The government announced a major initiative to address the challenges of stressed assets and weak banking balance sheets. This follows on some earlier actions to address the indebtedness problem in the corporate sector. Together, these can be expected to have a significant impact on the economy, boosting credit, growth, and employment. In the Economic Survey of 2014-15, we first identified the Twin Balance Sheet (TBS) challenge afflicting the Indian economy. TBS clogs the economy, depriving it of demand and the lubrication that oils and feeds that demand. Resolving the TBS challenge comprehensively requires 4 Rs: recognition, recapitalisation, resolution, and reform. Banks must value their assets as far as possible close to true value (recognition) as RBI has been emphasising; once they do so, their capital position must be safeguarded via infusions of equity (recapitalisation) as the banks have been demanding; the underlying stressed assets in the corporate sector must be sold or rehabilitated (resolution) as the government has been desiring; and future incentives for the private sector and corporates must be set right (reform) to avoid a repetition of the problem, as everyone has been clamouring.
On recognition, I want to advance/hazard a Subramanian law of recognition, or rather non-recognition. The amount of stressed assets always and everywhere is at least 10-20% more than what it is always and everywhere claimed to be. While we know the magnitude of the underlying problem, it would only be prudent to assume that we have not identified all of it. In May 2017, the government passed an ordinance to promote resolution. RBI followed up decisively by identifying on June 13, 2017, 12 loan accounts to be taken up under India’s new Bankruptcy Law with its tight deadlines and well-specified resolution process. These loans account for about 25% of the current NPAs (not the overall stressed assets) in the banking system. Another 30-40 cases have since been added to the list, and if settlement does not take place, they may also enter the bankruptcy process. Market participants have pointed out that the resolution procedures are still in their infancy, untried even for small cases. It has been argued that even if the system does work well, it might still not lead to resolutions if debtors are able to challenge the procedures in the courts. Only time will tell if some of these challenges will delay or stymie the resolution process.
Even as the new measures aimed at resolution unfold, it is worth thinking about the longer-term strategic approach about the other Rs. Burdened by stressed assets and the atmosphere of uncertainty, banks, especially PSBs, have had to focus on their NPAs than on new lending. Data shows that inadequate demand cannot be the full explanation for the credit slowdown because the growth in lending by private sector banks is robust and much greater than for the PSBs. Rather, the problem is PSBs are in damage limitation mode rather than seeking out new clients and opportunities. An important and simple way of addressing that is to provide banks with the money to clean up their balance-sheets so that they have the financial ability and managerial attention span and incentive to refocus on their core activity of lending. That is what the government has announced on Tuesday. The package consists of three parts. Rs 18,000 crore from the budget, `58,000 crore that banks would raise from the market over the next two years. All this, however, is residual resource mobilisation under the earlier reform package called Indradhanush. What is new, however, is that the government also is committed to issuing Rs 1.35 lakh crore as “recapitalisation bonds” over the current and next fiscal year. These bonds—after taking into account the existing provisioning and the recoverable value of the underlying loans—will ensure a healthy capital base for the PSBs, also consistent with international norms and standards. It is likely that the recap bonds will be placed with the banks for which the government will get an equivalent holding of equity in the banks.
But, what are the costs—economic and accounting—of recapitalisation? First, the true fiscal cost of issuing the Rs 1.35 lakh crore worth of recapitalisation bonds is the interest payment of about Rs 8,000-9,000 crore. But that cost can be offset by the confidence impact of addressing the critical economic bottleneck, thereby increasing credit supply, private investment and growth. The rest is all accounting. Second, so what is the accounting? If central government issues the recap bonds, its DEBT will go up. Third, but do recap bonds add to the fiscal DEFICIT? It depends. Under standard international/IMF accounting, recap bonds do NOT increase deficit; they are “below-the-line” financing. But under India’s convention, these bonds would add to deficit. Fourth, IMF convention is economically more intuitive because bonds are a capital transaction, their issuance does not increase directly demand for goods and services and has no inflationary consequence. It is a capital transaction because on the one hand it increases the government’s liability but it also increases its assets. The overall or net financial position of the government remains unchanged.
Finally, the accounting is to some extent moot. Of course, there is a cost to recapitalisation consisting of the additional interest burden on the recap bonds. But these costs were always there. The government is already liable to banks as owner (for the unrecoverable part of the underlying loans that were made). Issuing bonds merely makes explicit an implicit liability; or rather puts on the books what is a contingent liability. All the effort invested in the previous Rs will become more effective and have more bite if also accompanied by the fourth R—reform. Reform will ensure that the problems that India has faced over the last few years will not recur in the future. The recapitalisation will raise the moral hazard question: isn’t this a bailout of the bad lending and borrowing decisions of the past? To some extent, moral hazard is unavoidable.
But moral hazard must be minimised and that is where reforms come in. The finance minister has said that reforms to accompany the recapitalisation would be formulated in the period ahead. Reforms must be animated by a vision of where we think the banking sector should be in, say, 5-10 years, financing a double-digit growing economy. There is a view that there are too many banks, and a few unviable ones at that. The aim must be to shrink or narrow the scope of the unviable banks, as former RBI Governor YV Reddy has argued. In this view, recapitalisation must be selective and incentive-based, directing it to those banks where the “bank for the buck” in terms of new credit creation will be maximum. Since all banks must maintain a minimum capital adequacy, one possibility would be to recapitalise the unviable banks only to the extent necessary to finance their current balance-sheet size while explicitly not providing for their growth.
The other question confronting the recapitalisation strategy is whether to recapitalise by leaving the stressed loans on banks’ balance-sheet or taking them off. The latter would have two benefits. The cleaner the balance-sheet, the more likely that the private sector will be willing to become owners or equity-holders. Another reason is : as long as the loans remain on the books, bank management will remain distracted by having to deal with them, taking attention away from finding good projects. The elephant in the room is majority private sector participation. India needs to have both large public sector and private sector banks, competing domestically and being competitive internationally. In one view, achieving this would require allowing majority private ownership. Such ownership is not a panacea, nor will it ensure that imprudent lending and moral hazard will not arise.
Public discussion of private sector ownership has emphasised the benefits that will derive from less political interference and politically-directed lending that public ownership has led to in the past. Other benefits: the freedom to recruit and retain personnel and procure from most efficient sources; avoiding the excessive caution in decision-making that often flows from a variety of constraints imposed by referee institutions. It is striking how much caution, inertia, and fear PSB managers experience. That must be addressed. India has moved from “socialism with limited entry to capitalism without exit.” It is very difficult to get out of inefficient and unproductive production whether in agriculture, fertiliser, civil aviation. But the TBS problem has revealed an exit problem of a unique and perverse sort: Exit is especially difficult when PSBs lend to private sector companies. Once the bad lending occurs, getting out is difficult for fear of being seen as favouring certain groups/promoters.It may be better to have more private-to-private lending and even private-to-public lending. But the public-to-private lending model has proved toxic. In 2013 India suffered from a Twin Macroeconomic Deficit problem. This then gave way to the Twin Balance Sheet Challenge. It is time to move past both sets of twins.
Edited excerpts of the author’s speech at Khalsa College, Delhi University, on October 25