ECONOMIC SURVEY 2016-17 Summary Chapter – 4 The Festering Twin Balance Sheet Problem

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Following is the Summary of ECONOMIC SURVEY 2016-17 – Chapter – 4 : The Festering Twin Balance Sheet Problem

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Introduction

In February 2016, Banks reported that nonperforming assets had soared, to such an extent that provisioning had overwhelmed operating earnings. As a result, net income had plunged deeply into the red.

Effects

• Investors fled from public sector bank shares
• It brought the prices of public sector bank shares to very low levels.

What were the reasons?

RBI’s Asset Quality Review

• Normally, non-performing assets (NPAs) soar when there is an economic crisis, triggering widespread bankruptcies.
• But there was no such thing in India; instead GDP was growing at good pace.
• Initially it was said that the reason was the RBI’s Asset Quality Review (AQR), following which banks cleaned up their books, clearing the large amount of accumulated NPA over many years.

Other reasons

• But as the NPA kept on rising, later it became clear that the AQR was not the only factor at work.
• While, more than four-fifths of the non-performing assets were in the public sector banks, where the NPA ratio had reached almost 12 percent.
• On the corporate side Credit Suisse reported that around 40 percent of the corporate debt it monitored did not earn enough to pay the interest obligations on their loans.
• It proved that India was suffering from a “twin balance sheet problem”, as both the banking and corporate sectors were under stress.

India’s NPA comparison with other countries

At its current level, India’s NPA ratio is higher than any other major emerging market (with the exception of Russia), higher even than the peak levels seen in Korea during the East Asian crisis.

Then why India’s economy didn’t collapse?

• Contrary to East Asian crisis, India’s economy kept on rising with a brief period of interruption.
• This happened because Indian companies and banks had avoided the boom period mistakes made by their counterparts abroad.
• They were prevented from accumulating too much leverage by 2 measures:-
• While prudential restrictions kept bank credit from expanding excessively during the boom.
• Capital controls prevented an undue recourse to foreign loans.
• On the other hand, bulk of the problem has been concentrated in the public sector banks, which not only hold their own capital but are ultimately backed by the government, whose resources are more than sufficient to deal with the NPA problem. As a result, creditors have retained complete confidence in the banking system.

As India’s TBS experience still remains deeply puzzling, this chapter attempts to answer four sets of questions:

• What went wrong – and when did it go wrong?
• How has India managed to achieve rapid growth, despite its TBS problem?
• Is this model sustainable?
• What now needs to be done?

For some years, it seemed possible to regard TBS as a minor problem, but it has become clear that the problems of the stressed firms might actually imperil growth.

• To avoid this outcome, a formal agency may be needed to resolve the large bad debt cases like the East Asian countries employed after they were hit by severe TBS problems in the 1990s. In short, the time may have arrived to create a ‘Public Sector Asset Rehabilitation Agency’.

What went wrong?

• The origins of the NPA problem dates back to the decision taken during the mid-2000s.
• During this period for the first time in the country’s history, everything was going right: corporate profitability was amongst the highest in the world, encouraging firms to hire labour aggressively, which in turn sent wages soaring.
• Firms made plans accordingly. They launched new projects worth lakhs of crores, particularly in infrastructure-related areas such as power generation, steel, and telecoms, setting off the biggest investment boom in the country’s history.
• Within the span of four short years, the investment-GDP ratio had soared by 11 percentage points, reaching over 38 percent by 2007-08.
• This time saw extraordinary increase in the debt of non-financial corporations.

Implications of soaring debt

• As the companies were taking on more risk, things started to go wrong.
• Costs soared far above budgeted levels, as securing land and environmental clearances proved much more difficult and time consuming than expected.
• At the same time, forecast revenues collapsed after the GFC; projects that had been built around the assumption that growth would continue at double-digit levels were suddenly confronted with growth rates half that level.
• In addition to this firms that borrowed domestically suffered when the RBI increased interest rates to quell double digit inflation.
• And firms that had borrowed abroad when the rupee was trading around Rs 40/dollar were hit hard when the rupee depreciated, forcing them to repay their debts at exchange rates closer to Rs 60-70/ dollar.
• Higher costs, lower revenues, greater financing costs — all squeezed corporate cash flow, quickly leading to debt servicing problems.

What Explains the Twin Balance Sheet Syndrome with Indian Characteristics?

There is a difference in situations of the economies which collapsed in the pressure of TBS in contrast to India, which stand still even in the pressure of TBS

Unusual structure of the economy

• India even during the boom of 2000’s was suffering from the severe supply constraint, there was ample room for economy to grow even as the infrastructure investments themselves
  did not prove financially viable.
• In comparison, the US boom was based on housing construction, which proved far less useful after the crisis. And the US never suffered from severe supply constraints.

