Inflation in India: potential breach of MPC mandate

There is much breast-beating over the possible breach of the upper limit for inflation of 6 per cent set for the MPC. The RBI has come in for flak from some quarters.

The critics make no allowance for the fact that the challenges facing the world economy are unprecedented. To be doctrinaire in one's approach in such a situation is not helpful.

The inflation rate for the current year is projected at 6.7 per cent (without factoring in steps the RBI would take to contain it). The RBI's approach, reflected in the views of its three members on the MPC, is to bring inflation to within the tolerance band without too much of a sacrifice of growth. I cannot see how this approach can be faulted.

The Indian economy's growth rate sank to 3.7 per cent in 2019-20. Thereafter, in 2020-21 it declined by 6.6 per cent.  It recovered to 8.7 per cent in 2021-22. Real GDP in 2021-22 was just 1.5 per cent above the level in the pre-pandemic year of 2019-20. Under the circumstances, it is impossible for the RBI to ignore the growth imperative. 

Some argue that growth is not part of the mandate of the MPC. Well, it is part of the mandate of the RBI. Are the three RBI representatives on the MPC required to be blind to considerations of growth when they sit on the MPC? The MPC works within the framework of RBI just as RBI, while autonomous, works within the framework of government.

To those who say that the MPC mandate is sacrosanct, I would say: it is certainly not part of the mandate to kill the Indian economy!  

For a vigorous defence of the RBI's approach, you may read Michael Patra's address of June 22.

I have commented on the issue in my last column in BS. As the article is behind a pay wall, I reproduce it below.

FINGER ON THE PULSE

T T RAM MOHAN

Negotiating India’s soft landing  

The glass is half-full. Inflation at the moment may be above the upper limit of the inflation targeting framework but there is room for optimism about growth prospects for the Indian economy in 2022-23.

The inflation rate needs to fall. But analysts seem to be having second thoughts about the degree of monetary tightening that needs to happen. That is the cause for optimism about growth.

The CPI inflation rate touched 7.9 per cent in April followed by 7 per cent in May. In June 2022, the MPC raised its inflation forecast for 2022-23 to 6.7 per cent. There was panic amongst market analysts. Some analysts saw the repo rate going up to as much as 6.25 percent in 2022-23 over the starting point of 4 per cent.

There seems to have been a rethink since. RBI Deputy Governor Michael Patra’s well-argued address on June 22 to the PhD Chamber of Commerce and Industry has had a sobering effect on the markets. After the address, the yield on the ten-year government bond fell by 18 basis points. That says something about the credibility of RBI’s pronouncements on monetary policy.

Mr Patra made three important points. First, he indicated that we might expect inflation to fall back into the tolerance band of 2-6 per cent by the fourth quarter of 2022-23. Secondly, Mr Patra seemed hopeful that “monetary policy actions in India will be more moderate than elsewhere in the world”.

The third point is potentially more controversial. Mr Patra indicated that inflation may exceed 6 per cent for three successive quarters, which would be a breach of the MPC’s mandate. However, if India’s GDP can grow at 6-7 per cent in this year and the next, “the RBI will have fulfilled its mandate of prioritising price stability while being mindful of growth.”

Read together, the second and third points could be interpreted to mean that interest rate hikes hereafter would not be so drastic as to cause GDP growth to fall below 6 per cent. This approach may result in a breach in the accountability mandate of the Monetary Policy Committee (MPC). So be it, Mr Patra seemed to suggest.

Some are outraged. How could the MPC countenance such a breach? Mr Patra has a plausible response: these are “extraordinary times”. Nobody can disagree. Having just emerged from successive waves of the pandemic, the world economy is facing new supply constraints. The last thing we need now is that, in reining in demand, we create supply constraints within the Indian economy as well. The critical issue in managing inflation is not so much the precise level of inflation as the predictability of it. The RBI must not give guidance that misleads the market. That is clearly not the case here.

So far, so smooth. The spoiler could be the actions of the US Federal Reserve. The Fed has of late taken a ‘we will do whatever it takes’ approach to fighting inflation. Market analysts feel the Fed could hike interest rates by a further 120-150 basis points in the months ahead. If the RBI were to match that, the repo rate could rise to as much as 6.4 per cent. That would render a soft landing difficult for the Indian economy.

The best outcome would be that the Fed does not hike the policy rate as much as feared. The other possibility is that the RBI does not have to match the Fed’s rate hikes. The price to be paid is a further flight of portfolio funds and a depreciation in the rupee.  We can live with such a depreciation. Despite the fall in the exchange rate of the rupee with respect to the dollar, the 40-currency real effective exchange of the rupee has remained virtually unchanged in May 2022 compared to May 2021.

Mr Patra is right. When it comes to a soft landing, India is better placed than the US and many European economies. Even at May’s inflation rate of 7 per cent, inflation in India is 2.5 percentage points above the average for the previous five years. In the US, the difference is about 5.5 percentage points. Monetary tightening required is greater in the US.

Secondly, as the latest annual report of the Bank of International Settlements notes, the Phillips curve, which gives the trade-off between inflation and unemployment, has turned flat in the US in recent years. The flatter the Phillips curve, the greater is the monetary tightening required to produce a given fall in the inflation rate. In India, the Phillips curve seems to have acquired its normal shape after having been relatively flat for six years starting 2014. (RBI Bulletin, November 2021).

Mr Patra’s address, which echoed many points the RBI Governor had made earlier, may prove to have been a turning point in shaping the inflation trajectory in the months ahead.

Banking sector in good shape

The health of the banking sector is yet another cause for optimism about the economic outlook. The latest Financial Stability Report of RBI points to several indicators of improvement.

Gross Non-Performing Assets (GNPAs) were at a six-year low of 5.9 per cent of advances in March 2022. They are expected to fall further to 5.2 per cent in March 2023. Capital adequacy in the banking system averages 16.7 per cent, a full 5.2 percentages points above the regulatory minimum.  Provision coverage ratio is at a healthy 71 per cent. Annual credit growth in June 2022 was 13.1 per cent, a rate last recorded in March 2019. India’s banking system can be said to have emerged from a banking crisis that lasted nearly a decade.

If the projected NPA level is correct, regulatory forbearance during Covid has paid off. It hasn’t ended up postponing the day of reckoning, as critics had feared.  

Unless the geopolitical situation worsens considerably, the Indian economy should manage growth of 6.5-7 per cent in 2022-23 while inflation falls gradually to within the tolerance band. In today’s troubled environment, that would be a considerable achievement. It would show that the Indian economy is stronger today than in earlier crises and we are getting better at macro-economic management.

