- Wealth PMS (50L+)
On today’s show, Shray asks Deepak about government borrowing and debt, how the RBI can help bring down borrowing costs, the new rules that make your provident fund much less attractive and how we can now invest directly in Government bonds instead of Fixed Deposits.
Hi everyone! and welcome to episode 35 I think, of the Capitalmind podcast. Gravity existed temporarily, but the stock markets have ignored it and once again begun their irresistible upward move. But we’re here today because the budget for the ages that happened actually has been very interesting, and so we brought in Deepak today to talk about government debt, borrowing, GDP, inflation and how this impacts your investment opportunities, everything ranging from your I guess EPF not looking all that desirable anymore, to you now having access to government securities directly and a change in how you may choose to invest your money going forward.
So, Deepak Welcome! And I guess let us get started. So, look as expected, we had our budget, it is the year post the covid crisis or we are still kind-of in it and borrowing has gone up. So, can you give us an understanding? I mean, have we just really increased the borrowing a lot? And what is happening with that?
Yeah, I think you know, firstly, thanks Shray! This is a welcome start to a Capitalmind Podcast 2021.
I think you know about the government borrowing and, just to give an example of how crazy the situation is, we wanted to borrow only about 6 or 7 Lac crores last year. The government borrows because it spends more than it earns. And when it does, the difference happens to be a certain number. It’s called the fiscal deficit, and we finance the fiscal deficit by borrowing.
So last year, that number was supposed to be 7 Lac crores of borrowing. And now [next year] we’re talking of 12 Lac crores. Now the deficit itself is 15 Lac crores. Part of that deficit is going to be borrowed from small savings. What they call Small Savings Fund is essentially your PPF and National Savings certificates and post office deposits and so on is called small savings.
Small savings are a big source, in the sense, interesting source. They are budgeted to be last year, about 2.5 lac crores. They actually ended up borrowing four and a half or about 4.8 Lac crores from small savings and you know this next coming year they are saying it will be 4 lac crores, so it is the amount the government will get financed by post office deposits and PPF and so on.
Now this is an interesting point about this. We will come to that in terms of how that has come about, but the rest of the borrowing is coming from the markets. Because 12 lac crores of gross borrowing, when I say gross it is new securities that will be issued, but you know some securities will get paid back which were issued earlier. So, what was borrowed in 2010 as a 10-year Bond will now mature, so they will have to pay those back. So, the gross borrowing will be 12, the net borrowing will be about 9.5 or so, 2.5 lac crores of repayments that are happening. It is quite a big number, and the size of the GDP is about 195 Lac crores as of now.
But is that with that temporary 24% fall?
Yes, yes. I mean the 24 percent is actually a fall compared to the last quarter, so it is a quarterly GDP fall, right? So effectively, 200 lac crores fell to 194 lac crores, and we will get the new numbers end of this month. So probably be 195.
So, let us say 200 lac crores (200 trillion). One lac crore is a trillion. So, of that, the government is freshly going to borrow around 5%, just under 6 gross or 5 net, is how much they are going to borrow. This is not an incredibly huge amount considering it’s been a Corona year, or you had a summer displacement and so on, but that actually talks to you about what they are really not doing, which is not much. I mean, they are not doing much. They are just re-jigging a lot of the expenditure to make it a little more transparent. So earlier we used to hide that expenditure in other places, and now we are actually showing it so.
OK, makes that actually is a great segue into my next question. So fine. 12 lac crores. We get the number. It isn’t actually as you said, a very high number in some ways. So where are we spending it? And I think here you have some points. You’re not very happy with where we’re spending it.
Yeah, I mean I think to an extent where you know you would say that the Corona’s displaced(sic) has created a lot of issues and stuff like that. There are two kinds of expenditure really. Some expenditure will help people survive. So, you could look at a food subsidy as something that helps people survive. It means the government buys food from the farmers when they otherwise may not have other places to sell it, so it gives them a guaranteed payment.
But the government may not be able to use the food, so it rots. So that is a food subsidy which does not help everybody, but it helps one set of people – the farmers. Despite whatever was said, we have spent four and a half (4.5) Lac crores last year. This is much more than the two lac crores or so budgeted or less than 2 lac crores actually, so we have spent more than 2X the amount we budgeted on buying food from farmers.
They are not going to use all that food, and a lot of it is going to go rot, but that’s fine because farmers get paid in a time when you know the whole supply chains were short, so.
See what I guess why you don’t like it is you’re spending this money to keep these folks afloat. So, to that extent, you achieve one objective, but then not much more beyond that.
Yeah, so if you think of it as (an)expenditure that has to be done because if you stop it then too many people will, you know, have trouble.
It would be terrible. I mean yeah.
Yeah, so you’re doing that. So, subsidies from fertilizers to food to kerosene are those kinds.
Then there are interest payments. Now what we don’t realize is, of the 34 Lac crores that we are spending next year, or we are going to spend next year, 8L Crores – 25% of it – is going to be only to pay interest on the money we have already borrowed.
That is crazy to an extent because we have about 110 Lac crores of government borrowing in total. We are paying 8%. The government is paying 8%. You and I would kill to get 8% but obviously somebody is getting 8% so the government is actually paying 8%.
That just sounds too high!
It’s ridiculously high and to the extent that you know it dwarfs everything else. The next highest single layer of expenditure is defence, which is 3.5 lac crores.
So less than half of interest payments.
Yes, and that’s revenue expenditure, not capital. But let’s assume that the expenditure just on defence.
Oh, got it.
Which is to about 30 or 40% more or less required because you need to defend the nation, but some of it is also going to be useful in the future in terms of research because whatever the defense does, it actually creates infrastructure for further civilian work. So, for instance, if the defence builds a bridge that does not mean the bridge is completely useless. Tomorrow civilians will use the bridge and perhaps use it for Commerce as well. So, some part of defence expenditure – the whole Internet, by the way was a defence expenditure item in the US that started off as that and now look where it has come. So that was the US defense but in India also there is a lot of stuff that the defense uses that will become useful – airports for exaple. Contentious to say this was a good thing, or bad. But Interestingly, the rest of it.
