Honorable Finance Minister of India,

On Tuesday, June 10, 2014 prominent bankers in India met you to lobby for a National Asset Management Company (NAMC). If this proposal, or anything even closely resembling it, goes through, it will break the backbone of the Indian economy.

Three years ago, when I wrote an email to the then Finance Minister of India, I anticipated this moment. At that time, almost all the economists and bureaucrats, oblivious to the fundamentals at play, were hailing the ~9% rate of “growth”. Below is an excerpt from one of my emails I wrote on August 3, 2011 to Pranab Mukherjee warning him about an impending slow down in the economy and a subsequent banking crisis:

“Up until this point, everything will go as it should but then our government will feel the pressure to intervene and, might deviate the economy from the path to correction. This is where India would need a strong political will and a strong Finance Minister to take the right steps and steer us through the crisis, not out of political expedience but for the nation’s interest.

The pressure will come from a choice between the interest of the party, which is re-election, and that of our nation, which is a sound economy. India is financing its current account deficit with its capital account surplus. Revenue from 3G license auction enabled the government to finance the spending for one year and kept the fiscal deficit close to 5%. Amount of short term debt and debt to foreign countries are at unprecedented levels. The collapse will result in a reduced tax base and the government will not be able to meet its fiscal commitments. Going bank on these commitments will jeopardize its re-election. On the other hand, there will be banks crying SOS. In these banks the government might find an accomplice. Instead of cutting spending, allowing the banks to fail and seizing the opportunity to disinvest, the government might relent to the pressure and take steps that will increase its chances of re-election. It might be tempted to reduce the interest rates, bail out the banks and borrow more, from people and from the banks. In the worst case scenario, the government will pursue quantitative easing and increase spending to spur growth. This might keep a temporary lid on interest rates and allow the government to borrow more. However, this will result in more inflation, and eventually inflationary expectations and a downgrade will increase the interest rates triggering the ultimate inflationary collapse leaving the Indian economy paralyzed.

Paying taxpayers’ money to the banks for the risks they have taken is the worst mistake the government can make. It is like giving a gambler money to play in a casino with a condition that profits will belong to the gambler, and losses to the tax payers. The government should not follow this path under any circumstances.”

[The full email is pasted post script.]

As expected, NPAs of the 40 listed banks have swelled to more than $40 billion with more than 40% increase in 2013 alone. These banks are now lobbying with the Finance Ministry to set up a NAMC, a government sponsored enterprise, to use public money to pay for their private mistakes. If the government surrenders to these lobbying efforts, it will not only create a moral hazard but will also worsen inflation in India.

The government, already more than a trillion dollar in debt, is running a massive fiscal deficit, so in effect, what the banks are proposing is an Indian version of Quantitative Easing (QE) i.e. printing money to buy bad assets from the banks. Emulating the QE program of the U.S. is not pragmatic; the QEs that the Fed has been pursuing since November of 2008 have already started backfiring. I have discussed the dynamics prevailing in the U.S. economy in my article “The Changing Game of Ben Bernanke“. When you read this article, please keep in mind that, unlike the U.S. dollar, the Rupee does not enjoy a reserve currency status. So any QE by the RBI is going to have very quick repercussions.

Governments all over the world want to be seen as trying to do something. However, any form of government intervention to come out of this situation will only worsen it. Why? Because what is happening is not a problem; it is a solution, and the most efficient one. Market forces are working to liquidate the malinvestments of the past several years and put the freed resources to more efficient uses. An intervention by the government will only prolong the painful period of recovery our economy must go through.

Let us take an example to understand the implications of a government bailout of banks. A samosa maker applies for a $10,000 loan from a bank to invest in a state of the art machine that makes spherical samosas. The bank makes an assessment of his ability to pay back the loan using the revenue from his business and extends him a line of credit against the machine as collateral. Unfortunately, customers did not appreciate spherical samosas any more than they did the regular ones, and the smell of the oil the machine used for lubrication became a cause of concern for some of the customers. As a result, the samosa maker incurs losses and is not able to pay back the loan. The loan becomes a non performing asset for the bank. The bank confiscates the machine but is unable to sell it in the market even at a high discount. Free market is working to liquidate the malinvestment, i.e. investment that people do not value.