Roe v Wade: the economics of abortion

Martin Sandbu, writing in FT, argues that the recent US Supreme Court judgement overlooks the economic implications of abortion and the judgement is flawed for that reason. (Please see my earlier post below first).

In his judgement, Justice Alito said that a balance has to be struck between the "interests of a woman who wants an abortion" and the individual states'  "interest in protecting fetal life". It was for individual states to determine where that balance lay.

Sandbu argues that not granting abortion in the interest of protecting fetal life has serious economic implications for the women involved. He cites a study that has shown that women denied abortion are more likely to end up in poverty than those who were not. There are other studies that have shown that women who had the right to abortion had a better chance of finishing college and getting a professional occupation.

The right to abortion not only has implications for poverty and inequality in society, it also influences the equations between the sexes. Besides, Sandbu argues, those who profess concern for fetal life have not shown much interest in providing the necessary economic support to those denied abortion and who are compelled to raise children in trying circumstances. The anti-abortionists often are also against welfarist measures.

These are all valid and fairly incontrovertible points. But how does change the fundamental proposition put forward by the US Supreme Court? Faced with all the above facts, it is legislatures that have to make choices and they have to make those choices based on their understanding of the will of the people. If people in a given state believe that denying abortion results in an incorrect balance between individual and societal interests, they are free to give expression to their will through the power of the ballot.

I'm afraid the point I made in my earlier post on the subject does not change: the Supreme Court ruling is about what the Constitution says, it is not about taking a position on abortion

Roe V Wade: it's about interpreting the US Constitution

There has been outrage over the judgement of the US Supreme Court overturning the historic judgement in Roe V Wade that affirmed women's right to abortion. 

A commonly heard observation is that right-wingers, who hate abortion, have been planted in the Supreme Court by Republican administrations and they have had their way.

One needs to be clear about what the US Supreme Court has said. The Court does not say that abortion is bad and should be outlawed. No, it says that the US Constitution does not include the right to abortion. So, if people want the right to abortion, it is up to individual states to make legislation that reflects the will of the people. 

The SC is interpreting the Constitution as it understands the document. It is not taking a position on abortion. If the people of the US want an overarching legislation that confers the right to abortion across states, it is is up to Congress to make suitable amendments to the US Constitution. I'm afraid many of the harsh comments on the judgement seem to overlook these points.

FT has provided excerpts from the judgement that make the above points crystal clear. Here is a quote from the majority judgement written by Justice Samuel Alito:

We hold that Roe and Casey (another ruling on the abortion question) must be overruled. The constitution makes no reference to abortion, and no such right is implicitly protected by any constitutional provision, including the one on which the defenders of Roe and Casey now chiefly rely — the Due Process Clause of the Fourteenth Amendment. That provision has been held to guarantee some rights that are not mentioned in the constitution, but any such right must be “deeply rooted in this nation’s history and tradition” and “implicit in the concept of ordered liberty”.

A concurring judgement by Justice Cavanagh provides the clarification I mention above:

 To be clear, then, the court’s decision today does not outlaw abortion throughout the United States. On the contrary, the court’s decision properly leaves the question of abortion for the people and their elected representatives in the democratic process.  ..... In sum, the constitution is neutral on the issue of abortion and allows the people and their elected representatives to address the issue through the democratic process. In my respectful view, the court in Roe therefore erred by taking sides on the issue of abortion.

 

Fintech fantasies: banks aren't going to disappear

There is talk of 75 digital banks coming into the banking sector in India. There has also been talk of Fintech, of which digital banks are a subset, posing a threat to traditional banks.

I have looked at the literature and the evidence thus far. I don't buy the argument that Fintech poses a threat to banks. 

Here is my article in BS, Fintech challenge is a fantasy.

Here is the article in full for those who can't access the article at the website.

FINGER ON THE PULSE

T T RAM MOHAN

 Fintech challenge is a fantasy

Digital banks are a threat, not so much to banks as to banking stability on account of the systemic risk they pose

 

The government is poised to launch 75 digital banks soon, so the headlines proclaimed. If you thought a sleek set of new banks was going to challenge incumbents, you would have been mistaken. What will be launched are Digital Banking Units (DBUs). These are a new way of making available digital products of existing banks and non-banking financial companies (NBFCs).  

What exactly are DBUs? The Reserve Bank of India (RBI) has a definition that runs into four lines. In essence, these are outlets where people can avail of banking products mostly on their own. There will be personnel to assist them but these will be kept to the minimum. In other words, a DBU can be seen as a branch that operates mostly in a digital (or paperless) mode. 

If the idea is to increase penetration or inclusion in under-served areas, scepticism is in order. Even highly literate customers prefer the convenience of walking into a normal branch to meet many of their banking needs. To suppose that in under-served areas, people will be able to help themselves to any but the most basic banking products (say, deposits) is a stretch. 

DBUs may be able to grow deposits quickly but they are unlikely to do be able to do much on the asset or fee income side. To be able to push a range of digital products in under-served areas, banks will need adequate and highly trained staff.  . At best, by eliminating paper, DBUs can reduce processing time and help enhance employee productivity.  

DBUs are one way in which digital products can be offered. In this model, the digital products stay within the bank. Digital products can also be offered through digital banking subsidiaries or by standalone digital banks. In the late 1990s and early 2000s when online banking came into vogue abroad, banks did experiment with digital banking subsidiaries. These did not work and were subsumed into the parent. r Standalone banks based on internet banking did not survive either.

Standalone digital banks (also called neo-banks) have made a comeback, thanks to the mobile phone. They are part of the broader category of players labelled Fintech. Fintech, which is the provision of financial products through electronic platforms, can happen in three ways. One, through entities that compete with banks (such as digital banks). Two, through entities that collaborate with banks by providing a range of services, such as customer acquisition, KYC checks, loan processing and screening, loan collection, risk management, customer management and so on. Three, through entities that eliminate the need for financial intermediation, for example, peer-to-peer lending platforms.

The most direct threat to banks comes from standalone digital banks. These have not happened in India. But we do have evidence of their record elsewhere. The Global Financial Stability Report (April 2022) provides a useful summary. The threat posed by digital banks, it turns out, is vastly exaggerated. 

Digital banks have grown fast in places such as Brazil, the UK and South Korea. The best among them have market capitalisation comparable to that of the top banks, thanks to rapid loan growth. The high valuations ignore the higher risks that digital banks take and their poor margins and profitability.  

Digital banks don’t quite take banks head-on. They typically target high risk customers that banks tend to avoid. These include: Individuals with lower incomes or lower credit scores, commercial real estate and unsecured lending.  Despite the higher risks they take, digital banks have a lower provision coverage than traditional banks. Their yields on loans are about the same. They have a less loyal depositor base but their liquidity ratios are lower.  