For instance, subsidies. Subsidies become one of the biggest expenditure items after defense. So, the first one [interest expense] is a waste. The second one [defence] is OK, well half good half just required. The third one [subsidies] is again required not good kind of item. So, you end up spending more than half of their government expenditure and stuff. That is OK. We spend a fraction of this on Health, which is actually beneficial because it will help people be healthy and productive. On education, which is obviously productive in the later years. So, on the stuff that will yield us great returns. On infrastructure we are spending a little bit is fair but this time of two lac crores or two lac odd crores on at least the big items of infrastructure.
The interesting thing about that is, that’s what’s going to give us great returns in the future, and we’re spending relatively smaller amounts on that versus everything else. So, the quality of the expenditure is not huge. One thing that they have done this year is taken out some of the hidden items.
So, for instance, they said ‘listen we are spending 2.5 lac crores on food subsidies. So, look at that and say, hey, this is you know what? I know it is 4.4 lac crores last year, which is much higher but earlier than that was just one lac crores. So how come we are spending 2 1/2 times?
The answer was they were already spending two lac crores. But except that the Food Corporation of India, which typically buys the food from the farmers, would then go borrow the money from the small savings fund. So the small savings will get about four lac crores and give one lac crores to FCI and the remaining 2.5 to 3 lac crores it would give to the government. So now the government is saying, “Listen forget this farce. Let us just take more money directly from the Small Savings Fund and give it to the FCI.
So, this cleans up the books a bit so that there is fewer, if I may say, compartmentalized things which you don’t get visibility into.
Yes, and so will borrow less from the market relatively and borrow more and give more to the FCI. But that doesn’t change much. So, some elements of this change in the next one year are just cleaning up the books and making it straightforward. Some of it is of course required new expenditure. We are going to spend a lot on the vaccine. I think they have put budget about 35,000 crores. They might end up spending more than that on the vaccines, but this is actually not a budget where you are saying the government is going all out and spending like crazy.
They are doing very interesting things. So, if you look at the good expenditure there is a tremendous amount of interesting things that are happening. So, roads, for instance, they are building more roads. But let us take one example of how government spending can actually be good.
Today you have trains that travel on tracks and those tracks are designed to be 2 tracks, one track one way and the other track for the other way. And these are the same tracks carrying both mail and passenger trains, so mail mean goods’ trains.
Freight, I guess?
Freight. The problem with this is that the goods’ trains are enormously bulky. They have certain compartments which you have to stuff your things in, and if you don’t have the compartments, you have an empty thing on which you might have a truck made to stand, which then helps the truck go from one place to the other faster.
They take the same lines as passenger trains when passengers are obviously more important. So, when a passenger train comes by behind you, the mail trains are relatively slower. You have this mail train that is put into a sideline, you know, a sidetrack. And then the passenger train passes and only then does the mail train come back on. So, mail trains take long amounts of time, then they have they use the same platforms as the passenger trains. Passenger train platforms are not very long. So, and also, they are not very conducive to unloading goods, so you end up with this suboptimal place where you might have a few bogeys that cannot be unloaded on the mail train. You’ve to move the train a little bit for them to be unloaded, and so on. Then the last one is that you know because the passenger trains do not tend to travel to ports quite often, the connectivity to ports is patchy and therefore ports are also where goods come in. So that’s where goods need to be moved so the scheduling becomes all complicated between passenger and Mail and all that stuff.
To avoid some of this, the government has anyway said ‘listen, we need a dedicated freight corridor.’ Which means two separate lines – one for going, one for coming back – which will carry only freight trains. What this does is quite dramatic. They have not only done this, but they have also said we will have a completely new architecture. The size and the height of trains today can carry a bogey and a little bit, so it is like may be 15 feet. You know that is about the size of your train. To accommodate these, the tunnels maybe about 20 feet- 25 feet high, I don’t know. I’m just making a guess. What they’ve done with this is, with the freight corridor, they’ve said ‘no, no, we gotta think again.’
Let us assume that there are Mail trains that carry only freight. I mean goods’ trains that carry only freight. Why should we have bogies? Just have containers. Your standard shipping containers can be dropped straight onto the train. You can have two-kilometer-long trains with multiple engines in the middle that give it energy and you can have this travel at a fair speed because there’s only mail trains traveling on a track. You can schedule many more Mail trains. Now, the last part is they are going to double stack these.
That means there will be one container on top of the other, much higher in height compared to a regular train. So, you get something that is now a completely new architecture that can carry a massive amount of freight, and they are connected straight to ports. So, the Western dedicated freight corridor will go from JNPT I think, in Mumbai (Bombay) across to Gujarat where there are a bunch of ports. And then they will connect onwards really.
The idea here is that the ports will generate the container traffic, which can then be transported to Delhi or somewhere in the middle. There will be completely different platforms for this, which are more conducive to loading and unloading of freight with cranes and so on. This changes the game because now suddenly you have a lot more traffic that can be carried beyond the trucking system.
Trucks are slow. Trucks have a relatively lower amount of volume that they can carry. They have this whole, you know I have to wait, and you know crossing state levels, have to get inspected for GST and so on. Also, one single train, think of it as two kilometers, can probably carry as much as I don’t know, 400 or 500 trucks now, especially if double stacked. So, you can get a lot more done. So, what you are doing is creating a productivity benefit.
So, this is, I mean and to dive into the point even more, the issue is that productivity. This is where I mean, you really would like the government spending to go to because this will yield tremendous benefits going forward to everyone.
Yes, so think about the benefits of – I have a perishable stuff in Bombay that needs to be transported to Delhi today.
Today I won’t transport it because trucks take 12 days, but if a dedicated freight corridor gives me an ability to reach daily in one day, I have the ability to say let’s do it. If we can do something like that, you can increase the productivity of a lot of things. That means prices will come down because availability is a problem. And I was talking about this recently, have talked about it in bunch of podcasts and stuff.
You know there was my average shoe budget was, let’s say, ₹4,000 a year and I would go and buy. I’m not very fancy but you know there are these comfortable shoes that I like to buy. Earlier there used to be these branded ones like an Adidas or Nike or something like that that I have got more than 4K sometimes. It was OK because those shoes lasted you couple years and so on.