The bank now goes to the Finance Minister and asks for money to cover its losses. The banker knows that the government has a lot of money it collects from hard working individuals, many of whom are very poor. It is a myth that the poor in India don’t pay taxes. The price poor people pay for goods would have been much lower if the government did not collect taxes on just crude oil for example. In fact, the poor might be paying a higher percentage of their income in taxes, as a greater portion of their income goes into consuming artificially high priced goods. “Subsidies” in India are not subsidies, they only reduce a fraction of the tax burden imposed by the government.So the banker in effect asks the Finance Ministry to give him poor people’s money to cover for his mistake.

The government is running a fiscal deficit, so to pay the bank, it “borrows” from the RBI. The RBI prints money out of thin air and gives it to the bank. More money pours into the market. More money chasing the same amount of goods (remember there are no additional goods in the form of spherical samosas in the market) causes more inflation, which hits the poor the hardest as they are the last recipients of the new money supply. In short, the bank and the borrower benefit at the expense of the poorest in India. The bailout also creates a moral hazard; with the government’s put option, the bank is now encouraged to make even riskier loans to more samosa makers. Similarly, when the government goes into debt to pay the salaries of an ever increasing army of government officials who don’t produce anything, it creates inflation as there are no goods to back up the additional money supply. Even if a state government is not able to pay its debt, it should be allowed to default, so that it is not able to raise money for unnecessary projects in the future.

 

If there is something the Finance Ministry can do, i.e. if it prioritizes strengthening of the fundamentals of the Indian economy over short term alleviation of banks and malinvested borrowers, it is using this opportunity to sell off government’s stake in banks and completely deregulate the banking industry. I have made the case for privatizing the banks in layman’s language in my article “Republic of Ghaziabad“.

I hope you don’t fall for fear mongering, which might ensue if you don’t bail out the banks, and take the right steps.

 

Sincerely,

Shubhendu Pathak
shubhendu.pathak@gmail.com
202-770-9483

Email 2/5

Sub: Indian Economy and Our Last Hope
Date: August 03, 2011

Honourable Finance Minister,

It is with sincere regard for your service to the nation and trust in your will to solve the problems in India that I am sharing this concern and analysis with you. This email is in continuation of my previous email titled ‘Economy of India and Our Fight Against Corruption’ dated June 16, 2011 in which I described the odds stacked against the Indian economy. I have attached that email post script. As you might have noticed, many events I had described in the email have started playing out.

In this email I discuss the recent steps taken by the government and the pitfalls that the government should avoid when our economy starts shrinking in the coming months.

The RBI recently took the right step of increasing the interest rates to slow down inflation in India. The ensuing effects of this step i.e. a slowdown in the economy will put tremendous pressure on the government to steer away from the current stance. The following analysis suggests that the government and the RBI should not move away from the current stance of increasing interest rates under any circumstances, and should take additional steps to move away from the dollar to solve the inflation problem in India.

The government’s current step of increasing the interest rates to control inflation, although correct, is only a part of the solution of the inflation problem in India. The argument that inflation in India is due to global increase in commodity prices and supply side pressures is a complete nonsense. The inflation is occurring in India primarily due to two reasons. Cheap dollars available to investors abroad are being used to pump up a speculative bubble in India. The government is buying these dollars and expanding its dollar reserves, and printing rupees out of thin air, by encouraging new loans, to maintain the currency peg. The U.S. is printing the dollars into oblivion and we are bearing the brunt. This same mistake, called sterilization in China, is driving inflation in their country. There are many lessons to learn from China; this is definitely not one of them. In addition to the government reserves, there are illegitimate dollars, either bought in exchange for rupees or deposited directly, which many allege are more than the reserves, that are being stacked in Swiss banks. The other reason of inflation is the indiscriminate spending by the government. The government has raised the salaries of government officials and waived off loans of farmers, with a complete disregard of their productivity.