Response of Financial institutes towards crisis:-

• In other countries, creditors would have triggered bankruptcies, forcing a sharp adjustment that would have brought down growth in the short run.
• While the strategy adopted by India was to “give time to time”, meaning to allow time for the corporate wounds to heal.
• Although difference in size of bad loans, both India and China provided generous amounts of bank financing to allow highly levered corporations to survive. And in both countries this strategy has proved successful so far in allowing rapid growth to continue.

How this strategy be made sustainable?

• For financing strategy to be sustainable, two scenarios would need to materialise: “phoenix” scenario and “containment” scenario.
• Under the “phoenix” scenario, accelerating growth would gradually raise the cash flows of stressed companies, eventually allowing them to service their debts.
• Under the “containment” scenario, the NPAs would merely need to be limited in nominal terms. Once this is done, they would swiftly shrink as a share of the economy and a proportion of bank balance sheets, since GDP is growing at a nominal rate of more than 10 percent.

But the containment scenario doesn’t look possible now as by the end of 2015 earnings had diminished to Rs 20,000 crore per quarter. By September 2016 they had fallen to just Rs 15,000 crore per quarter.

Their interest obligations are mounting – and if they borrow more, this will only cause the gap to widen further.

Illustration of the problem

The situation in the power sector illustrates the more general problem. To cover costs, these companies need to sell all the power they are capable of producing at high tariff rates. But the opposite is happening:

1. Plant load factors (PLF, actual electricity production as a share of capacity) are exceptionally low – and they are falling.
2. Meanwhile, merchant tariffs for electricity purchased in the spot market have slid to around Rs 2.5/kwh, far below the breakeven rate of Rs 4/kwh needed for most plants, let alone the Rs 8/kwh needed in some cases.

As a result, cash flow for most private power generation companies falls far short of what is needed to service their interest obligation.

Other problem

• Countries with TBS problems tend to have low investment, as stressed companies reduce their new investments to conserve cash flow, while stressed banks are unable to assume new lending risk.
• This seems to be happening in India, as well. Private investment, which had been soaring at the height of the boom, slowed sharply to a 5 percent growth rate and Public investment has still not been sufficient to arrest a fall in overall investment.

Effect of TBS

• At least 13 of these banks accounting for approximately 40 per cent of total loans are severely stressed.
• With such a large fraction of their portfolios impaired, it has become extremely difficult for them to earn enough income on their assets to cover their running and deposit costs.

Steps taken by RBI

RBI has deployed several mechanisms to deal with the stressed asset problems, 3 of these mechanisms are particularly notable:-

Establishment of private Asset Reconstruction Companies (ARCs)

• Many ARCs have been created, but they have solved only a small portion of the problem, buying up only about 5 percent of total NPAs.
• The problem is that ARCs have found it difficult to recover much from the debtors. Thus they have only been able to offer low prices to banks, prices which banks have found it difficult to accept.

Strategic Debt Restructuring (SDR) scheme

• Under thiscreditors could take over firms that were unable to pay and sell them to new owners.

Sustainable Structuring of Stressed Assets (S4A)

• Under this, creditors could provide firms with debt reductions up to 50 percent in order to restore their financial viability.

Analysis of the schemes

Success of schemes, however, has been limited. There are several reasons why progress has been so limited:

• Loss recognition: – The Asset Quality Review (AQR) was meant to force banks to recognise the true state of their balance sheets but bank keep on evergreening loan.
• Coordination: – The RBI has encouraged creditors to come together in Joint Lenders Forums, where decisions can be taken by 75 percent of creditors by value and 60 percent by number. But reaching agreement in these Forums has proved difficult, because different banks have different degrees of credit exposure, capital cushions, and incentives.
• Proper incentives: – The S4A scheme recognises that large debt reductions will be needed to restore viability in many cases. But public sector bankers are reluctant to grant write-downs, because there are no rewards for doing so.
• To address this problem, the Bank Board Bureau (BBB) has created an Oversight Committee which can vet and certify write-down proposals.
• Capital: –The government has promised under the Indradhanushscheme to infuse Rs 70,000 crores of capital into the public sector banks by 2018-19. But this is far from sufficient.

Difficulty in sorting out issue of over-indebtedness

The large, over-indebted borrowers are particularly difficult to resolve, for several deep-seated reasons:

• Severe viability issues: – At this point, large write-offs will be required to restore viability to the large IC1 companies (those companies whose earnings do not even cover their interest obligations).
• Acute coordination failures: – Large debtors have many creditors, who need to agree on a strategy. This is often difficult when major sums are involved.
• Serious incentive problems: – Public sector bankers are even more cautious in granting debt reductions in major cases, as this may attract the attention of not only the investigative agencies, but also the wider public.
• Insufficient capital: – Debt write-downs in the case of the large debtors could quickly deplete banks’ capital cushions.
• The new bankruptcy system is not yet fully in place, and even when it is, the new procedures (and participants) will need to be tested first on smaller cases.

The alternative in the form of PARA

In other words, for the big firms the road is not only littered with obstacles but seems to be positively blocked.All of this suggests that it might not be possible to solve the stressed asset problem using the current mechanism.

