the festering twin balance sheet - taxguru.in festering twin balance sheet problem 83 figure 1....

CHAPTER

The Festering Twin Balance Sheet Problem

04

“The most costly outlay is time.”

– Antiphon the SophistAthens, 5th Century BCE

For some time, India has been trying to solve its Twin Balance Sheet problem–over-leveraged companies and bad-loan-encumbered banks -- using a decentralised approach, under which banks have been put in charge of the restructuring decisions. But decisive resolutions of the loans, concentrated in the large companies, have eluded successive attempts at reform. The problem has consequently continued to fester: NPAs keep growing, while credit and investment keep falling. Perhaps it is time to consider a different approach – a centralised Public Sector Asset Rehabilitation Agency that could take charge of the largest, most difficult cases, and make politically tough decisions to reduce debt.

I. IntroductIon

4.1 In February 2016, financial marketsinIndiawererockedbybadnewsfromthebanking system.Oneby one, public sectorbanks revealed their financial results forthe December quarter. And the numberswere stunning. Banks reported that non-performing assets had soared, to such anextent that provisioning had overwhelmedoperating earnings.As a result, net incomehadplungeddeeplyintothered.

4.2 Thenewssetoff alarmbellsamongstinvestors,who responded by fleeing publicsector bank shares, bringing their pricesto such low levels that at one point themedium-sized private sector bank HDFCwasvaluedasmuchas24publicsectorbanksputtogether(Figure1).

4.3 What had happened?Normally, non-

performing assets (NPAs) soar when thereisaneconomiccrisis, triggeringwidespreadbankruptcies. This is precisely whathappened inEastAsiaduring1997-98 andtheUS andUK in 2008-09.But therewasnoeconomiccrisisinIndia;tothecontrary,GDPwasgrowingataworld-beatingpace.Nor had there been anymajor calamity inthecorporatesector;nolargefirmhadgonebankrupt.

4.4 At one level, the explanation wasstraightforward.TheRBIhadconductedanAssetQualityReview(AQR),followingwhichbankscleaneduptheirbooks,sweepingawaythedebris thathadaccumulatedovermanyyears.Butthisonlybeggedadeeperquestionof howsomuchdebrishadaccumulatedinthefirstplace.Moreover,as2016proceededitbecameclearthattheAQRwasnottheonlyfactor at work. Themandated adjustments

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83The Festering Twin Balance Sheet Problem

Figure 1. Market Capitalisation - Public Sector Banks & HDFC (Rs. trillion)

Source: Bloomberg.

were completed in March. But NPAsnonetheless continued to climb, reaching 9percent of total advances by September --double theiryear-ago level.Equallystrikingwas the concentration of these bad loans.Morethanfour-fifthsof thenon-performingassetswereinthepublicsectorbanks,wheretheNPAratiohadreachedalmost12percent(Figure2a).

4.5 Meanwhile, on the corporate side,

CreditSuissereportedthataround40percentof thecorporatedebtitmonitoredwasowedbycompanieswhichhadaninterestcoverageratiolessthan1,meaningtheydidnotearnenough to pay the interest obligations ontheirloans(Figure3).1

4.6 As this data filtered into the publicconsciousness, it became clear that Indiawas suffering from a “twin balance sheetproblem”, where both the banking and

Figure 2. Gross NPA Ratio(Per cent of Gross Advances)

Figure 3. Share of Debt Owed by Stressed Companies*

34%

35%

36%

37%

38%

39%

40%

41%

2013 2014 2015 2016 2017Q1 2017Q2

Source: Reserve Bank of India for NPAs; Credit Suisse for debt share.*: Percent of debt owed by companies that have interest coverage ratio less than one, where cash flow is measured by EBIT, earnings before interest and taxes. Based on sample of 3,700 listed nonfinancial companies. Debt share numbers are for end-March for 2013-2016. H117 refers to the first half of FY17.

1 TheanalysisinthischapterhasutilizedtheCreditSuissedatabase,particularlyitsinformationon3700listedfirms.

0%

2%

4%

6%

8%

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14%

FY04

FY05

FY06

FY07

FY08

FY09

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FY14

FY15

FY16

H11

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All banks Public sector banks

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12-Feb-15 12-Feb-16 12-Feb-15 12-Feb-16

Public Sector Banks HDFC

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84 Economic Survey 2016-17

corporate sectors were under stress. Notjustasmallamountof stress,butoneof thehighestdegreesof stressintheworld.Atitscurrentlevel,India’sNPAratioishigherthananyothermajoremergingmarket (with theexception of Russia), higher even than thepeak levels seen in Korea during the EastAsiancrisis(Figure4).

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Brazil China Russia South Africa Korea (2000) India

Figure 4. NPA Ratios: Selected Countries (Per cent of Gross Loans)

Source: RBI for India. World Development Indicators, World Bank for others.

4.7 How can this possibly be explained?Typically,countrieswithatwinbalancesheet(TBS)problemfollowastandardpath.Theircorporations over-expand during a boom,leavingthemwithobligationsthattheycan’trepay.So,theydefaultontheirdebts,leavingbankbalance sheets impaired, aswell.Thiscombination then proves devastating forgrowth, since thehobbledcorporationsarereluctant to invest,while those that remainsoundcan’tinvestmucheither,sincefragilebanksarenotreallyinapositiontolendtothem.

4.8 This model, however, doesn’t seemtofit India’s case.True, Indiahadboomedduring the mid-2000s along with theglobal economy. But it sailed through theGFC largely unscathed, with only a briefinterruption in growth before it resumedat a rapid rate. According to conventional

wisdom, this happened because Indiancompaniesandbankshadavoidedtheboom-periodmistakesmadebytheircounterpartsabroad. More precisely, in this view, theywerepreventedfromaccumulatingtoomuchleverage,becauseprudentialrestrictionskeptbank credit from expanding excessivelyduring the boom, while capital controlsprevented an undue recourse to foreignloans.

4.9 If this narrative is correct, then it ispuzzlingthatIndianonethelesswoundupwithatwinbalancesheetproblem.Conversely,ifthenarrativeiswrongandIndiafollowedtheclassicpath to theTBSproblem, then it isunclearwhytheconsequenceshaveseemedsominor.

4.10 One reason for the modestconsequencescomesreadilytohand.InotherTBScases,growthwasderailedbecausehighNPA levels had triggered banking crises.ButthishasnothappenedinIndia.Infact,therehasnotevenbeenahintof pressureonthebankingsystem.Therehavebeennobankruns,nostressintheinterbankmarket,andnoneedforanyliquiditysupport,atanypoint since theTBSproblemfirstemergedin 2010. And all for a very good reason:because the bulk of the problemhas beenconcentrated in the public sector banks,whichnotonlyholdtheirowncapitalbutareultimatelybackedbythegovernment,whoseresources are more than sufficient to dealwiththeNPAproblem.Asaresult,creditorshave retained complete confidence in thebankingsystem.

4.11 That said, India’s TBS experienceremains deeply puzzling. This chapterattemptstoanswerfoursetsof questions:

• Whatwentwrong–andwhendiditgowrong?

• HowhasIndiamanagedtoachieverapidgrowth,despiteitsTBSproblem?

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Box 1. Why is a Public Sector Asset Rehabilitation Agency (PARA) Needed?TheargumentforPARAisdevelopedatlengthinthethirdsection.Butitisworthoutlininginadvancethesevenstepsthatleadtothisconclusion.1. It’s not just about banks, it’s a lot about companies.Sofar,publicdiscussionof thebadloanproblemhas

focusedonbankcapital,asif themainobstacletoresolvingTBSwasfindingthefundsneededbythepublicsectorbanks.Butsecuringfundingisactuallytheeasiestpart,asthecostissmallrelativetotheresourcesthegovernmentcommands.Farmoreproblematicisfindingawaytoresolvethebaddebtsinthefirstplace.