All the recipients of this newly issued money, i.e. people employed by the service sector and the government now have more money to bid for the goods available in the market. This is driving the prices higher in India.

On top of this problem, the goods available in the market are reducing because the economy is shifting away from manufacturing. The industrial sector growth is waning at an alarming rate; it slowed to 5.6% in May compared to 8.5% a year ago. Trade deficit is about 7% of GDP. Majority of our imports are consumed and do not contribute to capital formation. We are now importing more than we are exporting, consuming more than we are producing. The question is ‘Where are the dollars to finance the trade deficit coming from?’ They are coming from investors who are selling dollars to buy rupees to speculate in the Indian market. Why are they selling their dollars? They are selling their dollars because they are available to them at a very low, and manipulated, interest rate.

The inflation is wiping out the savings of hard working Indians, and transferring the wealth to recipients of the new credit supply. These recipients are people working in the Finance, Insurance and the Real Estate sector (also known as the FIRE sector for understandable reasons), and other service sectors that are essentially exchanging debts, speculating and not adding much value to the economy.

Although increasing interest rates will restrict the money supply and strengthen the rupee, speculation encouraged by the rupee purchased by dollars will be hard to curb. The cheaply available dollars will keep on pouring. In addition to increasing the interest rates, the government will have to stop purchasing more dollars or dollar denominated assets, and move away from the policy of pegging the rupee to the dollar. Unless, the government does so, inflation will continue to rise. An interest increase without stemming the root cause will not curtail inflation.

The rupees purchased with the dollars are primarily being invested in the FIRE sector. The U.S. has become a net consumer of the world, and by buying these dollars, we are not only feeding it, but are allowing growth of a little parasite, the speculative service sector, within our economy. It is like the big parasite has infected our economy with a baby parasite which is growing every day. High interest rates and a diversification away from the dollar will kill this parasite and we should allow that to occur.

Confused economists will cry that we need dollars to buy oil, so we should devalue the currency so that we can export enough to get the required dollars. The fact is that market forces are much more efficient in deciding how much oil our economy actually needs, and will drive the valuation of the rupee in accordance. Any manipulation leads to misallocation of resources; a pertinent example of this misallocation is that of the employees in the FIRE sector buying bigger and bigger cars and using them to commute to and fro office every day. These people add little value to the economy by exchanging debts, but are able to buy big cars that consume oil and jam the roads of Indian cities. When this phony service sector collapses, we would not need the oil that is currently being wasted by these commuters, and the resources that are currently being used to manufacture big cars will be available for use in areas that make meaningful contributions to the economy. People will start buying efficient cars like Alto and Maruti 800 instead of gas guzzlers, and the Indians driving the cars would be the ones who are earning money via addition of value.

Economic virtues suggest that the correct way to encourage exports is to become efficient in production so that prices decrease and our products become competitive even with a strong currency. This will take time but it is exactly what we need. Expanding credit supply to devalue a currency only transfers wealth from hard working individuals to speculators.

Although increasing the interest rates is the right step, it is what will follow that will determine whether we emerge out of this ‘manthan’ with a weak or a strong economy. The inflation, lagged by an increase in credit supply which has taken place over several years, will continue to rise, and the RBI should continue to increase the interest rates, not slowly but at a very rapid rate regardless of the slowdown in the economy. This will trigger a deflationary collapse of the phony service sector economy we have built over the past few years. This is good as it is the service sector that is responsible for inflation, both because it is the channel via which new money is being sprinkled on the economy, and because the sector is not producing any goods people can buy. No matter how bad the collapse may look, this would be the healthy approach and will allow our economy to recover after a couple of years.