But on Amazon or Flipkart, one of those two places, I noticed recently that we had a shoe available for ₹400. And it looks pretty good. I said OK, let me get it and it was there, was comfortable and I bought more than one of them. But even if I bought more than one of them, my budget for shoes, if you may, I do not have a budget, but I’m just saying how much I spent. It is about 25% of what it was, which means all if you did, was to improve the infrastructure of getting something across to me, you have reduced prices. And if that can happen with Flipkart and Amazon, what happens with the dedicated freight infrastructure?
Things change dramatically for prices. So, your increasing infrastructure availability actually helps reduce prices and increase availability. So, your demand may remain the same. In fact, the demand may go up now suddenly.
If a factory was going to get started somewhere close to Delhi, it couldn’t get raw material on time. Suddenly it can restart operations because it’s getting that raw material on time. It’s able to send its finished goods also by the same route.
There’s a lot of things start increasing in terms of productivity, demand and supply. All of this increases GDP. This is good expenditure because whatever you spend on this, you will make manyfold that back in terms of revenues, taxations. People in the middle making money, they’ll pay taxes. The people using the DFC itself will pay the railways money. There will be so many indirect ways of earning money out of this entire thing for the government, that this is actually a good expenditure, it actually benefits the lives of Indians. That’s what the government exists for.
So, I think this is one of the reasons why I think government expenditure is actually a good thing in sometimes. And therefore, you should not evaluate this expenditure as saying, “oh, you know what they’re spending so much, the dedicated freight corridor will probably take eight years to come.” So, what if it takes 8 years? It is OK because we are all going to live beyond 80 years for the most part. And we should plan to or if we do not, our next generation will.
Point is taken but good expenditure I get. Subsidies expenditure, which ideally, you’d be able to get out of. But we understand if there are pressures you have to keep people functioning right now. There is nothing you can do on that. But one thing which I think I really want to bring the conversation to is that 8% number. If your pending 8% on interest on the one lac crores, and so how much was it used?
8 lac crores.
Eight lac crores on interest, that’s not so nice, and that doesn’t feel like desirable expenditure at all.
It is not, in fact, if you think about it, the government shouldn’t be paying 8% when none of us are getting 8% at some level and the government pays 8% because it borrowed at times when the coupon rates were relatively high. You could replace that by saying let’s at one time move this expenditure over. And say, let’s transition the old rates to the new rates. The new rates are also not very low.
What’s happened because of this increased government borrowing plan is that people have gotten spooked and said, “Oh my God, how are we going to finance this? I mean, this is crazy man. We can’t have a government borrowing so much from the market.” And maybe, maybe it’s come to a point where these 8% number has to be reduced. If not by the market itself, then perhaps by policy and perhaps by RBI. What does RBI do? It controls the interest rates in the economy. How is it controlling the interest rates? If the most safe borrowing which is the government’s borrowing Is actually trading at much higher yield than anything else the non-government people can get at?
Which means, at 6% for 10 years there are barely a few banks that offer that kind of rate. In fact, and almost nobody offers a 10-year deposit. And even if they do, they offer it at 5.5 – 5 .75. For senior citizens they may offer at 6- 6.5. But essentially what we’re saying is that the government itself is borrowing at more than maybe the regular public is willing to accept. And at longer term, which is the 40-year cycles, the government actually paying closer to 7%, which is ridiculous. So, I think there are ways to mitigate this, and we can ..
Yeah, I think that was one place where you are very happy with the budget because it has clearly given some meaningful thought to how we can potentially mitigate this.
Yeah, I mean though of course they have not done a few things I thought we would expect but let me give you this you know three ways, if you may, that the government can finance a deficit.
So, one of the first ways to finance the deficit is that we have got the RBI at one level, and the RBI is, you know, one of the biggest parts of our financial system. It is a very key part of the financial system, as is the Fed in the US. Now what has QE meant in the West? In the West, they said will maintain low rates, so they go to the market and actually buy bonds in order to bring the rates down. I mean of course they do not say it is in order to bring the rates down, but effectively, that is what they do. India at the same time can have a similar concept by the RBI where it says – listen RBI could intervene in the market in order to bring rates down, not because they want to own government bonds or whatever.
The simple point is this, if interest rates for government bonds are high, that means interest rates for corporates are going to remain even higher. Government can’t borrow at a cheaper rate than corporate can, so anybody – any corporate is looking at longer term loans – is simply not getting anything cheap and we’ve talked in our first episode of our podcast, about how India is this extremely high cost of capital country.
We should print shirts with that, and we say this often.
Yes, we keep saying high cost of capital, but you know we are a country that needs lower cost of capital. The RBI’s stated policy saying “we will have lower cost of capital” but they refused to actually follow through and say that this is what’s happening and so according to me the RBI should go in and say ‘listen I don’t care if the short-term interest rates are low. I want even the longer-term interest rates to be lower.’
The Fed has done this in the past. The ECB does this all the time. Bank of Japan also will do it, but the point is simple. Interest rates need to be lower, which means you need to get them to 4.5-5% or even lower, for this country to be able to say ‘listen, it’s OK’.
Now, how can you do this? The RBI can buy bonds. The RBI can and will and does buy bonds. To give you an example, it has 40 lac crores – $550 billion US Dollars in – they call it Forex reserves. But assume most of that money is used to buy US bonds and European bonds and so on. The amount of Indian bonds that it has- 13 Lac crores. We’re 1/3rd that the RBI, India’s own central bank, owns. I have no grudge against them owning 40 lac crores of Forex – they use whatever you want, I don’t care.
But you can’t say that because I have that I can’t buy government bonds. It makes no sense whatsoever. And the government bonds percentage, as a percentage of the RBI balance sheet, has been roughly the same even for the last five years. Why not increase that? Because you’ve had a Corona, you know that the quality of expenditure is improving. You need to increase this and reduce the burden on the government in some way. The RBI has one of the biggest balance sheets of the country and I’ll come to that at a later point. But biggest equity as a percentage of balance sheet, I think equity is about 35%. But the point is the balance sheet is expanding. Balance sheet is expanding at an alarming rate. We’ve printed about 8 lac crores more last year.
Where is this going? I mean I we are not buying our own debt, where is this going?
