymously and probably at a much faster pace. Anyone can author a post and just send it across. And after it has been forwarded a few times, no one has any idea of who has written it. The anonymity that the social media provides is a big reason why fake news is created in the first place.  

4) Also, given that the social media is more or less free, it comes with the capacity of endless repetition. This is what political parties all over the world try to make use of, by feeding content that their supporters like to believe in and creating hatred towards a class or a community or a caste or a religion.

Or simply offering nonsensical reasons for an economic trend like petrol and diesel prices are high because oil bonds need to be repaid. As Abhijit Banerjee and Esther Duflo write in Good Economics for Hard Times: “The problem with echo chambers is not just that we are only exposed to ideas we like; we are also exposed to them again and again and again, endlessly.” So, every time petrol and diesel prices rise, the oil bond angle is whipped out all over again, because there is no cost attached to it. Also, as Sowell writes: “sober analysis seldom has the appeal of ringing rhetoric.”

In fact, the production of fake news is impacting the traditional mainstream media which wants to do good journalism. As Banerjee and Duflo write: 

“Circulation of news on social media is killing the production of reliable news and analysis. Producing fake news is of course very cheap and very rewarding economically since, unconstrained by reality, it is easy to serve to your readership exactly what they want to read. But if you don’t want to make things up, you can also just copy it from elsewhere.”

The larger point here, as Banerjee and Duflo put it, is ‘the economic model that sustained journalism as a location for “public space” (and correct information) is collapsing’. In this scenario, ‘without access to proper facts, it is easier to indulge in nonsense’.

Of course, this is not to say that the mainstream media is all kosher. It is not. But that is another topic for another day.

5) The major issue at play here is, whether you support the current government or not. This has led to a situation where there is a great need among many people to support the government on everything and anything. What George Orwell called groupthink is at work here.

As Christopher Booker writes in Groupthink—A Study in Self Delusion: “A group of people comes to be fixated on some belief or view of the world which seems hugely important to them.” In this case, the view is that the current Narendra Modi government can do no wrong. Hence, if petrol prices are more than Rs 100 per litre in many parts of the country and diesel prices are very high, there must be a genuine reason for it, for which the current government is not responsible.

And this is where the fake story of oil bonds comes in and satiates the minds of such individuals. Social media like WhatsApp just helps achieve this at a fast pace and an almost costless sort of way.

Also, once such people have a reason, they go out of their way to defend it. As Booker writes: “They are convinced that their opinion is so self-evidently right that no sensible person could disagree with it. Most telling of all, this leads them to treat all those who differ from their beliefs with a peculiar kind of contemptuous hostility.”

This explains why many family WhatsApp groups where people used to share good morning and happy birthday messages, have turned into virtual battlefields. But the trouble is, such individuals are not doing their own thinking. They are just believing in whatever they have been told.

As Booker writes: 

“They have not looked seriously at the facts or the evidence. They have simply taken their opinions or beliefs on trust, ready-made, from others. But the very fact that their opinions are not based on any real understanding of why they believe what they do only allows them to believe even more insistently and intolerantly that their views are right.”

They have become victims of groupthink and are likely to continue to be so.

To conclude, as Alan Rusbridger, writes in Breaking News – The Remaking of Journalism and Why It Matters Now: “ Bad information [is] everywhere: good information [is] increasingly for smaller elites. It [is] harder for good information to compete on equal terms with bad.”

Bad news is driving out good news. And WhatsApp, as a medium, is at the heart of it. 

India’s International Black Money Can’t Be Brought Back Though It Can Keep Coming Back

Black money has been a hot topic among us Indians over the past few years, especially Indian black money that has been stashed abroad, over the years. Possibilities of getting this money back to India have been raised and extensively discussed and can lead to flaring up of tempers on the University of WhatsApp.

In this scenario, any news item on the Indian black money stashed abroad tends to fly off the charts. The University of WhatsApp has been buzzing over the last few days on the news of Indian black money in Swiss Banks having gone up in 2020. This has led to surprise among the supporters of the present dispensation and happiness among those against it.

