1. Column: India’s credit boom, and bust

Column: India’s credit boom, and bust

Banks need to have some way to avoid the drag on new lending created by existing bad loans

By: | Published: December 23, 2015 12:21 AM

Bankruptcy reform in India is being pursued in the shadow of major debt problems in the country’s corporate sector. These problems are, in turn, reflected in a high level of non-performing loans in India’s banking sector. In previous columns, I have argued that India’s banks need to do a better job of credit risk management (CRM), including credit assessment, to avoid future problems. While I have held that this is a relatively easy reform, in terms of economic and political costs, it will not address India’s immediate problems of corporate debt. For that matter, full bankruptcy reform will also take time.

To understand what needs to be done, an excellent starting point is a recent analysis of India’s 2004-08 credit boom, by Ajay Shah, presented at a recent conference on macroeconomics and finance (goo.gl/yc3Z54). Shah documents the growth of industrial credit by banks during India’s growth spurt, which coincided with high global growth, and included two years in which the country’s growth rate crossed 9%. Subsequently, of course, the global financial crisis caused a major recession, which has had delayed but continuing impacts on India.

Shah goes beyond aggregate data to examine firm-level data. By comparing firms that had significant increases in bank credit with those with very similar characteristics, except that they did not partake of the boom in bank credit, he shows that one class of firms did not do worse than the other. The “credit boom” firms had some temporary gains in assets and sales, but these advantages dissipated quickly, relative to the firms that did not increase borrowing as much. This may tell us that banks did not do a great job of picking firms to lend to, or it could be that they did they best they could given the pool of potential borrowers. And it could be that changes in external conditions made benefiting from additional credit difficult. On the bright side, this analysis suggests that banks were not completely throwing money away in their lending activities during the credit boom.

Shah’s matching procedure does not capture certain groups of firms that benefited from the credit boom, because they could not be paired with similar firms that did not increase their borrowing in the same way. Given the aggregate problems, he concludes by focusing attention on types of firms that are not captured in the matching analysis, “The distress of Indian banking from 2013 onwards may, then, potentially be rooted in loans given in the boom years to younger firms, larger firms and firms in infrastructure and construction.” This conclusion reinforces and solidifies what has been understood more informally so far. It also highlights some of the subtleties of India’s corporate debt problem, beyond CRM policies that are broadly suboptimal.

The analysis of bank borrowing in the credit boom and subsequent firm performance hints at structural problems that may be difficult to resolve. To the extent that problems arose in infrastructure and construction, part of the cause may be political influences on lending decisions, whether because of individual connections, or because of pressures to advance investment in those sectors. In such circumstances, expertise in CRM could become irrelevant.

It is also possible, of course, that banks did not have the expertise for assessing large, complex infrastructure projects. Much of the evidence on weak CRM policies exists in the branch-level surveys. Large loans will be evaluated much higher up in the organisation, where expertise should be greater, but there is also greater complexity of projects, as well as more scope for political pressure.

Ultimately, however, enhancing CRM practices is necessary—it just means something different at the level of projects and lending that is likely at the root of the current corporate debt problem. The country’s banking regulator can surely do more to raise CRM standards. What is to be done meanwhile? Postponing recognising problems through restructuring exercises seems to have failed, as one might expect. In a new scheme, banks have become de facto owners of some firms with bad loans, but they need an expedited path to liquidating these positions, since they cannot be expected to start managing these firms’ operations. This needs urgent attention and perhaps some ad hoc solutions until a new bankruptcy legal framework is put into place.

Meanwhile, banks need to have some way to avoid the drag on new lending created by bad loans. India needs more aggressive recapitalisation of its banks than has so far been proposed. In such cases, reluctance to acknowledge the problem and move on from it is always more costly than the alternative. In a separate blog piece, Ajay Shah speaks of the threat of “Japanisation” of India, which captures the idea of many years of slow growth coming from failure to clean up firm and bank balance sheets. Japan was already rich when that happened to it. India is poor, and has a working age population bulge. Employing them requires new investment, which requires revitalising credit. And that needs to be done as quickly as possible.

The author is professor of economics, University of California, Santa Cruz

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