Handling Toxic Assets in Indian Banking
There is broad consensus among economic pundits that the economic reforms initiated by then Prime Minister PV Narasimha Rao in1991–96, which ushered in the liberisation phase for India, was carried forward by the Atal Bihari Vajpayee government in 1999–2004, ushering in next set of reforms. The Vajpayee government was also prudent in managing the economy, which resulted in 8.4% growth in the final year and while tightly managing budget and ensuring fiscal deficit well below 4 percent, which was considered remarkable. The good run for economy which started in 2003–4 continued for a period of 9 years till 2011–12.
While UPA I did not undertake any policies to hinder growth, UPA II phase marked a radical left shift in the government policies, which resulted in several policies that were growth deterrents, such as blanket denial of environment clearances and the freeze of top bureaucratic personal in decision making due to a spate of corruption scandals that rocked the country. When Modi came to power in 2014, he started initiating a slew of measures to kick start the economy, but with little effect to stimulate the economy and spur the growth as per the expectations of the mandate he was voted in for.
During 2015, when India asserted that it was growing at 7.5% and had beaten China for the first time, sceptics doubted the CSO growth number that was put out. The questioning was primarily due to fall in exports, fall in corporate profits, fall in sales of vehicles (passenger vehicles, motorcycle, tractor), decline in loan growth in banks and stalled industrial projects. It was only later apparent that what was seen were symptoms, and the root cause of the problem was large growth in Non Performing Assets (NPAs) in banks, which was stalling the economy and not allowing it to grow at the potential expected despite a massive push given by the RBI and the government.
Later in the year, Raghuram Rajan as governor started asset quality review (AQR) of the banks, following which the massive ‘window dressing’ that the banks had undertaken on their bad assets started becoming visible. This resulted in the disclosure in February 2016 that a majority of Indian public sector banks were sitting on large NPAs. NPAS shot up from 4.41% of banks assets in 2015 to 7.91% in 2016, which was an eye-opener to many about the severity of problem plaguing the Public sector banks primarily.
How did the Banks get into such bad shape?
The origin of this problem dates to the time of the growth years of 2005–8. Given the massive exuberance of the economy and massive growth seen by domestic companies during the period, they went in for large scale merger and acquisitions (eg. The Tata Corus acquisition), often borrowing from local banks and cheap credit overseas due to low interest rates based on the asumption that Indian economy will continue to grow at robus phase and even reach the double digit growth. They anticipation was that the Indian economy will continue to grow for a 30 year period, like China did from the 1980s, or would go to double digit growth rate, and the calculation for debt servicing was made with these hypotheses in mind.
Indian being a democracy unlike China, Government polices took a radical left shift when it went in for massive amounts of redistributive policies like MNREGA, RTE and other dole-based policies during UPA II without sufficient policies to continue to stimulate the economy and sustain growth. Also, counterproductive policies like retrospective taxes and land acquisition bills undermined investor confidence. Further, the US economy saw recession in late 2008, which had an adverse impact on global economy which is increasingly interconnected.
When the economy started to overheat and double digit inflation started to persist, RBI followed a tight monetary policy which increased the interest rate, resulting in increase in interest payment costs. For companies which had borrowed externally, the rupee depreciated significantly against the dollar forcing them to repay at a Rs 60–70 rate against loans borrowed at Rs. 40. The tight monetary policy put the brakes on growth, and companies were hit with the double whammy of lower growth and higher interest servicing costs.
Breaking the deadlock — Enter Demonetization
On November 8th, Modi government, in a bid to break the deadlock, announced a policy of currency transfusion of Rs. 500 and Rs. 1000 notes with new notes of Rs. 2000 value, albeit with restrictions to go with it due to shortage of supply of new denomination currency. The banks which earlier had 6 lakh crore of NPA now have 14 lakh crore of deposits in a span of 50 days thanks to the new policy. While the NPA would not go away and banks still need to persist with them, using measures such as litigation to recover as much as possible, banks would be in better position due to increased deposits after demonetization, which can temporarily spur investments and rejuvenate the economy.
In the long run, India’s growth story will be decided by how India will be able to insulate itself from the ill effects of bad loans in banks and ensure that credit is available to SMEs, which are the job creators. While Vijay Mallya’s 6000Cr debt has got all the media attention, the rest of the Rs 5.94 lakh crore of bad loans have not got as much media attention.
The Economic Survey 2016–17 report had envisages a PARA (Public Sector Rehabilitation Agency) to work on these toxic assets, similar to the TARP program following the collapse of Lehmann Brothers and the recession in the US in 2008. The toxic asset build-up is primarily due to the exchange rate, interest rate and growth rate calculations, and corporate expectations gone wrong.
Any attempt to clean up this will attract widespread criticism from honest tax payers and honest loan payees, who see this as moral hazard problem. Since the bad debt will keep rising, delay in tackling the problem will mean that the bill to the government and banks will continue to increase at a geometric rate. This is a quagmire that the government needs to traverse in order to ensure sustained double digit growth, which is the only panacea for lifting 200 million above the poverty line.