India’s Big Government
Page 41
Initially, banks only lend to businesses that are expected to generate enough cash to repay their loans. But as time progresses, the competition between lenders increases and caution gets thrown to the winds. Money is doled out left, right and centre, and it normally doesn’t end well.
This is the basic premise of the Financial Instability Hypothesis. Minsky essentially theorised that there are three stages of borrowing. The December 2015 Financial Stability Report did explain these three stages. Nevertheless, a better explanation can be found in L Randall Wray’s book Why Minsky Matters—An Introduction to the Work of a Maverick Economist.
As Wray writes: “Minsky developed a famous classification for [the] fragility of financing positions. The safest is called ‘hedge’ finance (note that this term is not related to so-called hedge funds). In a hedge position, expected income is sufficient to make all payments as they come due, including both interest and principal.”643 Hence, in the hedge position, the company taking on loans is making enough money to pay interest on the debt as well as repay the debt itself.
What is the second stage? As Wray writes: “A ‘speculative’ position is one in which expected income is sufficient to make interest payments, but principal must be rolled over. It is ‘speculative’ in the sense that income must increase, continued access to refinancing must be expected, or an asset must be sold to cover principal payments.”644
Hence, in a speculative position, a company is making enough money to keep paying interest on the loan that it has taken on, but it has no money to repay the principal amount of the loan. In order to repay the principal, the income of the company has to go up, or banks need to agree to refinance the loan, i.e., give a fresh loan so that the current loan can be repaid. The third option is for the company to start selling its assets in order to repay the principal amount of the loan.
And what about the third stage? As Wray writes: “Finally, a ‘Ponzi’ position (named after a famous fraudster, Charles Ponzi, who ran a pyramid scheme—much like Bernie Madoff’s more recent fraud) is one in which even interest payments cannot be met, so that the debtor must borrow to pay interest (the outstanding loan balance grows by the interest due).”645
Hence, in the Ponzi position, the company is not making enough money to be able to pay even the interest that is due on its loans. In order to pay the interest, it has to take on more loans. This is why Minsky called it a Ponzi position.
Charles Ponzi was a fraudster who ran a financial scheme in Boston in 1919. He promised to double the investor’s money in 90 days. This was later shortened to 45 days. There was no business model in place to generate returns. All Ponzi did was to take money from new investors and hand it over to old investors whose investments had to be redeemed. His game got over once the money leaving the scheme became higher than the money being invested in it.
Along similar lines, once companies are not in a position to pay interest on their loans, they need to borrow more. This new money coming in helps them repay their loans as well as pay interest on them. And while they can keep borrowing more, they can keep paying interest and repaying their loans. Hence, the entire situation is akin to a Ponzi scheme.
This is precisely the point that the RBI was trying to make in the December 2015 Financial Stability Report, though not in a very straightforward way. But then, central banks and central bankers are known to sometimes make very obvious points in a circumlocutory manner.
As we have seen earlier in the chapter, many Indian corporates which have borrowed from banks have very low interest coverage ratios. Hence, they have not been earning enough to keep paying their interest and repaying their principal.
In this scenario, it is but natural for them to degenerate into Ponzi schemes, where fresh money is required to keep repaying interest as well as the principal amount. Of course, this could not have been achieved without the active help of the banks themselves. If banks had not been ready to give them fresh loans, there is no way that these corporates would have been able to run Ponzi schemes. But this is precisely what the banks did.
Let’s look at some figures. Between July 2014 and July 2015, banks lent a total of Rs. 1,20,900 crore to industry as a whole. The lending to industry went up by 4.8 per cent, in comparison to the 10.2 per cent growth between July 2013 and July 2014.
The situation gets even more interesting when we take a closer look at the numbers. Bank lending to the infrastructure sector between July 2014 and July 2015 grew by Rs. 71,600 crore. Within the infrastructure sector, lending to the power sector grew by Rs. 59,400 crore. Lending to the iron & steel sector grew by Rs. 27,100 crore during the year.
