Black Money & Demonetization

The Government of India announced that the Rs 500 and Rs. 1000 denominated currency notes will cease to be legal tender. The move was targeted towards tackling black money, corruption and terrorism. After initial euphoria, questions began to emerge. What are the costs of this demonetization? Will it be effective if people can still create new black money thereafter? Will it increase the GDP? Will it increase inflation? What about tax revenues? We look for answers.

Black money and demonetisation

To start off, black money is a wider societal ill and demonetisation is but one step in the war against black money.

Black money and black economy are also two different constructs. The terms shadow economy and underground economy are also used as synonyms for black economy. 

Black money is the currency of black economy. It refers to illegal money earned from illegal sources which has not been disclosed to the government. The advantage of black money is that it links into the legitimate economy, uses the advantages of the legitimate economy but does not pay the costs.

Research on tackling black money

The issue of black money has been well-explored. The National Institute of Public Finance and Policy has been active in research about black money. Their 1983 survey of estimates of Black Money[1] led to a report on Aspects of Black Money[2] in 1985. The Report of 2012 titled Measures to tackle Black Money in India and Abroad[3] and the 2012 White Paper on Black Money[4] by Ministry of Finance covers the various research studies and updates them. These studies however have not been able to determine a consistent estimation of the black economy. The estimates, including from other sources, vary from 15% to 45% of the total economy. The papers, however, give a broad spectrum of mechanisms to deal with black money.

Apart from the above Indian initiatives, there have been global initiatives to tackle “underground economy” or “shadow economy”. Primarily, the principles remain the same. Internationally, I find, they focus more on facilitating voluntary compliance than enforcement. Maintaining trust and confidence in tax system takes precedence[5]. They also recommend risk based monitoring mechanisms, coordination amongst revenue departments and education among other things[6].

Principles of tackling black money

The first principle is that remove the systemic pain that leads to creation of black money in the first place. Blame lies with the tax department. Black money is nothing but money generated in legitimate transactions which are hidden from government so as to avoid paying the transaction cost (usually tax) in the legitimate economy[7]. This is usually done by using physical cash. This cash thereafter must be processed to convert into consumption or investment. Black economy refers to various activities, transactions etc. that help process this physical cash, create returns on this cash, facilitate consumption using this cash etc. 

The second principle has two parts. First, not all cash transactions are necessarily black money transaction. They become black money transactions only if they are hidden from the legitimate economy. Thus, a shop-keeper who does not give receipt but declares the sale (it’s only hypothetical) does not create black money. Conversely, a shop-keeper who gives a receipt but discloses other receipt book to the tax authorities (happens all the time) creates black money transaction. Second, the black money must at some time or other be plugged into legitimate economy. Thus, it cannot be done using user-created currency that cannot be exchanged with local currency. So it depends on legal tender. It means somewhere down the chain there must exist a person for whom part of this black money is legal cash income which he can use for his own consumption in legitimate channels. Usually, this is the construction worker, or other poorest of the poor who will give certain services and his income will remain under the government radar. It can also be illegal traders in gold or diamonds etc. who can convert this into precious items that have quasi-legal tender status. 

The third insight is that black economy is continuously fed by parts of white economy that go underground. Quite a few people who do not want to promote black money contribute to it. They are either coerced – say developer forcing buyer to pay him in cash or government officer seeking bribes in cash. Therefore, preventing white money from becoming black the starting point. The recommendations of Report titled Measures to tackle Black Money in India and Abroad describe some strategies. The core principle is to increase the cost of converting legitimate money into cash (wherein government loses ability to track it) and reducing the cost of electronic transfer also promotes electronic transactions. 

Black money flows through a separate channel. Such channel has infrastructure to handle black money. The fact is black money seldom remains in cash. It moves into high value items like real estate, diamonds, gold, films etc. The people involved in these sectors have well-evolved mechanisms to absorb black money. One way is to create entire value chains that use only cash. It is easy in sectors where workers/suppliers are unorganised, contract workers – e.g. Construction, films production etc. Bringing systematic regulations that make it easy for the participants in the value chain to accept electronic payments will curb black money.

Black economy depends on black money financiers. These are money lenders earning like 2% per month on their investments for financing the activities in black money friendly sectors. Film financing, construction financing, financing retailers, dance bars, alcohol, etc. These financiers also need enforcement mechanism to ensure their money is safe. Naturally they ally with criminal elements. Al Capone, the famous Chicago mobster, was previously an enforcer but later a financier. 

Black money faces the same invest or consume choice as legitimate money. On the investment side, it seeks sectors that are friendly for black money. So those people who buy many apartments from developers and developer later sells these for profit, are contributing to investment side when their agreements are not registered and do not pay stamp duty. Jewellers and traders of precious stones also contribute helpfully in this area.

On the consumption side, black money seeks to buy three things legitimate goods that can be consumed openly (i.e. normal things in abnormal amounts – say many shoes, many suits etc.), illegitimate goods that can be consumed secretly (banned or imported exclusive foods – caviar or expensive wines, expensive furnishings, home decorations etc.) or stored secretly (high-end safes, etc.). Within these sectors there exists trails that lead to the people hoarding the money.

Black money is also used in legitimate investments. Foreign channels play critical role. Quite substantial investments in P-Notes is actually round-tripped black money. The key aspect of these instruments is create anonymity by being away from arms of the laws of the country from where income can be fed into the legitimate hands. In such cases, the source of income is illegal. Thus, many businesses in tax-havens such as Mauritius, Cayman Islands etc. exist to convert illegal money into legal money. Many of these investments come under the purview of money laundering.

Incentives for electronic transactions help prevent use of cash. Income tax deductions on credit cards or e-payments up to a certain limit can incentivise electronic transfers. South Korea used credit card income deduction experiment has been hailed as a success by OECD.