Digital banks’ potential for fee income is lower because they deal with lower income clients. You might think they would have lower operating expenses because of the absence of brick-and-mortar. Not at all. What they save on branches is more than offset by huge marketing expenses. Not surprisingly, most are loss-making.   So much for digital banks  threatening traditional banks and taking away market share from them

Digital banks are connected with banks through the inter-bank market and also through the various services they provide. They are lightly regulated at the moment. But as they grow bigger, regulation will have to be tightened, as the GSFR report observes. Digital banks are a threat, not so much to banks as to banking stability on account of the systemic risk they pose. 

That goes for the broader world of fintechs too. Fintechs have made an impact in the payment space. But that does not mean that they can mount a serious challenge to the core banking functions, taking deposits and making loans.  

For one thing, the experience of the past two decades suggests that the centrality of the branch to banking remains. Digital banking cannot wholly substitute the branch when it comes to customer acquisition. It is a tool for customer retention, an added service that banks provide by way of holding on to customers. 

Branches remain relevant, first, because of the sense of solidity they give customers, the ability they confer for cross-selling more than the most basic products and as a 24*7 means of advertising a bank’s presence. As mentioned earlier, digital banks have to spend enormous amounts on acquiring customers.   . Lacking any overall cost advantage, digital banks necessarily have had to seek out riskier, higher-yielding products and customers.

Secondly, banks have not been idle in response to the perceived threat from fintech. They have adopted many of the tools of fintech  and sought to reinvent many of their businesses. They have acquired fintechs. They are collaborating with fintechs by outsourcing activities they think fintechs can do better. 

We have seen this happen with other challengers or innovators. NBFCs were at one time seen as a big threat because they were nimbler than their bigger banking rivals. Banks responded by themselves offering the high-yield products that were considered the preserve of NBFCs. They have done so either within their existing business or through NBFC subsidiaries. We have reached a point where an NBFC’s nirvana lies in turning itself into a bank! The same has happened with micro-finance. Banks have found one way or another to venture into micro-finance. Ditto with payment products. 

What players such as NBFCs, micro-finance institutions and payment entities have done is to get banks to think through their business models and get better. Fintech is likely to serve the same purpose. The notion that fintech will displace banks is a fantasy. Banks will imitate fintechs or swallow them, they aren’t going to disappear.

 

Russian default will not be Russia's fault

When the West responded to the Russian military operation in Ukraine with brutal sanctions, everybody said a Russian default was imminent. Russia's foreign exchange earnings would collapse, the ruble would go through the floor, the Russian economy would be brought to its knees and Russia would renege on its sovereign dues.

Nothing like that has happened. Russia's export earnings from oil and gas have boomed as  prices have shot up and the West has been unable to avoid buying Russian oil and gas. The Russian ruble has turned out to the best performing currency in recent weeks.

If a Russian default happens, it will not be because Russia does not have the means to repay debt but because sanctions will not allow Russian payments on debt to go through the international system. Until now, servicing of debt payments was exempt from sanctions but the US has now allowed the exemption to expire. Russia has wired a $ 100 million payment that was due but it's not getting cleared. Too bad for the bond holders.

In the case of many of the borrowings from abroad, there is a clause that allows Russia to repay in ruble. For that, bondholders will have to open ruble accounts with Russian banks. That may also not be possible under sanctions. In that event, a Russian default will happen. Perhaps for the first time, a default will happen not because the borrower can't pay but because the lender can't accept the payment! It certainly won't be Russia's fault. 

By the way, whatever happened to the financial crash in China that was supposed to happen after the Evergrande default? No crash has happened, the news of the crash has disappeared from the media.  

Gerhard Schroeder: How free is the Western world?

Just how much freedom is there today in the West? We know that after 9/11, many governments, including those in the US and the UK, armed themselves with sweeping powers to take away an individual's freedom on suspicion of links with terrorism. There is very little recourse in such cases.

But leaving aside restrictions linked to terrorism, just how much freedom of expression do people have even otherwise? You may not be jailed for certain things but the social and economic costs of veering from the mainstream or establishment line can be pretty steep.

A classic illustration is the hounding of Gerhard Schroeder, former Chancellor of Germany, no less. Schroeder is a friend of Putin's and he has refused to join the strident condemnation of Putin in his country from Russia's actions in Ukraine. Schroeder is certainly open to criticism for his position. But we are seeing is a lot worse. 

Schroeder was Chairman of the supervisory board of Rosneft, the Russian oil company, and Chairman of the shareholders' committee  of the Nord Stream gas pipeline projects. Schroeder came under pressure to quit these positions after the Russian operation in Ukraine. When he refused, he lost access to his office at the Bundestag. Next, the EU parliament drafted a resolution extending sanctions to individuals sitting on the boards of Russian companies. Schroeder has now decided to quit the two boards. 

Schroeder has also faced a storm of outrage consequent to the alleged atrocities in Bucha caused by Russia, he told an interviewer that the incident would have to be investigated, a perfectly reasonable stand to take! It is just not possible to have a legitimate disagreement on some matters in the supposedly free societies of the West. If this is the plight of a former Chancellor of Germany, just imagine what dissenters in, say, the media or academic would have to face.

India has come in for severe criticism in the Western media in recent years for displays of intolerance of dissent. Without in any way justifying acts of intolerance in India, it is time to tell the West: Physician, heal thyself.

Loophole in Places of Worship Act 1991?

The Places of Worship Act 1991 has been in the news. Very simply, it is Act of Parliament whereby the religious character of any place of worship, as it existed in 1947, cannot be disturbed. An exception made to the Act was the dispute site in Ayodhya.

If that is so, how could  the mosque in Varanasi (Gyanvapi) come under challenge? Meaning, how could any court entertain a challenge? That is the stand of prominent Muslim groups. Since the character of the place cannot be changed due to the Act, where is the question of any court entertaining any petition related to the mosque?

I can't pretend to be a legal expert. From what I have read in the papers, it appears the Act has another exemption. It exempts places of worship that qualify as ancient monuments. So, if there is a Shivalinga inside the Gyanvapi mosque, as the Hindu petitioners in the case content, does it become an ancient monument so that the Act does not apply to this site? And if it does not, does that mean access to the site will have to divided between Muslims and Hindus? Or can the Hindus claim the site itself/

In the Ayodhya case, the Supreme Court decided the matter looking at the case as one of a land dispute. The party that could establish that it had had greater access to the land over the centuries won, namely, the Hindus. How would the Gyanvapi dispute be resolved if the petition of the Hindus is considered maintainable?

I await the wisdom of legal experts.

Can boards ever keep executive pay in check?

My answer is a blunt 'No'. Boards cannot get executive pay within reasonable bounds- they will almost always tend to err on the excess. 

