What is twin balance sheet problem?

Twin balance sheet problem refers to simultaneous stress in the balance sheet of corporate sector as well as banks. Typically, countries with a twin balance sheet (TBS) problem follow a standard path. Their corporations over-expand during a boom, leaving them with obligations that they can’t repay. So, they default on their debts, leaving bank balance sheets impaired, as well. This combination then proves devastating for growth, since the hobbled corporations are reluctant to invest, while those that remain sound can’t invest much either, since fragile banks are not really in a position to lend to them.

But India’s twin balance sheet problem has its own unique character. The internationally experienced model doesn’t seem to fit India’s case. True, India had boomed during the mid-2000s along with the global economy. But it sailed through the Global Financial Crisis (GFC) largely unscathed, with only a brief interruption in growth before it resumed at a rapid rate. According to conventional wisdom, this happened because Indian companies and banks had avoided the boom period mistakes made by their counterparts abroad. More precisely, in this view, they were prevented from accumulating too much leverage, because prudential restrictions kept bank credit from expanding excessively during the boom, while capital controls prevented an undue recourse to foreign loans.

Balance Sheet Syndrome with Indian Characteristics

 

India’s TBS experience remains deeply puzzling. In other TBS cases, growth was derailed because high NPA levels had triggered banking crises. But this has not happened in India. In fact, there has not even been a hint of pressure on the banking system. There have been no bank runs, no stress in the interbank market, and no need for any liquidity support, at any point since the TBS problem first emerged in 2010. And all for a very good reason: because the bulk of the problem has been concentrated in the public sector banks, which not only hold their own capital but are ultimately backed by the government, whose resources are more than sufficient to deal with the NPA problem. As a result, creditors have retained complete confidence in the banking system. The main distinguishing features of TBS problem in India are following:

  • India did indeed follow the standard path to the TBS problem: a surge of borrowing, leading to over leverage and debt servicing problems.
  • The consequences of TBS were different in India from standard model elsewhere.
  • Even as Indian balance sheets have suffered structural damage on the order of what has occurred in crisis cases, the impact on growth has been quite modest. TBS did not lead to economic stagnation, as occurred in the U.S. and Europe after the Global Financial Crisis and Japan after its bubble burst in the 1990s.
  • To the contrary, it co-existed with strong levels of aggregate domestic demand, as reflected in high levels of growth despite very weak exports and moderate, at times high, levels of inflation.
  • India developed its own unique version of TBS: what recent Economic Surveys called a ‘Balance Sheet Syndrome with Indian Characteristics’.

Reasons behind TBS problem in India (What went wrong)?

  • The origins of the NPA problem lie not in the events of the past few years, but much further back in time, in decisions taken during the mid-2000s.
  • During that period India’s GDP had surged to 9-10 percent per annum, more than any country in the world.
  • For the first time in the country’s history, everything was going right: corporate profitability was amongst the highest in the world, encouraging firms to hire labour aggressively, which in turn sent wages soaring.
  • It seemed that India had finally “arrived”, earning the long-awaited reward for the efforts made since 1991 to establish a modern, competitive economy.
  • And the next step seemed clear: the country was going to join the path blazed by China, in which double-digit growth would persist for several decades.
  • Firms made plans accordingly and launched new projects worth lakhs of crores, particularly in infrastructure-related areas such as power generation, steel, and telecoms, setting off the biggest investment boom in the country’s history.
  • During this period, within the span of four short years, the investment-GDP ratio had soared by 11 percentage points, reaching over 38 percent by 2007-08.
  • This investment was financed by an astonishing credit boom; also the largest in the nation’s history, one that was sizeable even compared to other large credit booms internationally.
  • In the span of just three years, running from 2004-05 to 2008-09, the amount of non-food bank credit doubled.
  • There were also large inflows of funding from overseas, with capital inflows in 2007-08 reaching 9 percent of GDP.
  • All of this added up to an extraordinary increase in the debt of non-financial corporations.
  • The impact of all these developments was that as double digit growth beckoned, firms abandoned their conservative debt/equity ratios and leveraged  themselves up to take advantage of the perceived opportunities. But just as companies were taking on more risk, things started to go wrong. Costs soared far above budgeted levels, as securing land and environmental clearances proved much more difficult and time consuming than expected.
  • At the same time, forecast revenues collapsed after the Global Financial Crisis (GFC); projects that had been built around the assumption that growth would continue at double-digit levels were suddenly confronted with growth rates half that level.
  • Also financing costs increased sharply. Firms that borrowed domestically suffered when the RBI increased interest rates to quell double digit inflation. And firms that had borrowed abroad when the rupee was trading around Rs 40/dollar were hit hard when the rupee depreciated, forcing them to repay their debts at exchange rates closer to Rs 60-70/ dollar.

How Corporate Balance Sheets worsened

Higher costs, lower revenues, greater financing costs — all squeezed corporate cash flow, quickly leading to debt servicing problems. By 2013, nearly one-third of corporate debt was owed by companies with an interest coverage ratio less than 1(“IC1 companies”), many of them in the infrastructure (especially power generation) and metals sectors. By 2015, the share of IC1 companies reached nearly 40 percent, as slowing growth in China caused international steel prices to collapse, causing nearly every Indian steel company to record large losses. The government responded promptly by imposing a minimum import price, while international prices themselves recovered somewhat, thereby affording the steel industry some relief. Even so, the IC1 share remained above 40 percent in late 2016. Thus the corporate sector came into red in India and it still continues that’s why economic survey calls it a “festering problem”.

