Good Budget or not, there is nothing to suggest a change from the view, consistently held by this blog for nearly two years now, that the biggest immediate challenge facing the Indian economy is the resolution of its banking crisis. And yes, it is an as yet unrecognized crisis, not a mere problem. Fundamentally, India's banking sector is clearly in the red, with negative equity. And without addressing this, all other efforts are only tilting at the windmills.
Consider four graphics from Credit Suisse, the go-to source on banking sector problems. The first shows the latest on all types of stressed loans, an estimated 13.4% of all loans.
The second is a table which captures the acuteness of stress, with stressed loans at 230% of public sector banks' capital and stress asset cover of just 16%,
The third one estimates the capital infusion requirements till 2018-19 to be in the range of $34-53 bn, of which just $8 bn is budgeted,
And the final graphic appears to indicate that things may worsen still, given the rising corporate indebtedness. It finds that, among its sample of 3700 listed non-financial companies with cumulative debt over $500bn, the share of companies having interest coverage ratio less than one rose to 41% of the sample companies debt at the end of Q3 2016.
Five observations below.
1. All these problems were no secret to keen observers of the economy, and therefore, it is indeed surprising that the banking regulator has chosen to act with the current alacrity only now. The banking regulator was behind the curve both in preventing the problem and its recognition, and is now behind in its redressal too.
2. A far higher magnitude of recognition and haircuts may be required, especially in some sectors. And this may need to happen fairly quickly, or risk increasing the scale of the insolvency and raise the resultant resoluction costs. In such cases, there is no point in waiting in the hope that market prices will rise and demand will improve, since the scale of indebtedness is so high that there cannot be any light at the end of the tunnel. The Credit Suisse, for example, estimates that many of the largest steel firms have debt per tonne of production which is many times more than their replacement cost or unit EBITDA even with the minimum import prices. In fact, almost 86% of steel sector debt is stressed, against just 10-20% currently recognized as NPAs.
3. This requires "deep surgery" that goes beyond asset disposals and recapitalization. It involves governance reforms to public sector banks, revisiting infrastructure contracting assumptions and principles, and anchoring growth expectations at realistic levels. It demands hunkered down growth targets and strategies.
4. In an eco-system where fraud and malfeasance are never far away, and which is also gripped by decision paralysis, the regulator needs to be wary of the potential incentive distortions associated with such resolution activity. For example, currently, apart from the direct recognition process, the RBI already has the Corporate Debt Restructuring (CDR), Strategic Debt Restructuring (SDR), and the 5-25 takeout financing schemes. In both the latter two, the banks have been using Security Receipts (SRs), issued by Asset Reconstruction Companies (ARCs) in return for stakes in assets disposed as part of SDRs, and covertible preferential shares (CPS) that banks take in regular bilateral restructuring and SDR process. There is the very strong risk that SRs and CPSs could end up becoming the parking grounds for hiding bad assets within bank balance sheets, instead of their recognition, haircuts, and disposal.
It is no surprise that the RBI recently warned banks about the possibility of promoters of companies establishing shell companies to repurchase their assets which are auctioned off at much lower prices.
5. What complicates the problem is the unique nature of the sector, where information failures can play havoc. While the true extent of the problem needs steps for immediate recognition, its resolution may have to be prudently phased over time. A shock therapy of sudden disclosure, disposals, restructuring, provisioning, and recapitalization will most certainly parlayze the credit markets and even bring down many banks. Instead, recognition has to be followed by a clear (to the extent possible) and predictable reform path that reassures the markets. All along, once recognized, the RBI needs to put in place stringent information reporting requirements, and have the information rigorously scrutinized by its forensics and analytics division. All this requires credible and far-sighted leadership at multiple levels.
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