R Gandhi
Dear RBI, It's Not About Hoarding Notes, It's About Shortage of Cash
In the press conference that followed the monetary policy on December 7, 2016, R Gandhi, one of the deputy governors of the Reserve Bank of India(RBI), said: "We reiterate that there is adequate supply of notes and hoarding of notes helps nobody's cause."
The impression that the RBI is trying to create is that all is well and that it is the hoarders are responsible for the mess that prevails on the cash front, all through the country. But is that really the case?
In a press release dated December 8, 2016, the RBI said: "During the period from November 10, 2016 and December 7, 2016, banks have reported that banknotes worth Rs 4,27,684 crore have been issued to public either over the counter or through ATMs."
The total value of the Rs 500 and the Rs 1,000 demonetised notes amount to Rs 15.44 lakh crore. Hence, the notes replaced amount to close to 27.7 per cent of the demonetised notes. Before the notes had been demonetised the total value of currency stood at Rs 17.87 lakh crore. This basically means that around 23.9 per cent of the currency that was in circulation before demonetisation has been replaced.
Hence, around one-fourth of the currency is back in circulation. The question is why doesn't it feel like one-fourth? Why does it continue to be difficult to carry out cash transactions? The answer is straightforward.
To replace the Rs 500 and Rs 1,000 demonetised notes, the government printed the Rs 2,000 note, first. This means that there is no note between Rs 100 and Rs 2,000. Hence, every time one tries to spend the Rs 2,000 note, it is tough going because the other party simply doesn't have enough change going around.
This, despite the fact that the RBI has supplied: "lower denomination of the notes, that is Rs 100, Rs 50, Rs 20 and Rs 10… over its counters," as well. In fact, it has supplied 19.1 billion pieces of denomination of these notes over the last one month. As deputy governor Gandhi put it "This is more than what the Reserve Bank had supplied to the public in the whole of the last three years."
While the RBI said that a total of 19.1 billion pieces of notes of small denomination were printed, it doesn't provide us with a breakdown of numbers. It doesn't tell us how many Rs 100 notes were printed, how many Rs 50 notes were printed and so on. Hence, there is no way of finding out the total value of these notes that had been printed.
Nevertheless, it is safe to say that the total value of the lower denomination notes printed and pumped into the economy, would essentially amount to around 5-6 per cent of the total currency in circulation before demonetisation. Hence, the bulk of the notes printed have been Rs 2,000 notes. Given this, there isn't enough change going around, which means even those who have Rs 2,000 notes are finding it very difficult to use it.
What this means is that the 23.9 per cent figure of the total amount of currency replaced in comparison to the currency in circulation before November 8, 2016, when demonetisation was carried out, is overstated to that extent.
There is another problem with the Rs 2,000 note. There is a huge rumour going around that it has been launched as a stop-gap arrangement and is likely to be demonetised soon. This rumour perhaps comes from what was mentioned in the press release accompanying the demonetisation decision. As the press release said: "High denomination notes are known to facilitate generation of black money… Infusion of Rs 2,000/- bank notes will be monitored and regulated by RBI." It is well worth remembering that the original motive of demonetisation was to tackle black money and fake notes.
How will the situation play out in the days to come? Will things improve by the end of this month as the prime minister has repeatedly told the nation? As Urjit Patel said during the course of the monetary policy press conference: "What we have done over the last two weeks is recalibrated our production towards the 500 and the 100." This is going to improve the situation a little, given that as more 500s hit the market, the chances of the 2000s being accepted will also go up, as more change becomes available.
Having said that it will take some time for the situation to get back to normal. With 500s and 100s being printed the rate of currency replacement will slow down. It takes four 500 rupee notes to replace the currency that one 2000 rupee could.
Further, it is worth remembering here that the capacity of the printing presses supplying RBI with notes is around 300 crore notes per month. This, when the presses work 24 hours a day and for the full month.
The total number of 500 rupee notes demonetised stand at 1716.5 crore. At 300 crore notes a month, it will easily take five to six months to replace the total lot. Even if all the notes are not printed, given the push towards cashless, it will be a while before there is enough cash going around in the economy.