Strategies for tackling Black Money

The distillation of various approaches can be summarised as under:

1. Establish identity of persons (through PAN Card, Aadhar Card etc.) operating in the country – citizens and foreigners.
2. Enable low the cost direct bank transfers (Implementation of NEFT/IMPS/RTGS and other formats) including direct transfers of subsidies to the beneficiaries under the Aadhar scheme.
3. Enable electronic register of assets (Underway through electronic land records, digitisation of revenue records)
4. Reform tax system so that cost of compliance is lower than cost of tax evasion. (through initiatives such as Saral forms, e-filing, self-declaration etc.) Indirect tax system through simplification (GST).
5. Widen the net for disclosure by filing Income Tax return. (auto-processing returns for tax refunds)
6. Regulations that increase costs for black money creating activities. (Prevention of Corruption Act etc.)
7. Create attribution chain for funds entering and exiting the country (such as through P-Notes, FDI, Prevention of Money Laundering Act etc.)
8. Create e-trails of both incomes and expenditure.
9. Control on holding of cash and physical money including Indian and foreign money. (FEMA, recent demonetisation)

It is clear that black money clean up is underway on many fronts. Many of the pieces of puzzle have been put in place.

Semantics of the current demonetisation

Demonetisation is the mechanism by which the government states to withdraw the money which is current legal tender. The government being sovereign can take such decision. The effect of this announcement is that the currency notes in circulation will now cease to be valid tender and can only be exchanged at the banks. Demonetisation of higher denomination notes as an idea has been around[8].

There are two important issues with respect to the present demonetization. First, that the notes ceased to be legal tender from midnight of 8th November just 4 hours after announcement. So in effect the only places where they will be accepted will be banks. Second, even the banks have been given time until when they can accept the notes – 30th December. Third, the cash swap carries restriction. Thus, in effect the announcement forces these notes into the banks deposits within a short period of time.

As per RBI estimates[9], 15billion notes of 500 denomination (approx. Rs. 7853.75 billion) and 6 billion notes of 1000 denominations (approx. Rs. 6325.68 billion) exist. In addition, RBI estimates that fake 0.2 million notes of Rs. 500 and 0.15million notes of Rs. 1000 were discovered. The actual number of fake notes in circulation will be higher. These will be worthless from 09 November 2016 but you can get the credit for the money held as these notes in the form of bank deposit. Naturally, those who can disclose deposits equal to the amount they hold in cash will have no problem.

Hasn’t it been done before?

Indeed, it has. The first demonetization took place in 1946 and Rs 1000 and Rs 10,000 notes were demonetized. Later in 1978, Rs. 1000, Rs. 5000 and Rs. 10,000 were demonetized. This is the third time demonetization has taken place. 

The critical difference is in the quantum however. The first and second demonetisations effected really high value notes which formed a small part of notes in circulation. We can arrive at the estimates by comparing the denomination of the note with the annual per capital GDP. In 1960, India’s per-capita GDP was Rs. 400 (then currency), in 1978 per capita GDP was Rs. 1722/- whereas today it is Rs. 103,000/- (today’s currency). [10]Thus in 1960, a 1000 Rupee note was 2.5X and in 1978 it was 0.5X per capita GDP, considerably easy to withdraw. The second aspect is that today the 500/- and 1000/- currency notes represents ~85% of physical money in circulation. At that time, it was considerable less[11].

RBI earlier removed pre-2005 notes of all denominations from circulation as they have fewer security features compared with subsequent notes. The process of removing the older notes from circulation continued for nearly one year. The deadline was extended till December 2015 and those notes continued to remain legal tender till November 8. This was not exactly demonetisation but removing from circulation and has now subsumed into the present demonetisation.

Why attack the cash?

First, who holds black money in cash? Mostly corrupt people. Their pay-offs are in suitcases and hoarded in their houses. These are balances held till they find their target investments. A lot of black money itself is mainly held in gold and land. 

As explained earlier, cash, i.e. black money is the currency of black economy. The government cannot do much about black money that remain stagnant if it remains a legal tender. But remove the legality of it and the government is able to alter the cost-benefits equation of corruption. Demonetisation attacks the currency supply of the black economy. But removing the cash available to buy these gold and you affect the supply chains in black economy. When the flow gets interrupted the cost of corruption increases and payoff reduces dramatically. Such action attacks the chain that processes black money.

It is possible that as a result land prices and gold prices will fall. If land prices fall, middle class will be able to purchase land. If gold purchases are reduced, the forex pressure on INR will ease a bit. Thus, legitimate money which was being priced out of the economy gets an opportunity. Further, it prevents the black money processing chains from forcing white money into black.

Inflationary or Deflationary 

Firstly, part of the actual money in circulation is never recovered. Depending on various conditions, at least 20% of this paper money will never reach banks. This stock of money is lost. Many believe this to be deflationary. It isn’t. Since this money was never within the legal purview it was meaningless anyways. From government’s point of view, it was like the money we forgot in an old diary and the diary was lost. This money did contribute to the economy but to smaller extent.

Some say “but this money was being used to buy Audis and other luxury goods”. This is weak argument. Audi as a company does not receive unaccounted money (if they do that is criminal as well). The black money chain in such cases effectively starts with the dealers who game the system by discounting the vehicle or by making the vehicle pre-owned, prior owner being the dummy person. In either of these cases the black money is circulating to other illegal users. If such deals are curtailed it is good – not bad. In any case a black money purchaser who pays Rs. 2.5 million to buy Rs. 4 million Audi then can buy a Skoda legitimately. 

Will it work?

One argument is we tried it in 1978 and failed. Of course we failed. First the notes demonetized were too large for the size of the economy. Second, we can fairly estimate that the black economy may not have used the super high value notes as much too. The present action has better chance of success as it proceeds logically. First, people across India were given an Identity card (Aadhar), then bank accounts were opened for them (Jan-Dhan), and people across India can transfer money using SMS today. No strategy can succeed without proper systems in place. This time there are better mechanisms that people can switch to.

Another argument is that people can deposit the money now and withdraw cash five months later for black money transactions. Of course they can. But there are various laws in place that track the cash withdrawer. These guidelines were framed for Prevention of Money Laundering Act. As per RBI rules under that, every withdrawal needs a PAN card reference. Further, every branch manager is required to file detailed statement of weekly/monthly cash transactions. The cost-benefit for legitimate fellows becomes high. It is easier to monitor for the tax authorities. One person claims to have sent his 200 or so employees to convert old currency into new currency. Thus, per day at Rs. 4000/- per person he is converting Rs. 0.8million into cash. So has the system failed? The answer is no. It appears from the logical approach followed by the government that this is merely the beginning of effort against black money. I suspect these two mechanisms will be taken care of in subsequent actions. 

