1. UDAY: Financial engineering at its best

UDAY: Financial engineering at its best

If we want to clean up the public sector mess, schemes such as UDAY should be applied to all sectors under both the central and state govts

By: | Published: May 9, 2016 6:12 AM

The UDAY scheme—Ujwal Discom Assurance Yojana—is probably one of the largest financial engineering schemes that have been undertaken in India, that too by the government. It’s an attempt at disciplining electricity distribution companies (Discoms) that have built up large amount of debt, partly due to their inefficiencies as well as policies pursued by state governments. By transferring the onus on to the states, they have made them responsible for future reforms in the system.

Two issues come up, however. The first relates to a moral hazard, which all such schemes involve where there is restructuring of debt. Will there be an incentive to continue doing what they are doing, knowing fully well that there will be a resuscitation package awaiting them at some point of time? The second is whether the same should be extended elsewhere, because what works well for Discoms should work well for other such enterprises also.
In brief, UDAY works this way. There is an outstanding liability of Rs 4.3 lakh crore for all Discoms put together.

Assuming all states accept this scheme, 75% of this amount will move over to state governments’ books in two years, FY16 and FY17. The balance 25% will be restructured by banks, with a guarantee being given by the state. Future losses will have to be progressively taken on by the state, which is a punitive action for not pursuing reforms. States now become responsible for the actions or rather inaction of their Discoms. Hence, Discoms have to necessarily become efficient and cut down on their transmission and distribution (T&D) losses and revise tariffs.

As far as restructuring is concerned, the so-called ‘mother of all financial engineering’ takes place. For every Rs 100 of debt that is passed on to the government by the bank, a fresh bond is issued at a lower rate of, say, 8%, instead of 12-14% that the bank was receiving as interest on the loan from a Discom. Banks and insurance companies will subscribe to these bonds and give money to respective state governments, which will be used to repay the bank the loan of a Discom for Rs 100. Hence, it would be an accounting entry if both the parties are banks.

If the buyer is an insurance or pension company, then there would be different parties involved. Banks who purchase these bonds can sell them in the market, obtain liquidity and ease their balance sheets. Insurance companies and pension funds would be interested in such long-term paper which yields a satisfactory interest rate. The same for loans would be difficult. Hence, the entire process is part of the accounting theatre involving alchemy, where low-quality debt gets converted into high-performing bonds as they come from governments, which never default.

As it involves the government, there is zero risk in the exercise, unlike the CDOs or ABS that ruled in the US when similar engineering took place. But such a situation cannot be without a catch, as even though new money is not being moved, at the end of the day someone is paying for the same. In this case, it is the banks that bear the cost on their books, as they will now receive a lower interest of 4-6% for having their loans converted to bonds. The government takes on the debt and is exempted from FRBM for two years, but has to service the debt for the next 10 years with the issuance of new bonds. Those buying them would do so as a private placement arrangement and would not need to do any mark to market. Hence, both the debt market and banking system have also become major partners in this exercise.

The first issue is whether this creates a moral hazard? It does, because while Discoms pass on the debt to the state budget, there is no punitive action if reforms do not take place. The FRP (Financial Restructuring Plan) also tried the same, but with limited success, as states which went in for restructuring passed on part of their debt but did not invoke reforms. The current scheme plugs this loophole by asking the state to bear future losses to ensure that it will bring in this discipline. But often states which own Discoms loathe increasing tariffs because of political compulsions. Therefore, there is still the risk that the second part of the equation will not be fulfilled. While asking states to bear the losses makes imminent sense, the state government could just decide to compromise on the capex or discretionary expenditure in order to meet the fiscal deficit target of 3% and soak in the losses of Discoms. This possibility cannot be ruled out.

The other issue which can be put on the table is that if UDAY works for, say, state governments, the same can also be done at other levels. Sick and loss-making central PSUs have accumulated losses of R60,000 crore as of FY15. Using the same logic, the central government can take on the loans associated with these losses in a similar manner. BSNL, Air India, MTNL, Hindustan Photo Films and Mangalore Refinery are the largest loss-making central PSUs. By transferring these loans to the budget, a similar clean-up of these enterprises could be done. Also, Air India can be made to turn around with the losses being cleared by the Centre and the company being given a chance to start afresh.

UDAY has been a very innovative project undertaken to address a growing problem which has so far not been an NPA but could be any day, given that there is not much being done to address the core issue of efficiency and professionalism. It is similar to the CDR cases that were addressed by banks through a restructuring package with tenure and terms of loans being altered suitably. As governments are involved, there is zero risk and that’s what makes this move tenable.

If we are looking to clean up the public sector mess, the same should be applied to all sectors under both the central and state governments. The advantage will be that by bringing in a professional approach, we can dispense with the old baggage, which will also make them suitable candidates for disinvestment at a later date, as it is high on the central government’s agenda in the coming years.

The author is chief economist, CARE Ratings. Views are personal

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  1. B
    Bharat Bhagnani
    May 9, 2016 at 7:15 am
    Its an excellent article. One clarification, the 8% bonds will be issued by whom? the discoms or the central government?I wasn't really clear with the 4th paragraph of your article.. if you could kindly elucidate further.Otherwise it was a brilliant read.

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