The Rise of Goliath

by AK Bhattacharya

  The mood was also buoyant. Every other company was planning to invest big, and borrowing merrily. This led to a rise in the debt of companies, which were seemingly attracted by the prospects of higher growth in spite of the fact that they had given up caution, settled for a debt–equity ratio that was a little unsafe and they were becoming even more indebted. The situation got even riskier as the external environment became adverse. Apart from rising inflation jacking up costs, these projects also became victims of bureaucratic lethargy and the red tape. Securing environment clearances and acquiring land posed difficulties, delaying the rollout of the projects. Another external factor that took them by surprise was the global financial crisis of 2008, which upset the growth assumptions based on which most companies had planned their expansion of capacity and investment in new projects. The Lehman crisis that led to the collapse of many financial giants led to bailout measures from the US Federal Reserve. These resulted in a loose monetary policy to boost consumption. The consequence was the inflation rates shot up and the banks had little option other than recasting loans to protect their assets. The Indian economy too was not spared from the impact of these developments.

  A double whammy hit the Indian companies when domestically their cost of borrowing rose with the RBI jacking up interest rates in a bid to rein in inflation. Higher interest rates also meant that the companies’ cost of servicing the loans increased, which put pressure on their profit margins as well. And for companies that had borrowed in the international markets, their costs went haywire with the rupee depreciation. From around Rs 40 a dollar in January 2008, the value of the Indian rupee against the US dollar fell to around Rs 65 by September 2013. With the Indian companies’ exposure to external commercial borrowing having already risen significantly, the impact on their projects and financials was adverse as their repayment liability in rupee terms rose. Several Indian companies, with significant exposure to foreign currency convertible bonds (FCCB) or external commercial borrowing, ran the risk of default. They included Subex, Moser Baer, Aksh Optifibre and GTL Infrastructure.2

  The situation got so bad that higher costs, lower revenues and increased financing costs gave rise to a debt-servicing problem for many of these companies. The government’s Economic Survey for 2016–17 estimated that by 2013 the interest–coverage ratio deteriorated to an alarmingly low level. Interest–coverage ratio is an indicator of a company’s earning ability to pay off its dues or clear its debt and interest liabilities. It, therefore, shows the ease or difficulty with which a company can pay for its interest costs on the debts it has incurred. Since this ratio is arrived at by dividing a company’s earnings before interest and taxes by its interest expenses, any figure lower than 1.5 raises serious questions about the company’s ability to meet its interest costs. Companies with an interest–coverage ratio of less than 1 accounted for about a third of the total corporate debt. In other words, repayments on almost 33 per cent of India’s corporate debt had become doubtful by 2013.

  It was a recipe for disaster—both for the companies that had become hugely indebted and the banks that were now staring at the prospects of one-third of their corporate loans turning sick or non-performing.

  Worryingly, many of these companies were from the infrastructure sector having invested in projects in power generation and metals, many of them in steel. Yet another external development hit some of these companies badly. China began experiencing slowing growth and that triggered a fall in international steel prices. Steel prices fell globally as also in India, adversely affecting the earnings of Indian steel companies, which had premised their new projects and expansions on steady growth in their price realization.

  By 2015, almost 40 per cent of corporate debt was accounted for by companies with an interest–coverage ratio of less than 1. The government stepped in by imposing a minimum import price, to prevent Chinese steel companies from dumping their products in the Indian market. The move helped the Indian steel companies, but they along with other companies in different sectors continued to remain under stress as the overall market situation was yet to improve. Even by 2016, the share of companies with an interest–coverage ratio of less than 1 in total corporate debt of Indian banks remained high at 40 per cent.