The more fundamental answer is that black money is not a pool but a chain. Break the chain or make the chain costly and you inconvenience the poor who did not have access to bank systems. But with Jan-Dhan accounts, poor have ready access to banking channels (though not credit). So if you are law-abiding citizen then you can sail through mostly unscathed no matter how poor you are.

Black money in real estate gold etc. 

Usually, black money is used to purchase the following items – gold, precious metals, precious stones, real estate, high end consumer goods, high-end liquor, drugs, and entertainment. The total quantity of Gold, precious metals, precious stones, liquor and certain high end consumer goods in the market that is disclosed and purchasable is unknown. Their price is reasonably known. The quantity of real estate, entertainment etc. is known but their prices are not known to the government. For high-end alcohol, drugs and other items, both quantity and price are unknown to the government. 

This sort of black-money driven consumption is out of purview of the legitimate formal economy. The effect of demonetization on such consumption will be positive. Either this spending will cease thus reducing illegal imports of gold, precious metals, stones, liquor, drugs, entertainment of certain types (dance bars for example) etc. Other parts will integrate into the formal system thus prices of real estate, entertainment will generate legitimate revenue for government.

In short, the demand for these items will not be affected that much in short term and definitely not in long term. There is no denying that the contours of demand will shift from shadow economy to formal economy.

No magical government windfall gain

One argument goes that if a certain portion of the cash does not get deposited then RBI will no longer have to be liable for those notes. That reduced liability will be transferred to Government. If you estimate that about 30% of the currency notes will not come back, Government could be receiving about 30% of Rs. 14 Trillion is more than Rs. 4 Trillion. Such gains will be a game changer. Such arguments are naïve as they come from misunderstanding of how central bank balance sheet works[12] and also how money is created. 

One must remember that Balance sheet is an accounting construct to understand the capital deployment. Destruction of soiled notes, removal of older notes and other activities also do not create any income for government. Such activities merely adjust the balance-sheet on the liability side only. Simply put, there will be no gain to the government if RBI’s liabilities are written off. 

The issue in present case is the quantum of readjustment. If RBI balance sheet shrinks by 30% one fine day, there will be panic. But this effect can also be muted by writing down in phased manner while keeping the liability alive on paper. If this was possible you could have seen demonetization every 5 years. The only effect is that it will improve the quality of RBI balance sheet but no further.

The second part of the argument is that such a windfall need not wait for demonetization. The windfall is nothing but quantitative easing. That has consequences and is a well debated concept. 

Do Terrorists carry money in trunks?

One of the stated aims of the demonetization was to tackle terrorism. It has met with lot of ridicule. People are asking if terrorist do carry money in suit cases while coming across the borders. Again these people are missing the point. 

In fact, money laundering is one of the most important financing mechanism for terrorists. It was after 9/11 that the US initiated substantial push towards enacting of anti-money laundering laws to prevent financing of terrorists. The anti-money laundering investigations fails when the money trail leads to cash. In India the terror-finance trail starts and ends with cash making it impossible to get early alerts of terrorist active in the country. Demonetisation will upset the financing chain for the terrorists.

As noted, black money is the currency of black economy. It is the black economy, including financiers that need extra-judicial enforcement mechanisms. The terror groups are at the apex of criminal elements that provide this enforcement mechanism. If film producers do not pay their financiers, they get call from D-company – in effect an enforcement call. The black economy is also as innovative as any other. The criminal elements then seeking alternative revenue streams indulge in various terror activities. The terror finance chain comprises gold, diamonds and counterfeit currency. The counterfeiters don’t keep the money in cash but quickly convert it into legitimate, legal bank accounts through SMEs and other small businesses. Using these fronts these terrorists use this money to buy information and access. The actual terror attack is only the “last-mile” effect. The ultimate “attackers” are usually pawns without any knowledge of systems.

Yet, the main effect of demonetisation and subsequent introduction of new notes will be to increase the costs of the counterfeiters. It will serve to shock this supply chain.

The unscrupulous SMEs

The biggest elements in the black money creation chain are the SMEs. SMEs are flexible entities like sponges when it comes to cash. The question of scale of SMEs in the black money chain is mind boggling. Over years I come to believe that at least 30% of SMEs exist solely for serving the black money chains and about 80% contribute to the black money chain (many don’t have a choice). 

Their modus operandi is thus. SMEs themselves exist so as to help tax management. I refrain from using tax evasion because many of these acts are in fact legal and encouraged by law. Next, using a complicit banker the SME’s get loans. Their auditors are complicit in the process too. Now, unscrupulous promoters siphon cash away from these entities and fund private gains/marriages etc. Banks lending to SMEs are left holding the bag. This has also caused substantial stress in the bank balance sheets. Many of these SMEs are quite lax about filing financial statements with the authorities.

Thanks to the demonetization, some of these SMEs will be used to convert the black money from promoters’ holdings into the SMEs holdings. Conversely, those having illegal cash can push it into the SME balance sheet and “make it legal”. Readers may have guessed that banks will benefit from this when their bad loans suddenly start turning good. The net effect, I suspect, will be positive. 

It is clear that the next element in the fight against black money should be SMEs. These entities are critical elements and cannot be missed for this fight to succeed.

Other black money creators

There are other critical elements in black money chain or black economy. These elements represent turning smaller amount of white money into black by aggregation and misrepresentation.

For example, take NGOs. Some of the NGOs existing only on paper. Their model is thus. These NGOs collect legitimate amounts from citizens and push it into causes like animal shelters, girl child, medical aid to needy etc. The main problem is that the costs of these NGOs is unreasonably high. They also commit fraud by misrepresenting number of animals and kind of facilities etc. creating a source of black money for the promoters who get salary and or benefits like cars and drivers from the NGOs.

Cooperative banks are another piece of the puzzle. These accept smaller deposits from individuals and loan to founders and directors. The process is illegal and escapes the law only because it is not regulated by the RBI but by Politicians who are themselves directors in such institutes.

Government aided/recognized schools, colleges and institutions which look innocuous and have no actual teachers, students or infrastructure but simply using approvals from complicit education officers create a chain wherein legitimate money turns into black money. Others institutes have proper systems but use management quota to pool students’ money into black money pools for the founders. Some use both mechanisms.

