The business of lending money at usurious rates against the collateral of gold is booming. Banks and non-banks are currently dishing it out at the rate of 1,20,000 new loans a day - yes, a day!
At last count, the business was reckoned to be worth Rs 80,000 crore and growing at the rate of over 70 percent for non-bank finance companies and around 35 percent for banks.
Between last year and this year, the two big boys of the gold business, Muthoot Finance and Manappuram Finance, have grown like gangbusters: the former by 96 percent, and the latter by 170 percent.
There are two reasons why this boom is showing no signs of flagging. One is the fall of microfinance institutions, which have been in a tailspin ever since Andhra Pradesh issued an ordinance last year regulating interest rates and curbing strong-arm methods of loan collection. These loans have thus gotten tougher.
Secondly, with gold prices zooming, borrowers have discovered that they can raise more money with the same collateral. Last year, around this time, international gold was just over $1,200 an ounce. On Tuesday, it was more than $1,875. That's more than a 50 percent rise in a year - besting all other asset classes.
What this means is that if you as a borrower had raised Rs 6,000 by pledging Rs 10,000 worth of gold jewellery last year, the same pledge can help you raise an additional Rs 3,000 today.
And that seems to be what borrowers are doing. For example, Muthoot Finance, one of the market leaders, saw the average ticket size of its gold loans rise 24 percent in the past four quarters when gold prices rose 17 percent, according to a Kotak Securities research report.
Manappuram Finnance, according to Edelweiss Securities, saw gold loans rise 20 percent against an increase in gold stocks of 13 percent. This means 7 percent of the rise in loans is related to the price of the gold (or its ticket size), rather than more gold being brought in as collateral.
People are borrowing more against the same gold.
This is fine as far as it goes, but it could have a huge downside if the gold price suddenly starts falling. Remember, the US sub-prime crisis had its roots in people who borrowed more from banks when the values of their properties were rising before the 2008 crisis. When the real estate market collapsed after the Lehman bust, banks were stuck with huge bad loans - and borrowers with unserviceable debt.
Nothing like that may happen with gold, since everyone is bullish on the metal against the backdrop of the uncertainties over global growth, and worries about the future of the dollar and the euro. Gold is the only safe haven left.
But every surge in gold prices inevitably leads to a fall at some point when the rise has to be digested by the market. When gold prices zoom, many people also cash in. India has 15,000 tonnes of private gold - or maybe even twice as much. There is no guarantee that some of that gold won't be sold to book profits, thereby bringing prices down.
The short point is this: while the long-term trajectory of gold is up, the short-term cannot be predicted. And gold loans are anything but long-term. According to Edelweiss, over 52 percent of gold loans are taken for less than three months. Only 13 percent is longer-term (above one year).
There are six reasons why the gold loans business needs to start getting cautious from now on.
One, gold prices could peak anytime, and when it starts falling - as it surely will at some point - loan defaults will start rising. Since the average loan size for Manappuram is around Rs 70,000, quite clearly the borrowers are not the rich. Muthoot says its average ticket size is Rs 30,000-35,000. They probably come from the middle and lower middle classes, where vulnerabilities are higher.
Two, the industry is too concentrated in the south. Some 75 percent of Manappuram's business is in the south. The microfinance business hit a speedbreaker precisely because it had put all its eggs in one basket - Andhra Pradesh. The gold loans business is not so bad, but concentration in the south is still too heavy for comfort.
Three, growth rates will start slowing down progressively as the business grows. Rates of 100-200 percent are more or less over. Muthoot is likely to see its annual rate drop from 96 percent last year to 43 percent in 2011-12, says Kotak.
Four, competition is growing. Interest rates are high since gold lenders are essentially competing with money lenders. At lending rates of 20-22 percent for non-banks and a bit lower for banks, the margins are simply too mouth-watering. Almost all finance companies are planning to get into gold loans, with Mahindra Finance being a recent entrant last year. Indiabulls is another.
Five, there is a possibility of greater regulatory intervention. Given the scale of the business, the Reserve Bank is keeping a wary eye cocked on this business. Earlier this year, it said that bank loans to non-bank finance companies given against the collateral of gold will not be treated as priority sector lending. This pushed up interest rates by 1-2 percent immediately. More regulatory action may follow, if the central bank starts worrying about the possibility of a gold loan bubble building up in the system.
Six, private companies lend against lower margins. Unlike banks, which lend 55-65 percent of the value of gold mortgaged, private companies give out higher proportions of 70-80 percent. This means the safety margins are thinner for them. Moreover, with the RBI getting into the action, they are having to borrow from the market at higher costs to fund their loan-books. Muthoot Finance is currently in the market to raise non-convertible debentures at 12.25 percent.
At Rs 80,000 crore and growing, the gold loan business has reached a stage where growth will slow down, competition will thin down margins, and the risks grow steadily higher.
In Andhra it only took a couple of suicides among the poor to earn the wrath of the government and bring the business down crashing. Recoveries are now less than 20 percent among microfinance lenders.
Gold is different, but it too cannot defy the laws of economics forever. The loan bubble cannot continue to build indefinitely.