Hence, the point is that people are not hoarding cash. There simply isn't enough cash going around. But what about all the raids all across the country and the cash being found during these operations? Isn't that hoarding cash? Yes. Nevertheless, these seizures at best amount to a few hundred crore, which is a minuscule part of the overall currency that has been printed and pumped into the economy. At times, one does get excited looking at absolute numbers, but to put things in a proper perspective, it always makes sense to look at percentages.
To conclude, currency or cash is not the only form of money going around. There are other forms as well. Nevertheless, for a country where 98 per cent of the consumer transactions happen in cash, cash remains the major form of money. How difficult it is to understand this basic fact?
The column originally appeared on Equitymaster on December 12, 2016
Categories Equitymaster, Vivek Kaul's Diary Tags Black Money, demonetisation, Hoarding, not enough cash, R Gandhi, RBI, Urjit Patel
Demonetisation is Dead — Long Live Demonetisation
When the Facts Change, I Change My Mind. What Do You Do, Sir? – often wrongly attributed to John Maynard Keynes.
In the press conference that followed today's monetary policy, one data point and one clarification, has essentially made clear that Narendra Modi's big demonetisation plan is not going the way it was expected to.
When the plan was announced a month back on November 8, the one big aim of the plan was to tackle black money along with fake currency notes. Black money is essentially money that has been earned through legitimate or illegitimate means, but on which taxes have not been paid.
As on November 8, 2016, 685.80 crore Rs 1,000 notes were in circulation. Over and above this, 1716.50 crore of Rs 500 notes were in circulation. The total value of demonetised notes amounted to Rs 15.44 lakh crore.
These notes were demonetised and suddenly had no value. These notes can be deposited in banks and post offices, up to December 30, 2016 and the money will be credited in the bank account or the post office savings account.
The Reserve Bank of India (RBI) in a press release dated November 28, 2016, had said that Rs 8,11,033 crore worth of demonetised notes had been deposited back with the banks. Over and above this, Rs 33,948 crore worth of demonetised notes were exchanged for new notes as well as notes that continued to be legal tender. Initially, notes of up to Rs 4,000 could be exchanged. This was increased to Rs 4,500. Then decreased to Rs 2,000 and finally done away with.
By value the demonetised notes of Rs 500 and Rs 1,000 formed more than 86 per cent of the currency in circulation. The hope was that a certain portion of this currency would be black money held in the form of cash. And this black money would not be deposited into banks, for the fear of generating an audit trail.
In the process, black money would be destroyed. QED.
This logic seemed flawless that almost everybody bought it initially, including yours truly. The belief was that almost 20 per cent of the high denomination notes are black money. (I am yet to figure out how experts writing on the issue arrived at this figure. But once they did, almost everyone seemed to use it).
The total value of the demonetised notes stood at Rs 15.44 lakh crore. Given this, 20 per cent of Rs 15.44 lakh crore worked out to around Rs 3 lakh crore. It was then said that this amount will not make it to the banks. The assumption was that those with black money will not manage to get their old demonetised notes exchanged for the new or the currently legal ones.
Thankfully, I did not fall for this totally. In the letter dated November 11, 2016 (Modi's Next Shot on Black Money Should…) I had worked with the assumption that around one-third of the black money won't get converted and hence, close to Rs 1.1 lakh crore of currency will get destroyed.
In fact, almost every other analyst and economist talked about close to Rs 3 lakh crore being destroyed. It was rather amateurish of them to assume that the Indian public won't be able to convert their black money into white. There are various ways through which this has happened, which I will discuss in a separate piece.
As mentioned earlier up to November 27, 2016, Rs 8.11 lakh crore of demonetised notes had made it back to the banks. Since then, the RBI hasn't put out any new data. Nevertheless, in the press conference that followed the monetary policy today, the deputy governor of RBI, R Gandhi, said that close to Rs 11.55 lakh crore of demonetised notes had made it back to the banks.
This means that around 75 per cent of the demonetised notes are already back with the banks. (Rs 11.55 lakh crore divided by Rs 15.44 lakh crore of demonetised notes). With 24 days still to go until December 30, the last day of depositing demonetised notes, chances are almost all the demonetised money will come back to the banks.
This is something that the Revenue Secretary Hasmukh Adhia told The Indian Express: "The government expects the entire money in circulation in the form of currency notes of Rs 500 and Rs 1,000 which have been scrapped to come back to the banking system."