2. It is an economic problem, not a morality play.Withoutdoubt,therearecaseswheredebtrepaymentproblemshavebeen causedbydiversionof funds.But the vast bulkof theproblemhasbeen causedbyunexpectedchangesintheeconomicenvironment:timetables,exchangerates,andgrowthrateassumptionsgoingwrong.

3. The stressed debt is heavily concentrated in large companies. Concentration creates an opportunity,becauseTBScouldbeovercomebysolvingarelativelysmallnumberof cases.Butitpresentsanevenbiggerchallenge,becauselargecasesareinherentlydifficulttoresolve.

4. Many of these companies are unviable at current levels of debt requiring debt write-downs in many cases.Cashflowsinthelargestressedcompanieshavebeendeterioratingoverthepastfewyears,tothepointwheredebtreductionsof morethan50percentwilloftenbeneededtorestoreviability.Theonlyalternativewouldbetoconvertdebttoequity,takeoverthecompanies,andthensellthemataloss.

5. Banks are finding it difficult to resolve these cases, despite a proliferation of schemes to help them. Among other issues, they face severe coordination problems, since large debtors havemany creditors,withdifferentinterests.If PSUbanksgrantlargedebtreductions,thiscouldattracttheattentionof theinvestigativeagencies.Buttakingoverlargecompanieswillbepoliticallydifficult,aswell.

6. Delay is costly.Sincebankscan’t resolve thebigcases, theyhave simply refinanced thedebtors, effectively“kickingtheproblemsdowntheroad”.Butthisiscostlyforthegovernment,becauseitmeansthebaddebtskeeprising,increasingtheultimaterecapitalizationbillforthegovernmentandtheassociatedpoliticaldifficulties.Delayisalsocostlyfortheeconomy,becauseimpairedbanksarescalingbacktheircredit,whilestressedcompaniesarecuttingtheirinvestments.

7. Progress may require a PARA.PrivateAssetReconstructionCompanies (ARCs)haven’tprovedanymoresuccessfulthanbanksinresolvingbaddebts.Butinternationalexperienceshowsthataprofessionallyruncentralagencywithgovernmentbacking–whilenotwithoutitsowndifficulties--canovercomethedifficultiesthathaveimpededprogress.

• Isthismodelsustainable?

• Whatnowneedstobedone?

4.12 The answers to these questions arecomplex. But the policy implications canbe summarised easily enough. For someyears, it seemed possible to regard TBS asa minor problem, which would largely beresolvedaseconomyrecoverytookhold.Butmore recently it hasbecomeclear that thisstrategywillnotwork.Growthwillnotsolvethe problems of the stressed firms; to thecontrary,theproblemsof thestressedfirmsmightactuallyimperilgrowth.

4.13 Toavoidthisoutcome,aformalagencymaybeneededtoresolvethelargebaddebtcases – the same solution the East Asiancountries employed after they were hit by

severeTBSproblemsinthe1990s.Inshort,thetimemayhavearrivedtocreatea‘PublicSectorAssetRehabilitationAgency’(PARA,Box1).

A. What went wrong?

4.14 The origins of the NPA problemlienot in the eventsof thepast fewyears,butmuchfurtherbackintime,indecisionstaken during the mid-2000s. During thatperiod, economies all over the world werebooming, almost no country more thanIndia, where GDP growth had surged to9-10percentperannum.Forthefirsttimeinthe country’s history, everythingwas goingright: corporate profitability was amongstthehighest intheworld,encouragingfirmsto hire labour aggressively, which in turnsentwagessoaring.ItseemedthatIndiahad

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finally “arrived”, earning the long-awaitedreward for the effortsmade since 1991 toestablish a modern, competitive economy.Andthenextstepseemedclear:thecountrywasgoingtojointhepathblazedbyChina,inwhichdouble-digit growthwouldpersistforseveraldecades.

4.15 Firms made plans accordingly. Theylaunchednewprojectsworthlakhsof crores,particularly in infrastructure-related areassuchaspowergeneration,steel,andtelecoms,setting off the biggest investment boominthecountry’shistory.Withinthespanoffourshortyears, the investment-GDPratiohadsoaredby11percentagepoints,reachingover38percentby2007-08(Figure5).

4.16 This investment was financed by anastonishingcreditboom,also the largest inthe nation’s history, one that was sizeableevencomparedtootherlargecreditboomsinternationally. In the span of just threeyears,runningfrom2004-05to2008-09,theamount of non-food bank credit doubled.

Figure 5. Gross Capital Formation: Aggregate and Private Corporate (Per cent of GDP)

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And this was just the credit from banks:therewerealsolargeinflowsof fundingfromoverseas, with capital inflows in 2007-08reaching9percentof GDP.Allof thisaddedup toanextraordinary increase in thedebtof non-financial corporations. Put anotherway,asdoubledigitgrowthbeckoned,firmsabandoned their conservative debt/equityratios and leveraged themselves up to takeadvantageof theperceivedopportunities.

4.17 But justascompaniesweretakingonmorerisk,thingsstartedtogowrong.Costssoaredfarabovebudgetedlevels,assecuringland and environmental clearances provedmuch more difficult and time consumingthan expected. At the same time, forecastrevenues collapsed after theGFC; projectsthat hadbeenbuilt around the assumptionthat growthwouldcontinue atdouble-digitlevelsweresuddenlyconfrontedwithgrowthrateshalf thatlevel.

4.18 Asif theseproblemswerenotenough,financingcostsincreasedsharply.Firmsthat

Source: Central Statistics Office.

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borrowed domestically suffered when theRBIincreasedinterestratestoquelldouble-digitinflation.Andfirmsthathadborrowedabroadwhen therupeewas tradingaroundRs40/dollarwerehithardwhentherupeedepreciated, forcing them to repay theirdebtsatexchangeratesclosertoRs60-70/dollar.

4.19 Higher costs, lower revenues, greaterfinancing costs — all squeezed corporatecashflow,quickly leading todebt servicingproblems. By 2013, nearly one-third ofcorporate debt was owed by companieswith an interest coverage ratio less than 1(“IC1 companies”), many of them in theinfrastructure (especially power generation)and metals sectors. By 2015, the share ofIC1companiesreachednearly40percent,asslowinggrowthinChinacausedinternationalsteelpricestocollapse,causingnearlyeveryIndiansteelcompanytorecordlargelosses.The government responded promptly byimposing a minimum import price, whileinternational prices themselves recoveredsomewhat, thereby affording the steelindustrysomerelief.Evenso,theIC1shareremainedabove40percentinlate2016.

B. What Explains the Twin Balance Sheet Syndrome with Indian Characteristics?

4.20 Inotherwords,contrarytoconventionalwisdom, India did indeed follow thestandardpath to theTBSproblem:asurgeof borrowing, leading to overleverage anddebtservicingproblems.WhatdistinguishedIndiafromothercountrieswastheconsequence of TBS.EvenasIndianbalancesheetshavesuffered structural damage on the orderof what has occurred in crisis cases, theimpact on growth has been quite modest.TBS did not lead to economic stagnation,asoccurredintheU.S.andEuropeaftertheGlobal Financial Crisis and Japan after its

bubbleburst in the1990s.To thecontrary,itco-existedwithstronglevelsof aggregatedomesticdemand,asreflectedinhighlevelsof growth despite very weak exports andmoderate, at timeshigh, levelsof inflation.In other words, India developed its ownuniqueversionof TBS:whatrecentEconomic Surveys called a ‘Balance Sheet SyndromewithIndianCharacteristics’.