  What happened in India during those years was a classic replay of events that have taken place in many other countries and are globally characterized as a twin balance sheet problem. There was a sudden spike in borrowing. The corporate sector was overleveraged and faced debt-servicing problems. At the same time, financial companies, or primarily the banks, were weighed down by rising volumes of non-performing or bad loans, which eroded their capital. As there was some reluctance or delay in the government recapitalizing the banks as their majority shareholder, fresh lending for projects suffered, which in turn raised a question mark on growth and the much-needed investments in key infrastructure areas.

  Yet, India’s twin balance sheet problem was different in quality and its outcomes. For one, its impact on economic growth was not very significant compared to what happened to many other developed countries in Europe and the US, where there was economic slowdown after the global financial crisis of 2008. Ironically, the predominance of public-sector banks in India’s financial sector ensured that the adverse impact of the twin balance sheet problem on the economy’s growth prospects was significantly minimized. Even though the public-sector banks saw the volume of their sticky loans rising, there was no way the government, as the majority shareholder, reined them in for fear of any adverse impact on investments. A government keen on an early removal of the infrastructure gap in the economy was using its lever of control on the banks it owned to keep the loan flow unimpeded. Even the RBI, led by a former finance secretary, agreed to indulge in regulatory forbearance and allowed the banks to restructure their stressed assets so that their loan programmes remained unaffected.

  The absence of an effective law on bankruptcy to wind up companies that failed to honour their loan repayment obligations also helped in prolonging the twin balance sheet problem. Instead of even enforcing the available legal provisions like the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, which could have been used for recovery of bad loans, the government, the banks and the central bank maintained an accommodative stance towards defaulting debtors. This was done in the hope that the economy would perhaps turn for the better, like it did from 2004 onwards, and the troubled projects would turn the corner, resolving the twin deficit problems in the process.

  Then and Now

  By 2014–15, the banking sector allowed troubled enterprises to defer their loan repayment schedule and forbearance accounted for as much as 6.4 per cent of their outstanding loans. In addition, fresh loans too were extended to them so that these enterprises could regain strength to overcome the financial headwinds till demand recovered. Ironically, this only led to an increase in the overall burden of stressed assets as the financial system now had to bear the burden of not only actual bad loans but also those that were restructured or ever-greened.

  The Economic Survey for 2016–17 quoted market analysts to state that the unrecognized debts were ‘around 4 per cent of gross loans, and perhaps 5 per cent at public-sector banks’. The total stressed assets for the banking sector by the end of 2016–17 thus had been estimated at 16.6 per cent, of which 9 per cent loans were gross NPAs and another 3.6 per cent were restructured. For the public-sector banks, the situation was worse at a total stressed assets estimated at 20 per cent—of which 11 per cent of loans were gross NPAs and 4 per cent loans were restructured. In this respect, the Survey had argued that India was following the model made famous by China, which too had followed a path of allowing a credit surge, irrespective of the magnitude of stress, to keep the growth engine revving. However, there are serious doubts and questions on the sustainability of that model as subsequent years, at least in India, began to show.

  This was also not the first time that Indian ba
nks ran up huge amounts of sticky loans or Indian companies became unsustainably leveraged. The banking sector’s NPAs had risen as sharply between 1997 and 2002, when they were estimated at 11 per cent of gross advances. The problem was more acute for public-sector banks at 12 per cent of NPAs, as the private banks performed better and their numbers brought down the NPA level by a percentage point. Of course, the total size of NPAs was lower at Rs 71,000 crore in 2002, compared to the total gross advances estimated at Rs 6.81 lakh crore.

  Like the 2013–16 NPA crisis, the banking mess in 1997–2000 was also caused by a combination of domestic and international factors. The Asian meltdown of 1997 had its own impact on Indian exports and companies in particular. The nuclear tests conducted by the Indian government in May 1998 evoked a strong response from the global community and financial flows to India were impacted as the US, Japan and other countries imposed sanctions on India. These sanctions were lifted only after a few years. Making things worse for the financial sector were the economic slowdown—the annual growth rate declined from 7 per cent in 1994–97 to 5 per cent in 1997–2002—and the downturn in the information technology industry as the high expectations of business growth in the wake of the Y2K phenomenon turned out to be exaggerated and remained largely unfulfilled. The turn of the century had given hopes to the information technology industry that likely disruptions in view of the advent of the new century and the resultant technological need for adjustments would keep their business growing at a rapid pace. However, such hopes were simply exaggerated and eventually dampened the Indian economy’s prospects.