The latest case in point is JP Morgan. Shareholders at the bank have voted against the pay package recommended by the board for six top executives at the bank, including CEO Jamie Dimon. The package amount to -umm...- only $ 201.8 mn. Dimon stands to get $50 mn from a one-time award. The shareholder vote on exec pay is non-binding in the US. But it does send out a strong signal. Boards may pretend to notice the signal but it is unlikely to change board behaviour a great deal.

The board has conveyed that it is giving a large one-time award to Dimon because it wants him around for many more years. Dimon is 65 and has been at the helm since 2005, that is, for 17 years. If the board thinks nobody in the world can replace Dimon, then it is confessing to a major failure: it has failed to find a successor. It is also acknowledging that JP Morgan's business is unsustainable- there is only one person who can run it.

How absurd! It is not that Dimon is irreplaceable. It is just that the board finds it expedient not to disturb the status quo. And one good reason for that might be that disturbing the status quo could be that any change would be annoying to the CEO.

Boards just can't get executive pay right any more than they can get succession planning right. There is a common reason for the two failings. Boards are in thrall to CEOs. Board members owe their appointments, in large measure, to the CEO and they owe their continuance in office to the CEO. (Forget the nonsense about the Nominations Committee of the board deciding board memberships. Few boards would induct a board member without a nod from the CEO. It would be rare for a board to turn down names proposed by the CEO himself.). And a board membership at the top firms in the world means something- the money is good and the prestige riding on a board position is not to be sniffed at.

I can only reiterate what I have said several times before: we need to change the way board members are appointed if we want serious board room reform. Board members must be appointed by multiple stakeholders- shareholders, banks, financial institutions, employees. Self-selecting boards are a recipe for dysfunction- and spiralling CEO pay, among other things. 

Narcisstic bosses: how does one deal with them?

An article in FT that uses Robert Maxwell, the newspaper baron (long deceased), as a model of a narcisstic boss has a short answer to the question pose above: find another job. But that, as it suggests, is easier said than done: we all have financial needs, so we can't chuck up a job at will.

Very true. But there is another problem as well. There is a high probability that the organisation you move to would also have its share of narcissistic bosses. And the higher you go, the greater the narcissism.

In a book I wrote in 2015, Rethinc: what's broke at today's corporations and how to fix it, I cited a study that showed that the proportion of psychopaths among CEOs was far above that in the general population. Psychopathic traits include things such as a lack of empathy, a tendency to manipulate others, etc. These are qualities one would also associate with narcissism. 

Success in the corporate world- and, perhaps, most walks of life (perhaps, with the exception of advanced research)- is won on the strength of such qualities. This may not sound very pleasant but the heights of success are not for the faint-hearted. It is through a certain disregard for scruple, ruthlessness and self-admiration that people rise. Narcissism breeds success which fuels more narcissim. At the very top, the individual begins to think he is infallible, so he has no patience for anything other than adulation and flattery. He certainly has no room for dissent.

When people go into meetings and stay silent, heartily endorse whatever the boss is saying or indulge in outright flattery, they recognise that these are the things that will help them survive and prosper. They understand they are dealing with a narcissist, if not a psychopath, and fall in line because the costs of not doing so are painfully high. There may be a few honourable exceptions but what I have described here is pretty much the norm.

What can we do about it? Get together will colleagues and take the matter to the board ? No way. There will not be any takers for the petition. And it's no use going to the board because the board too has its fair share of narcissists who will not be able to relate to things such as fairplay and justice.

In government, your job is protected and you can choose to forswear ambition and do your job in your little corner. Alas, in the private sector, there is little choice other than to grow a thick skin. Psychopathic bosses are the primary reason why organisations are so toxic and one reason those toiling in them nurse all kinds of ailments. 

If that sounds a trifle gloomy, please do let me know if you have better suggestions.

High inflation: could central banks have acted earlier?

Prices are surging everywhere. Central banks are being panned for not having acted early enough. In the US, the Fed is said to waited for too long before raising rates. In India, the RBI is being criticised for being dovish on inflation.

I beg to disagree. The sort of inflation that the Ukraine conflict has unleashed could not have been anticipated by central banks. 

The IMF has forecast inflation of  5.7 percent in advanced economies and 8.7 percent in emerging market and developing economies—1.8 and 2.8 percentage points higher than projected last January, a month before Ukraine erupted. Nothing that central banks could have done would have altered the basic post-Ukraine inflation trajectory.  

In India, the RBI could have raised the policy rate in February, 2022. It could have signalled a less accommodative monetary policy. But these actions would not have made much of a difference to the inflation outlook.

I elaborate in my BS column, Blame Ukraine conflict, not central banks.

FINGER ON THE PULSE

T T RAM MOHAN

 

Blame Ukraine conflict, not central banks

The origins of the inflation shock the world is experiencing are primarily political, not economic or monetary

 

The global economy faces a combination of slowing growth and rising inflation in 2022. Many commentators ascribe it to the excesses, fiscal and monetary, of the past several years. They are wrong. The deceleration in growth and inflation of the magnitude we are seeing now are more on account of the conflict in Ukraine.  

 

To grasp this, you only need to look at forecasts before and after the Ukraine conflict that commenced in February 2022.

 

Let us take the growth forecasts first. The year 2022 was to have been the year of recovery for the world economy from the ravages of Covid-2 in 2021. In October 2021, the IMF’s World Economic Outlook (WEO) saw the world economy growing at 4.9 per cent. In its April 2022 issue of WEO, the IMF projects world economic growth at 3.6 per cent in 2022 or 1.3 percentage points below the October 2021 forecast. Note that the April forecast is 0.8 percentage points below the forecast of January 2022, a month before the Ukraine conflict erupted.  

 

So, yes, the world economy was slowing even before the conflict in Ukraine. Prices of commodities had started rising due to the recovery in the world economy. Central banks had started responding with an increase in interest rates and this was impacting private consumption and investment.

 

But Ukraine has greatly amplified the deceleration in growth. The sanctions against Russia have no precedent and have disrupted long-standing supply chains and trade linkages. Inflation, as we shall see, has received an enormous boost. Capital flight from emerging economies is putting pressure on exchange rates, giving central banks another reason to raise interest rates.

 

Increases in interest rates threaten to undermine government finances across economies. Western banks are poised to take a hit of around $10 billion on their exposures to Russia. Western corporates retreating from Russia face huge write-offs. There is, above all, uncertainty about the course of the war and the possibility of secondary sanctions against nations found to be violating sanctions imposed on Russia. All this will tell on growth. One cannot compare the slowdown projected prior to February 2022 with what faces us post-Ukraine.

 

The comparison of trends in inflation pre- and post-Ukraine is even more compelling.