What does this tell us? Between July 2014 and July 2015, banks gave out Rs. 98,700 crore, or 81.6 per cent, of the Rs. 1,20,900 crore that they had lent to industry to the two most troubled sectors, namely, infrastructure and iron & steel. These sectors formed around 19.5 per cent of the total lending carried out by banks and 40 per cent of their stressed assets.
In fact, this was around the time that the RBI had warned in the June 2015 Financial Stability Report that “the debt servicing ability of power generation companies [which are a part of the infrastructure sector] in the near term may continue to remain weak given the high leverage and weak cash flows. Banks, therefore, need to exercise adequate caution while dealing with the sector and need to continue monitoring the developments very closely”.
Hence, the question is: Why were banks still lending to power companies and iron & steel companies? The answer lies in the fact that many of these companies had degenerated into Ponzi schemes by then and needed fresh loans to keep repaying their debts. If the banks hadn’t given them fresh loans, they would have defaulted on their loans.
Hence, the banks gave these companies fresh loans in order to ensure that their loans didn’t turn into bad loans, and so, in the process, they managed to kick the can down the road. This is again because of the principal-agent problem, where the interests of the managers running the PSBs are not in line with public interest. Of course, the principal-agent problem in this case is because of Big Government.
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The Reserve Bank of India categorises large borrowers as borrowers with an outstanding loan amount of Rs. 5 crore or more. This is where the problems lie. As the Financial Stability Report of June 2016 points out: “[The] share of large borrowers in total loans increased from 56.8 per cent to 58 per cent between September 2015 and March 2016. Their share in GNPAs also increased from 83.4 per cent to 86.4 per cent during the same period.”
This basically means that not only have large borrowers taken 58 per cent of all loans, but they are responsible for 86.4 per cent of all the bad loans. In fact, the bad loans ratio of large borrowers stood at 10.6 per cent as on March 31, 2016. As on September 30, 2015, it had stood at 7 per cent. When it came to PSBs and their lending to large borrowers, the bad loans ratio stood at 12.9 per cent as on March 31, 2016.
Hence, the bad loans to big borrowers have been going up. One reason, as I have explained earlier in the chapter, is that the RBI has been forcing PSBs to recognise bad loans as bad loans.
Of course, even among the large borrowers, there are many categories. While banks are able to go after the small enterprises which have taken on loans and are not in a position to repay them, the same cannot be said about the very large borrowers.
As Raghuram Rajan had said in November 2014, the full force of bank recovery is “felt by the small entrepreneur, who does not have the wherewithal to hire expensive lawyers or move the courts, even while the influential promoter once again escapes its rigour”. “The small entrepreneur’s assets are repossessed quickly and sold, extinguishing many a promising business that could do with a little support from bankers,” Rajan had further said on that occasion.646
The Financial Stability Report does not give a detailed breakdown of the large borrowers, but it does give us a very interesting data point about the top 100 borrowers among the large borrowers (basically the biggest borrowers
, whose defaults can bring down banks).
As the Report points out: “[The] top 100 large borrowers (in terms of outstanding funded amounts) accounted for 27.9 per cent of credit to all large borrowers…. There was a sharp increase in the share of [the] GNPAs of [the] top 100 large borrowers in [the] GNPAs of all large borrowers from 3.4 per cent in September 2015 to 22.3 per cent in March 2016.”
What does this mean? The loans given to the top 100 borrowers among the large borrowers constitute 27.9 per cent of all loans given to the large borrowers. As on September 30, 2015, the bad loans of the top 100 borrowers among the large borrowers had amounted to around 3.4 per cent of the bad loans of all large borrowers. By March 31, 2016, this had jumped to 22.3 per cent of the bad loans of all large borrowers.
What does this tell us? It tells us very clearly that banks were treating its largest borrowers with kid gloves and not recognising their bad loans as bad loans. This could possibly have been done by restructuring their loans. This is the only possible explanation for the bad loans of the top 100 large borrowers jumping from 3.4 per cent of all large borrowers’ loans to 22.3 per cent within a period of just the six months between October 2015 and March 2016.