Instead a centralised approach might be needed. One possible strategy would be to create a ‘Public Sector Asset Rehabilitation Agency’ (PARA), charged with working out the largest and most complex cases.

Functions of PARA

• There are many possible variants, but the broad outlines are clear. It would purchase specified loans (for example, those belonging to large, over-indebted infrastructure and steel firms) from banks and then work them out, either by converting debt to equity and selling the stakes in auctions or by granting debt reduction, depending on professional assessments of the value-maximizing strategy.

Benefits of PARA

• Such an approach could eliminate most of the obstacles currently plaguing loan resolution.
• It could solve the coordination problem, since debts would be centralised in one agency;
• It could be set up with proper incentives by giving it an explicit mandate to maximize recoveries within a defined time period;
• And it would separate the loan resolution process from concerns about bank capital.

From where will the funding of PARA come?

1) Government issues of securities: –This would increase the debt stock, but could actually strengthen the government’s financial position if establishing PARA hastens the resolution of the stressed asset problem.

2) Capital Market: – A second source of funding could be the capital markets, if the PARA were to be structured in a way that would encourage the private sector to take up an equity share.

3) RBI: – The RBI would (in effect) transfer some of the government securities it is currently holding to public sector banks and PARA. As a result, the RBI’s capital would decrease, while that of the banks and PARA would increase.

Challenges that need to be resolved

But three major issues have bedevilled other agencies, and would need to be resolved to ensure a PARA would actually work as intended.

• First, there needs to be a readiness to confront the losses that have already occurred in the banking system, and accept the political consequences of dealing with the problem.
• Second, the PARA needs to follow commercial rather than political principles. To achieve this, it would need to be an independent agency, staffed by banking professionals. It would also need a clear mandate of maximizing recoveries within a specified, reasonably short time period.
• The third issue is pricing. If loans are transferred at inflated prices, banks would be transferring losses to the Rehabilitation Agency. As a result, private sector banks could not be allowed to participate – and then co-ordination issues would remain – while private capital would not want to invest in the Agency, since PARA would make losses.

Conclusion

The Economic Survey 2015-16 emphasized that addressing the stressed assets problem would require 4 R’s: Reform, Recognition, Recapitalization, and Resolution.

One year on, how much progress has been made?

Reforms

• This is the second time in a decade that such a large share of their portfolios has turned nonperforming – unless there are fundamental reforms, the problem will recur again and again.

Recognition

• After years of following a financing strategy, banks have realised that the financial position of the debtors has deteriorated to such an extent that many will not be able to recover. Accordingly, following the RBI’s Asset Quality Review, banks have recognised a growing number of loans as non-performing.

Recapitalisation

• Because of NPA banks will need to be recapitalised – the third R — much of which will need to be funded by the government, at least for the public sector banks. But recapitalisation, for all its importance and attention received in the public discourse, is not the need of the hour.

Resolution

• Rather, the key issue is the fourth R: Resolution. For even if the public sector banks are recapitalised, they are unlikely to increase their lending until they truly know the losses they will suffer on their bad loans. The question, then, is how to speed up resolution.

East Asian example

• After the 1990s crisis, East Asian countries were able to resolve most of the large cases within two years. One reason, of course, was that the East Asian countries were under much more pressure: they were in crisis, whereas India has continued to grow rapidly.
• But a second reason why East Asia was able to clean up its problem debts so quickly was that it had more efficient mechanisms.
• India has been pursuing a decentralised approach, East Asia adopted a centralised strategy, which allowed debt problems to be worked out quickly using the vehicle of public asset rehabilitation companies.

A brief overview of the RBI schemes

The 5/25 Refinancing of Infrastructure Scheme

Under this scheme lenders were allowed to extend amortisation periods to 25 years with interest rates adjusted every 5 years.

The scheme thus aimed to improve the credit profie and liquidity position of borrowers, while allowing banks to treat these loans as standard in their balance sheets, reducing provisioning costs.

Private Asset Reconstruction Companies (ARCs)

ARCs were introduced to India under the SARFAESI Act (2002), with the notion that as specialists in the task of resolving problem loans, they could relieve banks of this burden.

Strategic Debt Restructuring (SDR):

The RBI came up with the SDR scheme in June 2015 to provide an opportunity to banks to convert debt of companies (whose stressed assets were restructured but which could not finally fulfil the conditions attached to such restructuring) to 51 percent equity and sell them to the highest bidders, subject to authorization by existing shareholders.

Asset Quality Review (AQR)

Resolution of the problem of bad assets requires sound recognition of such assets. Therefore, the RBI emphasized AQR, to verify that banks were assessing loans in line with RBI loan classification rules.

Sustainable Structuring of Stressed Assets (S4A)

Under this arrangement, introduced in June 2016, an independent agency hired by the banks will decide on how much of the stressed debt of a company is ‘sustainable’. The rest (‘unsustainable’) will be converted into equity and preference shares.

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