4.21 What could possibly explain India’sexceptional experience? In part, and asmentioned in the first section, the unusualstructure of its banking system, whichensured there would be no financial crisis.Butotherfactorsalsoplayedarole,includingthe unusual structure of the economy.India has long suffered from exceptionallysevere supply constraints, as the lack ofinfrastructure has hindered expansionof manufacturing and even some serviceactivities,suchastradeandtransport.Theseconstraints were loosened considerablyduringtheboom,asnewpowerplantswereinstalled,andnewroads,airports,andportsbuilt.Asaresult,therewasampleroomforthe economy to grow after theGFC, evenastheinfrastructureinvestmentsthemselvesdidnotprovefinanciallyviable.So,thelegacyof thehistoricmid-2000sinvestmentboomwas a curious combination of both TBSandgrowth. Incomparison, theUSboomwas based on housing construction, whichprovedfarlessusefulafterthecrisis.Andinanycase,theUSneversufferedfromseveresupplyconstraints.

4.22 Perhapsthemostimportantdifferencebetween India and other countries,however,wasthewayinwhichthefinancialsystem responded to the intense stress oncorporations. In other countries, creditorswould have triggered bankruptcies, forcingasharpadjustmentthatwouldhavebroughtdowngrowth in theshort run (evenas thereconfiguration of the economy improved

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long run prospects). But in India this didnot occur. Instead, the strategywas, as thesayinggoes,to“givetimetotime”,meaningto allow time for the corporatewounds toheal. That is, companies sought financialaccommodationfromtheircreditors,askingforprincipalpaymentstobepostponed,onthegrounds that if theprojectsweregivensufficient time theywould eventuallyproveviable.

4.23 Initially,thisrequestseemedreasonable.Forastart,the“givingtimetotime”strategyhad worked well in the previous businesscycle, during the early 2000s.At that time,nonperforming loans had also reachedhigh levels, but they then subsided a fewyears later when demand picked up andcommodity prices recovered. It seemedsensible to assume the samemighthappenthistimetoo,becauseIndiawouldeventuallyneed the infrastructure capacity that wasbeing installed. Accordingly, banks decidedto give stressed enterprises more time bypostponing loan repayments, restructuringby2014-15nolessthan6.4percentof theirloans outstanding (Figure 6a). They alsoextendedfreshfundingtothestressedfirmstotidethemoveruntildemandrecovered.

4.24 As a result, total stressed assets havefar exceeded the headline figure of NPAs.To that amount one needs to add therestructuredloans,aswellastheloansowedbyIC1companies thathavenotevenbeenrecognisedasproblemdebts–theonesthathavebeen“evergreened”,wherebankslendfirmsthemoneyneededtopaytheirinterestobligations.Marketanalystsestimatethattheunrecogniseddebtsarearound4percentofgrossloans,andperhaps5percentatpublicsector banks. In that case, total stressedassetswouldamounttoabout16.6percentof banking system loans – and nearly 20percentof loans at the statebanks (Figure6b).2

4.25 Inmany ways, then, India’s path hasresembled thatof China, albeiton amuchsmallerscale,sinceIndia’sestimatedbadloansarejustone-sevenththeamountassessedforChina (Table 1). Both countries providedgenerousamountsof bankfinancingtoallowhighly leveredcorporationstosurvive.Andin both countries this strategy has provedsuccessful so far in allowing rapid growthtocontinue.Butthereremainsaquestionofwhetherthemodelistrulysustainable.

Figure 6a. Restructured Loan Ratio(Per cent of Gross Loans)

Figure 6b. Total Stress(Per cent)

2%

3%

4%

5%

6%

7%

8%

9%

FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 H117Public sector banks All banks

0%

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10%

15%

20%

25%

FY14 2Q17 FY14 2Q17

All banks Public sector banks

GNPA Restructured Unrecognized

Source: RBI, except unrecognized stressed assets estimated by Credit Suisse.

2 Thereductioninrestructuredassetsafter2014-15occurredlargelybecausemanycompaniesfelloutof compliancewiththerestructuringagreements,leadingbankstoclassifymanyof theloansasnon-performing.

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Table 1. Estimated Non-Performing Loans

India China India China

1998-99 2002 2016@ 2015

Total ($ billion) 14.0 209.1 191.1 1300Percent of total loans 14.7 23.4 16.6^ 15.5Percent of GDP 3.0 14.4 8.4 12.0MemoItemBank Credit to GDP (%) 20.5 108# 53.4* 137.5**

Source: IMF, RBI, Credit Suisse estimates. @: As per latest data available till September 2016. ^: Total stressed loans, which includes NPAs, restructured loans and unrecognised stressed loans; *Using outstanding credit to industry data from RBI as on March 2016; #: People’s Bank of China as reported in “Money & Credit: China Social Financing”, Yardeni Research, Inc., November 2016. **PRC 2016 Article IV consultation, IMF.

II. Is the strategy sustaInable?4.26 In principle, a financing strategycan indeed be sustainable. But for this tooccuroneof two scenarioswouldneed tomaterialise. Under the “phoenix” scenario,acceleratinggrowthwouldgraduallyraisethecashflowsof stressedcompanies,eventuallyallowing them to service their debts. Inotherwords,theinherentdynamismof theIndian economy would carry the impairedcompanies andbanks alonguntil the risingtide finally lifted all boats or covered therockyshoals.

4.27 Alternatively, even if the individualprojects themselves do not come right,the Indian economy could still grow outof its balance sheet problems. Under the“containment” scenario, the NPAs wouldmerelyneedtobelimitedinnominalterms.Oncethisisdone,theywouldswiftlyshrinkasashareof theeconomyandaproportionof bank balance sheets, since GDP isgrowingatanominalrateof morethan10percent.Inthatway,thetwinbalancesheetproblem,whileneverbeingexplicitlysolved,couldsimplyfadeawayinimportance.

4.28 Forsometime,thesescenariosactuallyseemed feasible. From 2012 all the way

through mid-2015, the EBIT of the IC1companies held steady around Rs 25,000croreperquarter,3givingrisetohopesthatat least the containment scenario wouldeventually materialise. But more recentlythe picture has changed dramatically. Bytheendof 2015earningshaddiminishedtoRs20,000 croreperquarter.BySeptember2016theyhadfallentojustRs15,000croreper quarter, as a modest recovery in themetalssectorwasoverwhelmedbyafurtherdeteriorationintheinfrastructurecompanies.In otherwords, aggregate cashflow in thestressed companies – which even in 2014wasn’tsufficienttoservicetheirdebts–hasfallenbyroughly40percentinlessthantwoyears.

4.29 These companies have consequentlyhadtoborrowconsiderableamountsinordertocontinuetheiroperations.Debtsof thetop10 stressed corporate groups, in particular,have increased at an extraordinarily rapidrate, essentially tripling in the last six years(Figure7).Asthishasoccurred,theirinterestobligationshaveclimbedrapidly.

4.30 Stressed companies are consequentlyfacing an increasingly difficult situation.Their cash flows are deteriorating even as

3 Thesefigures,andthoseinthefollowingfiveparagraphs,arebasedontheCreditSuissedatabase.

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theirinterestobligationsaremounting–andif they borrow more, this will only causethe gap to widen further. In some cases,companieshavetriedto“squarethecircle”by selling off some of their assets. Butthis has sufficedmainly to buy them time,since selling off assets provides immediaterevenues but leavesfirmswith less incometo service their debts in the future. Andeven in the short-term this measure hasprovedapalliativeforonlyafewcompanies.The aggregate financial position of thestressed companies consequently continuesto haemorrhage., with losses (roughly, theexcess of interest payments, depreciationand taxes over EBIT and asset sales) nowrunningaroundRs15,000croresperquarter,comparedwithasmallnetprofit twoyearsago.

4.31 The situation in the power sectorillustrates the more general problem. Thesetbacks discussed in the second sectionhaveledtocostoverrunsatthenewprivatepower plants of more than 50 percent in

nearly every case, and much more thanthat in many. To cover these costs, thesecompaniesneedtosellallthepowertheyarecapableof producingathightariff rates.Buttheoppositeishappening:

• Plantloadfactors(PLF,actualelectricityproduction as a share of capacity) areexceptionallylow–andtheyarefalling,tumbling to just 59.6 percent duringApril-December 2016 from 62 percentduringthesameperiodlastyear.

