Time to re-prioritise firm resolution SNAKES & LADDERS
Even though Covid-19 is an act of god, cleaning up balance sheets is central to Indian economic growth
It is only human to feel sympathetic towards firms which are adversely affected by the Covid19 shock. But there is no free lunch: If we are kind to borrowers, this comes at the expense of lenders, and it is not as if the lenders in India are in great shape either. To be an organisation is to constantly analyse the world, and respond to shocks, large and small. A healthy market economy is one with high flexibility of resource allocation, where firms change their processes, and experience birth and death, swiftly. Now that the dust has settled after the early Covid-19 shock, firm resolution is the need of the hour.
Standing in January 2020, what were the big ideas in Indian economic policy? A certain fraction of the firms were under stress and nearing default. Such balance sheet stress harms the economy. Stressed firms are absorbed in the day to day struggle of dealing with cash shortages and angry creditors. They are tempted to do low return-on-equity transactions in their thirst for cash. Stressed financial firms tend to fare poorly in grounding decisions on risk and reward, and have incentives to falsify their financial statements. Stressed firms are less likely to invest or increase their productivity; their contribution to the economic growth process is weak. The presence of firms, which are struggling to survive tends to depress the profit rates of healthy firms within the same industry.
In world history, we have seen many situations where countries have failed to confront such problems. The term “Japanisation” is used to describe the stagnation that comes from forbearance, from helping zombie firms linger. The decline of growth in China from 2010 onwards is partly about such Japanisation. After the 2008 crisis, by and large, the UK and the US did a good job of resolution, while continental Europe did not, which is one source of the sustained economic difficulties there.
At a conceptual level, the market economy is a process of constantly responding to changes in consumer preferences and technological possibilities. Every organisation has to look outside, form a view about the changing world, and change itself to respond to this new world. A healthy country is one in which firms constantly change themselves, in which capital and labour are constantly reallocated, to respond to shocks.
For these reasons, the key principle in pre-covid Indian economic policy was to stave off Japanisation, to foster firm resolution. Resolution can happen in three ways: Existing shareholders bring in new money alongside debt restructuring, or the firm is sold as a going concern, or the firm is liquidated. Through these three paths, the objective of economic policymakers was that the landscape of firms should achieve good financial health. This was the logic of the Insolvency and Bankruptcy Code (IBC), for nonfinancial firms, and the “resolution corporation” anticipated through the Financial Regulation and Deposit Insurance (FRDI) Bill. The IBC did generate some gains in this direction.
How does this thinking change when faced with the Covid-19 shock? On March 22, the economy was thrown into turmoil, all decision-makers were groping in the new situation to figure out what was going on. In every organisation, there was innovation in the business model and the internal processes, so as to deal with the new environment. Every management team in India has applied its mind, treating its volume of activity of February as the baseline, trying to get back to 100 per cent of that baseline. Some kinds of organisations are, of course, more affected than others. As an example, there cannot be an all-electronic workflow for moving human beings, so the airline industry has only come back to about 50 per cent of the output in February.
In late March, there was extreme uncertainty for everyone. For the bankruptcy process to work well, we require a relatively stable world in which multiple private persons can assess the prospects of a firm and come to the committee of creditors with proposals. Under the radical uncertainty of late March, it was hard for participants in the bankruptcy process to do this. Hence, it made sense, in late March, to suspend the working of the IBC.
That phase of radical uncertainty is now behind us. Myriad organisations have reinvented themselves in ways, small and large. The urban labour participation rate was 40.14 per cent on March 22; its lowest value was 31.77 per cent on April 26, and it has returned to 38.49 per cent on August 30. As we look around this landscape, we see some industries have fared very well (e.g. broadband telecom, e-commerce) and some industries have not (e.g. airlines, consumer-facing retail services, commercial real estate). The world has changed, but the contours of the new world are now visible.
It is the job of the market economy to absorb shocks and get back to a good allocation of the factors of production. It is time to see Covid-19 as one more shock. Covid-19 is an act of god, but it is no different from many other shocks that come along. As an example, it was no “fault” of a traditional retailer that modern e-commerce came along. Who is at fault is not important; what is important is to create conditions for the process of the market economy to play out. Hence, it is time to prioritise resolution (for both financial and non-financial firms).
There is another dimension in which a motherly approach towards borrowers will induce difficulties. For buoyant economic growth, healthy financial firms are essential. If there is a spirit of forbearance, and moratoriums or debt waivers are brought about to help borrowers, this will adversely affect the health of lenders. It is hard to resolve financial firms under conditions of uncertain debt enforcement. The agenda of returning to normalcy on debt contracts, resolution of non-financial firms and resolution of financial firms are thus inter-related.