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The SimpleMoney Podcast: Episode 1 - Current Account Deficits & The Punjab National Bank Scandal

Welcome to the first episode of The SimpleMoney Podcast, a weekly roundup of what's happening in the world of finance and macroeconomics, and how it relates to individual investors.

This week, we talk in-depth about two topics, and end with (what we think is) a humorous ode to some of our favorite money-related popular media.


Current Account Deficit

The first section of the podcast comes on the heels of a recent blog post by Pranshu, explaining what Current Account Deficit means, and why India's deficit doesn't bode well for it, especially if oil prices rise.

Current Account Balance is a country's Exports - Imports + Remittances. When a country has a high volume of imports compared to its exports, and if the remittances (such as foreign investment and expatriates sending their earnings back home) don't offset that gap, a country is said to be in a Current Account Deficit.

A large part of India's imports are made up of crude oil, with gold coming in at second place. In this episode, Pranshu explains how, even though there are many other countries (such as Vietnam and China) importing oil, because their exports are of a large volume, they don't face the same deficit that India does.

For most of India's history, it has been in a Current Account Deficit, teetering close to the brink of economic collapse in 1991, when its Current Account Deficit hit 3% of the GDP. The Gulf War had pushed global oil prices to never before seen heights. Years of economic mismanagement by the Indian government meant that foreign investors were not keen to lend the country money. But India needed that money to buy oil, and in 1991, there was only three weeks worth of foreign currency in the country. India had to receive emergency loans from other countries, even airlifting gold to England to receive one such emergency loan.

India emerged from this episode of near-economic collapse with economic liberalization, making the country more attractive to foreign investors, increasing the rate of Foreign Direct Investments (such as when a foreigner buys real assets in the country) and Foreign Portfolio/Institutional Investment (where foreigners invest in the financial markets). Foreign Portfolio Investment, called hot money, is not a reliable inflow of money as it can leave the country quickly, whereas FDIs are harder to liquidate.

Current Account Deficits tend to make a country's currency worth less, as the demand for dollars goes up while the supply stays more or less the same, making each subsequent barrel of oil more expensive for India.

How did this happen? India went from being an agricultural economy to a service-based one, seemingly skipping the manufacturing stage in the middle. China, on the other hand, spent several years building factories and infrastructure, getting itself to a secure and indispensable position in the global supply chain. India, unfortunately, couldn't get the manufacturing ball to roll, says Pranshu. Today, India finds it really difficult to compete with other countries in the manufacturing sector, since these countries have had a headstart.

India's only real solution to this problem is to export more. To drive exports up, we need to do the things that put the economy in good health: build infrastructure, have clear guidelines and rules and regulations; increase skill in the economy with better education. India can also try to secure a place for itself in manufacturing niches where the power of established competition will not overwhelm it. India needs to find the manufacturing equivalent to IT services, which it spread to the world with its low-cost model.

So what do investors do?
This is a difficult issue to plan for, especially if you don't have confidence in the economy in the long-term. Some ways for investors to do well: investing in companies that do well when India's rupee is undervalued, i.e. any company that makes money in dollars (such as most IT companies). Another option would be to invest in foreign markets by investing in mutual funds like the Frankling Templeton US Opportunities Fund, the Birla Sun Life Global Opportunities Fund, acting as a hedge against Indian stock markets falling due to oil prices.

Public Banks Come After Fire After Scandal Breaks Loose at Punjab National Bank

Scandal broke loose at Punjab National Bank after India's second largest public sector bank came out in mid-February, revealing financial fraud of approximately INR 11,000 crore (USD 1.8 billion), after renowned diamond merchant Nirav Modi and his business partners, including his uncle Mehul Choksi of Gitanjali Gems, defaulted on loans backed by PNB - loans that were provided with no collateral. PNB has blamed errant employees, while others question a system that has allowed this scale of financial fraud to go undiscovered over a period of six years.

Sindhuri describes how all the aspects of this story, while making for a sensational scandal, reveal some disturbing truths about India's public banking system.