  There were similarities as well as differences between what happened to the financial sector in 2013–16 and in 1997–2002. They were similar because both external and domestic factors were at play. Also, the sectors that showed exuberance in using debt to finance growth belonged, by and large, to the same sectors—steel, power, textiles and commodities. But the reasons that led to the NPA crisis in the two periods were different.

  The first difference lay in the fact that the NPA woes that hit the financial sector at the turn of the century were of a smaller size, while what happened in 2013–16 was much bigger in impact. Bank credit in 1997 was just 18 per cent of the GDP and was growing at the rate of 12 per cent per annum. But bank credit was about 32 per cent of the GDP in 2012, just before the NPA crisis of 2013–16, and was growing at over 24 per cent. The second difference, and a crucial one, was that the earlier NPA crisis solved itself without any major policy intervention. Commodity prices, which had remained depressed for several years and adversely affected the financial performance of many companies, had begun to rise again, indicating an upturn in the commodities cycle. This boosted overall demand, the pace of economic activities picked up and businesses got back in the black. Eventually, the NPA crisis had begun to get resolved virtually on its own and as a result of the upturn in commodity prices.

  Thus, there was no need for any preventive or remedial action either from the government or the RBI, even though there were many such demands. The NPA crisis of 2013–16, however, was bigger and more serious in nature. There was an early attempt to follow the steps that the government had adopted the previous time such a crisis had erupted: Wait out the crisis in the hope that the economy would recover, demand would pick up and the international economic environment would get better. This is perhaps one of the reasons for the delayed remedial action from the RBI and the government debating over what action it should take with regard to the public-sector banks.

  The question that will be debated for long is whether the RBI acted quickly enough to resolve the NPA crisis for banks. There were many warning signals for the RBI and the government to act more promptly and decisively to tackle the banking crisis. As early as in June 2014, the RBI’s Financial Stability Report had painted a rather grim scenario for the banking sector. It had noted the following:

  The banking sector is facing some major challenges, mainly relating to public-sector banks. Although there has been some improvement in the asset quality of scheduled commercial banks since September 2013, the level of gross non-performing advances as a percentage of total gross advances of public-sector banks was significantly higher as compared to the other bank groups. While the ownership pattern and recapitalization of public-sector banks are contingent upon government policy and the fiscal situation, there is a case for reviewing the governance structures of the public-sector banks, with a greater emphasis on market discipline.

  Even earlier on 4 September 2013, when Raghuram Rajan assumed office as the new governor of the RBI, the NPA concerns received due attention in his first statement. He said, ‘Finance is not just about lending, it is about recovery loans also. We have to improve the efficiency of the recovery system . . . I have asked Deputy Governor Dr Chakrabarty to take a close look at the rising non-performing assets and the restructuring/recovery process, and we too will be taking next steps shortly.’

  In spite of such concerns, the RBI and the government took several more months before any credible and effective action plan could be initiated to strengthen the public-sector banks and address the growing NPA problems of the banking sector. It was only in the middle of 2016 that the Insolvency and Bankruptcy Code got enacted to give powers to the banks to enforce early resolution of bad assets. And the government announced its public-sector bank recapitalization plan only in October 2017. As events would later show, this delay would cost the Indian economy and the financial sector dearly.