• Meanwhile, merchant tariffs forelectricitypurchasedinthespotmarkethave slid to around Rs 2.5/kwh, farbelow thebreakeven rateof Rs4/kwhneededformostplants,letalonetheRs8/kwhneededinsomecases.4

4.32 Asaresult,cashflowformostprivatepower generation companies falls far shortof what is needed to service their interestobligations;put anotherway,more than60percent of the debt owed by the privatepower producers is with IC1 companies.

Figure 7. Debt of Top Ten Stressed Corporate Groups (Rs billion)*

454 990

1,372 2,101

2,675

3,572

5,349

6,298 6,689

7,083 7,519

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

Source: Credit Suisse database. *Includes bank debt, bonds, External Commercial Borrowings, and other debt.

4 Of course,muchelectricity isbeing sold athigher long-term ratesunderPowerPurchaseAgreements (PPAs),but in someof these cases even these rates remainbelowcosts.And the shareof electricitypurchasedunderPPAsisfalling,asStateElectricityBoardsincreasinglyrelyonthecheapandabundantpoweravailableinthespotmarket.Notethatif therehadnotbeencostoverruns,atariff of Rs3/kwhwouldhavebeensufficienttoensureprofitabilityformostnewplants.

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AlsothereisscantsignonthehorizonthatPLFsandtariffsmightimprove.

4.33 At the same time, corporate stressseems to be spreading. For much of theperiodsincetheGlobalFinancialCrisis,theproblems were concentrated in the largecompanies which had taken on excessiveleverageduringthemid-2000sboom,whilethe more cautious smaller and midsizecompanies had by and large continued toservicetheirdebts.Startinginthesecondhalfof 2016, however, a significant proportionof the increases in NPAs – four-fifths ofthe slippages during the second quarter –camefrommid-sizeandMSMEs,assmallercompaniesthathadbeensufferingfrompoorsalesandprofitabilityforanumberof yearsstruggled to remain current on their debts.Thistrendislikelytocontinueinto2017.

4.34 Stress has also expanded to thetelecom sector, where interest coverageratios have deteriorated as new entry hasincreased competition, prompting a major

round of price-cutting. In short, stress onthecorporatesectorisnotonlydeepening;itisalsowidening.

4.35 There is yet another reason why theeconomymay not be able to grow out ofitsdebts:theproblemitself isbeginningtotakea tollongrowth.Asnoted in thefirstsection,countrieswithTBSproblemstendtohavelowinvestment,asstressedcompaniesreduce their new investments to conservecashflow,whilestressedbanksareunabletoassumenewlendingrisks(Dell’Aricciaet.al.[2012]).5 And this seems to be happeningin India, aswell. Private investment,whichhadbeensoaringattheheightof theboom,slowedsharplytoa5percentgrowthrateby2010-11.By2015-16, ithadactuallystartedto shrink, and in 2016-17 so far it seemstohavecontractedbymore than7percent(Figure 8).6 To cushion the impact on theoveralleconomy,publicinvestmenthasbeenstepped up considerably, but this has stillnotbeensufficienttoarrestafallinoverallinvestment.

5 Dell’Aricciaetalfindthatthreeoutof fivecreditboomswerecharacterizedbybelow-trendgrowthduringthesix-yearperiodfollowingtheirend.Duringthesebelow-trendperiods,annualeconomicgrowthwasonaverage2.2percentagepointslowerthanin“normal”times(excludingcrises).

6 BasedonStateandUnionGovernmentBudgets.

Figure 8. Growth in Real Gross Fixed Capital Formation (per cent)

Source: Ministry of Finance calculations.

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7 Leavingasidenon-recognisedor“evergreened”loans.

4.36 In the short run, the economy cancontinue to expand briskly on the back ofconsumption, with firms fulfilling demandbyusingthecapacitythatwasbuiltupduringtheboomyears.Butoverthemediumtermthedownwardtrendininvestmentwillneedtobereversed.

4.37 Meanwhile,TBSistakingaheavytollon the health of the public sector banks.At least 13 of these banks accounting forapproximately 40 per cent of total loansare severely stressed,withover20percentof their outstanding loans classified asrestructured or NPAs. With such a largefractionof theirportfolios impaired, ithasbecomeextremelydifficultforthemtoearnenoughincomeontheirassetstocovertheirrunninganddepositcosts.Banksaroundtheworld typically strive for a returnof assets(ROA)of 1.5percentorabove,shownintheredlineinfigure9a.ButIndianpublicsectorbanks are much below this internationalnorm.Infact,theirROAhasturnednegativeover the past two years. And as a result,investors are no longerwilling to pay “fullprice” for public sector bank shares: sharepriceshavefallentojusttwo-thirdsof theirbookvalue(Figure9b).

4.38 Public sector banks have respondedto their difficult financial situation in thestandardway.Theyhavetriedtoprotecttheircapitalpositionsbyminimizingthenewriskstheyaretaking,that isbyscalingbacktheirnewlending.Someof thelendingslackhasbeentakenupbyprivatebanks,buttherearelimits to theextent that theycanprovideasubstitute, because the public sector banks(in aggregate) aremuch larger.As a result,totalcredittothecorporatesectorhasbeendecelerating steadily. In real terms, suchcreditgrowth isnownegative, the lowest ithasbeenin23years(Figure10).

4.39 This gradual tightening of the creditconstraint has been felt rather unevenlyacrosstheeconomy.Householdcredit,wheredefaulthasbeenminimalandwhereprivatesector banks have a comparative lendingadvantage,hasbeenexpandingexceptionallyrapidly,fuellingthegrowthof consumption.Agricultural loans have also continued at agoodpace, as theyhavebeenprotectedbythe priority sector lending requirements.But corporates andMSMEs have been hitseverely.RealloangrowthtoMSMEsslowedsignificantlyin2014-15,andactuallyturnednegative during the past two fiscal years

Figure 9a. Public Sector Banks: Return on Assets (ROA) Ratio (per cent)

Figure 9b. Public Sector Banks: Market Capitalisation to Book Value Ratio

-0.5%

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1.5%

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FY06 FY08 FY10 FY12 FY14 FY16Pvt SBI Public sector banks (excl. SBI)

1.9

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Source: MoF. Source: MoF.

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Figure 10. Real Loan Growth to Industry* (Deflated by average of CPI-IW & WPI)

-10%

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*: Data up to end-November 2016 for FY17.

(Figure11a).Meanwhile,loanstocorporatesin the stressed sectors remained buoyantfor some time, in linewith the strategy ofkeepingthemafloat,butevenforthisgrouploangrowth turnedsharplynegative in realtermsduring2016-17(Figure11b).

4.40 Public sector banks have alsorespondedtotheirstressinanotherstandardway.Theyhavetriedtocompensateforthelack of earnings from the non-performingpart of their portfolio by widening theirinterestmargins(Figure12).Forexample,by

Figure 11a. Real Loan Growth*(MSME & Corporate)

Figure 11b. Real Loan Growth*(Stressed and Non-stressed)

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Source: RBI. *: Deflated by average of CPI and WPI. FY17 data as of November 2016. Corporate sector includes industry and services. Stressed sectors include mining, textiles, basic metals, gems and jewellery, construction and infrastructure.

Figure 12. Repo, Base Lending Rate and Term Deposit Rate (Per cent)

Repo Rate

Average Term Deposit Rate

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016

Average Base Rate

Average Term Deposit Rate

Repo Rate

Source: RBI. The base rate is the average of all banks. Average term deposit rate is for deposits of more than one year.

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Figure 13. Growth in Nominal Corporate Bank Credit, Corporate Bonds, and

Commercial Paper (Per cent)

-50%

-30%

-10%

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90%

Sep-13 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 May-16 Sep-16

Commercial Paper

Corporate Bond

Bank Corporate Credit

Source: Credit Suisse.