 The World Bank’s Commodity Markets Outlook (April 2022) shows that between January 2020 and December 2021, that is, over 24 months, energy prices rose at a compounded annual rate of 22.4 per cent. In 2022, in just three months from January to March, energy prices rose by an additional 34 per cent! Non-energy commodity prices rose by an annual rate of 18 per cent over the previous two years. In the first three months of 2022, these rose by an additional 13 per cent.

 

As a result, the World Bank’s forecast for energy prices in April 2022 is 92 per cent higher than in October 2021. For non-energy commodities, the forecast is 49 per cent higher. The forecast for food prices is a good 57 per cent higher. The Ukraine conflict has caused prices to soar in a way that central banks could not have anticipated earlier.

 

It makes no sense to criticise governments for having boosted spending, first after the global financial crisis (GFC) of 2007, and then after the Covid crisis. Nor can central banks be faulted for policies aimed at supporting growth. These policies saved the global economy from collapse after the GFC. They were also successful in containing the damage from the Covid crisis, in particular, to vulnerable groups, such as the poor and small enterprises. 

 

Proponents of Modern Monetary Theory (MMT) contend that the only limit to government spending is inflation, not government’s capacity to repay borrowings through future taxes. Critics of MMT say that its advocates have seriously under-estimated the inflation risk to government spending. This is by no means obvious. It is more plausible that the fault lies, not in the economic policies of well over a decade, but in the stars of NATO. The inflation shock we are seeing is political in origin. It is primarily on account of the NATO’s opting for a head-on confrontation with Russia over the eastward expansion of NATO.

 

Commentators say central banks have been late in reacting to inflation. This is strictly hindsight. Our analysis above suggests that prior to Ukraine, the US Federal Reserve was justified in waiting to see if the supply disruptions caused by Covid had played out. It had grounds to believe that a series of 25 basis points increases in the policy rate would suffice to head off inflation. No central bank can anticipate the sort of supply shock that has emanated from Ukraine.

 

Similarly, the Reserve Bank of India (RBI) may not have erred in forecasting an inflation rate of 4.5 per cent for India in 2022-23 last February. The revision in the inflation forecast to 5.7 per cent that happened in April is strictly a post-Ukraine event.

 

At a forecast inflation rate of 4.5 per cent, the RBI had grounds for prioritising growth over inflation. As long as inflation is within the band of 6 per cent, it is appropriate to prioritise growth especially at a time when the growth rate has been below the trend rate. When the inflation forecast moves closer to 6 per cent, it is appropriate to prioritise inflation.

 

Those who say that the RBI should be fixated at all time on an inflation rate of 4 per cent forget that there was a question mark over the continuance of the present band mandated for the MPC. The argument was made that, in the interest of facilitating a higher growth rate, the target rate for inflation could be raised to 5 per cent plus or minus two per cent.

 

The government decided to stay with the present mandate, perhaps, because it thought that relaxing the monetary policy target at the same time as the fiscal deficit target was being continuously deferred would unsettle foreign investors. Against this background, the RBI cannot be faulted for its interpretation of the inflation mandate.

 

The outlook for both growth and inflation has changed dramatically as a result of a force majeure event, Ukraine. It makes little sense to fault demand management for the effects of an unprecedented supply shock.

 

Credit Suisse woes: can banks be cured at all?

Can banks be cured of their penchant for taking excessive risk? Or is banking an ailment for which there is no cure?

The question is prompted by the astonishing confession of the Chairman of Credit Suisse, Axel Lehmann:

It has become clear that the challenges of the past were not solely attributable to isolated poor decisions or to individual decision makers,” he (Lehmann) told the Swiss lender’s shareholders. “Within the organisation as a whole, we have failed too often to anticipate material risks in good time in order to counter them proactively and to prevent them.

Well, if a bank can't anticipate material risks, what are its executives getting paid for? The problem, I suspect, is not lack of awareness of material risks. It is the way incentives operate in banking: heads I ( the bank manager) win, tails you (the shareholder) lose. If a banking bet goes hugely wrong, the shareholders and bondholders are left holding the can. The manager, at worse, will lose his job. He won't starve as a result: he will enough millions to live off for the rest of his life. As long as there are no penalties, including criminal penalties, for irresponsible decision-making and as long as banks are leveraged the way they are, it seems futile to expect bankers to behave. 

Credit Suisse has got singed on account of exposures to high-profile collapses. It lost $5.5 bn on account of its exposure to the disgraced fund, Archegos. And its clients have  $10 bn of their money trapped at a failed fund, Greensill Capital. 

An investigation carried out by law firm Paul, Weiss at the instance of Credit Suisse remarked that the bank's losses that the losses were the result of a "fundamental failure of management and controls" at the bank and a "lackadaisical approach to risk".

Makes you wonder. If this is the quality of risk management at the one of the best known names in the world of banking, what does it say about the efficiency of foreign banks? What does it tell us about the functioning of the boards of top institutions? Is corporate governance an illusion? Does it make sense at all to talk of foreign banks coming in and acquiring underperforming public sector banks in India? 

I leave it to you to ponder.

IIMA logo controversy-II: autonomy and the IIM Act

IIMA and the two other leading IIMs have enjoyed considerable autonomy ever since they were set up. Nevertheless,  starting in the early 2000s, faculty and the director set up a clamour for more autonomy, especially financial autonomy. I have never been able to quite figure out what they wanted. I guess they wanted full freedom of pricing in respect of the various programmes. They may also have been keen to come out of the Pay Commission straitjacket for faculty pay.

In 2008, freedom of pricing was granted: the fee for PGP  was increased by more than 150 per cent (and without any consultation with faculty whatsoever). Yet, the clamour for autonomy did not die down. The community wanted to be free from any sort of government control.

I was a little sceptical about this demand myself. My suspicion was that more autonomy meant freedom for the director to do as he pleased without any checks on the part of the government. It would not translate into more faculty autonomy. I sensed that the faculty's position would worsen if we came out of the government fold in practice, even if legally we we remained a public institution.

Some time in 2015, Smriti Irani introduced a draft IIM Bill that introduced better checks into the IIM system - or at least that was my view. The then director, Ashish Nanda, and several faculty decided to oppose it.

I saw nothing wrong with the Bill and wrote an article in the Hindu saying so. I pointed out that the IITs had done quite well for themselves while being under government control and that the IIMs need not fear any undue government intrusion. To my surprise, my article drew a torrent of favourable responses on the faculty notice board. As I mentioned earlier, faculty had long demanded more autonomy. However, over the years they (a large section of faculty) had seen the drift of power away from themselves to the  director and the board over the past decade and had come around to my view !