Such entities are inherently different from SMEs which exist to service the needs of a wealthy black money holder or create black money through banks. These elements will be hit substantially by the demonetization and their promoters will be forced to declare these amounts or destroy them. However, the issue is that they can continue to create black money sources since their model has not been dismantled.

Role of Religious and other public trusts

The model of trusts is a little different but they are as important elements in processing black money as SMEs and others listed above. The trusts are both receptacles and users of black money. They are not creators.

Some allow devotees to make small but numerous donations while spending substantial amounts on expenditures related to their promoters. Others are created out of anonymous black money donations with specific beneficiaries. Their nature makes them a hot-potato issue where they seem to be untouchable by any government, religious entities being protected by constitution. 

These trusts will die over time as their feeder mechanisms are constrained. Yet, the reason they are highlighted here is because within the next two months we will see a lot of trusts being formed with weird articles of constitution that violate the basic premise of laws on public trusts. 

So will demonetisation eliminate black money?

Not by itself. It is just one move of one piece in the chess board of black money. To check-mate the black money king, you have to win the board. There are various steps required as detailed above. Government can play all these moves and still fail if they play improperly. All we can say is that Government is playing well. But will it succeed? The efforts will bring massive amounts of cash into the banking system – a benefit in itself. Once the money is in the legitimate channels, it should be better utilized and revenue will be generated from its use. If that is success enough then yes. 

Then again the government has tackled GST which represents 2/3rd of its revenues. It has tried to increase the size of the pie on which taxes are imposed by forcing the transactions into formal economy. The next part is reform of Income Tax which will tackle the remain 1/3rd of the revenue. Then will come loophole plugging. There seems to be well thought out method to this madness. Rest time will tell.

Notes and links

[1] http://www.nipfp.org.in/publications/working-papers/1509/ 

[2] http://www.nipfp.org.in/book/927/ 

[3] http://dor.gov.in/sites/upload_files/revenue/files/Measures_Tackle_BlackMoney.pdf 

[4] http://finmin.nic.in/reports/whitepaper_backmoney2012.pdf 

[5] Comparing how some tax authorities tackle the hidden economy by UK National Audit Office Rand Europe 2009 

[6] Reducing opportunities for tax non-compliance in the underground economy – Information Note dated January 2012 

[7] The Shadow Economy Friedrich Schneider & Colin C. Williams, Institute of Economic Affairs, 2013 

[8] Proposed by various people such as Arthakranti and also by Peter Sands in essay titled Making It Harder for the Bad Guys: The Case for Eliminating High Denomination Notes, M-RCBG Associate Working Paper Series | No. 52 in February 2016 and later discussed by Lawrence Summers and others. 

[9] https://www.rbi.org.in/scripts/AnnualReportPublications.aspx?Id=1181 

[10] World Bank data in currency of respective year. Earliest data available is 1960 so we have used 1960 data. Devaluation was in 1946 which was way before this year. 

[11] The numbers based on estimates by various agencies. 

[12] For basics refer to Centre for Central Banking Studies Handbook – No. 32 Understanding the central bank balance sheet by Garreth Rule.

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Counter intuitive = Low rates / ZIRP/NIRP policies are actually bad for economy

We are told that when interest rates are too low, they are encouraging entrepreneurs to take risk. So we have low interest rate policy LIRP, Zero interest rate policy, ZIRP and negative interest rate policy NIRP.

However, these policies impacts the business models differently. At one end are business models, like infrastructure projects, that cannot add threshold value in the initial years of the venture. The low interest rate regime, allows a valuable gestation period for such business models. Often, government artificially lowers interest rates for such projects. At the other extreme, there are weak business models, those that are viable only in low return scenario. These business models, however, die out once the interest rates start rising. In between, there are experimental and innovative business models. Some of these use the low interest rate period to forge better, more robust models. Such businesses thrive later. Others, however, end up going bust. The role of banks is to identify each of these business models and fund them while appropriately mitigating the risks. 

How low interest rate leads to mal-investment 

A bank takes risk by investing in a venture. Interest rate is also a reward bankers get, for taking the risk. Ideally, even in lower interest rate scenario, those projects with best risk-return trade-off should get financed. 

However, in reality, lower yielding large borrowings backed by reputed corporates get access to financing more easily than new ventures. This means, irrational mega-projects or mal-investments of large corporates get financed at the cost of genuine investments of new ventures. Typically, such irrational mega-projects consume a lot of credit requiring load syndication. This has twin benefits for bankers. 

First, there is a higher degree of comfort in being with the herd. Secondly, bankers do not have to go through credit appraisal of many small entities of questionable risk profile. This makes them assign a lower risk to these projects than appropriate. Intelligent investors will find that this contradicts with the "diversification as risk management" strategy. But being with herd has a stronger lure and is treated as risk mitigation (though wrongly).

Further, at lower interest rates, debt starts being used as an instrument to amplify equity returns. With unchanged return on capital employed, you can have higher return on equity when return on debt reduces. Return on debt is function of interest rates and lower share it claims from the total returns made by the firms. 

Thus the second blow to new ventures comes from crowding out. It implies that even in a low interest rate environment, small businesses and entrepreneurs may not have access to lower cost capital. Therefore this impacts the long-term strength of the economy. 

In high interest rate scenario, the irrational mega-projects seem less promising. Hence, contrary to popular belief, it may be easier for smaller businesses to compete in high interest rate scenarios.

This is particularly true when there is some demand in the system.

What happens when there is no demand?

When there is no demand in the economy, low interest rates / ZIRP / NIRP etc are said to stimulate this demand. This, to my simplistic mind, sounds like offering desserts to the already overfed diner  (AOD) with the hope to eliminate world hunger. Let me explain.

We hope this AOD, when offered with a free desserts will take them and pass them along to the hungry. In this method we depend on the magnanimity of intentions of our already overfed diner. Then we presume he shall act on his instincts and find worthy hungry who can transmit the benefits to others. It is quite possible our Glutton may pass the desserts to his friends or family and each can be a little more fatter. Are we, then to wait for all the gluttons to be severly beefed up or porked up before the trickle down starts to the hungry?