It’s coming back to the RBI because the RBI gives it to banks. Banks say we can’t lend anymore. Banks park it back to the RBI at 3.35% and everybody is happy. But the point is this, until people actually lend… now the fear of RBI printing is inflation, right?
Eventually, if the government feels like it only needs the RBI to by its debt and doesn’t have to deal with the market, yes, then at some point right now you may be happy with both the government and the RBI to some extent, but eventually you can’t perhaps have that level of trust. So, if the government continues, what is the word they say – Monetize its debt through the RBI – that could eventually lead to a state where the interest rate spirals out of control.
Yes, I think, or inflation spirals out of control, but I think that we have had this in the past. We have had till 1999 or so RBI directly buying government debt. It should not buy by government directly. It should buy it in the market. The idea is to reduce market interest rates, not to reduce the cost of the government.
You want to reduce market interest rates by saying that the government needs to pay less in order for private citizens to play less or private corporate to pay less. So, your idea is that. Not to say that I want to directly buy from the government. Do not directly buy from the government, buy from the market. It is a better way. This is the only way. It is the prescribed way, the West has done it and I do not care what the credit rating agencies say, but we are really doing exactly what the West is doing.
And we should be doing that, we should not be afraid of it and therefore the RBI needs to print more, both by primary and secondary. When I say primary and secondary, it means primary means, let us say auctions. Then there are auctions of government bonds, RBS sells bonds. RBI on the other end has auctions where it buys government bonds? So, these two options are separate things. So, in the auctions it announces I am buying 20,000 of government bonds, please come and tell me your bids. That is one way to do it. Other way is to go directly to the market and say, listen, are you willing to sell me this at ₹100, I will buy it? Or what is next? ₹101.00, I am willing to buy that as well. So, if they go and do that and they have done this.
Last week alone, the yields spiked. The RBI went in and there was an extra option of 22,000 crores or 20,000 crores. Because of which, the yield went to 6.1% or so. The RBI said, ‘listen, I’m not comfortable with that.’ There was a bond auction failure. The yields continued to spike up, so what the RBI did next week was to go and quickly buy up 25,000 crores worth of bonds in one day. This is exactly the way they should be doing things. They should not announce what they are doing beforehand. But they should say ‘my stated goal is to keep the interest yields low, because if I have my short-term yields at 3.35, how can my long-term yields be 6.1? That makes no sense whatsoever. So, if you guys ever drive-up long-term yields because of whatever fears you have, I have no problem. I am going to come in and buy. I want to bring the yields down to whatever level I think is comfortable.’ This is perfectly fine for the RBI to say.
And if the RBI think something is going out of hand, then they have the ability to act. They do this with the USD INR all the time. Now, if they were allowing markets to determine everything, then they should allow the market to determine the USD INR as well. If people feel that they have a problem with RBI intervening in interest rates, then the addition of a problem in RBI intervening in market rates as well. Because we are not going to get one when we should not get the other.
So, my point is this – either leave it as a completely market run economy or decide what you want on everything. RBI is a player. RBI needs to own government bonds because that is how it prints more money, and it should use that mechanism to print money rather than buy USD to print money in order for the country to grow. Because in the end, the RBI’s balance sheet has to be strong. I mean it has to be not strong, well has to be backed by some asset. We should have more of those as Indian assets than foreign assets.
We have gold. We don’t even have the gold in India. Most of the RBI gold is not even in India. It’s kept outside of India. And there they turn yellow in their pants if everybody asks them to bring the gold back to India. Why don’t you have more Indian assets? It’s not like people complain about this and say, “no, but foreigners there, they won’t accept their money back in Indian rupees.” Yes, of course they will man. They are the ones who invest in stuff that has Indian rupees. They are not investing because RBI will pay them back. They are investing because it is a free market. It is a free market to that extent and that when they want their money back, they can get it through. Just because the RBI has rupees in comparison to the ratio of dollars that they have, they are not going to run away.
I think the RBI is perfectly fine to print, and if it does, there will be a reduction of market requirements. So, for instance the 25,000 crores last week. If they do something like 2 lac crores, there is not going to be much. I told you know 13 lac crores is the amount that the RBI owns in government bonds, 40 lac crores about the RBI owns of US and other country bonds. So, you bring the 13 to 16, let us say. To three lac crores more? You add three lac crores, it is going to reduce the market requirements from 9 lac crores net to six lac crores net.
That’s a third gone.
That’s a third gone right now and it doesn’t change the RBI equation very much. And this is one of those special years when you have to do it and I’ll tell you why. Because one of the reasons that deficit is so high is because revenues are low. So if you look at the Corporation taxes this year there about 5.47 Lac rupees – 547 thousand crores – versus 2019-20. Now remember, this is 2 years back when they first cut corporate rates. Taxes collected were actually 5.5 Lac crores. So essentially, we are lower taxes in this coming year than two years ago. That’s because the intermediate year of Corona had losses, so people are going to use the profits of next year to offset those losses and therefore pay lower taxes.
What does this mean? That the subsequent year after that they won’t have any losses left to offset, and therefore you will have a much higher tax collection.
Again, good revenue.
Because you may be taking a one-year hit, but eventually your revenue is good. So personal tax on the other end have gone up because you know we got 42% taxes at one level, you got dividends being taxed, We’ve got a bunch of other things, so they do expect that personal tax will grow by about 20-25%, which I think they are seeing anyways regardless of what we look at.
Where we’re seeing personal taxes being paid at a much higher level.
Thus, the last part of course is GST.
GST they collect about one lac crores a month, 12 lac crores a year, half of that goes to the States and then we are left with about 6 lac crores for the central government. So, if you consider personal income taxes at about 6 lac crores, GST at about 6 lac crores and Corporation tax about 5 lac crores, that is 17 lac crores.
They make money in a couple of other ways.
Petrol taxes! Yes, that is massive because it is about 35-33k crores a month.
They don’t want to give that easy.
I remember this model nearly doubled last year, so when crude goes up, we do have a problem. But they do make a fair amount on petrol and diesel, and that’s another big source of income. They make a little bit on customs, 1.3L crores, that is not a huge amount. But one more other area that they have actually seen an interesting impact is of where the disinvestment comes in. So, the disinvestment is interesting because disinvestment is where the big part of government revenues come in.