The Ministry of Human Resources Development (MHRD) invited responses to the draft Bill. Nanda circulated a note that was highly critical of the draft Bill. It was  to be sent to the Ministry via the online link provided. I wrote to him saying that I disagreed with him. The question of greater autonomy, I said, had not been properly debated by faculty. I suggested that the matter be debated and a vote taken on the draft Bill. Only if the vote was in favour should his note be sent as the Institute's response, otherwise it should go strictly as his personal response. 

Nanda did not reply. He and the then Chairman, AM Naik, went on to hold a press conference where the Chairman denounced Irani for trying to reduce the IIMs to a post office of the government. Irani took umbrage and gave vent to her feelings in a TV interview.

The debate I had asked for never happened. Nanda (and a few other IIM directors) kept meeting with the government. In the meantime, it turned out that the PMO itself favoured much greater autonomy than Irani had contemplated. Irani was moved to another ministry and Prakash Javadekar took her place. Thereafter, in 2017, the IIM Act was enacted which took the autonomy of the IIMs to a higher level.

The point is that the views of IIM faculty were not factored into the drafting of the Act. The dialogue was between the government and a few IIM directors.

Once the Act was passed, the number of government nominees on the Board of Governors was reduced from four to two. These two nominees (one each of the central and state government) ceased to take interest in the proceedings, leaving it to the rest of the board to take all decisions. The other members on the board are representatives of industry, alumni and two faculty of the Institute. 

Everybody knows what the 'board' anywhere is, even in the corporate world. It is basically the CEO. The CEO comes up with proposals which boards duly approve, except where there is a serious crisis in an organisation. Now, this is the case even in the corporate world where boards are subject to company law, securities regulations, exchange regulations, investor scrutiny, etc. The majority of boards are dysfunctional and ineffectual, which is why we keep going on and on about corporate governance.

In the IIM context, boards are not subject to any of the checks mentioned above. Nor is the government now acting as a check. The result is that autonomy has, in effect, become untrammelled freedom for the director. This is the case even at the leading IIMs. One can well imagine the situation at the lesser IIMs.   

This has been going on for some five years now since the IIM Act was passed.  Within six months of taking over as director, Nanda proposed that the iconic Louis Kahn structures (including faculty and staff residences) be demolished. He wanted faculty and staff to move into multi-storied structures to be built for them at one corner of the campus near the Azad Society gate. An exception would be made for the director himself- he would he housed in a newly constructed bungalow.

Faculty asked what would happen to the entire stretch between the Azad gate and the main building. Nanda said it would be a "green area'. We heard unofficially that the entire construction project would cost more than Rs 200 crore. Fortunately, the board did not favour the idea. Many of us wondered why the construction of new buildings would be a priority for a director who was said to have come on a two year sabbatical from Harvard. We had supposed that institution-building was more about institution than building. 

In 2020, the present director and the board revived the proposal. The staff residences near Azad gate were demolished. Two ugly, multi-storied structures are under construction. The director wanted to do away with the student dorms as well except for a few outer ones. The main building structures would remain. There was an outcry not just in India but abroad. Several petitions were sent to the Chairman.  That stopped the board in its tracks. 

The point is not that existing structures can never be replaced by new ones. But the case for doing so has to be properly made. Can the existing structures not be renovated using current technology? What are the relative costs of renovation and new construction? Alas, such a case was not made. The project was sought to be rushed through under a cloak of secrecy.  

Now, we have the logo controversy. I have written about it in my earlier post.  The issue is the same: why are these decisions being taken without proper consultation with all stakeholders?

The answer is that greater autonomy has meant poor oversight and no checks on the director. That is why we are now seeing a faculty revolt at IIMA. The government needs to understand this. The situation cannot be rectified by merely arriving at a compromise on this issue. We need to step back and examine where the IIM Act went wrong. 

I am afraid the situation cannot be set right without government intervention and a re-look at key provisions of the IIM Act. 

I have written about it in my column, Time to revisit the IIM Act,  in BS. The article is reproduced below for those who don't have access to the website.

Time to revisit the IIM Act

The government must jettison its hands-off attitude towards the IIMs and address the governance deficit

T T Ram Mohan

There has been turbulence at IIM Ahmedabad (IIMA) in recent weeks. Almost half the faculty are upset with changes in the logo announced by the director and have written to the chairman of the Board of Governors. Faculty members have also raised issues of governance, including violations of long-established norms.  

Other IIMs have not been free from trouble. At IIM Calcutta, there was a breakdown in communications between the previous director and the faculty in 2021. The matter was resolved only by the departure of the director before her term ended. At IIM Rohtak, the board gave a second term to the present director even as a controversy attending his first term remains unresolved. One could go on. There is a case for reviewing the experience with the IIM Act of 2017, and making the necessary course corrections.

IIMA is the premier management institution and has historically had the best governance amongst the IIMs. It is worth taking a closer look at IIMA following the IIM Act and deriving the necessary lessons for governance in the IIM system.

The issue at IIMA is not merely the changes to the logo. It is also the process followed in doing so. The director got two logos approved by the board and then informed the faculty about the change. It doesn’t seem to have occurred to the board to ask: What does the faculty think?

That hurts. IIMA has long prided itself on being a faculty-governed institution where key decisions — admissions, placement, course syllabi, recruitment of faculty, etc. — are taken by the faculty. That is its uniqueness and the secret of its success.

Over the years, faculty governance has got eroded and decision-making has moved from the faculty to the board. A pivotal moment came in 2008 when the institute announced a more than 100 per cent increase in the fee for its post-graduate programme. The faculty were informed about about the biggest increase in fee in IIMA’s history after the board had approved it.

Several issues agitating the faculty have remained unresolved. One that has figured in the current controversy is the appointment of two faculty members to the board. The noble intent was that the two members would act as a bridge between the faculty and the board. At IIMC and IIMB, the faculty elects its representatives to the board. At IIMA, the director selects them.  As a result, faculty members on the board at IIMA are not spokespersons for the faculty body.  Another contentious issue is the absence of norms for the appointment of Dean, a post one rung below the director. 

The IIM Act has given a fillip to the erosion of faculty governance at IIMA.  The leading IIMs had enjoyed considerable autonomy even before the IIM Act. The Act gave formal shape to such autonomy and enhanced it by leaving the appointment of the chairman and the director to the board. 

The crucial change that has come about after the IIM Act is that the government decided not to influence the working of the IIMs. The central government and the state government have one representative each on the boards. These nominees play a passive role where they used to be active. Earlier, faculty could expect the government to intervene if the chairman was unresponsive. Now, they have little recourse. 