It sound like bull-shit method to me. Particularly I cannot understand why you are preventing the hungry from feeding themselves - either by employing them or letting entrepreneurs do it by financing them with reasonably priced debt/credit. These entrepreneurs are left to finance their ventures with credit cards, overdrafts and other very high cost financings at considerable peril. Now since these financing schemes are not on the business side, they are paid out of the post-tax income generated by the firm (but they should have been tax deductable at firm stage itself). This is doubly onerous for the entrepreneurs. 

Treat Interest rate like friction

A better model is to think of interest rate like engineers think of friction. Some is good, too much is bad, too little is bad too. In fact friction analogy should be best suited for determining neutral rate of interest. 

Economist too think of interest rate as friction. To the economist - road mileage of the car represents growth, fuel represents capital availability or liquidity. The economists' metaphor of friction is flawed. They need to get their metaphor right.

Engineers will tell you - you need to maximize friction at the tyres and eliminate it from the engines. At the clutch and brakes too you need friction. So you need interest rates high at some places and low at some others. So Economists better figure out where you want low interest rates and where you want high interest rates. Note the question is where not when. 

In Sum

The hazards of the LIRP, ZIRP and NIRP far outweigh the benefits. These policies do not pass the smell test. We need a better understanding of interest rate as a tool for improving economic growth.

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Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms". A version of this argument was made in Subverting Capitalism back in 2010 and also posted on this blog in 2012. Nothing, it appears, has changed.

Is assessment of risk a function of interest rate?

The interest rate that can be charged by the bank has  two limits.

The Lower bound equals what the central bank charges the bank. Any lower and the bank will make a loss on its lending portfolio.

The Upper bound is the ability of the risk taker to bear the burden of return. Thus, if a bank lends to a business that makes 10% return on capital employed - it cannot charge more than 10% else it will be unviable for the borrower to seek the debt at all.

The Actual interest rate charged is determined by a combination of the following factors:

1. An assessment of returns of the business based on the economy and her business 
2. Income of the borrower in total 
3. The value of the collateral pledged against the loan as a security should the borrower be unable to bear that return 
4. The demand for loans AND/OR
5. How well the other loans are doing (health of bank's loan portfolio) AND/OR
6. A combination of these along with global factors

Spread

Bankers think of returns as spread they make on top of the lower bound, i.e. rate set by the central bank. 

Risk V/s Spread

Now, in the mind of the banker risk is correlated with the spread. When the banker perceives higher risk she fattens the spread. This "risk" we talk about is risk resulting to the banker. It does not mean risk of the borrower alone. So if the bankers' portfolio is turning bad, the banker will still increase the spread - partly to compensate for the loss she suffers and partly because she assesses the general economic environment to be more risky. Thus, even if the central bank reduces the benchmark interest rate, the banker is reluctant to pass it on if she can avoid it. This creates tighter conditions putting more stress on the borrower. This is why Scot Sumner argues the monetary conditions were actually tight when we were almost at ZIRP.

In an economy that is weak, it acts as a stronger head wind for borrowers. It reduces their ability to borrow and to service their current borrowing. They want to pay down their debt and reduce their loans. Therefore, the economy contracts further. The banks seem happy at first, but soon realise that other borrowers who are not prudent are pushed to default. The implication of this on the bank depends on the mechanics of the process - the proportion of those who default v/s those who pay back, the chronology in which it happens etc.

In the next phase, the economy recovers, predominantly with equity capital. Equity can absorb the losses since it is built for higher risk. The surviving firms and individuals are left with core strength to  thrive in intense competition and are more prudent with capital allocation. The banks thereafter can lend to these survivors to help them scale up.

What does this mean?

This means, 

1. There is inherent value to competitiveness that signifies its ability to survive and repay the debt and repay the equity at decent returns. This ability reduces with increasing leverage by the borrowers. Thus when Anat Admati suggests investment banks have capped leverage ratios to 20 or 10 it makes sense.
2. Banks' business model seems to encourage the use of debt only to amplify equity returns. It is fine in a way but if that is the objective then banks should reduce/cut lending at lot earlier than they do. Naturally, in times of distress when the return ON capital matters lesser than the return OF capital, banks get into big trouble. It seems they get confused about what is their business model. 
3. Maybe, better than ZIRP, unleashing a new Government-backed Good Bank to pick up assets at distressed prices at lending rates with narrow and fixed spreads can work better. If the size of this bank is large enough in relation to the banking system, it may result in a lesser shock to the economy.

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Double whammy of withdrawal of funds from emerging markets

In the past few trading sessions, there has been a considerable withdrawal of funds from the emerging markets. We can attribute this to two basic reasons.

Firstly, we have seen reduction of QE from $85 billion to $65 billion in the last four months. Secondly, we have seen an upward pressure on interest rates in the developed world. These two factors have combined to create A double whammy. At the time when funds are scarce, we have a reverse potential difference that is pulling money towards developed markets. This perverse situation will lead to substantial abatement of money flows from emerging markets to the developed markets.

In addition, there is already in place, an incentive to emerging markets sovereigns to invest in developed market treasuries for mercantilistic reasons.

I believe, these three forces will lead to substantial correction in equity markets in developing countries. Hence, we will see drastic correction in Indian equity markets. I also think, the same logic will hold for other developing countries.

I will be trying to close my open positions as soon as I can. Let us hope that we are able to ride out this turbulent phase. However, I do not think that this turbulence will last more than three months. Therefore, it is essential to get into the market say around end-April.

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Explaining Indian Policy Paralysis

A lot of recent comments, including mine, have pointed out the lack of policy commitment from the government. I believe there is a reason to this policy logjam and it may reverse quite quickly, to surprise of many, making the current time most critical time to invest in the country. To warn this is a conjecture.