4.42 Summing up, for some years thefinancing strategyhasworked, in the sensethat it has allowed India to grow rapidly,despite a significant twin balance sheetproblem. But this strategy may now bereachingitslimits.Aftereightyearsof buyingtime, there is still no sign that the affectedcompaniesareregainingtheirhealth,oreventhatthebaddebtproblemisbeingcontained.Tothecontrary,thestressoncorporatesandbanks iscontinuing to intensify,andthis inturnistakingameasurabletolloninvestmentand credit. Moreover, efforts to offsetthese trends by providing macroeconomicstimulus are not proving sufficient: theincreaseinpublicinvestmenthasbeenmorethanoffsetbythefallinprivateinvestment,whileuntildemonetisationmonetaryeasinghadnotbeentransmittedtobankborrowersbecause banks had been widening theirmargins instead. In these circumstances,it has become increasingly clear that theunderlyingdebtproblemwillfinallyneedtobe addressed, lest it derails India’s growthtrajectory.

III. What needs to be done?4.43 TheRBIhas over the past few yearsintroduced a number of mechanisms todeal with the stressed asset problem (seeAppendix).Initially, theschemesfocusedonreschedulingamortisationstogivefirmsmoretimetorepay.Butasitbecameapparentthatthefinancialpositionof thestressedfirmswasdeteriorating, theRBIdeployedmechanismstodealwithsolvencyissues,aswell.

4.44 Three of these mechanisms areparticularlynotable.Forsometime,theRBIhas been encouraging the establishment ofprivate Asset Reconstruction Companies(ARCs),inthehopethattheywouldbuyupthebad loansof thecommercialbanks. Inthatway,therecouldbeanefficientdivisionof labour,asbankscouldresumefocusingontheirtraditionaldeposit-and-loanoperations,

December2016thegapbetweentheaveragetermdepositrateandtheaveragebaseratehad grown to 2.7 percentage points, from1.6percentagepointsinJanuary2015.Itwasonly following the extraordinary influx ofdepositsconsequentondemonetisationthatpublicsectorbanksfinallycut their lendingratesbysignificantamounts.

4.41 The widening of spreads, in turn,has encourageddisintermediation from thebanking system. The increase in marginsmeans that performing borrowers anddepositors are effectively being taxed inorder to subsidise the non-performingborrowers. Inevitably, the good borrowersare seeking funding elsewhere: from thecommercial paper market for their shorttermneedsandthebondmarketforlonger-termfinancing(Figure13).Thiscould, inaway,beconsidereddesirable,asitishelpingdevelopthecountry’scapitalmarkets.Butifthistrendof disintermediationcontinues,itwillleavemuchof the“tax”burdenontheMSMEs,whocannotdecampfor thebondmarkets, since they require the knowledge-intensive type of lending that is providedonlybybanks.Thistrendmayalsoposerisksfor the banks themselves, who risk beinjgleftwithjusttheriskierones,withthebetteronesmigrating.

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while theARCs coulddeploy the specialistskillsneededtorestructurecorporatedebts.

4.45 This strategy, however, has had onlylimited success. Many ARCs have beencreated, but they have solved only a smallportion of the problem, buying up onlyabout5percentof totalNPAsatbookvalueover2014-15and2015-16.Theproblem isthatARCshavefounditdifficulttorecovermuchfromthedebtors.Thustheyhaveonlybeenabletoofferlowpricestobanks,priceswhichbankshavefounditdifficulttoaccept.

4.46 So the RBI has focussed morerecentlyon twoother,bank-basedworkoutmechanisms. In June 2015, the StrategicDebt Restructuring (SDR) scheme wasintroduced,underwhichcreditorscouldtakeoverfirmsthatwereunable topayandsellthemtonewowners.Thefollowingyear,theSustainable Structuring of Stressed Assets(S4A)wasannounced,underwhichcreditorscould provide firms with debt reductionsup to 50 percent in order to restore theirfinancialviability.

4.47 In principle, these schemestaken together might have provided acomprehensive framework for dealingwithsolvencyproblems.Their success,however,hasbeenlimited;whiletwodozenfirmshaveentered into negotiations under SDR, onlytwo cases have actually been concluded asof end-December2016.AndonlyonesmallcasehasbeenresolvedsofarunderS4A.

4.48 Thereareseveralreasonswhyprogresshasbeensolimited.Inpart,theproblemissimplythattheschemesarenew,andfinancialrestructuring negotiations inevitably takesome time. But the bigger problem is thatthe key elements needed for resolution arestillnotfirmlyinplace:

• Loss recognition. The AQR wasmeant to force banks to recognise thetrue state of their balance sheets. But

banksnonethelesscontinuetoevergreenloans, as the substantial estimates ofunrecognisedstressedassetsmakeclear.

• Coordination.TheRBIhasencouragedcreditors to come together in JointLenders Forums, where decisions canbe takenby75percentof creditorsbyvalue and 60 percent by number. Butreaching agreement in these Forumshas proved difficult, because differentbanks have different degrees ofcredit exposure, capital cushions, andincentives. For example, banks withrelatively largeexposuresmaybemuchmore reluctant to accept losses. Insomecasesthefirm’s lossesaren’tevenknown,fortheydependontheextentofgovernment compensation for its ownimplementationshortfalls,suchasdelaysinacquiringlandoradjustingelectricitytariffs.Anddecidingcompensation isadifficultandtime-consumingtask;manycasesarenowwiththejudiciary.

• Proper incentives. The S4A schemerecognisesthatlargedebtreductionswillbe needed to restore viability in manycases. But public sector bankers arereluctant tograntwrite-downs,becausethere are no rewards for doing so. Tothecontrary, there isan inherent threatof punishment,sincemajorwrite-downscanattracttheattentionof investigativeagencies. Accordingly, bankers haveevery incentive to simply rescheduleloans,inordertodefertheproblemsuntilalaterdate.Toaddressthisproblem,theBank Board Bureau (BBB) has createdanOversightCommitteewhichcanvetand certify write-down proposals. Butit remains openwhether it can changebankers’incentives.

• Capital.Thegovernmenthaspromisedunder the Indradhanush scheme toinfuseRs 70,000 crores of capital into

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thepublicsectorbanksby2018-19.Butthisisfarfromsufficient,andinherentlyso, because there is a principal-agentproblem, arising from the separationof the institution with financialresponsibility(thegovernment)fromitsdecision-makingagent(thestatebanks).If the government promises undulylarge funds in advance, the banksmaygrant excessive debt reductions. Butbanksdonotreceivesufficientassuranceof funding,theywillnotbeabletograntcompaniesenoughdebtrelief.

4.49 Inshort,theroadtoresolutionremainslittered with obstacles, even for the mostordinaryof baddebtcases.Thebulkof theproblem,however,isnotlocatedinordinarycases. To the contrary, stressed assets areconcentratedinaremarkablyfewborrowers,withamere50companiesaccountingfor71percent of the debt owed by IC1 debtors.On average, these 50 companies owe Rs20,000 crores in debt, with 10 companiesowing more than Rs 40,000 crores apiece.Andthe large,over-indebtedborrowersareparticularly difficult to resolve, for severaldeep-seatedreasons:

• Severe viability issues. At this point,largewrite-offswillberequiredtorestoreviability to the large IC1 companies.The amounts varywidely from case tocase,andrequireathoroughanalysisofthe accounts to ascertain. But a broadidea canbeobtainedby calculating thedebtreductionthatwouldbeneededtoreduceinterestobligationstothecurrentlevelof cashflows. Basedon thedatafor the year ending September 2016,

about33of thetop100stresseddebtorswouldneeddebtreductionsof lessthan50percent,10wouldneedreductionsof51-75percent,andnolessthan57wouldneedreductionsof 75percentormore.8

• Acute coordination failures. Largedebtorshavemanycreditors,whoneedto agree on a strategy. This is oftendifficultwhenmajorsumsareinvolved.

