Resolving bad loans

Urjit Patel’s warning needs a policy response

The Indian economy contracted by about 24 per cent in the first quarter of the current fiscal year and output is likely to shrink even in the second quarter. The overall decline in output and continued weakness in the real sector would increase difficulties for the financial sector. It is possible that non-performing assets (NPAS) in the banking system would be higher than what is being projected. The latest Financial Stability Report of the Reserve Bank of India (RBI) projected an increase in the gross NPA ratio to 12.5 per cent under the baseline scenario, and it can go up to 14.7 per cent in a very severe stress scenario by the end of the fiscal year. While the NPAS are bound to rise, it is worth asking if the system has the capacity to deal with such a situation. The banking system was struggling even before the pandemic. The RBI has now allowed a one-time restructuring of loans. While the details of the programme are awaited, it will be important to ensure that it is not used to hide bad loans, which might suit most stakeholders in the short run. The borrowers would benefit as they can delay the repayment, banks would not have to show bad loans, and the government will have to put less capital in public sector banks. But the problem may persist as it has for many years.

It is in this context that comments made by former RBI governor Urjit Patel in a recent interview to The Hindu, and also elaborated in his book Overdraft: Saving the Indian Saver, need policy attention. To be fair, both the government and the RBI made a serious attempt to address the NPA issue through the Insolvency and Bankruptcy Code (IBC). However, things changed after a point and rules were relaxed. Dr Patel notes that a reversal of possibly the most important structural reform in recent years, in a way, is being accepted. Regrettably, all this happened before the pandemic and it is likely that rules would further be relaxed. While the delay in recognition of bad loans might make the bank balance sheet look better, it will affect the chances of sustainable recovery. The inability of the system to resolve NPAS in time results in misallocating resources and raises the cost of money for all borrowers, including the government. The IBC process is also under threat from another angle. As reported by this newspaper, the bidders of assets are now seeking to reschedule payments. This could again dent the IBC process. Thus, the government must ensure that the relevance of the law is not lost.

However, the bigger problem, as Dr Patel underscores, is the broader macroeconomic management. The way the government manages its finances leaves very little scope for countercyclical measures in the case of a slowdown. As a result, the government ends up using the banking system to stimulate the economy. Even in the present circumstances, it is trying to push credit. It is critical to recognise that the extension of the same policies would not yield different results. Dr Patel’s blunt warning on the direction of decisions since his departure from the RBI should be taken seriously, and merits a studied response from both the government and the central bank on how they see the issues that he has raised. The policy response to emerging challenges in the financial system will have a bearing on India’s potential growth in the medium to long run.