1. Indian politics has undergone a change of mechanism in financing. A significant (non-trivial) percentage of money deployed in politics comes from stock markets where it remains invested in distributed accounts. 
2. This implies that the stock markets must have a good peak about a year before the election. Year being the approximate time required to oil the election machinery of the political parties.
3. This also implies that there should be a good opportunity to invest around 2 years before the election without which the peak referred above will have no meaning. 
4. Political money is gained from rent-seeking and corruption and not invested in first three years as it is being collected at that time. It is usually available around 2 years after new government takes office, the bulk being available around 3 years time. (term of government = 5 years in India)
5. Insiders inform me that Late Mr. Pramod Mahajan (parliamentarian of BJP) was amongst the pioneers of such strategy around 2002-03. Subsequently ruling party Congress, inducted relevant talent into this strategy. Some say, former finance minister P. Chidambaram, known for his investment sense, may have used this means earlier. Though I have heard conflicting reports that state branches of parties in South using similar means since 1998-99.
6. While earlier efforts benefitted from a global bull market, current efforts require ingenuity to create returns in an adverse global macro environment. 
7. I hear that ruling party has taken an ingenious approach to current problem. The first phase of the strategy is to create policy misdirection, increase rhetoric and in general cause panic and injure investor sentiment (only enough to create a equity market). The second phase is to establish policy direction and build credible reform base that should lead to uptick in equity markets.
8. The magnitude of money involved is not small. Even small district magistrates have wealth in excess of INR 50 million. Politicians have access to money in excess of INR 200 million each. There are tons of them. However, substantial amount of this money is in black (cash not accounted or declared) and thus cannot be funneled into the equity markets. However, the numbers are mind-boggling.

Thus, I expect:

1. Reform process to gather steam from current levels.
2. Increasingly positive policy news of reform and clarity coming from governments.
3. In general improving investment climate.
4. Proactive and improved response from government to cushion or even counter negative news coming from global economies.
5. Government may talk the market up.

Implication for Equities:

1. I believe this current level is a bottom for next year or more.
2. From this point we will move up is a sustained manner till beyond March of next year (around).
3. At that point we may see a sharp correction as money starts being pulled out of the markets.
4. So, this is time to be long India and get out by March next year.
5. Risk is that if all start working on the same strategy exit needs to be critically examined.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Investors are at the gates - When will India open them?

One of the big problems driving Indian inflation is lack of investments. The investors are here; the question is where is the government. 

How to get investments?

First rule of investments is that higher uncertainty should be compensated by higher return potential of investment. If the return available from the Indian market is given then government can increase investment by reducing uncertainty. 

Indian government is doing exactly opposite.

In general government is failing on many levels and the Indian courts are able to stem the erosion in some areas but in critical policy areas the constitutional arm of government, the RBI, is not empowered to do much. And it has done all it can. Sadly RBI cannot undo what 8 years of inaction has borne to bear. 

Policy nuisance 

The current UPA government came after 5 years of NDA rule. The NDA government had good alignment of strategic direction and policy follow-up. In the first term,  the UPA government was befuddled with coalition issues thereby creating policy ambivalence. However the developmental inertia of previous NDA terms proved beneficial in hiding the policy ambivalence. However the second term is characterized by lack of strategic direction in policy. The policy, rather strangely, is moving in the opposite direction in general. The haphazard manner of conducting policy has confused investors, both domestic and foreign. If the government just stops this policy nuisance we can hope to hobble along a reasonably correct path.

Knowing Congress - future is bleak

The most reasonable forecast is bleak. The only possibility is that a looming crisis may kick the government into action. Just like Churchill's America, at the very last, India will do the right thing. So here is waiting for the crisis, hoping for the dark clouds to see some silver lining... 

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Elite Bonds are equivalent to sub-prime SIVs

Germany and France are mulling elite bonds - essentially government bonds issued by AAA rated countries of EU to finance sub-prime countries of EU.

I read this as equivalent to sub-prime SIVs at the height of Sub-Prime Crisis. At that time, sub-prime loans were bundled with prime loans to create a fiction of higher ratings. The assumption was that these individual component loans are not correlated.

I see the same problem with elite bonds though mechanism is a little different. A curtain is drawn over the component EU states to give illusion of AAA ratings to the Greek Debt. If we have learnt something from the sub-prime crisis this bond issue should fail. 

However, I don't think we have learnt any thing from it. So prepare for a Christmas surge in global equity markets.

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India view: Brace for flood of money

I must be sounding ridiculous but that is exactly what I expect to happen in near future. If the developed world investors are keen to retain their wealth, which they are, they will want to move to economies where conventional growth is still possible.

Conventional and unconventional growth

Conventional growth refers to well understood process of growth. In the emerging economies, we know what needs to be done. We need to build infrastructure, power plants etc. That investment will trigger efficiencies which will push EM economies on to a growth path. The history of development of the western world provides the understanding of this process and there is ample evidence as to what works and strategies for growth. This is the opportunities wealth retaining funds will eventually seek as compared to unconventional growth in developed markets.

I have argued previously that growth in developed markets will depend on two forces. The first is renewal and maintenance of infrastructure that already exists and second refers to the new kind of infrastructure and development that is essential. The new kind is uncharted territory and requires patient capital the likes we deploy in R&D. Possible candidates are Water-related infrastructure and forestation related investments. I call them Green and blue options. These investments are more of the Private equity variety than what normal funds would like.

The coming money flood in EM
The money eventually has to move to EMs before EM economies adjust their currency regimes reacting to resultant imported inflation. That implies funds will compete to reach EM shores, in all probability, creating a sharp uptick in EM equity markets.

My strategy
I am going all in as the markets decline. My focus is domestically driven revenues. It means I am avoiding Indian IT companies for strategic reasons. I find Indian consumer goods firms a bit over-valued, though I own telecom stocks as proxy for consumption story for short term. My focus is on infrastructure stocks (GVK, L&T) and banks. I am not very sure about Indian asset valuation story so I am staying away from real estate (except for occasional  short term high risk investments in Unitech which appears to be below its liquidation value). I expect the sector to start turning around when housing deals start happening on ground. I believe that should take 3-5 years at least. However, I do like Indian Hotels which, I believe to be a well managed company with sensible management. I do expect domestic auto firms (Tata Motors, Ashok Leyland and Maruti) to become big players in the coming decades and their current valuation provides a good entry point. In all above cases I am betting on liquid names and large volume stocks only.

It is possible that I am early and will need to hang on to the strategy for a little while. Let us see how things go from here.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

What spooked the Indian markets yesterday?

NSE Nifty-50 India June 20, 2011

Yesterday, Indian markets tanked in the first session. Look at the adjoining chart of Nifty, which is broader 50 stock index and more liquid. Popular media identified the reason as renegotiation of a tax treaty between India and Mauritius. I don't believe it. I think this is an example of retrofitting explanations. 