• Serious incentive problems. Publicsectorbankersareevenmorecautiousingrantingdebtreductionsinmajorcases,as thismayattract theattentionof notonly the investigativeagencies,butalsothewiderpublic.Atthesametime,statebanksareoftennotinapositiontotakethealternativerouteof convertingtheirclaimstoequity,takingoverlargefirms,andthenresellingthem,evenwhenthisisclearlythevalue-maximisingsolution–andeventhoughitisencouragedunderSDR.

• Insufficient capital.Debtwrite-downsin the case of the large debtors couldquicklydepletebanks’capitalcushions.

4.50 Inotherwords, for thebigfirms theroad isnot litteredwithobstacles. It seemstobepositivelyblocked.

4.51 CouldthenewBankruptcyLawprovidea viable alternative way forward? In someways, going down the path of bankruptcywouldmakesenseforcaseswherethewrite-down needs are particularly large, whichmakes them ill-suited for S4A and SDR inthefirstplace.Theproblemisthatthenewbankruptcy system isnot yet fully inplace,andevenwhenitis,thenewprocedures(and

8 Basedonmanysimplifyingassumptions.Cashflowismeasuredbyearningsbefore interest, taxes,depreciation,andamortisation (EBITDA); the46companieswithnegativecashfloware included in thegroupthat requiresmorethan75percentdebtreduction.Itisalsoassumedthatthereductionininterestobligationsisproportionaltothereductionindebt.Perhapsmostimportant,thecalculationisbasedonthepremisethatcashflowswillremainunchangedinthefuture.Insomecases,itmaywellimprove,forexampleasdemandforsteelrecoversfromitscyclicaltrough.Butinothercases,theassumptionmaywellbeoptimistic,ascashflowsof stressedcompaniesasagrouphavebeendeterioratinginthepasttwoyears,asexplainedinthefourthsection.

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participants)will need tobe testedfirst onsmaller cases. Some considerable time willconsequently elapse before the system willbereadytohandlethelarge,complexcases.

4.52 Inotherwords,thestateof playisthis:it has now been eight years since the twinbalancesheetproblemfirstmaterialised,andstill no resolution is in sight. And becausethefinancialpositionof thestresseddebtorsis deteriorating, the ultimate cost to thegovernment and society is rising–not justfinancially, but also in terms of foregoneeconomic growth and the risks to futuregrowth.

4.53 These difficulties raise a fundamentalissue. Most economic problems are bestresolvedthroughmarket-basedmechanisms,in which commercially-motivated actorsoperate within government-designedframeworks.Butinthiscase,thismechanismdoesn’tseemtobeworking,becauseof theconstraints and distorted incentives, whichhaveproveddifficulttoeradicate.

4.54 Allof thissuggeststhatitmightnotbepossibletosolvethestressedassetproblemusingthecurrentmechanism,orindeedanyother decentralised approach that mightmaterialise in the near future. Instead acentralisedapproachmightbeneeded.

4.55 One possible strategy would be tocreate a ‘Public SectorAssetRehabilitationAgency’(PARA),chargedwithworkingoutthe largest and most complex cases. Suchan approach could eliminate most of theobstaclescurrentlyplaguingloanresolution.Itcouldsolvethecoordinationproblem,sincedebtswouldbecentralisedinoneagency;itcould be set up with proper incentives bygiving it an explicit mandate to maximizerecoverieswithinadefinedtimeperiod;anditwouldseparatetheloanresolutionprocessfrom concerns about bank capital. For allthese reasons, asset rehabilitation agencieshavebeenadoptedbymanyof thecountries

facingTBSproblems,notablytheEastAsiancrisiscases.

4.56 How would a PARA actually work?There are many possible variants, but thebroad outlines are clear. Itwould purchasespecifiedloans(forexample,thosebelongingto large, over-indebted infrastructure andsteelfirms)frombanksandthenworkthemout,eitherbyconvertingdebttoequityandsellingthestakesinauctionsorbygrantingdebt reduction, depending on professionalassessments of the value-maximizingstrategy.

4.57 Once the loans are off the books ofthe public sector banks, the governmentwould recapitalise them, thereby restoringthemtofinancialhealthandallowingthemtoshifttheirresources–financialandhuman–backtowardthecriticaltaskof makingnewloans. Similarly, once the financial viabilityof theover-indebtedenterprisesisrestored,theywillbeabletofocusontheiroperations,rather than their finances. And they willfinallybeabletoconsidernewinvestments.

4.58 Of course,allof thiswillcomeataprice,namelyacceptingandpayingforthe losses.Butthiscostisinevitable.Loanshavealreadybeen made, losses have already occurred,and because public sector banks are themajorcreditors,thebulkof theburdenwillnecessarily fall on the government (thoughthe shareholders in the stressed enterprisesmayneedtolosetheirequityaswell).Inotherwords,theissueforanyresolutionstrategy–PARAordecentralised--isnotwhetherthegovernmentshouldassumeanynewliability.Rather, it is how to minimize the existingliability by resolving the bad loan problemas quickly and effectively as possible. Andthatispreciselywhatcreationof thePARAwouldaimtodo.

4.59 That said, the capital requirementswould nonetheless be large. From wherewouldthisfundingcome?Partwouldneedto

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comefromgovernmentissuesof securities.Thiswouldincreasethedebtstock,butcouldactuallystrengthenthegovernment’sfinancialposition if establishing PARA hastens theresolutionof thestressedassetproblem,sincedoingsowouldreducetheamountthatwouldultimatelybeneededtocompensatebanksforthelossesonthebadloans.

4.60 Asecondsourceof fundingcouldbethecapitalmarkets,if thePARAweretobestructuredinawaythatwouldencouragetheprivatesectortotakeupanequityshare.Inaddition,capitalmarketscouldhelpreplenishthecapitalof thepublicsectorbanks,if thegovernment were willing to sell down itsholdings.

4.61 A third source of capital could bethe RBI. Themechanism for doing this isstraightforward(Box2).TheRBIwould(ineffect) transfer some of the governmentsecurities it is currently holding to publicsector banks and PARA. As a result, theRBI’s capital would decrease, while that ofthebanksandPARAwouldincrease.Therewould be no implications for monetarypolicy,sincenonewmoneywouldbecreated.

4.62 Of course, establishing a PARA isnot a panacea. In fact, experience withgovernment-runassetrehabilitationagencieshas not been uniformly positive. Threemajorissueshavebedevilledotheragencies,andwouldneed tobe resolved toensureaPARAwouldactuallyworkasintended.

4.63 First, there needs to be a readinessto confront the losses that have alreadyoccurredinthebankingsystem,andacceptthepoliticalconsequencesof dealingwiththeproblem.If loansarewrittenoff,therecouldbeaccusationsof favouritism; if defaultingcompaniesaretakenoverandsold,thiscouldbe seen as excessively strong government.The only defence against such chargeswouldbetoensurethePARAisthoroughlyprofessional,withplansthatmaximize–and

areseentomaximize–recoveryvalue.

4.64 Second, the PARA needs to followcommercial rather than political principles.To achieve this, it would need to be anindependent agency, staffed by bankingprofessionals. It would also need a clearmandateof maximizingrecoverieswithinaspecified,reasonablyshorttimeperiod.Thebest,perhapstheonlywaytoachievethisisto set up a structure like theonedone fortheGSTNetwork,which isbroadlywithinthe aegis of the public sector but withgovernmentowning49percent.

4.65 Thethirdissueispricing.If loansaretransferred at inflated prices, banks wouldbe transferring losses to the RehabilitationAgency. As a result, private sector bankscould not be allowed to participate – andthen co-ordination issues would remain –whileprivatecapitalwouldnotwanttoinvestin the Agency, since PARA would makelosses.Toget around thisproblem,marketprices could be used, but establishing themarketpriceof distressed loans is difficultandwouldprovetimeconsuming.