The IIM Act says that the board is accountable to the government. It requires IIM boards to evaluate the performance of the institute once every three years through an independent agency, submit an action taken report to the government and place the report in the public domain. A visit to the websites of IIMA and IIMC fails to elicit any such report.  At IIMB, an external review is said to be nearing completion. The Ministry of Education must immediately ascertain how many IIM boards are compliant with the relevant provisions of the IIM Act.   

In the US, the boards of higher education institutions are filled with large donors who have enormous stakes in those institutions. Competition among the leading schools is fierce. Both these factors make for accountability. If a school’s ranking drops sharply, heads will roll because the boards care. 

In India, the leading IIMs do not have meaningful competition. Board members come and go and have virtually no stake in the IIMs. It is futile to expect IIM boards, as they are constituted today, to enforce accountability or provide redress.  

We thus have a serious governance deficit in the IIM system. There is no meaningful accountability of the director or the board. The governance deficit needs to be addressed. 

First, the government must jettison its hands-off attitude towards the IIMs. Until such time as a regulator for higher education is created, the government will be required to play the role of umpire at the IIMs. 

The IIM Act must be amended to revert to the earlier position of four government nominees, two each from the central and state government. These nominees need not be from the Ministry of Education. The government may appoint qualified persons to represent it in the same way it appoints independent directors at public sector enterprises.  Once the government nominees start playing an active role, comatose boards will spring to life.

Secondly, the government must constitute an IIM Advisory Board (IAB) that is tasked with commissioning an independent performance audit of each IIM every three years as required under the Act. It makes no sense to ask the boards to commission the audit because the boards themselves need to be evaluated.  The IAB may also be asked to propose chairmen and directors for the lesser IIMs and, if thought necessary, for the leading IIMs as well. Its role would be similar to that of the Banks Board Bureau for public sector banks. 

Thirdly, the IIM Act must be amended to ensure that faculty members on the board are chosen by the faculty and not by the director.

Fourthly, the government nominees on the board must insist on clearly defined criteria for important posts such as those of Dean, membership of the board and membership of the Committee that evaluates faculty. 

The IIMs are public institutions that owe their autonomous status to the generosity of the government. It would be tragic if the formidable brand equity of the IIMs were to be squandered for want of accountability in the system.

 

IIMA logo controversy-I : symptom of a deeper malaise

IIMA announced a change in its over sixty-year logo recently. The director had told the faculty that the board had approved two logos, one that retained the original Sanskrit quote and another that did not retain it (and was intended for an international audience).

Faculty protested against the changes that had been made without consulting them. Here is one of the many media stories on the subject. The Institute then came out with an announcement. Here is a part of it:

The proposed logo continues the legacy of the original logo, retains the status line in Sanskrit (VidyaViniyogadVikasa) as in the original, the colour rendition has been improved, the fonts modernized, the 'jaali' inspired brand mark has been made more amenable to communication in digital media, and the brand name made more distinct. The proposed logo is to be released in June of this year after the annual vacation.

But the controversy has not died down. Current and retired faculty and alumni have mounted a campaign against any change in the logo. Some point out that leading universities in the world have retained their logos for centuries.

Like many of my colleagues, I find the new logos distasteful. But that's not the point. The point is that faculty are miffed over the fact that they were not consulted.

Those who know about IIMA would know that it what conceived as a 'faculty-governed' institution, that is, key decisions would be taken by the faculty. Legally, all powers vest with the board. The board delegates powers to the director. Successive directors have chosen to be guided by the faculty, in effect, sharing powers with faculty. This beautiful construct was the work of Vikram Sarabhai, the scientist, and Ravi Matthai, the first full-time director of IIMA. 

The idea that something as important as a change in the Institute logo can happen without any faculty input is revolting to anybody associated with IIMA.

The erosion in faculty governance is not sudden, it has happened over time and over the tenures of several directors. To me, a turning point was the fee increase of over 150 per cent in 2008. Faculty were told about the increase via email on Convocation day after the increase had been approved by the board. Some of us who had not checked our email got to know from the newspapers the next morning! No explanation was given for the stupendous increase in fee.

There is an interesting post-script to that episode. After the fee was announced to the public, it came up for 'approval' at a subsequent faculty meeting. Somebody asked what was there to approved since the board had already taken a decision on the matter and announced it to the world. One of the lackeys of the director chimed in to say that the approval sought was not for the fee itself but the components thereof- how much for the academic programme, how much for the hostel, mess, etc! So much for faculty governance.

Over time, the lack of consultation has extended to various matters. Centres have sprung up without faculty approval or discussion. Important appointments have happened in arbitrary ways. IIMA has, for years, followed the 'Nominations' process for appointments to administrative positions, such as Dean. The director would invite nominations from faculty. The idea was that the leadership would emerge from within instead of being imposed from above.

I have no idea how well it worked in the initial years. What I do know that, in recent years, it has been  nothing but a fraud perpetrated on faculty by successive directors. Faculty put in their nominations and the director sticks to his pre-meditated choices. In some cases, we came to know that the director had sounded out individuals for positions even before nominations were sought.

On one occasion, the director appointed a contemporary of his from IIMA at Visting Faculty for one year. A year later, the concerned area found the individual unsuitable for a permanent position. The Director then gave him a five year appointment as VF and proceeded to elevate him to the post of Dean (alumni), a  post just one rung below the Director. Evidently, none of the permanent and senior faculty qualified for the position.

There are three Deans at IIMA. Prior to the IIM Act, one of the Deans was eligible to officiate as Director when the incumbent stepped down and until a new director was appointed. So we could, in principle, have had someone who did not qualify or a permanent position presiding over the faculty of the Institute in his capacity as Officiating or Acting Director!

There is also a complete absence of norms for other appointments such as membership of the Faculty Development and Evaluation Committee and faculty membership of the Board of Governors. Earlier, many of these positions went by seniority- you had to be a full professor and one of the senior-most faculty would be chosen. All that has fallen by the wayside. Directors have made these appointments according to their whims and fancies.

The current turmoil at IIMA thus has deep roots. The logo issue is a symptom of a deeper malaise, the steady erosion of faculty governance and the shift in decision-making from the faculty to the board (in effect, the director). 

The sad part is that things have become worse after the IIM Act that has conferred greater autonomy on the IIMs. I will post separately on that subject. 

HDFC Bank-HDFC merger: euphoria is misplaced

After the initial spurt in stock prices after the announcement of the merger of the HDFC duo, prices have fallen back. There is a better appreciation of the realities.

Yes, the merger was required, more so by HDFC because of the obvious difficulties in sustaining earnings growth. But that doesn't mean that the new entity is going to produce fabulous returns. The chances are that returns of the merged entity will be lower than that of either entity before the merger. 