  The Rajan Era

  Raghuram G. Rajan, who was the governor of the RBI for three of the years when India’s banking crisis went from bad to worse, has an interesting anecdote to explain why Indian promoters and Indian bankers have a mindset that is largely responsible for bringing down the financial sector to its knees. Early in his tenure as the RBI governor (he moved from North Block as chief economic adviser in the finance ministry to head the central bank in Mint Road in Mumbai in September 2013), Rajan happened to be seated next to the CEO of a public-sector bank during a plane ride. The conversation Rajan had with the bank honcho revealed a lot about how bankers looked at credit discipline.3

  The bank CEO told Rajan about a well-known promoter of a company, who was gaming the banking system by paying off the loans taken from one bank with the money obtained from drawing a loan from another bank. This was his way of financing his enterprise, even though it was clear to both the banker and the promoter that it was a failing business. On one occasion, the promoter had promised the banker that the loan would be repaid with the money he was getting. But what he did instead was to divert that money to one of his other enterprises. A promise was broken. The banker was angry. When a curious Rajan asked the banker about his action in response to the non-payment of his loan, the reply showed how accommodating the banking system had become. ‘I cut his credit line by 20 per cent,’ the banker had said. ‘In most countries with a strong financial system, broken promises by an incompetent borrower would be met with a complete cut-off of credit and the initiation of recovery measures,’ Rajan observed in one of his commentaries on the problem of stressed assets in his book, I Do What I Do. In India, all that the banker could think of was to cut the lending by only a fifth of the borrower’s credit line.

  Rajan found two other reasons responsible for the banking system’s failure to resolve its stressed assets. One, even though there were quite a few laws on the statute book that could be used to recover secured debt, the effectiveness of such legal recourse was fairly limited. Indeed, there were at that time at least two laws aimed at helping banks and financial companies recover their debts and facilitate the securitization and reconstruction of loans—the Recovery of Debts Due to Banks and Financial Institutions Act, 1993, and the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. While the former operated through debt recovery tribunals (DRTs), the latter facilitated the creation of asset reconstruction firms and allowed securitization of loans.

  I
n spite of that, however, these laws were mostly used against small promoters, who presumably could not use the services of professional lawyers to defend themselves under these laws. In contrast, affluent promoters with political connections would get away by using the best lawyers, who could use the judicial system to the advantage of the borrowers. Not surprisingly, the amount recovered through the DRTs under the Recovery of Debts Due to Banks and Financial Institutions Act, 1993, was meagre at just Rs 30,590 crore in 2013–14, compared to Rs 2.36 lakh crore of outstanding debt that was waiting to be recovered. While the recovery rate was pretty low, more worrying was the delay—an average wait of four years, against the mandated six months. This also meant that the backlog of cases with DRTs kept rising.

  The second reason cited by Rajan was that bankers were generally averse to taking a patently commercial decision like writing down debt for fear of investigative agencies. There were many cases where a commercially sound decision taken by a bank on restructuring or settling the loan was a subject of inquiry by investigation agencies and the bankers involved in taking such decisions had been asked to defend their decision. This was also a factor for an excruciatingly slow pace of resolution of stressed assets in India.

  The third reason, which Rajan did not specifically cite as a factor contributing to NPAs in the banking sector but nevertheless had a significant role, was the growing nexus between bankers and India Inc. Rajan did talk about how bankers were reluctant to get tough on promoters of companies for violating a loan contract or were averse to taking stringent steps for the recovery of their loans. But behind this reluctance and aversion was the existence of a cosy relationship between some bankers and India Inc.’s leaders. A working paper on frauds in the Indian banking industry,4 brought out by the Indian Institute of Management, Bangalore, estimated that, between 2013 and 2016, ‘public sector banks in India had lost a total of Rs 22,743 crore on account of various banking frauds’. It attributed such frauds to the ‘lack of adequate supervision of top management; faulty incentive mechanism in place for employees; collusion between the staff, corporate borrowers and third party agencies; weak regulatory system; lack of appropriate tools and technologies in place to detect early warning signals of a fraud; lack of awareness of bank employees and customers; and lack of coordination among different banks across India and abroad’.