However, governments all over the world are known for taking the wrong decisions, and I hope that you do not relent to the pressure of following the confused herd when our economy slows down. With rising interest rates, many businesses will fail and the speculative bubble will burst. The double whammy for the Indian economy will come from the collapse of the U.S. economy. This is tied to the propped up demand in the U.S., some of which has found its way to the Indian economy in the form of service sector jobs. When the interest rates rise and/or U.S. economy collapses the resulting urban army of unemployed people will default on their home and car loans adding to the bank losses. Indians who were feeling wealthy due to their high home prices and spending a little more than they otherwise would have spent will reduce their discretionary spending. Manufacturing sectors will not be spared as the phony demand evaporates leading to more layoffs. Reduced demand for homes due to high interest rates, and a high inventory in the market will drive the house prices further down leading to more defaults.The banks will have to book massive write downs.

Up until this point, everything will go as it should but then our government will feel the pressure to intervene and, might deviate the economy from the path to correction. This is where India would need a strong political will and a strong finance minister to take the right steps and steer us through the crisis, not out of political expedience but for the nation’s interest.

The pressure will come from a choice between the interest of the party, which is re-election, and that of our nation, which is a sound economy. India is financing its current account deficit with its capital account surplus. Revenue from 3G license auction enabled the government to finance the spending for one year and kept the fiscal deficit close to 5%. Amount of short term debt and debt to foreign countries are at unprecedented levels. The collapse will result in a reduced tax base and the government will not be able to meet its fiscal commitments. Going bank on these commitments will jeopardize its re-election. On the other hand, there will be banks crying SOS. In these banks the government might find an accomplice. Instead of cutting spending, allowing the banks to fail and seizing the opportunity to disinvest, the government might relent to the pressure and take steps that will increase its chances of re-election. It might be tempted to reduce the interest rates, bail out the banks and borrow more, from people and from the banks. In the worst case scenario, the government will pursue quantitative easing and increase spending to spur growth. This might keep a temporary lid on interest rates and allow the government to borrow more. However, this will result in more inflation, and eventually inflationary expectations and a downgrade will increase the interest rates triggering the ultimate inflationary collapse leaving the Indian economy paralyzed.

Paying taxpayers’ money to the banks for the risks they have taken is the worst mistake the government can make. It is like giving a gambler money to play in a casino with a condition that profits will belong to the gambler, and losses to the tax payers. The government should not follow this path under any circumstances.

The scenario described above has already started playing out. The banks have purchased about $ 39 billion worth of SLR securities since April, double the amount of loans issued during the period. Another gimmick that banks might try when the interest rates rise further is that of holding securities under the HTM category so that they don’t have to mark them to market. Efforts like these are like manipulating a thermometer when it reads a higher temperature. Please kick them out of your office when they give you this argument.

One advantage that India has over other economies is the massive holdings of gold with the families. Some people might make the mistake of not defaulting due to social taboos and pay for their loans from their family savings or holdings of gold. Although, the likeliness of this happening is less, the government should discourage this as it is tantamount to stealing hard earned money from people and giving it away to speculators. This gold will help India recover in later years.

In the Ponzi scheme of the U.S. dollars, as with all the Ponzi schemes, the last ones out will suffer the most. China has already started making its moves. Let us not be the last ones to move away from the dollar. We can use the reserves to buy gold and future contracts of oil. We can also make efforts to trade with the OPEC in their own currencies or a basket of currencies and export agricultural commodities to these countries. This will need a lot of guts and efforts from our politicians, but it will be worth the effort.

I sincerely hope that you take the right steps in the coming months, and that history looks back at you as the captain who steered India through the crisis.

I would greatly appreciate a reply/acknowledgement from you.

Sincerely,
Shubhendu Pathak

CC: Dr. D. Subbarao, Honourable Governor, RBI
BCC: Dr. Manmohan Singh, Honourable Prime Minister

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