It’s more like one time kind of revenues. The government owns so much that it would keep disinvesting for the next six years and it would be a continuous stream of revenue. They want about 2L crores, a little bit less than 2L crores in disinvestment receipts. But you see they are disinvesting from LIC this year. That should be a big one.
The second one is BPCL. BPCL alone should be worth 75k crores, so that is a fairly big number. When I say 75k crores it is for 50% of BPCL, values that company at a 1.5L crores. OK forget 75. Let us say for 50k crores, valuated at about 1 Lac crores. For a company that has this kind of retail reach, so many petrol stations that it owns, and it has as distributors, it has a refining arm, it has a marketing arm, it has cooking gas, it has a bunch of other products. So, it literally is a behemoth, and you are valuing it at just less than $15 billion? It sounds ridiculous and remember, I mean many of these things, the debt-to-equity ratios are so low that they can further leverage and massively increase their footprint, without too much effort. So, you have that lever. That one lever where you say if I put in some more money, I could get 4X returns. You do not get it right now because of unions, government ownership, all that stuff, but give it to a private player and all that stuff vanishes and you know, you have productivity benefits that are much higher.
So, I think the government should retain a little bit of ownership, so that it can benefit from the future gains and see how bad it’s running its own PSU’s, but at the same time sell most of it. You will get disinvestment receipts this year. Now this is revenue. This is all good, right? But RBI can also give revenue. So, that is another part that I was talking about is that RBI not just buys bonds, but RBI’s balance sheet contains these 40 Lac crores of dollars that it has bought over time.
Now RBI is one of the most conservative banks in the world, in the sense that it has one of the largest equity ratios in its balance sheet.
So, for every Rs 100 that it has on its balance sheet in terms of size, it has about Rs 30 to 35 of equity. This is ridiculous. People have known it is ridiculous, and everybody is scared to tell the RBI and even the RBI is like, ‘OK listen if I’m allowed to keep this money…’ It is retained profits. Profits that RBI makes, it retains.
Now, RBI makes a lot of money. It retains most of it and gives the government some dividend 50k crores, 60k crores and so on. But it makes much more than that and I will tell you how much.
So, the equity percentage of the RBI balance sheet is about 30-35%. They constituted a committee to say how much is optimal. They said between 18 and 25%. So, we take about 22.5%. That is still 10% of RBI’s balance sheet which would be about 10 Lac crores. That is the extra. I mean, it is just way too high or way too big a balance sheet.
And there are many ways you can take it out. So, for instance, you assume that what forms part of that balance sheet?
It’s simply that the RBI has bought dollars overtime. Sometimes it bought dollars when the rupee was 40. So, it owned $1.00 and on the liability side it has a rupee at ₹40. So, the asset is 40, liability is 40. But the rupee went to 75.
So, the asset side went to 75. What happened on the liability side? So, they created something called a reserve. This is a profit because it is marked to market, but it is not a profit they have realized, so they call it a currency translation, currency revaluation reserve. OK, but it is really profit. So, if you sold the dollar and bought it back you would have the profit. It is a realized profit if you sell it and buy it back.
So, this is an extra item, and this extra item has ballooned up to 8 lac crores.
They have 40 lac crores in dollars, 8 lac crores in the Forex translation reserve.
Why do you need it? Oh listen, if the rupee appreciates, then the RBI will lose money. Yes, of course, but how much should it appreciate? Well, you know I don’t know. So, at 75, will the RBI let it go to 60? Probably not, it is too much. It is going to hurt too much. So, RBI is going to aggressively buy dollars if the rupee starts to appreciate so much. So, 75 can become 72, maybe 70, maybe 65, but I do not think they will allow it to go to 60. So, if you say that listen 20% is too much, 15% is OK. That is 5% of holding, that is 1/4th of the current reserve, which is 8L crores currently can go down to six lac crores.
Take the two lac crores out. You can easily engineer this. Just sell a few dollars and buy it back instantly and you have these 2L crores of realized profits that you can pay to the government as a dividend.
This is saying I’m reducing the size of the balance sheet according to the committee that was constituted to figure out how big the RBI balance sheet should be, which told me that it should be 22.5% but I am making it 27, instead of 35 that it is right now. So, I can then give two lac crores from this currency translation reserve.
The second big reserve is something called a contingency reserve. Now that I don’t understand this. Because a central bank in India is or in the world is very special. The central banks is the only institution where a rupee is a liability, not an asset.
So, the rupees that it prints is a liability for the balance sheet. But any rupee owned by anybody else is a asset. On the RBI balance sheet, anytime there is a crisis, it prints more rupees.
What does it do? It expands its balance sheet. It does not need a contingency reserve to protect its balance sheet. It has a foreign currency translation reserve, and a foreign currency translation does not actually result in real losses anyway, so there is nothing that can harm RBI’s balance sheet which can in any crisis RBI only increases it.
So why does it need a contingency reserve? Because the RBI is distrusting of the government and at this point, I see no reason for us to trust the RBI more than we trust the government, to be honest. And I feel that the RBI should not… in many other countries they do not allow the central bank to own so much. Because Central Banks have the power to keep on printing. You see once you cross 10%, you are done. You have to stop. Which means, above 10% you have to pay any extra 10% of equity… Which means if your balance sheet size is 100, if you cross 10 in equity than anything more than 10 has to be paid to the government compulsorily as a divided. The government says, ‘listen, if you’re in trouble, I’ll back you, don’t worry.’
Which means the government will borrow money from the market in order to finance its equity of the RBI if required. It is never required. No central bank in the world requires equity infusions other than like stupid countries which denominate their own currency in dollars.
And even you know in Venezuela you don’t need central bankers. You need government rescue. Governments need to be rescued, not central banks.
So, I do not see a reason for this, and the government can carve out …instead of 4L crores..OK, be stupid, but be stupid to the extent of only two lac crores. Take out two from here. Take out two from foreign currency translations reserves. That is 4L crores.
I said this last April. Saying ‘this is the crisis the government ought to get money from the RBI.’ There is 4L crores available then, and there is now! They can pay 4 Lac crores in dividends. If that dividend goes to the government, it is not borrowing. It is revenue.
