Cash-for-Gold Loans Hide Shadow-Banking Risks in India
When Rashmi Deshmukh needed money for her hand-knit clothing business in Mumbai, she couldn’t wait for bank approval. Instead, she put up her wedding jewelry as collateral at a loan-for-gold company to get cash on the spot.
Muthoot Fincorp Ltd., which advertises three-minute gold loans and has 3,125 branches across India, charged 24 percent annual interest. While a bank gets half that rate, it would have loaned her less and required paperwork, she said.
“It’s faster, it’s easier, it isn’t cheaper, but I get more for my gold from Muthoot than the bank,” said Deshmukh, 37, who borrowed 250,000 rupees ($4,576) in October because she had more orders than yarn ahead of this year’s holiday season.
Assets at non-bank lenders such as Muthoot have increased 20 percent annually for the past five years to $670 billion, according to a November report by the Financial Stability Board. That makes India the world’s second-fastest-growing market, after Indonesia, for lending outside the banking system, or shadow banking. It also poses risks for a country where 65 percent of the population and 92 percent of small businesses don’t have access to banks, World Bank and government data show.
With non-bank companies accounting for almost 40 percent of India’s financial system, policy makers are struggling to tame inflation and reverse slowing growth, said Ashima Goyal, a Mumbai-based economics professor and member of the central bank’s technical advisory committee. While the Reserve Bank of India raised interest rates 13 times from mid-March 2010 through April of this year, inflation has remained above 8 percent for 21 of 26 months, according to data compiled by Bloomberg.
Having so much money outside government control “stands in the way of smooth transmission of monetary policy,” Goyal said. “This challenge is at the root of India’s struggle to administer policy that will trigger the kind of growth the world is expecting out of India.”
The largely unregulated shadow-banking system also creates risks for Indians putting money into alternative investments. More than 6,000 people in the southern state of Tamil Nadu filed complaints in the past five months after investing in emu farms that failed to pay promised returns. Sahara group, which owns New York’s Plaza Hotel, was ordered by India’s Supreme Court in August to refund 22 million investors $3 billion obtained through improper bond sales in the country’s largest case involving a non-bank financial firm.
The official figure for India’s shadow-banking industry counts only what non-bank financial companies register with the central bank. The true size is much larger, including private lending and money channeled into more than 10,000 collective investment funds known as chits.
“It’s impossible to calculate,” said Kavita Rao, an economist at the National Institute of Public Finance and Policy in New Delhi who was appointed by the government last year to lead a panel to study the black-market economy. “India’s shadows are dark and deep. There’s just no way to know how much our informal lending is worth.”
If the government knew where all loans went, it could more effectively target measures to direct the economy, said Shinjini Kumar, a director at PricewaterhouseCoopers LLP in Mumbai.
“When liquidity goes and gets trapped and doesn’t create economic activity, that’s where there’s great concern for stunting economic growth,” Kumar said.
Expansion of India’s $1.85 trillion economy slowed to 5.3 percent in September, from 11.2 percent in March 2010, when it was the highest in at least a decade, according to the government statistics office. November’s wholesale price index was 7.24 percent, the highest inflation rate among so-called BRIC nations -- Brazil, Russia, India and China.
While raising interest rates should increase the cost of money and discourage inflation, non-bank companies, which need only a license to lend money, aren’t subject to central bank limits on how much they can charge.
The Reserve Bank has been tightening regulation of non-bank lending to “reduce the risk in the system,” Deputy Governor Anand Sinha said in an interview while visiting Kolkata on Dec. 6. “Shadow banking is seen as a dirty word,” he said. “What we are trying is to keep an eye on that segment and whenever necessary take necessary action.”
The central bank on Dec. 12 published draft guidelines aimed at tightening the rules for non-banking firms. The proposals call for Reserve Bank approval of ownership transfers, increased scrutiny of directors and greater disclosure in financial statements.
In November, the government banned banks from granting loans for the purpose of buying gold. The move was designed to prevent cash from exiting the banking system and no longer contributing to financial activity, such as lending, that fosters economic growth.