First, look at the reason. Tax treaty being negotiated has been under negotiation since 2006. The negotiations broke down in 2008 and resumed earlier this year. There has been no meeting, no discussion and no rumor that the treaty was signed. I don't think investors are as idiotic to sell-off on this kind of event. Can we assign it to irrational behavior? I don't think so. If it was a precipitation of Greek crisis I could assign it to irrational behavior but not this. This is pure idiotic if traders have behaved the way did. I simply cannot believe people who pulled the trigger were looking at the treaty. The treaty negotiation news conveniently broke at the wrong time.

Second, some rudimentary analysis of treaty will tell you that Mauritius government is against taxation or sharing crucial information (though they have agreed to collaborate with Indian agencies on investigations). Further, most of Indian bureaucrats and politicians have routed money back through Mauritius. In effect, both sides of the negotiating table do not want capital gains tax or information sharing. So not much is going to be achieved on the treaty front. A rudimentary analysis will tell you this.

Third, look at the sharp fall with volumes. I guess a first trigger is through some algorithm at play rather than a thinking trader. The later drop down is more from margin calls being triggered than any fundamental issue. It is possible the algorithm may have estimated a fall to 5275 levels and adjusted to this very quickly triggering a panic in the process. It looks more like a work of computer than a human being.

In sum, I do not think a flesh and blood trader could have dumped that much volume in that short a time on that news. Alas, in the din of media drums the real explanations may be lost for ever. 

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Real Estate forecast - I told you so edition

Back in the middle of 2007 it was clear that property markets across the world are overheating. However, ground realities, in terms of property off-take were yet to show visible signs of a slowdown. During a presentation to top management of an Indian public-sector bank, I advocated enhancing the credit standards for lending to real estate developers. I had mentioned that a slowdown in Indian real estate markets is imminent and while timing cannot be correctly ascertained, we (me and my employer) believed that it could be sooner rather than later. My presentation was met with intense skepticism and hostility. The real estate loan portfolio, the bank recently declared, has lost all its capital and not much hope exists of any recovery. In the details I find that almost all the loans since 2007 have gone bad.

Now, apart from a little trumpeting "I told you so", there are important lessons. First, from a credit side, an early warning is a boon. It presents an opportunity for actionable strategy. The bank in question could have easily adjusted its loan portfolio by tightening the credit norms and intensively screening the borrowers. For short term equity investments, the early warning is nearly meaningless.

In the later part of the 2007, I made another forecast about Chinese real estate developers, this time for equity investment. The firms, some mentioned in the Bloomberg report above, were showing robust growth and off-take. Yet, by all measures, a slowdown in Chinese residential market was imminent. The question was of timing. The early warning is difficult to interpret in case of equities. It was generally agreed to reduce exposure to these companies. Yet, the timing of it all remained an issue.

The idea in ST equities is to forecast the trigger. Clearly, for property developers, the trigger is capital availability. For real estate developers, the first step of a slowdown shows constraints in long term capital availability. In the later stages, short term funding becomes difficult to tie-up. Leading to panic selling of sale-able units leading to softening of prices.

The 2007-call turned out ok because of global slowdown of 2008 pulling out capital thus leading to correction in real estate developer stocks. However, recently, S&P Cut China Property Developers to ‘Negative’ - Bloomberg. It means developers may suffer even more in coming months.

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Mechanics of Asset Bubbles

This is my 250th post on this blog. Thank you for being kind and patient readers.

Barry Ritholtz has a post titled Checklist: How to Spot a Bubble in Real Time | The Big Picture. He puts across a list of conditions that we can watch to spot bubbles. While I agree with the post as a whole I would like to make some modifications to it from investor's thinking point of view. Barry himself is an investor so the end objective of the post is same as mine, to find opportunity to make money.

Let us delve into the mechanics of asset bubbles. All bubbles eventually burst. To understand nature of bubble burst however we must understand bubbles. The nomenclature "bubbles" is misleading when compared to their bursting behavior. Asset bubbles are more like balloons rather than bubbles. Some deflate gradually, some burst open when pricked by risks, others inflate to the point of no return. It is important for investors to identify the bubble and understand when it may burst.

Asset bubbles have three central elements. First being spotting inflating asset prices. The second refers to spotting risks that may cause bubble to burst. The third refers to spotting the timing of bubble bursts. Barry's post deals with all three however, I believe, they are mixed up in his list. 

Spotting possibilities of bubbles

To know if there is a possibility of a bubble we need to consider a few indicators:

1. Standard deviation of valuations: As standard deviations increase beyond 2, we should start considering a possibility of bubbles.
2. Elevated returns: The returns in the markets are high and, more importantly, consistently high. The consistency bit is a flag.
3. Unusually low volatility: The low volatility is another, albeit important, side of consistency in high returns. Volatility is an indicator of doubt. It indicates how much the market believes in higher asset prices. Higher volatility indicates that markets are testing the reasonableness of prices. It may be possible to have reasonably consistent annual returns but  still have high volatility throughout the year. 
4. Robust trading volume: It is difficult to imagine a healthy increasing volumes accompanied by low volatility but such conditions do exists during bubble period. The number of houses bought, number of people who trade in equity markets, etc.
5. Increase in employment: Driven by the bullish forecasts the bubble-prone sector goes into a hiring overdrive.
6. Increase in credit growth: Credit is a measure of low-risk-seeking capital. When all investors think the sector is low-risk quantum of credit flows to the sector increases seeds future bubbles.

Risks to bubbles

While above indicators reveal the possibility of a bubble, they do not specifically indicate the risks that may cause the bubble to burst. The risks emerge from causes of bubbles to their effects.

1. Perverse Incentives: These are difficult to track down before the burst but is eventually obvious. A diligent investor needs to understand the "why" behind the behavior of participants in that sector.
2. Unintended consequences: The frontiers of regulations (or de-regulations) often harbor seeds of bubbles. The problem with regulations in particular is that it can be reversed in a spur-of-the-moment decision by relevant authorities leaving investors in the lurch.
3. Excess Leverage: As the popular opinion of low-risk permeates through the financial world, firms are encouraged to take on more debt increasing their leverage. Increasing equity prices also puts pressure on management to deliver high returns. Managers rejig the capital structure to increase return on equity for the same return on capital. The easiest way to achieve this is by increasing leverage.
4. New products: Barry refers to only financial products however any product that teases regulatory acceptability can create risks. Financial products are more potent because they tend to affect multiple sectors and economy as a whole. Naturally, financial products have been at the forefront of biggest bubbles in history.