So, it actually makes that 400,000 cores. OK, do not give it in one year. Give it in two years. 2L crores this year, two lac crores next year. If you reduce two lac crores this year, your net borrowing, which we brought down by saying ‘RBI will borrow 1/3, will take 1/3 of the borrowing from 9 lac crores, bring it down to six. Now it will bring it down to four. Now four is a point where, you know, even a normal year would borrow 7. So, four is much less than 7, so you can increase the demand. Or rather, reduce the supply requirement of external borrowing. External borrowing is another thing.
But this is just one way. I mean the many ways that the RBI as a single player can dramatically change this equation for the next one year. And I think as a post Corona year, we absolutely deserve it.
One of the things coming into this is it’s not, as you know, just about the government or the RBI. As you had pointed out before we started recording, now we as just say the average citizen with the average investor also getting into the mix. With our PF now looking little less attractive and G-Sec directly available to citizens. So, in a sense, they’re playing with the demand generation at the individual level as well. Could you talk a bit about that?
So, you know if you look at government securities, who are they bought by? Largely banks. Because banks, you know when you deposit ₹100 into the bank, the bank has to take about 16-17-18, I do not know what the number is right now. But something called SLR.
This is the statutory liquidity ratio which tells banks that they have to have at least a certain percentage of all their assets, all their deposits, in government bonds. So that means for every ₹100 you give a bank about 15-19-20, whatever the number is, has to go straight to government bonds. So that’s a natural demand for government bonds.
This also insurance companies which are required to have a certain amount in government bonds. There are pension plans, Provident funds, mutual funds, liquid funds for instance that need to have this. So, this is institutional demand for government securities. Now some part of that will change.
So, for instance, yes, as you said normally people will get taxed on the amounts, they put into their provident fund above Rs 2.5L a year.
Which is like just twenty or twenty-two thousand a month, right? So that actually makes this significantly less attractive, right?
Yes, so apparently last year 62k crore was this number, where people had put in more than 2.5L rupees per month, so that amount amounted to 62k crores.
So, a lot of that will probably start reducing. I mean fairly quickly.
Assuming that goes to zero, it may not, but because you know still may be OK, but assuming that goes to zero, that’s 62,000 crores less available to buy government bonds. Assuming that they bought other bonds with 10,000 crores, you have about 50,000 crore lower demand, which can also spike up yields next year.
This actually is a weird problem. So, what will happen now is that, that reduction has to be offset by something else. What is that something else? Say you look at ULIPS – insurance policies which are linked to the market – where you say that above 2.5 lac will not be allowed to be called tax free at maturity.
So, what this does is dramatically reduce the attraction for ULIPS, but what will insurance companies do? Offer more traditional policies? More traditional policies require a higher component of government securities. ULIPS usually invest in the market. So traditional policies, since they require more government securities, will have naturally higher demand. So, you might balance out one versus the other. But institutional demand, I don’t think is going up that dramatically.
But the other interesting part.
So let’s look at the two other areas beyond the Indian institutions – foreign institutions or foreign players, and Indian retail.
So foreign institutions, India already has a limit that says you can’t buy more than so much.
The foreigners are so much below the limit that it is not funny. But they also reason for that, “Oh, if you want to buy a foreign institution, you have to buy with at least three years left to maturity. And then if you buy something that’s four years left to maturity and one year passes, then you have to think about who you can sell it to, because you may not be able to sell it to another foreign institution. Or you can’t sell it down to one of your other funds because it’s at a lower maturity.”
So, all these complications make people think, ‘dude, we do not want this headache, we will just go buy like, I do not know, Korean Bond. It doesn’t matter because they don’t have all these restrictions.’
So, the foreign institutions are not really interested unless we dramatically reduce regulation, and we should.
I mean it is just politics in a sense or you are dealing with other sentiments?
Yes. Then India could issue dollar securities abroad. Now again this is a political hot potato because they will say “oh, we’re selling India to the foreigner”. We’re not. You know, out of 110 lac crores of the government borrows, about 6 lac crores are borrowed abroad through some multilateral bilateral loans and so on. Very little from market bonds. So why don’t we issue dollar bonds abroad? Just one lac crores? I’m not talking about a huge amount one lac would be 1% of this government borrowing, 0.5% of GDP. Almost nothing. It will reduce our burden by maybe, I don’t know if you brought it down to you know say 9 lac crores. It’s reduced our borrowing burden off from local by 10%.
And if you’re seeing the RBI is also going to participate, it’s going to reduce it by a lot more.
But no, there’ll be a so many arguments you know in India, even if you build a policy that’s good, people will protest. They will put dharna outside Delhi and sit there for years.
Well, this one is Bombay no, RBI…
Well RBI is Bombay, I don’t know when they might put it somewhere, maybe Jaipur somewhere or you know. But the problem really is that the political nature of the country is that you will have crazy levels of protests for absolutely no reason whatsoever. Or people will invent reasons.
But this is good. Borrowing abroad is unilaterally good at this level. One lac crore, 5 lac crores also will not change the equation for India.
We have forex reserves and more than enough lack of productivity. When I say lack of productivity means we don’t have productivity. Tomorrow if increase productivity, the gains are so huge that the ability for us to return money is enormous compared to most of the countries which are aging, or which have matured. But those are countries that are borrowing a lot.
But we won’t do it. And that is also because we are scared of rating agencies. And they should be made irrelevant, like we have talked in another podcast (Episode 28 – why credit rating agencies are irrelevant and need a downgrade)
We will link to that.
Yes, yes. But Interestingly, this is only one layer, yeah?
I was very interested in the one like me. I mean people like me. All our customers who we migrate out of fixed deposits. As you’re saying you’re lending your bank or you’re putting money in your bank at what, 4-4.5% or even lower? Are you actually saying I can just bypass this whole middleman, which is the banking system and directly lend to the government at 6 plus or six or something close to it?
And you know, most countries allow their citizens to do that. Why do we need banks to invest in government bonds? Because the retail participant cannot.
Why do I need to? So, for instance, no bank in India offers 40-year loans. I’m 45 years old. I would love to have a 40-year stream of income predetermined.
Like an annuity.
But if I go to an LIC or an insurance company, which is the only one that’s available to offer me an annuity, they give me 4.5 – 5% net and that is taxable. So, it is like I am paying you money and then you are going to give me 5% back, for an illiquid annuity. Illiquid meaning that if I want to get some more money than you are giving me, I have no way to do that.