Thankfully, this game is now over. And for that the RBI deserves credit. The bigger challenge now lies ahead. The government, as the major owner of the PSBs, needs to make sure that these largest of defaulters are made to repay the loans that they have taken on from PSBs. This will ensure that it is payback time for the crony capitalists.
Given that such a thing has rarely happened in the past, it will be interesting to see how the Modi government goes about this. If it can clean this mess up, then the witticism that ‘telephone calls from the government to the PSBs have stopped’ will acquire a real meaning.
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Raghuram Rajan took over as the twenty-third Governor of the RBI in September 2013. Throughout his term, calls were made for lower interest rates. Starting in January 2015, Rajan started to cut the repo rate, and at the time of writing this, in July 2016, Rajan had cut the repo rate by 150 basis points. The repo rate is the rate at which the RBI lends to banks on an overnight basis. It acts as a sort of a benchmark to the interest rates that banks pay for their deposits and, in turn, charge on their loans.
One constant criticism of Rajan was that, because he did not cut the repo rate fast enough, both individuals and businesses did not borrow as much as they could have, and this led to the economy not growing fast enough.
Take a look at Table 11.4(a). It shows the non-food credit growth of the scheduled commercial banks over the past seven financial years. Banks give loans to the FCI and other state procurement agencies to buy rice and wheat from the farmers directly at the minimum support price. Once this figure is subtracted from the overall lending carried out by banks, what remains is the non-food credit.
Table 11.4(a) tells us very clearly that the growth in bank lending has slowed down considerably over the years. In fact, it had slowed down the most after Rajan took over as the RBI Governor in September 2013. So does that mean that Rajan should have cut the repo rate faster? This conclusion turns out to be incorrect if we look at some more data. Let’s look at the retail lending growth rate (see Table 11.4(b)) over the same period. These include home loans, vehicle loans, credit card outstanding, consumer durable loans, loans against shares, bonds and fixed deposits, and what we call personal loans.
Table 11.4(a): Non-food credit lending growth of banks over the past seven years.
Period Non-Food Credit Growth (in %)
March 20, 2015 to March 18, 2016 9.1
March 21, 2014 to March 20, 2015 8.6
March 22, 2013 to March 21, 2014 14.3
March 23, 2012 to March 22, 2013 13.5
March 25, 2011 to March 23, 2012 16.6
March 26, 2010 to March 25, 2011 20.6
March 27, 2009 to March 26, 2010 16.8
Source: Sectoral Deployment of Credit Data, RBI.
Table 11.4(b): Retail lending growth of banks over the past seven years.
Period Retail Lending Growth (in %)
March 20, 2015 to March 18, 2016 19.4
March 21, 2014 to March 20, 2015 15.5
March 22, 2013 to March 21, 2014 15.5
March 23, 2012 to March 22, 2013 14.7
March 25, 2011 to March 23, 2012 12.9
March 26, 2010 to March 25, 2011 17
March 27, 2009 to March 26, 2010 4.1
Source: Sectoral Deployment of Credit Data, RBI.
As we can see from Table 11.4(b), the retail lending growth during 2015-2016 has been the strongest of the past seven financial years. One of the reasons is obviously the fact that the RBI had cut the repo rate by 150 basis points between January 2015 and July 2016.
Now let’s take a look at Table 11.4(c), which shows the growth in lending to industry over the past seven financial years. The table clearly shows that the growth in lending to industry has been slowing down over the last seven financial years. The explanation for this is straightforward. As the bad loans due to lending to industry went up, the lending growth to industry slowed down. In fact, if we look at the growth in lending to industry between September 2015 and September 2016, the lending growth to industry has slowed down to 0.9 per cent. The lending to micro and small industries has fallen by 6.5 per cent. The lending to medium-level industries has fallen by 12.7 per cent. Only the lending to industries categorised as large has grown by 3.1 per cent.
