expert opinion: India's twin balance sheet problem
Can India grow at 8.5% per year? The answer to this question may lie in a caveat flagged by Chief Economic Adviser Arvind Subramanian. India, he warned, must address a Twin Balance Sheet (TBS) problem. On the one side, 40% of Indian corporate debt is owed by companies who are not earning enough to pay interest on their loans and on the other, 9% of the total banking system is sunk into bad loans, or non-performing assets (NPAs). After demonetisation, a third dimension has emerged: Rs15.28 trillion out of Rs. 15.46 trillion of cash in circulation (99%) unexpectedly found itself back with the banks. This has flushed them with funds, but with huge NPAs on the books and stringent rules about the capital adequacy ratio, they are unable to make new loans. All of this has slowed credit, and dimmed India’s prospects for economic growth.
How did India get here? At the turn of the millennium, Indian economy was booming, firms were expanding and credit was flowing. But in the aftermath of the global financial crisis of 2008, growth rates fell, revenues declined and interest rates went up. For a while the problem was simply covered up because GDP was growing and the NPAs were largely concentrated in public sector banks, which are of course backed by the state. Nobody had an incentive to write-off bad loans.
The Reserve Bank of India took several steps to address the problem: the Refinancing of Infrastructure Scheme, Strategic Debt Restructuring (SDR) the Sustainable Structuring of Stressed Assets (S4A), Private Asset Reconstruction Companies (ARCs) etc. But these efforts did not work. They either required too much coordination between borrowers and lenders, or they demanded too much courage from the banks in writing off loans. Given that credit at PSBs is influenced heavily by politics and patronage networks, there was fear of the four C’s—the Central Vigilance Commission, the Comptroller and Auditor General, the Courts and the Central Bureau of Investigation. So NPAs stayed on the books and continued to grow.
The government’s recent decision to infuse fresh capital of Rs 2.11 trillion rupees into public sector banks (PSBs) is yet another attempt to address the problem. Under the recapitalization plan government will purchase shares of PSBs worth Rs 180 billion; and also contribute Rs 1.35 trillion towards their equity capital through recapitalization bonds. The banks will also raise Rs 580 billion as capital from the market through new issues. Allocations to the banks are yet to be determined, but are expected to be based on size and performance. Interestingly, the capital infusion is accompanied by the strengthening of the Insolvency and Bankruptcy Code (IBC).
Will this plan work? At first glance, the strategy still fits into the framework of a textbook “principal-agent” problem. The principal (the government) has set aside large sums of money to give away. The agent (the banking system) has incentives to spend it quickly, but not carefully.
Even if we sidestep this obvious set of issues, there are many reasons to worry about the new policy. First, it is hard to know if it goes enough. Former Reserve Bank Deputy Governor KC Chakravarty recently argued that the capital infusion is just about 20% of NPAs in the system. In the past month alone, several private sector banks including HDFC Bank, Axis Bank and Yes Bank have reported fresh NPAs of about Rs 12,500 crores, and more banks are expected to come forward with even bigger numbers.
Second, the capitalization plan requires banks to raise more than half the money in the open market. The steady trickle of bad news on new NPAs is likely to dishearten investors. On this the past record does not inspire much confidence; they failed to raise Rs 1.1 trillion required of them under the Indradhanush scheme launched after the AQR last year.
Third, this policy does not really address the challenge of finding buyers for failing companies. Some auctions have gone wrong when owners or affiliates attempted to bid on their own firms. A modification of November 23, 2017, now disqualifies owners, promoters and a list of others in auctions. While this avoids the problem of owners buying their own bad assets for low prices, this policy may have the unintended consequence of pushing out many potential buyers and depressing company values.
Finally, the policy is silent on oversight. The RBI, a regulatory bureaucracy, is still expected to support a company’s management in making decisions about whether to accept a negotiated settlement or invoke the IBC code. This is problematic. A far better idea would be to form a high level committee of regulators, auditors and bankers and charge them with the task of oversight with full transparency and tight timelines for the largest NPAs.
The honest truth here is that this policy, like the previous ones, may not go far enough. What India’s banks really need is reform. 75% of the banking system is controlled by the government. For too long, lending has been subject to political and bureaucratic interference. PSBs need to be need to be restructured, merged or privatized through fundamental reforms. The system faces significant economic headwinds. Increased credit demand and money supply after demonetization might prove inflationary. Recapitalization will impact the fiscal deficit through a higher annual payment of interest and ultimately, though the repayment of the debt itself. The Government will also have to ensure that the banks run professionally through independent boards and do not again take unacceptable risks.
How these reforms pan out will determine whether India can sustain a growth of 8% in the coming years. As the Red Queen reminded Alice in Alice through the Looking Glass, “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!"
Dr. Shareen Joshi is an Assistant Professor at Georgetown University. She has worked as a consultant for the World Bank, the United Nations, the Hewlett Foundation, the Government of India, and several NGOs.
Hardayal Singh is a former bureaucrat from the Indian Revenue Services. He has served as Former Additional Secretary to the Central Vigilance Commission chief Commissioner of Income-tax in Delhi and Mumbai