Whereas why don’t I just go buy a government bond?
And it’s a 40-year bond and I could keep getting payments every year and if I want to sell it in the middle, I can sell a little more of it whenever I wanted. Those 40-year bonds are trading close to 7%. No bank is offering you 7% or anywhere close to it. What this will do is dramatically reduce people’s reliance on fixed deposits and instead start removing money.
And according to me every rich person, I’m saying whose net worth is say more than 20 – 25 crores, has a certain amount of money they want for preservation.
So, they put this money into, I do not know, maybe sometimes debt mutual funds and then fixed deposits. They should just put this money into 40-year deposit with the government.
Yes, you are getting some income …
And then you end up paying some tax on that, unfortunately…
Yes, but then you need the income anyway because people who have 25 crores plus may not have regular incomes. On the other hand, they might use the money itself to get income. So great way to get income even if it is taxable. And it makes your money safe. So safe from credit risks or anything that happens. You know that the government will always pay, and India is never defaulted in its history. I do not think it ever will.
But here is where I think this will change the game. Because if you change, if you allow retail to access deposit directly. Now, could you have done it earlier? It was very complicated. You could participate in auctions through brokers, but you could not sell what you had bought. What’s the point of that?
Second, you had your bonds in a demat system. Now the government actually has created two separate bodies. One is the RBI for managing the bond market and SEBI for regulating the equity market, but also part of the bond market and so, it is quite complicated.
The government has actually said ‘listen, we’re going to make this a single regulation for both government securities and SEBI.’
So, SEBI is most likely going to be the player that regulates both government securities and the bond and equity markets. RBI is kind of feeling this pinch. And till now, they have maintained a separate system called Securities General Ledger for government bonds, whereas SEBI has moved everybody into a Demat system.
Yeah, got it.
So, RBI said listen we are feeling the lack of power over here, but we are going to make this easier for the retail to directly invest. So, they are opening up retail investments into government securities. Which means you will have to create a separate account; it is not a Demat account. But you will directly buy from the RBI, then the RBI will directly pay you or the government will directly pay your bank account. You know what this change? It is very interesting, because when a bank buys a government bond, it gets maybe 7% interest. It pays almost no tax on that 7% interest because it is allowed to offset the interest it earns from the government bonds by the interest it pays on its deposits.
So, which is maybe what 3.5% or something?
So, let us say they get deposited at 5%. They borrow from the government; I mean they get the 7% from the government. So, they pay tax only on the 2% minus their expenses. So, net they might pay a tax on only 1%.
So that’s vanishingly little, yeah?
Now you reconsider 25% tax, we are talking of 25 paisa tax on ₹7.00 earned.
Which is not a great deal for the government.
But if you and I buy bonds.
Well, we painfully pay a lot, right? Almost Rs 3.
Yeah, let’s say we pay 30%, OK. So, on Rs 7, it is Rs 2.10 so 25 paisa from a bank versus Rs 2.10 from me. The effective cost to the government for the 7% bond on which they collect 25 paisa tax is 6.75. The effective cost to the government for a 7% bond they pay you and me is 4.9. Because we can’t offset it against anything.
So technically, it is a better proposition to give it to people who have no way to offset that tax than to give it to people who have ways to offset it. So this is also another way where the government can actually reduce its effective borrowing costs by earning more revenue on this money.
So, this is also a good thing, and the fact is that you can lock in your money for 40 years. This is amazing, what it does is increase demand for government securities and at the same time give you all these little benefits which you otherwise didn’t have.
This completely makes sense. As I said, I mean it is truly safer than your fixed deposit. It is not the most tax efficient, but as you said, sometimes you just do have to bite the bullet.
There may be ways to make it tax efficient. Government is already talking about infrastructure bonds that they will make as what is called zero coupon, which means you pay 100, you get 1000 at the end of say 20 years. But you pay no taxes until you get that ₹1000.
So, if government actually said, ‘listen for our infrastructure requirements, we will issue those infrastructure bonds which are tax free till the end. So out of that 900,000 crores that they plan to borrow, they issue 200,000 plus worth of infrastructure bonds. Suddenly retail becomes super excited with this, buys all of them. The banking system does not have to because banking system does not care about tax free and all that stuff, and suddenly you have a much lesser load on the banking system to buy government bonds. So, you could do that as well, and that is going to be another layer that is going to be directly available. It won’t be government bonds, it will be issued through an infrastructure institution like IIFCL or something like that, but whatever it is, it is borrowing.
And you know they are talking of a bad bank that all these all these things need to borrow. So, if those borrowings come at a lower rate, then you know you have a much, much more stable financial system. Of course, I would personally prefer to own direct securities from the government, because having one layer removed is not as useful as just having security directly from the government.
Remember also that these securities are super liquid, so you could go and even if you can’t sell them in the market, you can go to a bank and say give me a loan against this. The bank will give you ₹90.00 o every ₹100 of government bonds you almost instantly. Because banks love government bonds as a security because they know that no matter what happens, there’s no default on them.
Now, I think this is surprisingly optimistic podcast, but I’ll say I do have one caveat here. All of the stuff you’ve said is all contingent on low inflation. So, if inflation, if we are not able to control it or whatever that then destroys all of this, right? This whole argument does not make sense.
Yeah, so this is where I mean my views have changed. I used to think, “Oh when the RBI prints it will cause inflation.” But then we have got no inflation or next to nothing. Why? I mean what has happened.
You know, in the last 10 years when the US and the West have printed so much money. What are the biggest companies in the world? Apple, Microsoft, Amazon. None of them have meaningful amounts of debt. Most of them are cash rich to the point where their debt is very, very small as a percentage of their cash holdings. You have businesses which have very little debt, becoming the biggest thing in a time when the cost of debt is next to zero. What is happening, really?
It’s because low interest rates fuel productivity. And when we have productivity benefits, the companies that earn the most money out of that are companies with high operating leverages who therefore don’t need debt or wipe away the debt overtime. So effectively you are reaching a point where debt is not going to make things more attractive, but essentially going to make risk taking more attractive. And when you take risks, you increase productivity. When you increase productivity, you reduce prices.