Gold holdings by individuals and corporations total about $950 billion, a number that includes savings outside of the banking system as well as gold held in bank deposits, according to Bhargav Vaidya, director of B.N. Vaidya & Associates, a Mumbai-based gold-traders advisory firm. The metal is popular as a hedge against inflation and because it can be converted readily to cash or used as collateral for loans.
The central bank also reduced the limit on loans for gold to 60 percent of the value of the metal and increased the regulatory power of the Securities and Exchange Board of India to require greater disclosure by non-bank financial companies.
“The current policies are not enough,” Brinda Jagirdar, Mumbai-based chief economist for the State Bank of India, the nation’s largest lender by assets, said in an interview before the Dec. 12 guidelines were announced. “Consider shadow banking as the weakest point of the Indian financial system, then strengthen it with tighter regulation.”
The central bank said it was regulating 12,375 non-bank financial institutions as of May. Among the largest are Mahindra & Mahindra Financial Services Ltd. (MMFS) and Muthoot Capital Services Ltd., a publicly traded company controlled by the same family that runs Muthoot Fincorp and which also makes loans for gold.
About 270 of the firms take deposits paying no more than 12.5 percent interest and make loans for purchases such as motorbikes for rates ranging from 13.5 percent to 25 percent, according to bank data and the companies’ websites. Most of the others are consumer-finance lenders and investment funds.
“The line between formal and informal banking is blurred, pointing to India’s huge dependence on shadow banking,” said S. Ananth, who researches rural financial companies and is a former finance professor at Andhra Loyola College in the southern state of Andhra Pradesh. “Formal banking hasn’t reached rural places, and there’s latent demand for financial services, which the banking sector would take 30 years to meet.”
Muthoot Fincorp has seen business surge as people who once paid rates to money-lenders as high as 48 percent have turned to non-bank firms, said John Muthoot, chairman and managing director of the Cochin, India-based company. He said 70 percent of his outlets are in rural and semi-urban areas.
“We cater to our customers in ways banks can’t imagine,” Muthoot said. “I can take all of our services to their doorstep, which is a tremendous help to our customers because that saves them from shutting the door to their shops, or leaving the fields. For them, lost time is lost money.”
Shadow banking relieves pressure on commercial lenders, which don’t have the capacity to meet the demand of Indian borrowers, said State Bank of India (SBIN)’s Jagirdar.
“Don’t think of shadow banking as a horrible thing,” she said. “Without shadow banking, the stability of the Indian economy and its banks comes into question.”
Gyan Muhammad is one those who doesn’t have a bank account. The owner of a general store in New Delhi that sells matches, toffee, light bulbs and spices, Muhammad, 41, said he doesn’t earn enough or have the proper documents to qualify. Instead, he borrows from an officer at a nearby police station who moonlights as a money-lender.
Muhammad said he took out a loan of 60,000 rupees in October to help him replenish his inventory, cover rent and keep his brother’s taxi running. He promised to repay the debt plus 30 percent interest over 18 months. The officer, who acknowledged that he makes loans, asked not to be identified because lending money without a license is illegal.
“Banks are for the wealthy,” said Muhammad, whose shop brings in 10,000 rupees a month, not enough to meet expenses some months. “Without any money, what am I going to do with a bank account?”
Few shopkeepers, vegetable vendors and clothes-ironers in his neighborhood in the southern part of the city have bank accounts, he said. They borrow among themselves and from money- lenders such as the police officer.
“If they can’t borrow from him, they borrow from someone like me,” said Muhammad, who by re-lending at a markup also violates the law. “That helps me pay off the cost of my loan.”
Indians have been participating in informal lending for centuries, which is why most of the country’s 1.2 billion people don’t need bank accounts, said Kamal Bhambani, chief executive officer of Chandra Lakshmi Chit Fund Pvt in New Delhi. The unbanked often rely instead on so-called chit funds, community- run institutions in which each member deposits a fixed amount every month. The pot is doled out to one investor a month until everyone has received a share. The money is used for farm equipment, school fees or other large purchases requiring a lump sum that contributors otherwise couldn’t save on their own.