Given this, the question of black money being destroyed does not exist. What this means is that the black money in the system has been exchanged for new notes in various ways.
There is another angle here which was the subject of multiple WhatsApp forwards. And this is how it went. Every rupee out (except Re 1 notes) there in the financial system is essentially a liability for the RBI. (If you look at the Rs 100 note carefully, you will see the RBI governor saying, I promise to pay the bearer the sum of one hundred rupees, for example).
The hope was that with Rs 3 lakh crore not coming back to the banks, the liabilities of the RBI will shrink. To that extent, the asset side of the balance sheet of the RBI would also need to shrink and that would lead to the RBI giving the government a special dividend of Rs 3 lakh crore.
Other than being a subject of many WhatsApp forwards this was something that many economists also wrote about in their research reports. Those against this logic said that, just because the notes don't land up with the banks, does not mean that the RBI's liabilities come down.
Today at the press conference, the RBI governor Urjit Patel was asked about this and he said: "They still carry the RBI's liability as long as only the legal tender characteristic is withdrawn." This basically meant in simple English that the RBI balance sheet wasn't going to shrink and there was no question of a special dividend.
So where does that leave the Modi government? Revenue Secretary explained this to The Indian Express when he said: "Do you think that by simply depositing money in the bank account makes black money into white? It doesn't. It will become white when we charge taxes, when the Income Tax department can reach up to them by issuing a notice and questioning them."
The question is how many people will the Income Tax department go after, given their limited resources. Also, is this the way a government should go about raising revenue, by disrupting the entire economy?
Further, many people who have put money into banks are prepared to litigate and take this to court. As noted journalist Sucheta Dalal recently wrote: "Tax experts and retired income-tax commissioners have been confidently encouraging people to deposit their unaccounted money as this year's income under Sections 68 and 69 of the Income-tax Act and get away by paying 30% tax. While there is a good chance that this may lead to litigation, case law from the two previous instances of currency demonetisation in India (1946 and 1978) may support this stand."
All this brings us to the question whether demonetisation was really required? Will the tax that the government manages to collect through this effort, be more than enough to make up for the slowdown in economic growth that demonetisation is likely to cause?
Also, I really don't like the idea of the income tax department being allowed a free run.
The column was originally published in Vivek Kaul's Diary on December 7, 2016
Categories Equitymaster, Vivek Kaul's Diary Tags Black Money, demonetisation, R Gandhi, RBI, special dividend, Urjit Patel
Why Public Sector Banks Should Not Be Merged
Over the last few months there has been talk of the government merging public sector banks. The finance minister Arun Jaitley said so in his budget speech in February: "a roadmap for consolidation of Public Sector Banks will be spelt out."
In an interview to the Business Standard newspaper published on May 15, 2016, Jaitley said, "wait for a few days," when he was asked for a timeline on consolidation of public sector banks. Between February and May, there have been other occasions on which Jaitley has said that the merger of public sector banks is on the cards.
What is the logic behind the idea of consolidating or merging public sector banks? The government currently owns twenty-seven public sector banks, which is way too many. The idea is to merge some of these banks so that they can also compete globally. The size of these banks varies a lot. The State Bank of India is the biggest public sector banks and its balance sheet is seventeen times larger than the smallest public sector bank.
As Jaitley told Business Standard: "Our public sector banks(PSBs) also must be global players and therefore the idea of consolidating some of them."
While this is a noble idea, it does not solve the problem of bad loans from which all public sector banks are currently dealing with. This is something that first needs to be solved. It doesn't help anyone if a weak bank is merged with what looks like a relatively strong bank. And the problem of bad loans of public sector banks still hasn't gone away. It's alive and kicking.
As R Gandhi, deputy governor of the Reserve Bank of India, the banking regulator, said in a recent speech: "Merger of a weak bank with a strong bank may make combined entity weak if the merger process is not handled properly. The problems of capital shortages and higher non-performing assets (or bad loans) may get transmitted to stronger bank due to unduly haste or a mechanical merger process."
Gandhi also pointed out that there was very little past precedent to go on. As he said: "Recent merger of State Bank of Saurashtra and State Bank of Indore into State Bank of India may be seen as basically merger among group companies. The only example of merger of two PSBs is merger of New Bank of India with Punjab National Bank in 1993. However, this was not a voluntary merger."