As the Press Trust of India reported: “Funds parked by Indian individuals and firms in Swiss banks, including through India-based branches and other financial institutions, jumped to 2.55 billion Swiss francs (over Rs 20,700 crore) in 2020.” This is a jump from 899 million Swiss francs (Rs 6,625 crore) at the end of 2019.

The Press Trust of India rightly doesn’t use the term ‘black money’ in reporting the funds that Indian firms and individuals have parked with Swiss Banks. Some amount of money can be taken out of the country legally every year and be deposited in Swiss banks (or other foreign banks for that matter).

This is not to say that all the funds that Indians have placed with Swiss banks will be kosher. But the fact of the matter is there is no way of specifically knowing that how much of it is black money. Black money is basically money on which taxes have not been paid.

Of course, after the Press Trust of India reported on it, other news media latched on to this story. In their reports, the phrase funds parked in Swiss banks was replaced with the term black money.

And soon headlines which said that Indian black money in Swiss bank jumps, were all over the place. Politicians from other parties also reacted to this piece of news and said that this was because of increased corruption under the Bhartiya Janata Party. This shows us clearly why nuance is neither a strength in politics or on the University of WhatsApp, for that matter.

The government immediately issued a press release, in which it said: “Media reports allude to the fact that the figures reported are official figures reported by banks to Swiss National Bank (SNB) and do not indicate the quantum of much debated alleged black money held by Indians in Switzerland.”

In all this noise, the more important points on Indian black money which goes abroad or doesn’t come back in the first place, were never made.

Let’s look at them here.

1) The money that Indians had parked in Swiss banks in 2020 has been estimated to be at Rs 20,700 crore. One dollar was worth around Rs 74 on an average in 2020. This works out to $2.96 billion. For the ease of discussion, let’s round this to $3 billion.

Even if all this was black money (which it isn’t), no media house bothered to ask a very basic question. How come the Indian black money in Swiss banks was just $3 billion? $3 billion on its own is a large number. But in the context of a nation which has had a history of a huge black money, this isn’t even small change.

2) A lot of black money is generated through trade misinvoicing. As Global Financial Integrity (GFI), an organisation which specialises in this area, defines this as “a method for moving money illicitly across borders which involves the deliberate falsification of the value, volume, and/or type of commodity in an international commercial transaction of goods or services by at least one party to the transaction.”

Imports coming into the country can be over invoiced. In that process, money can go out of the country without the required taxes being paid on it. Further, imports can be under invoiced to not pay customs duty.

In a similar way, exports going out of the country can be under invoiced and money that should have come back to the country, and taxes should have been paid on it, continues to stay outside its borders.

A number is put to this misinvoicing through the value gap analysis. As GFI explains in a report: “For example, if Ecuador reported exporting US$20 million in bananas to the United States in 2016, but the US reported having imported only US$15 million in bananas from Ecuador that year, this would reflect a mismatch, or value gap, of US$5 million in the reported trade of this product between the two partners for that year.”

While data on imports and exports is never perfect, a significant portion of any value gap is a result of misinvoicing, in order to not pay tax on money earned and ensure that it continues to stay abroad, or to simply move money out of a country. This is the largest component of illicit financial flows globally. In India, we call this international black money.

3) As per GFI, the average value gap of India from 2008 to 2017, a period of 10 years, stood at $78 billion per year, which in total amounts to $780 billion. This means that a significant portion of $780 billion would have left India during these years or should have come back to India, but never did. Of course, this is just one period of ten years that we are talking about. All this didn’t just start happening in 2008. Now compare this with the $3 billion lying in Swiss banks. That’s not even small change.

Also, it is worth remembering that we are talking about black money through just the misinvoicing route. As GFI points out: “Many illicit transactions occur in cash to prevent an incriminating paper trail. For these many reasons, our estimates are likely very conservative.”