Understanding timing of bubble bursts

A few behaviors are prominently visible during the late stage of bubble formations. Typically,

1. Declining credit spreads: While I am using Barry's headings, the central idea he points to is bigger than credit spreads. During late-bubble phase, the price or yield or return distribution and risk distribution do not match. In normal times, higher risk implies lower prices and higher-but-volatile returns expectations while lower risks implies higher prices and lower but more stable return expectations. In other words risk-return equations become asymmetrical.
2. Declining credit standards: This is another face of risk-return asymmetry we discussed above. Firms with strained balance sheets get easy access to credit. It also indicates lower default rates on credit side and further acceleration in credit growth in the sector. The latest credit investments may be difficult to recover and hence are as good as write-offs.
3. Tortured Rationalizations: Almost all bubbles have advocates who have strong beliefs that they validate using unverifiable, anecdotal but mismatched data or new metrics that have no history. Be it eye-balls, estimating number of millionaires as proxy for premium housing demand, etc.
4. Trading volume spike: We note that high and steadily increasing volumes are marks of bubbles but accelerating volumes - spikes - indicate that end is near.
5. Interest rate changes: A credit-driven bubble is sensitive to interest rate changes. However, the sector may not react at the turn of interest rate policy. So when the central bank raises rates after a long cycle of declining rates, there seems to be no effect on the bubble sector. It is after two or three rate hikes that suddenly things start to fall apart.

While spotting bubbles is difficult, the difficulty can be reduced. Bubble-spotting is iterative process and takes a while to establish the conditions for bursting of bubble.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Retrofitting explanations - Don't listen to Finance news channels!

Why are food prices soaring? Why did the markets rise? Why did they tank? We get decisive answers to these question on news channels on daily basis. But almost everyone of them uses explanation retrofitting.

For example, take rising food prices. In such a context, discussing prices only in relation to demand supply seems inadequate. It may still be dominant variable influencing prices but the recent changes to prices cannot be explained by demand supply alone. For one, the change in consumption of emerging economies and change in prices over 5 year period does not tally the thesis. To infer demand supply realities from prices, i.e. doing reverse, is like retrofitting explanation to fit the thesis. Investors and talking heads are guilty of this en masse. The problem with retrofitting explanation is that it checks all the boxes, every cause-effect link seems strong. Except, there is often no link in reality.

Imagine what would happen if we started a school science experiment to produce oxygen only there won't be a test tube to collect the oxygen we have isolated. That would be released into the air. Thereafter, the teacher will ignite a match near the place where oxygen should have been collected and it will burn - a test that confirms oxygen. Now did the match burn from the oxygen we isolated from the experiment or did it burn using oxygen from the ambient air itself? In science this is a flawed experiment. But if a finance channel would definitely report it as success and, in all probability, markets will rise 1-2% because of such discovery!

To be fair to economics scientists, social systems are difficult to model because of this problem. The economists and social scientists know this and thus are always tentative in their evaluations. Famously, they are two-handed, they always propose an alternative explanation starting with "on the other hand...". Market analysts, on the other hand, are forceful in their views and exude confidence where there is none to be found in the foundations itself.

Investors, thus, must be vary of making mental models based on the forceful arguments of the market analysts. Such mental models are often just assumptions because of the flawed fundamentals. And these are the most difficult assumptions to challenge.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle. 

Cannot group India with other Emerging market

Over the past years, I spend part of time explaining this fact. India's economic structure is not like other emerging markets and hence we should not club those together. This goes when you are looking at bond yields, currency forecast or simply equity market valuations.

First, India is a consumption economy. Unlike other emerging markets that depend on US consumption, India is driven mostly by domestic consumption. Sectors like IT/ITES do have significant employment here and thus they do contribute indirectly to the consumption. However, the overall impact of IT/ITES is not as substantive as exports are to other emerging markets. Thus we need to look at India through a developed world lens.

Second, India functions despite of its government, again unlike other emerging markets. In other EMs government is a driver or enabler of growth. Not in India. In fact, wherever government interferes you have problems. So in that aspect too India is unlike other EMs.

Third, India has more efficient capital utilization pattern. Overall, the incremental Capital output ratio, ICOR, is higher in India. While a group of economists believe this is reflection of the stage of the economic development rather than character trait of India, I disagree. While the high level of ICOR is misleading, India will have better ICOR than comparable country at similar economic development level. However, this also means India will pay lesser for everything. In other words, if you expect certain demand at a price point in other countries, expect half that demand in India. MNCs found this very challenging at first. But at the right price point, there is ample demand than you can cater to.

Fourth, Indian banks, thanks to RBI's watchfulness, are very conservative. Even in Real estate lending, thanks to the black economy percentage charged by developers, the individual has higher skin in the game than in other markets. 

So during the next year when you look at investing in India, bear in mind that India is a consumption economy like the west. 

But what does this mean?

To me it implies some direct conclusions.

First, India can sustain a higher Debt-GDP ratio than other EMs. Since the payback comes from internal demand generation, the debt is likely to be more robust than other EMs. 

Second, it also means that India's economic model is directionally right, i.e. correct in intent, but low on scale, i.e. India is slow - very slow. This may mean higher stress on currency. Popular opinion on this topic is against me. People expect INR to continue to become cheaper vs. USD because of national debt. However, over time, people will realize the difference and try to flock into the INR. I do not expect it to happen in 2011 or 2012 but I have been wrong before. In any case, if it were to happen expect capital controls and regulation to manage the currency.

Third, infrastructure payback is likely to be longer. With India infrastructure story being marketed to death, I expect lot of infra-investment to come in without acknowledging this fact. Please expect payback to take longer than your models indicate.

Fourth, India may become a consumption driver of the world sooner than other EMs. It might take two decades more, but India may be first to contribute to global consumption rather than other EMs.

In sum

India is unique, it is a culturally in the middle. It is slow, but it is going the right way.

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My book "Subverting Capitalism & Democracy" is available on Amazon