More than 10,000 such funds are registered with the government, which requires quarterly filings on accounts to ensure they comply with the Chit Fund Act of 1982. Five states accounted for $2.4 billion in legal chit activity in 2006, and as much as 10 percent of the population participated, according to a 2009 report funded by the Bill & Melinda Gates Foundation, which called them an “innovative access to finance for low- income households.”
Chit funds are sometimes used to hide money from taxes and for illegal investments, Bhambani said, without elaborating.
“A few bad apples have given the chit-fund industry a bad reputation,” said Bhambani, who takes a 5 percent fee from each fund. “This is a necessary function of Indian finance because banking systems are too product-specific.”
The Gates Foundation-funded report found that the poor were far more likely to take risks than the rest of India’s population when investing, especially in chit funds.
“There’s just no financial literacy among people below the poverty line,” said Ananth, the researcher, who has studied non-bank financial companies, or NBFCs. “To them, everything is a bank. The office running a local pyramid scheme is a bank, the local NBFC is a bank, the chit-fund operator is a bank. They’ve become easy targets.”
India’s Ministry of Corporate Affairs is investigating 86 cases of investment funds not returning money they promised, according to a Nov. 30 statement.
Corporate Affairs Minister Sachin Pilot had told Parliament the previous day that the government was considering appointing a regulator to control Ponzi schemes cropping up around the country. Rules for community-based investment funds would be tightened to weed out fraud, according to an inter-ministerial document obtained by Bloomberg News. No timeline was set, and in the interim, the Securities and Exchange Board and state governments would retain oversight, according to the document.
The central bank encouraged state governments in 2006 to regulate informal lending. The measure never made it to state assemblies, Usha Thorat, a former Reserve Bank deputy governor, said in an Oct. 29 speech.
Among the most prevalent Ponzi schemes are those involving investments in livestock, including cows, goats and emus, the flightless birds prized for their meat.
Thousands of people who invested in breeding farms in Tamil Nadu have complained that owners didn’t deliver on promises to repay them with interest as high as 76 percent, according to S. Ganesh, the revenue officer in the state’s Erode district. The investments are given credence by TV and newspaper endorsements by Tamil movie stars, he said.
“Easy money and quick money are luring people into these schemes,” Ganesh said. “The yields they were promised were humanly impossible. Awareness has to be created among the people, especially when someone is offering more than 20 percent interest.”
About 70 people have been arrested and 17 are on the run, said M.K. Jaganathan, deputy superintendent of police in Erode. The government has seized 12,500 birds, and an auction is pending, he said.
Sahara India Financial Corp., part of Sahara group, didn’t make proper disclosures about its bond sales, the Securities and Exchange Board found. The Supreme Court ordered the company to repay investors in full, plus 15 percent interest.
It wasn’t the first enforcement action against Sahara. The firm was barred in 2008 by the central bank from taking deposits and told to refund investors by 2015 after it didn’t pay a minimum interest rate of 5 percent and follow regulations.
“Everybody has understood that SEBI’s only objective is to act against and malign the image of Sahara,” group holding company Sahara India Pariwar said of the securities board in a two-page advertisement that appeared in national newspapers over two days starting Dec. 2. Subsequent ads said the Supreme Court ruling required Sahara “to pay again the whole amount which has already been paid.” Ghulam Zeeshan, a spokesman for Sahara, didn’t respond to requests for further comment about the case.
Deshmukh, the apparel-company owner in Mumbai who turned over her jewelry as collateral, said she isn’t worried about getting her gold back. She plans to let Muthoot Fincorp hang onto it to for at least another year while she makes payments.
“I’ll get it back when I want it, I have no doubt,” Deshmukh said. “I can walk in and out of the place with cash in my hand without being delayed by bank procedures. A few extra points on my interest rate are worth the cost.”
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