Research evidence suggests that mergers tend to work when they lead to firing of employees. When two similar organisations merge, it leads to many sets of people having the same kind of expertise and skillsets. Hence, one set is gotten rid of.
For two banks merging this could mean, shutting down one of the two branches operating in the same area and then firing the employees of the branch which has been shut-down. This will bring down employee cost as well as operational costs. This is a good example of synergy that often gets talked about in case of mergers.
Having said that, nothing of that sort will be possible in India. Even a hint on this front can lead to labour unions going on a rampage. Jaitley made this clear in his interview where he said that consolidation shall be looked at "without adversely affecting labour employment considerations".
And without fewer employees after the merger of public sector banks, there is very little synergy that will be created.
Also, merging banks will not solve the most basic problem that the government owned public sector banks face—crony capitalism. A large part of bad loans that public sector banks are currently dealing with has been because of lending to crony capitalists. Till the public sector banks continue to be government owned, some set of crony capitalists will thrive.
If the government really wants to deal with this problem, then best way is to start privatising public sector banks. As far as fulfilling its social sector obligations is concerned, the government does not need to own 27 banks for that. Around five to six banks should be good enough.
(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])
The column was originally published in the Bangalore Mirror on May 18, 2016
Categories Arun Jaitley, Bangalore Mirror, Banking Tags Arun Jaitlley, merger of public sector banks, R Gandhi, State Bank of India
Does It Really Make Sense to Merge Public Sector Banks?
The government of India owns twenty-seven public sector banks(PSBs). It has often been suggested that the government should not be owning so many banks. Many of these banks are very small and hence, they should be merged so that they benefit from the economies of scale.
The situation was summarised by R Gandhi, deputy governor of the Reserve Bank of India, in a recent speech. As he said: "[The] banking system continues to be dominated by Public Sector Banks (PSBs) which still have more than 70 per cent market share of the banking system assets. At present there are 27 PSBs with varying sizes. State Bank of India, the largest bank, has balance sheet size which is roughly 17 times the size of smallest public sector bank."
Gandhi further said: "Most PSBs follow roughly similar business models and many of them are also competing with each other in most market segments they are active in. Further, PSBs have broadly similar organisational structure and human resource policies. It has been argued that India has too many PSBs with similar characteristics and a consolidation among PSBs can result in reaping rich benefits of economies of scale and scope."
The first thing that needs to be mentioned here is that most mergers fail. There is enough research going around to prove that. As the Harvard Business Review article titled The Big Idea: The New M&A Playbook points out: "Companies spend more than $2 trillion on acquisitions every year. Yet study after study puts the failure rate of mergers and acquisitions somewhere between 70% and 90%."
Hence, it is safe to say that most mergers fail and it is best to start with this assumption when any merger is proposed. And there is no reason to believe that the story for Indian public sector banks will be any different.
There have been two kinds of bank mergers in India. The first kind is when a bank which is about to fail is merged with a strong bank. The Sector 45 of the Banking Regulation Act 1949 empowers the RBI to "make a scheme of amalgamation of a bank with another bank if it is in the depositors' interest or in the interest of overall banking system."
The merger of Global Trust Bank with Oriental Bank of Commerce in 2004 is a good example of this. As Gandhi said in his speech: "Prior to 1999, most of the mergers were driven by resolution of weak banks under Section 45 of Banking Regulation Act 1949. However, after 1999, there has been increasing trend of voluntary mergers under Section 44A of Banking Regulation Act 1949."
The second kind of merger is the voluntary merger. As far as voluntary mergers go, a good example is the recent merger of ING Vysya Bank with Kotak Mahindra Bank. This merger had the so called synergy necessary for a merger to take place.
As Gandhi said: "One and most obvious has been voluntary merger of banks driven by the need for synergy, growth and operational efficiency in operations. Recent merger of ING Vysya Bank with Kotak Mahindra Bank is an example of this kind of consolidation. ING Vysya Bank had a stronger presence in South India while Kotak had an extended franchise in the West and North India. The merger created a large financial institution with a pan-India presence."