What explains difference between TBS in India and elsewhere?

Unusual structure of banking sector —- What happened in India was due to unusual structure of its banking system, which ensured there would be no financial crisis.

Unusual structure of the economy—- Other factors also played a role, including the unusual structure of the economy. India has long suffered from exceptionally severe supply constraints, as the lack of infrastructure has hindered expansion of manufacturing and even some service activities, such as trade and transport. These constraints were loosened considerably during the boom, as new power plants were installed, and new roads, airports, and ports built.  As a result, there was ample room for the economy to grow after the GFC, even as the infrastructure investments themselves did not prove financially viable. So, the legacy of the historic mid-2000s investment boom was a curious combination of both TBS and growth.

In comparison, the US boom was based on housing construction, which proved far less useful after the crisis. And in any case, the US never suffered from severe supply constraints.

Peculiar way of response from the financial system —- Perhaps the most important difference between India and other countries, however, was the way in which the financial system responded to the intense stress on corporations. In other countries, creditors would have triggered bankruptcies, forcing a sharp adjustment that would have brought down growth in the short run (even as the reconfiguration of the economy improved long run prospects). But in India this did not occur. Instead, the strategy was, as the saying goes, to “give time to time”, meaning to allow time for the corporate wounds to heal. That is, companies sought financial accommodation from their creditors, asking for principal payments to be postponed, on the grounds that if the projects were given sufficient time they would eventually prove viable.

Need for Asset Rehabilitation Agency (PARA) 

The need for PARA for solving the TBS problem can be understood by the following seven steps that lead to this conclusion.

  1. It’s not just about banks, it’s a lot about companies. So far, public discussion of the bad loan problem has focused on bank capital, as if the main obstacle to resolving TBS was finding the funds needed by the public sector banks. But securing funding is actually the easiest part, as the cost is small relative to the resources the government commands. Far more problematic is finding a way to resolve the bad debts in the first place.
  2. It is an economic problem, not a morality play. Without doubt, there are cases where debt repayment problems have been caused by diversion of funds. But the vast bulk of the problem has been caused by unexpected changes in the economic environment: timetables, exchange rates, and growth rate assumptions going wrong.
  3. The stressed debt is heavily concentrated in large companies. Concentration creates an opportunity, because TBS could be overcome by solving a relatively small number of cases. But it presents an even bigger challenge, because large cases are inherently difficult to resolve.
  4. Many of these companies are unviable at current levels of debt requiring debt write-downs in many cases. Cash flows in the large stressed companies have been deteriorating over the past few years, to the point where debt reductions of more than 50 percent will often be needed to restore viability. The only alternative would be to convert debt to equity, take over the companies, and then sell them at a loss.
  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 have many creditors, with different interests. If PSU banks grant large debt reductions, this could attract the attention of the investigative agencies. But taking over large companies will be politically difficult, as well.
  6. Delay is costly. Since banks can’t resolve the big cases, they have simply refinanced the debtors, effectively “kicking the problems down the road”. But this is costly for the government, because it means the bad debts keep rising, increasing the ultimate recapitalization bill for the government and the associated political difficulties. Delay is also costly for the economy, because impaired banks are scaling back their credit, while stressed companies are cutting their investments.
  7. Progress may require a PARA. Private Asset Reconstruction Companies (ARCs) haven’t proved any more successful than banks in resolving bad debts. But international experience shows that a professionally run central agency with government backing – while not without its own difficulties — can overcome the difficulties that have impeded progress.

Arguments for PARA

Experts suggest many alternatives to resolve the TBS problem and creation of a ‘Public Sector Asset Rehabilitation Agency’ (PARA) is one of them. It will be charged with working out the largest and most complex cases of default on repayment of loans by the corporate sector is being extended by experts. Such an approach could eliminate most of the obstacles currently plaguing loan resolution. It could solve the coordination problem, since debts would be centralised in one agency; it could be set up with proper incentives by giving it an explicit mandate to maximize recoveries within a defined time period; and it would separate the loan resolution process from concerns about bank capital. For all these reasons, asset rehabilitation agencies have been adopted by many of the countries facing TBS problems, notably the East Asian crisis cases.

How would a PARA actually work?

There are many possible variants, but the broad outlines are clear. It would purchase specified loans (for example, those belonging to large, over-indebted infrastructure and steel firms) from banks and then work them out, either by converting debt to equity and selling the stakes in auctions or by granting  debt reduction, depending on professional assessments of the value-maximizing strategy.

Once the loans are off the books of the public sector banks, the government would recapitalise them, thereby restoring them to financial health and allowing them to shift their resources – financial and human – back toward the critical task of making new loans. Similarly, once the financial viability of the over-indebted enterprises is restored, they will be able to focus on their operations, rather than their finances. And they will finally be able to consider new investments.

Price of resolving TBS problem

Of course, all of this will come at a price, namely accepting and paying for the losses. But this cost is inevitable. Loans have already been made, losses have already occurred, and because public sector banks are the major creditors, the bulk of the burden will necessarily fall on the government (though the shareholders in the stressed enterprises may need to lose their equity as well). In other words, the issue for any resolution strategy – PARA or decentralised — is not whether the government should assume any new liability. Rather, it is how to minimize the existing liability by resolving the bad loan problem as quickly and effectively as possible. And that is precisely what creation of the PARA would aim to do.

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