4.66 All three problems are formidableones,which ispreciselywhyotherschemeshavebeentriedfirst.Buttheseotherschemeshavenotworked, years haveflownby, andmeanwhile the costs are continuing tomount.ToparaphrasethelearnedeconomistMr.Holmes,“Onceyouhaveeliminatedtheimpossible, whatever remains, no matterhowdifficult,mustbethesolution.”

IV. conclusIon

4.67 The Economic Survey 2015-16emphasized that addressing the stressedassetsproblemwould require4R’s:Reform, Recognition, Recapitalization, and Resolution. Oneyearon,howmuchprogresshasbeenmade?

4.68 Start with the area where the leastamount of progress has occurred: thefirst R, Reform. The past few years have

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Box 2. Excess Capital of the RBI Last year’sEconomic Survey had raised the issueof the government’s excess capital in theRBI.That issue couldbecomeevenmoresalientthisyearbecauseof demonetization.

Thefigurebelowplots theextentof capital there is in theRBI,updating thecalculation in lastyear'sSurvey. Ifthereisademonetisationwindfall-notincludedhere-theRBIwillstandoutevenmoreasanoutlierintermsofgovernmentcapitalinthecentralbank.

Figure. Equity as Per cent of Central Bank Balance Sheet

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ThereisnoparticularreasonwhythisextracapitalshouldbekeptwiththeRBI.Evenatcurrentlevels,theRBIisalreadyexceptionallyhighlycapitalized.Infact,itisoneof themosthighlycapitalizedcentralbanksintheworld.So,itwouldseemtobemoreproductivetoredeploysomeof thiscapitalinotherways.

AssumingthattheRBIreturnsRs.4lakhcroreof capitaltothegovernment,whataretheusestowhichthiscapitalcanbeput?Itcouldbeusedinseveralgoodways:

First,forrecapitalizingthebanksand/orrecapitalizingaPublicSectorAssetRehabilitationAgency(PARA);

Second, for extinguishingdebt todemonstrate that the government is serious about a strongpublic sectorfiscalposition.

ThekeyprinciplethatshouldbeobservedinthisprocessisthattheexcesscapitalintheRBI,includingthatcreatedbydemonetisation,isabalancesheetorwealthgainandnotanincomegain.Hence,theusestowhichthisisputshouldbeof abalancesheetnature.

Itcannotbeemphasizedenoughthatanystrategytousetheexcesscapitalmustbedonecarefullythatinnowayunderminesorcircumventstherelevantlaws.Itmustalsobedonewiththefullcooperationof theRBItoensurethattheRBI’sindependenceandcredibilityareinnowayundermined.

Whatarethepossibleeconomicobjectionstosuchastrategy?

A. Adequacy of buffers

First,wouldtherebeadequatebuffersaftersuchareductionintheRBI’scapital?Sincealargechunkof RBI’sassets(nearly70percent)areintheformof netforeignassets(NFA),somearguethatitmustmaintainahighequitytoassetsratio.OneargumentisthatthelargertheNFAtototalassetsratioof acentralbank,themorevulnerableitis

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toexchangeratevolatilityrisks.NorgesBankof Norway,forexample,hasaNFAtototalassetsratioof 86percentandmaintainsanequitytoassetsratioof about45percent,evenhigherthantheRBI.

IstherereallyahighpositivecorrelationbetweenNFAandequityholdingsof acentralbank?Totestthisclaim,across-countrycomparisonplottingtheratioof NFAtototalassetsof centralbanksagainsttheratioof equitytoassetsisundertaken.Thecorrelationbetweenthetworatiosturnsouttobejust.09.Sojustasacross-sectionalempiricalregularity,itisnottruethathigherforeignassetsnecessitateorleadtotheholdingof morecapital.

Source: Central banks of respective countries.

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B. Likelihood of capital losses

Butthereallycriticalquestionisthefollowing:whatkindandmagnitudeof exchangeratechangecouldunderminethecapitalpositionof theRBI?

Notefirstthatvaluationlosseswillarisewhentherupeeappreciates.So,theappreciationof therupeerequiredtoresultinavaluationlossof Rs.4lakhcrorethatwouldinturnwipeouttheremainingcapitalof theRBI(assumingthatRs4lakhcroreisredeployed)iscalculated.Estimatesshowthattheexchangeratewouldneedtoappreciateby16.3percent.Intermsof thebroadbasedrealeffectiveexchangerate(REER)calculatedbytheRBI,theindexwouldneedtoriseto135.8.

Thelogicissimple:Rs4lakhcroresis16.3percentof foreignreserves(basedondataonforeignexchangereservesasonJanuary13,2017).Sotherupeewouldhavetoappreciatebyabout16.3percentrelativetotoday’sleveltowipeouttheRBI’scapital.ThatappreciationwouldtranslateintoaREERlevelasshowninthefigurebelow.Suchappreciationof therupeewouldleadtoadversecompetitivelevelsneverwitnessedintheIndianeconomyforthelast12years.Manufacturingwouldessentiallybewipedout.ItisthereforeclearthatsuchcapitallossescouldneverbeallowedtobeinflictedontheRBI.

C. Feasibility of averting losses

But can theRBI, even if didnotwant such appreciation, be able toprevent it?The answer is yes.There is afundamentalasymmetry intheoperationof centralbanks.Theirsupplyof foreigncurrency is limitedbuttheirsupplyof domesticcurrencyisunlimited.So,if thecurrencystartsappreciating,theRBIcanintervenetopreventitbybuyingdollarsandsupplyingrupees.Thiscannotbealwayspossiblewithcurrencydepreciationbecauseatsomepointof timetheRBIwillrunoutof dollars.Inotherwords,theRBIhasboththeabilityandincentivetoprevent

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largevaluationlossesthatwouldjeopardizeitscapital.9

A final concern: supposing that the excess capital were redeployed toward recapitalizing the banks, wouldredeploymentof RBI’sreservesamounttotheregulatorholdingastakeinitsregulatees-thecommercialbanks?Infact,whattheoperationwouldinvolveisthegovernmentalteringthecompositionof itsbalancesheet,transferringitsequityholdingsfromtheRBItothecommercialbanks.TheRBIwouldhavenoequityinthecommercialbanks.Norwouldtherebeanyimplicationsformonetarypolicy.

Theeasiestway to thinkabout this is to see theseoperations in twostages. In stage1, theRBI’sbalance sheetshrinksasusesitsholdingsof governmentsecurities(ontheassetside)topayadividendtothegovernment,therebyreducingitscapital(ontheliabilityside).Instage2,thegovernmentwouldissuenewdebttorecapitalizethebanks.Sointheend,governmentbondswouldsimplypassfromtheRBItothegovernmenttopublicsectorbanks.Intheprocesscapitalwouldalsoshift.Butotherwisenothingwouldchange;inparticular,themoneysupplyandoverallgovernmentequityholdingswouldbeunaffected.

D. International precedents

Finally,thereareprominentinternationalprecedentsforgovernmentsusingitscapitalinthecentralbankforitsownpurposes;andforbenefitingfromtheextinguishingof banknotesandusingtheexcesscapitalinthecentralbank:

• TheUSFederalReservegave$19billionfromitssurpluscapitaltofinancetransportationprojectsin2015.10

• In2004,theBundesbank,extinguisheditsolddeutschemarkcurrencyandcounteditasincomeintheprofitandlossaccountbecauseitwasdeemedhighlyunlikelythatthesewouldeverbeexchangedforeuros.

• TheBankof Israelrecordedagainof ILS220millioninits2010financialstatements(about$62millionatthetime)forthefacevalueof notesthathadpassedthelegaldateforexchangeandwerenolongervalidforuse.