Of course, this problem is not specific to India. China, Russia and Mexico were ahead of India, on this front, with an yearly average of $482.4 billion, $92.6 billion and $82.5 billion, respectively, during the period.

4) Take the case of 2016. The value gap of the misinvoiced imports and exports stood at $74 billion. As GFI points out: “The analysis shows that the estimated potential loss of revenue to the government is $13.0 billion for 2016. To put this figure in context, this amount represents 5.5 percent of the value of India’s total government revenue collections in 2016.” Given this, the government loses out on a significant amount of taxes because of international black money.

5) The question is, if so much money on which adequate amount of tax has not been paid, is going abroad every year or simply staying there, why doesn’t it reflect in the Swiss bank numbers. This is where things get interesting.

As the government press release referred to earlier points out: “These statistics do not include the money that Indians, NRIs or others might have in Swiss banks in the names of third–country entities.” This could be one possible reason.

6) The common perception in India is that all the black money that leaves India (or simply doesn’t come back) is in Swiss banks. This is totally wrong. There are around 70 tax havens all over the world. An estimate made by The Economist in 2013 suggested that: “Nobody really knows how much money is stashed away: estimates vary from way below to way above $20 trillion.”

And this money is spread all across the world and isn’t just held in banks in Switzerland. As Gabriel Zucman writes in The Hidden Wealth of Nations – The Scourge of Tax Havens, points out:

“In the past, Swiss bankers provided all services: carrying out the investment strategy, keeping securities under custody, hiding the true identity of owners by the way of famous numbered accounts. Today, only securities custody really remains in their purview. The rest has been moved offsite to other tax havens—Luxembourg, the Virgin Islands, or Panama—all of which function in symbiosis. This is the great organisation of international wealth management.”

Given this, India’s international black money could possibly be anywhere in the world. Also, a lot of this money is held “through intermediaries of shell companies headquartered in the British Virgin Islands, or foundations domiciled in Liechtenstein.” This ensures that the money is not easily traceable to those who took it out of the country or decided not to bring it back.

7) It is worth remembering here that all the focus on black money in India should have made people who stash their black money abroad, smarter. Clearly, when everyone and their grandmother knows about Swiss banks, the black money wallahs are bound to be cautious and ensure that they spread their money around across the world.

8) So, the question is how good are India’s chances of getting this money back? The money that has left Indian shores or should have come to India but never did, could be anywhere. Tax havens maintain secrecy to ensure that they remain attractive options for those who are looking to hide their black money. Hence, recovery will continue to remain difficult. If even a small part of this money is to be recovered, a massive amount of international cooperation will be needed.

9) While it might be difficult to recover black money from outside India’s shores, some of it does keep coming back to India through the foreign direct investment route. A lot of this money comes in through countries like Mauritius, Singapore, Netherlands and Cyprus. In 2020-21, 44% of the total foreign direct investment coming into India, came from these countries. This was a low figure in comparison each of the five years before that, when the proportion had stood at more than 60%. Of course, not all this money is India’s international black money, but a significant portion might be.

As the finance ministry white paper on black money published in May 2012 had pointed out:

“It is apparent that the investments are routed through these jurisdictions for [the] avoidance of taxes and/or for concealing the identities from the revenue authorities of the ultimate investors, many of whom could actually be Indian residents, who have invested in their own companies, though a process known as round-tripping.”

India’s international black money is also round-tripped to be invested in stocks. 

To conclude, instead of trying to chase this black money and get it back, it makes more sense for us to create economic conditions where this black money comes back to India and is invested in different projects. We should also try and simplify our tax system to ensure that the incentives to generate black money in the first place, come down. 

But then that hardly makes for great rhetoric and management of narrative, which is what Indian politics seems to be all about these days. As Thomas Sowell writes in Knowledge and Decisions: “Sober analysis seldom has the appeal of a ringing rhetoric.”

And that’s something worth thinking about.

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

Nirav_Modi

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

rupee

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.