India’s financial system gets a reset
With a bad bank, lower rates, and account aggregators, the country is ready for a cleaner credit cycle
India’s non-performing assets (NPAS) increased at the beginning of the last decade because of the natural turn of the business cycle, but also because much of the underwriting was done based on political due diligence rather than commercial due diligence. As we entered a strong dollar cycle globally from 2011-12 to 2020-21, the chickens came home to roost with the pandemic being the final kick.
A new reformist and anti-cronyist government in 2014 ironically worsened things in the short-term. Inflation targeting, the Insolvency Bankruptcy Code (IBC), the Real Estate Regulatory Act and the Goods and Services Tax increased uncertainty, even though they were growth enhancers in the long-term.
We also overdid the checks and balances on public sector lending, and some good solvent businesses entered the spiral of illiquidity even as many underlying frauds were exposed. Credit growth stalled and the NPA ratio worsened, with non-performing to gross loan ratio crossing around 10% in 2018, a number last seen in 2002. Despite some fiscal and monetary easing pre-covid-19 (around 2019), it was clearly not enough.
An entire way of doing business was reset as India Inc was forced to embrace digitalisation and formalisation more thoroughly. The earlier mechanism of inflating invoices, setting up projects with next to no real equity, and, if things went south, the sovereign picking the tab, was no longer viable. Equally, siphoning off large sums from minority shareholders made less sense now because of better transnational vigilance as well as limits on spending huge sums in cash domestically.
Demonetisation led to a lot of cash entering the banking system, but some of the benefits were wasted for two reasons. One, the then Reserve Bank of India governor, Urjit Patel, let the rupee strengthen inordinately in 2017-18 without seeing through inflation pressures — this gravely hurt exports and industry. He should have, instead, built up reserves. Two, the increase in personal peak income tax rates in 2019 was another stick, when a carrot was required to improve compliance.
Nonetheless, the bold steps outnumber the mistakes. Corporate tax rates were cut and a bunch of aggressive reforms have continued right through the pandemic. India’s Unified Payment Interface is being taken global, and the equally revolutionary account aggregators idea will lead to tax and payment meta-data being used for better analytics, and, hence, cheaper as well as more widespread credit. India is leading the world in public digital goods, and China’s recent crackdown on walled data gardens is a doffing of the hat. Sooner or later, America will follow, despite all the entrenched lobbies.
But, in the here and now, bank balance-sheets remain damaged. IBC has led to some clear gains, and we now even have a prepackaged version for micro, small and medium enterprises. The idea of not immediately having a bad bank was based on avoiding moral hazard — if banks know they will be bailed out by having their worst assets bought with reasonable or no haircuts, they will have zero incentive to do any diligence. That is a valid fear but, right now, we are at the other end of the spectrum — economic-financial sadism and masochism.
The pandemic has given us an opportunity to make a clean start, and we must grab it with both hands. Already, lower bond yields have partially repaired bank treasuries to some extent (lower yield means higher bond prices). If we are to build trillions of dollars worth of infrastructure in this decade, then we will need all hands on deck — developmental financial institutions, capital markets (INVITS, REITS where the government is also liberalising), and, of course, healthy private and public banks.
A consortium of banks coming together and floating an asset reconstruction company (ARC), with the government giving a limited guarantee for the paper (security receipts) that this National Asset Reconstruction Company Limited will issue, may well be just what the doctor ordered. ARC will remove almost $30 billion of NPAS from the system in two phases, and because the said debt will be owned by one entity, the further resolution through IBC is likely to be faster. The government guarantee is a reasonable $4 billion, is time-bound, and may not even be used but is absolutely critical. It may be a more efficient use of capital than more direct bailouts, though that cannot be ruled out. Depending on how this evolves, we may have to readjust a bit.
Healthy financial intermediation allows, for example, the young who are rich in human capital but not financial capital to borrow from those who have the latter. It allows the poor and the neo-middle class to climb onto the property ladder while systematically building an equity portfolio as well as reducing risks through insurance.
India cannot fully copy either the Anglo-american model of capital markets first because financial literacy remains an issue here (and indeed globally), nor can we copy the East Asian-continental European model of banks having close ties to industry and unions because our society and polity is far more heterogeneous.
Thankfully, we do not have to choose — while we will learn from everyone, we will craft our own way based on our genius, away from false binaries, and let others discuss the Indian model of finance. And that model just received a big reboot over the last few months.