Figure. Competitiveness Measured by REER*

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REER REER to wipe out RBI capital

Source: RBI.*: The 36-currency Real Effective Effective Exchange Rate is the weighted average of Nominal Effective Exchange Rate adjusted by the ratio of domestic price to foreign prices.

9 TheRBIalsofacesriskstoitsbalancesheetfrominterestratechanges.If interestratesincrease,thevalueof itsgovernmentbondholdingswilldecline,inflictingvaluationlosses.However,risksfrominterestrateincreasesarequantitativelylessimportantfortheRBIgiventhecompositionof itsassets.Moreover,theseriskswill,ingeneral,benegativelycorrelatedwithexchangeraterisks.

10 See https://www.bloomberg.com/news/articles/2015-12-01/fed-surplus-tapped-in-highway-bill-as-banks-get-dividend-break.

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demonstrated the singular virtue of apublic sector dominated banking system,inpreservingconfidence in thebankswhenproblemsarise.Buttheyhavealsoshownitsgreaterdisadvantages,inactuallydealingwiththeproblemsandindeedinallowingthemtomaterialise in the first place. This situationmightnotmattermuchif double-digitNPAsatpublicsectorbankswerearareevent.Butthisisthesecondtimeinadecadethatsuchalargeshareof theirportfolioshasturnednon-performing - unless there are fundamentalreforms, the problem will recur again andagain.

4.69 Indeed,once theTwinBalanceSheetproblemisresolved,therecouldbesignificantmoral hazard problems. Newly cleaned upbalance sheetsmay simply encourage bankmanagerstolendfreely,ignoringthelessonsof the past. Structural reform aimed atpreventing this can take many forms butseriousconsiderationmustalsobegiventotheissueof governmentmajorityownershipinthepublicsectorbanks.

4.70 Now consider the area where therehasbeen themostprogress: the secondR,Recognition. After years of following afinancing strategy, hoping that providing“time to time” would allow the stressedloanstocomeright,bankshaverealisedthatthe financial position of the debtors hasdeterioratedtosuchanextentthatmanywillnotbeabletorecover.Accordingly,followingtheRBI’sAssetQualityReview,bankshaverecognised a growing number of loans asnon-performing.

4.71 With higher NPAs has come higherprovisioning, which has eaten into banks’capitalbase.Asaresult,bankswillneedtoberecapitalised–thethirdR--muchof whichwillneedtobefundedbythegovernment,atleastforthepublicsectorbanks.Thismuchis automatic.But recapitalisation, for all itsimportance and attention received in the

publicdiscourse,isnottheneedof thehour.Notthemainneed,atanyrate.

4.72 Rather, the key issue is the fourthR:Resolution. For even if the public sectorbanks are recapitalised, they are unlikely toincrease their lendinguntil they trulyknowthelossestheywillsufferontheirbadloans.Nor will the large stressed borrowers beable to increase their investmentuntil theirfinancialpositionshavebeenrectified.Untilthishappens, economicgrowthwill remainundertheat.

4.73 The question, then, is how to speedup resolution. In India little progress hasbeenmadeeveneightyearsaftertheGlobalFinancial Crisis. Yet after the 1990s crisis,East Asian countries were able to resolvemost of the large cases within two years.One reason, of course, was that the EastAsian countries were under much morepressure: theywere in crisis,whereas Indiahascontinuedtogrowrapidly.

4.74 ButasecondreasonwhyEastAsiawasabletocleanupitsproblemdebtssoquicklywas that it hadmore efficientmechanisms.India has been pursuing a decentralisedapproach,underwhichindividualbankshavebeen taking restructuring decisions, subjectto considerable constraint and distortedincentives.Accordingly,theyhaverepeatedlymade the choice to delay resolutions. Incontrast East Asia adopted a centralisedstrategy,whichalloweddebtproblemstobeworkedoutquicklyusingthevehicleof publicasset rehabilitation companies. Perhaps it istimeforIndiatoconsiderthesameapproach.

references:1. Dell'Ariccia,Giovanni,DenizIgan,Luc

Laeven,&HuiTong,withBasBakker&JérômeVandenbussche,(2012),“PoliciesforMacrofinancialStability:HowtoDealwithCreditBooms“ IMF Staff Discussion Note SDN/12/06 (Washington, DC:InternationalMonetaryFund).

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appendIx

OverthepastthreeyearstheRBIhasimplementedanumberof schemestofacilitateresolutionof thestressedassetproblem.Thefigurebelowdepictstheseschemes.Inwhatfollowsabriefoverviewof theseschemesisprovided.

Figure. Chronology of RBI policy actions

The 5/25 Refinancing of Infrastructure Scheme:Thisschemeofferedalargerwindowforrevivalof stressedassetsintheinfrastructuresectorsandeightcoreindustrysectors.Underthis scheme lenders were allowed to extend amortisation periods to 25 years with interestratesadjustedevery5years, soas tomatch the fundingperiodwith the longgestationandproductive lifeof theseprojects.The scheme thusaimed to improve thecreditprofileandliquiditypositionof borrowers,whileallowingbankstotreattheseloansasstandardintheirbalance sheets, reducing provisioning costs.However, with amortisation spread out over alongerperiod,thisarrangementalsomeantthatthecompaniesfacedahigherinterestburden,whichtheyfounddifficulttorepay,forcingbankstoextendadditionalloans(‘evergreening’).Thisinturnhasaggravatedtheinitialproblem.

Private Asset Reconstruction Companies (ARCs):ARCswereintroducedtoIndiaundertheSARFAESIAct(2002),withthenotionthatasspecialistsinthetaskof resolvingproblemloans,theycouldrelievebanksof thisburden.However,ARCshavefounditdifficulttoresolvetheassets theyhavepurchased, so theyareonlywilling topurchase loansat lowprices.Asa result, banks have been unwilling to sell them loans on a large scale. Then, in 2014 thefeestructureof theARCswasmodified,requiringARCstopayagreaterproportionof thepurchasepriceup-frontincash.Sincethen,saleshaveslowedtoatrickle:onlyabout5percentof totalNPAsatbookvalueweresoldover2014-15and2015-16.

Strategic Debt Restructuring (SDR):TheRBIcameupwiththeSDRschemeinJune2015toprovideanopportunitytobankstoconvertdebtof companies(whosestressedassetswererestructuredbutwhichcouldnotfinallyfulfil theconditionsattachedtosuchrestructuring)to51percentequityandsellthemtothehighestbidders,subjecttoauthorizationbyexistingshareholders.An18-monthperiodwasenvisagedforthesetransactions,duringwhichtheloanscouldbeclassifiedasperforming.Butasof end-December2016,onlytwosaleshadmaterialized,inpartbecausemanyfirmsremainedfinanciallyunviable,sinceonlyasmallportionof theirdebthadbeenconvertedtoequity.

Asset Quality Review (AQR): Resolution of the problem of bad assets requires soundrecognitionof suchassets.Therefore, theRBIemphasizedAQR, toverify thatbankswere

June 2014:5:25 Flexible

Refinancing of Infrastructure

Mar-14 Dec-14 Mar-16

June 16: Scheme for Sustainable

Structuring of Stressed Assets

August 2014:Change in Asset

Restructuring Company (ARC)

Fee Structure

June 2015:Strategic Debt Restructuring

(SDR) Scheme

October 2015:Asset Quality

Review (AQR) Scheme

Sep-16

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assessingloansinlinewithRBIloanclassificationrules.AnydeviationsfromsuchrulesweretoberectifiedbyMarch2016.

Sustainable Structuring of Stressed Assets (S4A):Underthisarrangement,introducedinJune2016,anindependentagencyhiredbythebankswilldecideonhowmuchof thestresseddebtof acompanyis‘sustainable’.Therest(‘unsustainable’)willbeconvertedintoequityandpreferenceshares.UnliketheSDRarrangement,thisinvolvesnochangeintheownershipofthecompany.

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the festering twin balance sheet - taxguru.in festering twin balance sheet problem 83 figure 1....

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