How did it all start?
Starting in 2011, Punjab National Bank issued Letters of Undertaking (LoUs) which are essentially letters of guarantee to overseas branches of Indian banks so that Nirav Modi and his accomplices could take loans that they claimed to use to buy precious stones from international vendors. Why overseas branches? Because they provide loans in dollars, and tend to have lower interest rates.

How did PNB communicate these LoUs? By using SWIFT (Society for Worldwide Interbank Financial Telecommunication), which is the banking world's "WhatsApp messaging system." SWIFT has a code for each kind of transaction, allowing PNB to alert the overseas bank that it is acting as a guarantor for Nirav Modi's loan. The overseas bank, seeing that PNB is backing this loan, will remit the money to PNB.

Audits reveal that PNB allowed credit to roll over for Nirav Modi. When he was unable to pay back one of these loans, the bank issued another Letter of Undertaking, whose value was equal to the sum of the previous loan with its interest. The classic "borrow money to pay the old loan back" strategy.

In an ideal world, PNB would have protected itself by taking a collateral from Nirav Modi, one that is at least equal to or greater than the value of the loan that he is taking. But they didn't. So why would PNB do something like this? The bank gets fees for issuing these LoUs, which some estimates say totaled upto INR 200 crores in this case.

How did this happen for so long without anyone picking up on it? Well, for one, the SWIFT banking system at PNB wasn't linked to the Core Banking Solution, which keeps track of all of a bank's transactions, designed to prevent exactly what happened! So, once these overseas banks got a message on SWIFT saying that PNB was backing these loans, they put the money in PNB's Nostro account (account for international transactions), and none of this got recorded in the bank's main Banking software. So there was all this money piling up in the Nostro account, which someone knew about at PNB, because it was getting passed off to Nirav Modi and co, but it didn't show in the bank's financial books.

Financial fraud by manipulating the SWIFT messaging system isn't something that comes as a surprise to some Indians. This BloombergQuint piece talks about how, in 2016, after a financial fraud scandal in Bangladesh, the RBI issued two warnings about the potential use of SWIFT in financial malpractice.

Are public banks more complacent because they know they can't fail?
Regardless of how guilty Nirav Modi is, who allowed him to get away with this unconscionable level of unbacked borrowing? Punjab National Bank is the second largest public bank in India, second only to the State Bank of India, a behemoth of an institution. Can private banks afford to behave like this, knowing that there is no guarantee of a governmental bail out?

In 2008, as America was experiencing the Great Recession, the government and the Federal Reserve were putting a bailout plan in action to save some of the banks that had dealt in billions of dollars worth of subprime mortgage backed securities. Writing about the crisis, former Treasury Secretary Timothy Geithner, discusses the concept of moral hazard - one's tendency to increase exposure to risk after becoming insured against it. Did American banks take on substantial risk knowing that they were "too big to fail?"

Did Punjab National Bank act so lazily in terms of its system of checks and balances knowing that the Central Government would bail it out because it is a state-run institution, and therefore "too Indian to fail?"

Working in the financial sector means that someone is always going to try and outsmart the system; that's what money (or the prospect of more money) does to people. We have to be understanding, to a certain extent, of those frauds. But this instance wasn't an example of that. What happened at Punjab National Bank (and there's a lot that we don't know yet) reveals a lack of systemic accountability.

What about Nirav Modi's role in all of this?
Nirav Modi's role in this whole scandal remains nebulous. Did he knowingly outsmart the system, or is he someone who went bankrupt because of unlucky and/or bad financial decisions? If it's the latter, his exposure should never have been allowed to get this big. It should have been nipped in the bud by banks like PNB.

Nirav Modi came out after the scandal went public, accusing Punjab National Bank of essentially destroying his ability to find a solution to this economic crisis and to repay his debt, thanks to the villification that has enshrouded his image. His assets are frozen, and his negotiating power has been greatly compromised as the entire market knows that he might be in a hurry to liquidate his assets.


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