The issues are:

• The statutory requirements that will apply to the liabilities of HDFC
  
•  The difficulty in cross-selling deposits to HDFC customers
•  The managerial challenges of merger, including managing a more complex entity than before
• The problems with growing earnings on a larger base
• The prospect that the competitive landscape will have changed by 2025 when the presumed benefits of the merger will start kicking in

I elaborate in my article in Bloomberg Quint.

For those who can't access it, here it is:

HDFC Bank-HDFC merger signals goodbye to the halcyon days

T T Ram Mohan

HDFC Bank reported a return on assets (RoA) of 2.3 per cent last quarter and earnings growth of over 18 per cent. These are numbers that should make analysts and investors salivate- internationally, even an RoA of 1.25 per cent is considered very good.

Yet, the price to book value ratio of HDFC Bank was just 2.3 before the recently announced merger with HDFC, way below the multiples that the bank commanded at lower returns. The stock has underperformed the index over the past year.

Why so? Clearly, investors did not think that HDFC Bank could sustain high earnings growth.  

One reason surely was the bank’s low exposure to home loans: these constitute only 11 per cent of HDFC Bank’s portfolio.  A reasonable share of home loans in the overall portfolio of a private bank would be 25 per cent. Post the merger, management expects home loans will constitute 33 per cent of the overall book.

Right since the bank’s inception, not being able to have adequate home loans in its book has been an issue for HDFC Bank. The bank had the distribution capability but could not have its own home loan book because that would mean competing with its parent.  This did not matter much in the initial years because there was enough scope to grow through other products.

A few years down the road, HDFC Bank entered into an arrangement whereby the bank would sell HDFC’s home loans for a fee. It would also have the right to acquire 70 per cent of the home loans it had distributed as mortgage-backed securities. These securities would have the yield of home loans minus a servicing charge for HDFC. This gave the bank a product with a decent margin. But it wasn’t quite the same thing as being able to finance home loans on its own.

Analysts could see this clearly. So they would keep asking Aditya Puri, the former CEO of HDFC Bank, when the bank would do the obvious thing, namely, merging with HDFC. If memory serves correctly, Mr Puri had to tell analysts that that was the one question he didn’t want to hear any more! Mr Puri told analysts that the merger would happen when the timing was right.

The timing was never right in Mr Puri’s time because there was no way that Mr Puri would settle for a position that was less than that of the CEO. It would have been difficult for the parent’s top brass to settle for less either. There is little doubt, therefore, that the personality issue came in the way of the logical thing for HDFC Bank, namely, merger. The argument that interest rates have declined, so the cost for HDFC of complying with statutory liquidity ratio requirements is less onerous is correct. But high interest rates were not the principal hurdle to the merger.

Now, Mr Puri is no longer at the helm at HDFC Bank. Keki Mistry, Vice Chairman of HDFC Renu Karnad, Managing Director are both in their late sixties. There is no difficulty in their making way for the relatively youthful CEO of HDFC Bank, Sashi Jagadishan.

Without its own home loans, growth in recent years at HDFC Bank has come from MSMEs and the unsecured book. These are high-yield products but risky. Home loans have a lower yield but serve the purpose of lowering overall portfolio risk. Investors would prefer a bank whose growth was driven by the latter.

For HDFC, the parent, there was no problem in sustaining growth in the loan book because the potential for home loan growth remains huge in India’s under-penetrated market. The problem was being able to sustain its current margins in the face of tighter regulations.

Non-banking finance companies (NBFCs) have the disadvantage of not having access to low cost savings and current accounts. They had advantages. A big one was not being encumbered by the liquidity and priority sector obligations that banks face.   This is what is called ‘regulatory arbitrage’.

In October 2021, the RBI moved towards bringing regulatory norms for the larger NBFCs broadly in line with those for banks. In particular, the liquidity requirements for larger NBFCs were made the same as for banks with effect from 2025. The RBI’s intent is clear: the larger NBFCs must convert into banks.

The larger the NBFC, the greater its dependence on bank borrowings. Large NBFCs are thus a source of systemic risk. Better, then, that they submit themselves to the tighter regulation that applies to banks. There was no way that HDFC could have kept growing without considerable pressure on its margins. The answer was to access the low-cost funds available to HDFC Bank.

Mergers are touted as great strategic coups. Markets fall for this line and respond by boosting the stock prices of the two entities involved after  a merger  announcement. This has happened with the HDFC Bank- HDFC merger. For that reason, CEOs love mergers.

The prosaic truth is that mergers are confessions of failure: the failure to grow earnings on an organic basis. As our analysis shows, the HDFC Bank- HDFC merger is no exception.

Mergers are expected to reward investors through synergies and cost savings.  Alas, a large proportion of mergers- in some sectors and economies, the majority- fail, that is they failed to enhance the combined shareholder value of the two erstwhile entities. That is because the supposed benefits are overwhelmed by the complexity of the  larger entity. Every merger thus represents the triumph of hope over experience- every CEO hopes that his adventure will belong to the successful minority.

What of the HDFC Bank-HDFC merger? The two entities belong to the same family. HDFC’s employees are a small fraction of that of the bank but there is still the task of integrating the senior management of HDFC and resolving issues of who reports to whom.

Analysts talk of the benefits of scale. But these economies kick in at a much lower scale than that of the behemoth that will be created in the present merger. Beyond a certain scale, there is little to be gained.

Then, there is the potential for cross-sell. HDFC Bank can certainly push home loans in a bigger way to its customer base than before. Selling deposits of HDFC Bank to HDFC’s customer base is a more challenging proposition. HDFC’s customers would have their own banking relationships and switching from one bank to another is not easy. Had it been easy, HDFC could have  sold the bank’s deposit products all these years and collected a fee from the bank.

The merger is to be completed in 2024. The presumed benefits will happen in the years thereafter. The banking landscape then is unlikely to be the same. The newly consolidated public sector banks will have got to their acts together by then and may pose stiffer competition on both the liabilities and the asset side. Some of the NBFCs promoted by industrial houses may get the nod to convert into banks. Who knows what other changes are in store? The gains of the merger are thus subject to considerable uncertainty.

What is certain is the negative impact, post-merger, of the SLR and priority lending requirements against HDFC’s deposits. The returns of the enlarged HDFC Bank will fall as a result.  It Is not clear whether the RBI will allow HDFC Bank to directly hold the numerous subsidiaries of the merged entity. If the RBI insists on a holding company structure, that again will impose costs and returns will fall.

In sum, the merger is the answer to slower earnings growth faced by the two entities. We will have a giant that can be expected to do better than either entity would have done sans the merger. However, it is unlikely that the glorious past of either entity can be recaptured on a much larger base.  It does appear that the halcyon days of the HDFC duo  are over.

(Disclosure: The author is on the board of directors of IndusInd Bank Ltd. ttrammohan28@gmail.com)