The merger of Bank of Madura and Sangli Bank with ICICI Bank in 2001 and 2007, and the merger of Centurion Bank of Punjab by HDFC Bank in 2008, are other good examples of synergy based mergers.
But what does the word synergy really mean? One of former professors used to say that: "Since we are all born on this mother earth, there is some sort of synergy between us." That was his way of saying that synergy is basically bullshit. Once a merger has been decided on then people go looking for reasons to justify it and that is synergy. While that may be a very cynical way of looking at things, there is some truth in it as well.
Nevertheless, author John Lanchester does define synergy in his book How to Speak Money. As he writes: "Synergy: Mainly BULLSHIT, but when it does mean anything it means merging two companies together and taking the opportunity to sack people." He then goes on to explain the concept through an example.
As he writes "If two companies that make similar products merge, they will have a similar warehouse and delivery operations, so one of the two sets of employees will lose their jobs. The idea is that this will cut COSTS and increase profits, though that tends not to happen, and it is a proven fact that most mergers end by costing money…When two companies merge, the first thing that ANALYSTS look at when evaluating the deal is how many jobs have been lost: the higher the number, the better. That's synergy."
If two public sector banks are merged there are bound to be situations where both the banks have a presence in a given area. Synergy will demand that one of the branches be shut down. But given that the banks are government owned something like that is unlikely to happen.
Over and above this, there will be multiple people with the same skill at the corporate level. Will this duplicity of roles end, with people being fired? Highly unlikely.
Hence, the merger of two public sector banks, will give us a bigger inefficient bank. Further, there are very few examples of public sector banks being merged in the past. So, there is nothing really to learn from.
As Gandhi said: "Recent merger of State Bank of Saurashtra and State Bank of Indore into State Bank of India may be seen as basically merger among group companies. The only example of merger of two PSBs is merger of New Bank of India with Punjab National Bank in 1993. However, this was not a voluntary merger."
Also, it is worth remembering that public sector banks are facing huge bad loan problems. Many corporates who had taken on loans are not repaying them. In this scenario, if banks are merged without the bad loan problem being solved, we will have a situation where problems of two banks are basically passed on to one bank. That doesn't make the situation any better.
As Gandhi summarises the situation: "PSBs as a group have not been performing well during the last few years. There has been a large increase in Non-Performing Assets (NPAs). As a part of managing large NPAs, some suggestions have been made that perhaps a consolidation of PSBs can render them more capable of managing such challenges relatively better…Merger of a weak bank with a strong bank may make combined entity weak if the merger process is not handled properly. The problems of capital shortages and higher NPAs may get transmitted to stronger bank due to unduly haste or a mechanical merger process."
The column originally appeared on the Vivek Kaul Diary on April 27, 2016
Categories Banking, Equitymaster, Vivek Kaul's Diary Tags John Lanchester, Merger, Mergers Fail, R Gandhi, Reserve Bank of India, Synergy
Corruption in bank lending starts at very beginning
"Anyone with any sense had already left town…" – Bob Dylan in Lily, Rosemary and the Jack of Hearts
In the Daily Reckoning newsletter dated September 9, 2015, I had extensively quoted a survey carried out by EY. In this survey 64% of respondents believed that the bad loans of banks resulted primarily because of lapses in the due-diligence carried out by the banks, before the loans were sanctioned.
As the report which came along with the survey pointed out: "Third party agencies such as surveyors, engineers, financial analysts, and other verification agencies, etc., play a critical role in assuring financial information, proposals, work completion status, application of funds, etc. Lenders rely significantly on the inputs issued by such third parties."
And this system is being manipulated. "Reports are made as a routine, with little scrutiny. In some situations, the reports may be drafted under the influence of unscrupulous borrowers," the EY report pointed out.
In response to the column someone with a detailed knowledge of the loan processing and disbursal process of banks got in touch with me. He gave me two examples of the loan disbursal system being manipulated. This ultimately led to several banks ending up with bad loans.
The first case was of an unlisted entity in the business of manufacturing luggage, borrowing from two big public sector banks. The promoter of the company offered his equity in the company, as well as land and the factory, as a collateral. This transaction took place in 2007. The valuation report by a third party agency put the combined value of all the assets at Rs 35 crore. Against these assets the banks gave a loan of around Rs 27 crore. The promoter took this loan. He also borrowed Rs 3 crore more from the banks.