Table 11.4(c): Industrial lending growth of banks over the past seven years.
Period Industrial Lending Growth (in %)
March 20, 2015 to March 18, 2016 2.7
March 21, 2014 to March 20, 2015 5.6
March 22, 2013 to March 21, 2014 13.1
March 23, 2012 to March 22, 2013 15.1
March 25, 2011 to March 23, 2012 20.3
March 26, 2010 to March 25, 2011 23.6
March 27, 2009 to March 26, 2010 24.4
Source: Sectoral Deployment of Credit Data, RBI.
This tells us very clearly that interest rates are really not the issue, because the growth in retail lending has been the strongest in many years, despite the so-called high interest rates.
Also, banks have started taking into account the risk of default and building that into the interest rates they charge, something that they were perhaps not doing earlier. As Rajan said in a November 2014 speech:647
The promoter who misuses the system ensures that banks then charge a premium for business loans. The average interest rate on loans to the power sector today is 13.7 per cent, even while the policy rate is 8 per cent [the repo rate has since fallen to 6.25 per cent]. The difference, also known as the credit risk premium, of 5.7 per cent is largely the compensation banks demand for the risk of default and non-payment. Since the unscrupulous promoter hides among the scrupulous ones, every businessperson is tainted by the bad eggs in the basket.
The power industry promoters were paying 13.7 per cent interest when the interest on an average home loan was 10.7 per cent.648
What Rajan was saying is that the banks also need to build a credit risk premium into the rate of interest. This credit spread is essentially the building in of the possibility of the borrower defaulting into the interest rate being charged. If the risk of default in a particular sector is high, the interest rate banks will charge will also be high. This is the point that Rajan was essentially making. Given this, the good industrialists are paying a higher rate of interest because the chances that the bad ones won’t repay their loans are high.
Also, the larger point here is that the basic purpose of any bank is to lend the money it raises as deposits in a way that compensates it for the risk involved. The job of a bank is not to encourage the industry by offering industrialists loans at a low rate of interest.
Take a look at Table 11.4(d). It shows the retail loans and the loans given to industry as a proportion of the total loans given by the scheduled commercial banks.
As is clear f
rom Table 11.4(d), banks have been giving out a greater amount of retail loans over the years. Retail loans formed 5.3 per cent of the total non-food credit in 2009-2010. By 2015-2016, they had jumped to 41.5 per cent. In fact, if we look at the lending between May 2015 and May 2016, retail loans formed 45 per cent of the total non-food credit loans, whereas loans to industry formed around 4.8 per cent of the total non-food credit loans.
Table 11.4(d): Proportion of non-food credit bank lending to retail and industry over the past seven years.
Period Retail Loans as a Proportion of Non-Food Credit
(in %) Lending to Industry as a Proportion of Non-Food Credit
(in %)
2015-2016 41.5 13.4
2014-2015 33.1 29.8
2013-2014 17 43.4
2012-2013 19.8 50.5
2011-2012 13.8 53.8
2010-2011 17.6 46.6
2009-2010 5.3 58.7
Source: Sectoral Deployment of Credit Data, RBI.
This is a clear case of banks wanting to stay away from lending to industry. In fact, more specifically, this is a clear case of PSBs, on having to deal with a huge amount of bad loans from industry, wanting to stay away from lending to industry.
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In June 2016, Raghuram Rajan decided to go back to academics and not consider a second term as RBI Governor (not that the role was offered to him). This happened after a string of attacks questioning his being Indian and his American green card, among other things. After Rajan wrote a letter to the employees of RBI announcing this, many columns appeared in the media justifying the government’s decision to not offer Rajan a second term.
The chief argument that was made was that Rajan did not cut interest rates fast enough. Nobody bothered to explain what they meant by fast enough. As Chandan Mitra, a member of the Bhartiya Janata Party (BJP) and a newspaper editor wrote in a column: “Rajan’s emphasis on increasing savings fell on deaf ears because the middle class was… now impatient to spend, not save.”649