I’ve talked about DFC as one of the examples, but the idea is the same. You will always see reduced productivity when you have an inefficient organization, but if you make it more efficient, anything in the system more efficient, you dramatically reduce prices.
At a very basic level, if I had a country which was making 100, I don’t know widgets and we all survived on widgets and there was only ₹100 out there. The max you could pay is ₹1.00 per widget, because that is the whole money supply. If tomorrow somebody built a fantastic system that said from 100, I can make 200 widgets. So, increase productivity 2X. What would happen? There is only ₹100 to pay for 200 widgets, so prices would go down. So for the same money supply, and increasing productivity means prices come down. So, when you have 200 widgets for only ₹100 available, you will have price fall from 1 Re per widget to 50 paisa per widget. So, you would actually increase productivity and reduce prices.
So, what the central bank typically does is prints money to offset it. So, when they print money, they make it ₹200 in money supply and then 200 widgets. So, you got the price remaining the same. Now our productivity gains have been insane and huge and enormous.
Look at like say mobile phones. Phones have become cheaper. The cost of calling is become cheaper. You don’t pay for half the things you used to pay 10 years ago in the mobile telephone market. The Internet costs, access costs are reduced quite dramatically.
Sending money has become cheaper.
Sending money is become cheaper and easier and faster. Sending goods has become easier and faster. You’ve got more logistics companies now than you had earlier. And all of this – including more infrastructure, roads, trains, dedicated freight corridors, better Internet connectivity – all this contributes to reducing prices over time.
Now, inflation can only go up, for instance, if the demand for money is so much more than the supply of good. But if supply of goods is increasing at a dramatic pace, then the demand for money, even if it increases at some point, it may not ..it may be offset by the increase in supply.
But demand for money is also not going up quite dramatically. Look at how money is created. RBI prints money goes to a bank, which multiplies it.
RBI has printed a lot of money. That money is just coming back to the RBI and sitting in balance sheet because the banks are saying we don’t want to lend. Why do they not want to lend? Again, because some of the bigger companies in India are slowly getting to a point where they don’t want money as debt because they are realizing productivity benefits in paying down their debt.
Total debt in India for the corporates, has not increased since 2015. Not dramatically increased at least, maybe 5% in five years. This is insane because you have never had a five-year period in India where debt levels did not go up, at least 5 or 10% a year.
But the total debt borrowed, even a Reliance has become net debt free. It can’t become debt free because if it became debt free, the banking system would shudder and fall at Ambani’s feet. Because if Ambani paid back his loans, where’s that money going to go? And nobody else is there to borrow it. So Ambani has cash and Ambani has debt. So, he keeps the banks happy, and the banks of course have to keep him happy in some way. But it’s not Ambani of course, it is Reliance.
The point over here is this. It’s this factor. This increased money availability drives productivity and drives higher productive companies to repay their debt and therefore not required debt and therefore debt levels don’t go up. If debt levels don’t go up, the money supply does not increase. So, if the money supply does not increase, there is no velocity of money, which means you’re not going to get inflation. If the supply of money is growing at a moderate pace, but the supply of goods is increasing at a dramatic pace. Even if the demand of goods goes up, it is not going to cause inflation in any meaningful way. Because you can see that if the demand of goods is very high, the demand of money would go up. And demand of money is not going up in India, it’s not going up in the US. This is the first time this is happening in India, though the US has seen this footprint 10 years ago. We are 10 years behind them.
We’ve started our printing cycles now. When we, when we’ve seen what the US has seen in the last 10 years, that there’s been no inflation there. I don’t think we are going to see inflation here, apart from, of course, some massive catastrophe that happens in the West that causes interest rates to rise dramatically over there. I can tell you this. If the West sees rising dramatic interest rates, the West is finished.
Japan is bankrupt beyond imagination at 3% interest rates. Beyond that. It means Japan’s entire government revenue will not be able to be paid, just the interest. We say 8 lac crores over 34 is bad. They will be paying 34 out of 34 if their interest rates rise to 3%. In fact, I think it’s 2.5% now [as the tipping point].
So, you can’t have rising rates in the West. It is not going to happen, and if it is not going to happen, nothing is going to happen in India as well. So, if it happens, the whole world is coming crashing down. You know what, we are going to be part of that world and we are going to be part of that world whether we have high interest rates or low. So, we might as well use this opportunity to say, listen, let us build a better country. And you know, if the world goes down, we go down with it.
And that’s the risk we take.
What are not so positive but kind of risk-taking note to end on? But I do actually get your point and maybe I would just say one thing in parting. The rest of the world, as you said, there’s no alternative basically to the stock market or to directly investing in equities. But we at least in India maybe for the next couple of years or five years at most, we do have a bit of an alternative with a somewhat reasonably interesting debt.
Yes, yes. In fact, the government debt is the most interesting because that is the point where you are getting 7% almost risk free now, 7.2% perhaps some state government loans. Almost risk free. I don’t think we will find it easy to see these times again. There were times when the government bonds used to yield 10%. I remember those times. I remember them fondly, but I don’t think we see those times in any meaningful format. But debt is going to be interesting because debt will give us equity like returns if what I am saying comes true. That if our rates fall to 3- 4%, we will actually see dramatically lower, you know, numbers and we will long for those 7% rates that we are talking about in what seems like ok, that’s a nice number to have today.
People always crib about the fact that the older citizens have problems because they, you know, if you reduce interest rates, what’s going to happen to them? You know what, the government has made sure that if you have about 30 to 40 Lac rupees, that you can buy senior citizen level schemes for as much as nearly 8%,7.5-7.75%. So, they are safe and that is only for senior citizens.
I think interest rates ought to come down for everybody else. With a young country, we need lower interest rates. We’ve talked about this many times in the cost of capital, but I want to put it in context of the government borrowing. The only way you can cause interest rates to fall is that government has to borrow at a much lower rate. And if that happens, this 2021 year will be watershed for bonds, not just for equities.
And that’s a good note to end on, so thank you very much Deepak and I’m setting yearly reminders to remind you of your predictions, to see how they pan out. So, we’ll see how it goes.
Let’s, let’s see! And lovely to have all of you here. Thanks, Shray and thanks everyone for listening!