Later another valuer was brought in to examine the value of the assets, and the value of the assets was put at a much lower Rs 19 crore. The old valuer was dismissed but by then the damage had already been done. The company had given out a loan of Rs 30 crore against assets which were worth only Rs 19 crore.
Ideally the situation should have exactly been the other way around.
The second case involves a listed company in the building materials space. The company came out with an initial public offering in 2008-2009. The company was listed at a three digit price. Currently, the price of the stock is in lower single digits.
The company took loans amounting to Rs 325 crore from two big public sector banks and one of the bigger new generation private sector banks. The promoter did not stop at this. He borrowed more using his other listed entities as well. In 2013, he defaulted on the loans citing slowdown in construction activity.
Now he owes banks around Rs 1000 crore to the banks. The book value of the assets that banks have as a collateral is around Rs 225 crore. The market value is expected to be in the region of Rs 325-350 crore. The rest of the money was lent by banks against shares, which are now quoting in single digits.
In both the cases, the banks ended up with losses. Both the companies that we talked about are not very big companies and they were able to do so much damage to banks so easily. Now imagine what must be happening when the banks deal with the bigger corporates.
The Reserve Bank of India (RBI) governor, Raghuram Rajan, summarised the situation accurately in a speech last year when he said: "The promoter enjoys riskless capitalism – even in these times of very slow growth, how many large promoters have lost their homes or have had to curb their lifestyles despite offering personal guarantees to lenders?" Almost none.
In fact, these defaults have pushed Indian banks into a difficult situation. As R Gandhi, one of the deputy governors of the RBI, said in a speech he made on September 15: "The amount of non-performing assets [have] witnessed [a] spurt and as on March 2015, it was at 4.62. per cent of the gross advances of the banks in comparison with 2.36 per cent of the gross advances as at March 2011."
Further, non-performing assets or bad loans have grown at a much faster pace than the overall lending in the last few years. Along with the growth in bad loans, as I have often pointed out in the past, the restructured assets (where the tenure of the loan or the interest on the loan has been changed in favour of the borrower) have also grown.
As Gandhi pointed out: "The ratio of restructured standard assets to gross advances grew to 6.44 per cent as at the end of March 2015 from 5.87 per cent of gross advances as on March 2014. The total stressed assets (i.e., NPAs plus Restructured Assets) as on March 2015 were 11.06 per cent of gross advances."
All this has had a severe impact on profitability of banks. "The sharp increase in stressed assets has adversely impacted the profitability of the banks. The annual return on assets has come down from 1.09 per cent during 2010-11 to 0.78 per cent during 2014- 15," Gandhi said.
This has become a drag on the economy. The increase in bad loans and restructured assets also hurts those borrowers who have been repaying their loans without fail, as they end up paying higher interest rates. As Rajan said last year: "One consequence of skewed and unfair sharing is to make credit costlier and less available. The promoter who misuses the system ensures that banks then charge a premium for business loans." Hence, the next time the businessmen want the RBI to cut interest rates, they should understand they are a major part of the problem.
Other than the fact, that the banks lent more money than they should have [i.e. due-diligence wasn't proper], they also did not monitor the loans properly. In cases where money had been lent against shares, the falling share price should have led to some action from banks. But that doesn't seem to have happened.
The RBI has since asked banks to follow a proper credit-risk management system. As Gandhi said during the course of his speech: "The guidelines entail involvement of top Management, including the Board of Directors of the bank in actively managing the credit risk of the banks. Banks are required to put in place proactive credit risk management practices like annual / half-yearly industry studies and individual obligor reviews, credit audit which entails periodic credit calls that are documented, periodic visits of plant and business site, and at least quarterly management reviews of troubled exposures / weak credits."
While this will help banks in not making the same mistakes as they have in the past, it will do nothing about the mess that they already are in. For loans that have gone bad already or are in the process of going bad, all these steps are essentially too little and too late.
The column originally appeared on the Daily Reckoning on Sep 18, 2015
Categories Banking, Equitymaster Tags Bad Loans, Corruption, R Gandhi, Raghuram Rajan, RBI, restructured assets, Stressed Assets, Valuers