Schemes Launched After Note Ban Will Just Increase Banks’ Burden

Slew of schemes launched right after note ban will have a dampening effect on India’s economy, writes Sanjiv Bhatia.

Almost all government programs are started with good intentions, but the results are always the opposite of the intentions of the well-meaning people who originally backed it.

Milton Friedman (Nobel Prize Winner, Economics, 1976)

In a free ‘laissez-faire’ market, the interaction of supply and demand leads to price discovery. The market automatically adjusts supply and demand till an optimal or ‘equilibrium’ price is reached. If apples are in demand, the price of apples goes up, farmers grow more apples in response to the higher prices until there is an excess supply of apples, which forces prices down to the equilibrium price.

It is this self-correcting mechanism and constant price discovery that is the bedrock of a free market system. The system works efficiently, and no government intervention is required. The world has seen unprecedented wealth creation since the growth of free market economies.

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‘I Know it All’ Fallacy

The evidence for free markets is overwhelming: All developed countries have markets that are free, but every country that is poor is so because it suffers from obtrusive government intervention.

Despite this evidence, political leaders continue to meddle with the economy and financial markets. There are several reasons for this. Often, political leaders fall prey to the “I know it all” fallacy. They assume that citizens are helpless, incompetent, dishonest, stupid, and dangerous and need help from the “know-it-all” government. Additionally, power encourages hubris and leads to corrupting thoughts about the importance of the goal, and the need for the leader to do whatever it takes to fix things. Finally, there are always selfish political motivations at play.

Demonetisation Blunder

It is unclear what motivated Mr Modi’s unprecedented intervention in capital markets, but the results, like all government interventions, will be damaging to India’s economy and its financial markets. In a matter of two months, the world’s fastest growing economy with its dynamic young startups and new vibrant companies was brought to its knees. Cash disappeared, business transactions fell by more than 40 percent, working capital dried up, and capital formation came to a standstill.

But, instead of correcting course, Mr Modi doubled down. In his 31 December address to the nation, the PM took state intervention to a dangerous and unprecedented level. He directed banks to decrease interest rates on loans for low-income housing by up to 4 percent, guaranteed an 8 percent return on deposits made by senior citizens, and increased credit limits for some sectors of the economy.

Trouble for Banks

Mr Modi’s new ‘scheme’ of subsidising loans to one group, while simultaneously paying higher-than-market rates on deposits to another group, is double jeopardy for an already stressed banking system. There are currently over Rs 6 lakh crore of unpaid business loans and about Rs 5 lakh crore of outstanding agriculture loans under the Kisan Credit Card (KCC) program. In the face of this reality, it is alarming that no one at RBI is objecting to the government adding another scheme which will undoubtedly further stress the banking system.

Banks derive the interest rates they charge on loans by adding their cost of capital (the rates they pay on deposits) to operating costs and a risk premium that reflects the perceived risk of the borrower and the overall economic environment. Let’s illustrate this with an equation: R = C+O+P where R is the rate charged by the bank on loans, C is the rate it pays on deposits, O is the bank’s operating cost, and P is the risk premium.

By mandating that banks pay 8 percent interest to senior citizens, Mr Modi has fixed ‘C’. Demonetisation has increased ‘O’ for banks because employee time is being wasted in unproductive activities like exchanging notes and complying with tax authorities and enforcement directorates. And, certainly, ‘P’ is higher because of a stressed economy and the higher repayment risk associated with loaning money to low-income borrowers with no credit history.

What we have here is is the classic example of disequilibrium caused by government intervention in prices. The interest rate that banks will earn on loans, R, is less than their cost, the sum of C, O, and P.

Mr Modi’s scheme will force banks to charge 4 percent for loans that are costing them about 11 percent.

Hurting the Nation’s Growth

Mr Modi’s ‘scheme’ of providing below-market-rate loans for low-income housing is likely to meet the same fate. It is hard to understand how low-income people will ever repay these loans when their incomes have not increased but their debts would have. And, just like the KCC scheme, government-guaranteed cheap money will likely get diverted to increased consumption instead of housing. Clever low-income senior citizens will borrow at 4 percent and reinvest that money bank into the bank at a guaranteed 8 percent interest and create a money-making machine at taxpayer’s expense.

Free and unencumbered capital markets are efficient at channeling credit flows to the most productive users of capital. But, if financial institutions are coerced into providing capital to a favoured group, it leaves less capital available for other, more productive, sectors of the economy. By forcing banks to provide cheap capital for low-income housing, Mr Modi’s ‘scheme’ will hurt the nation’s growth by diverting capital away from businesses, capital investment projects, middle-class housing, commercial real estate and other productive sectors.

Managing the Economy

Mr Modi would be well advised to step back from his instinctive desire to manage the economy. Managing a national economy is far more complicated than administering the economy of a state. He means well but is getting poor advice from sycophants and people under him who lack the courage to tell him he is wrong.

Maybe he would be wise to listen to his critics instead, so he can better understand his mistakes and how to course-correct.

But whatever he does, Mr Modi needs to understand that government intervention in matters of commerce has unintended consequences. When those mistakes become apparent, the government is programmed to prescribe additional policy fixes which then lead to new unintended consequences. The economy is too complex an ecosystem, and things spiral out of hand very quickly. Free markets do make mistakes, but they are good at self-correcting; governments are not, and their mistakes keep compounding.

(The writer is Managing Director, Centre for Environmental and Economic Policy. He can be reached @SanjivbDr. This is a personal blog and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for the same.)

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