'Of Counsel': Arvind Subramanian on how RBI missed 'Draghi moment'

By not reacting faster to the 'twin balance sheet' crisis the RBI missed the opportunity to emulate the governor of the ECB's 'demarche of determination' in dealing with the European debt crisis

When I first took up the CEA’s job, I had the sense — which I articulated publicly two months into my tenure — that the corporate and banking sectors were both deeply stressed after the boom of the noughties. The problem turned out to be even more serious than I had originally understood, and my thinking on the strategy to address it evolved considerably. For example, I was initially in favour of creating a bad bank like many countries had done to solve the TBS  [twin balance sheet] problem. I still believe that a bad bank could have resolved the problem much more quickly, and hence at a lower cost to the taxpayer. However, I have accepted that a ‘judicial strategy’ was necessary, [because] … the government felt it lacked the legitimacy to deal with the problem directly. 

This judicial strategy has made a good start, facilitated by one of the big achievements of the government, namely, the passage of a new bankruptcy code. Even so, the year 2018 has proved an annus horribilis for the financial system with a series of scandals beginning with Nirav Modi, extending to some senior private bankers, then spreading to India’s non-bank financial companies such as IL&FS….

It cannot be emphasized enough that the origin of today’s TBS problems goes back to the early years of the new millennium, the Original Sin being the reckless lending that occurred during the boom period in which private infrastructure projects were financed not by the capital market, not by private-sector financial institutions, but by public-sector banks (PSBs). …

Both government and RBI [Reserve Bank of India] need to make major changes, including allowing for privatization of some public-sector banks and serious reconsideration of the RBI’s effectiveness as a regulator and supervisor. Without these changes, it will take too long to solve the recent problems, and they are likely to recur. … 

Even now, I find myself wondering why it took so long to address the TBS challenge, when it was such a serious economic problem. So perhaps it is worth going through the history of action and inaction, not to assign blame but to draw lessons for the future. 

The scale of mounting debt was first quantified and highlighted by the outstanding work of Ashish Gupta at Credit Suisse, one of the few heroes in the sordid banking saga, first with his report on Non-performing Assets (NPAs) in the corporate sector in 2010, followed by the ‘House of Debt’ report in 2011. The RBI had also been aware of the mounting problem in the early 2010s. 

Nothing fundamental was done to address the problem between then and 2014, either by the RBI or the previous government, a period of catastrophic neglect….

When the new government came into power in 2014, it took some action by implementing a package (Indradhanush, meaning rainbow) of recapitalizing the banks, and the RBI launched a series of initiatives to facilitate resolution between banks and companies. Not just in retrospect, but even at the time, it was clear that Indradhanush and the RBI’s efforts were inadequate financially and also failed to provide any mechanism for debt write-downs, which are at the heart of the TBS challenge.... 

The government’s cautious approach owed to a number of reasons. Growth accelerated in the first two years of the government’s tenure, creating the impression that the problem would solve itself. It also provoked the question of ‘how serious can the problem be if growth is so good?’ Moreover, being in fiscal consolidation mode, the government felt it did not have the resources to fill the gap that would have been left in the banks if the problem of the NPAs had been fully recognized and tackled. That made it difficult to go for solutions that are more serious. 

Perhaps the deeper caution of the government in grasping the nettle of the TBS could be attributed to the zeitgeist of stigmatized capitalism. The accusation of ‘suit-boot ki sarkar', the perceived differential treatment of indebted fat cats (corporates) versus debt-burdened poor farmers, and the fear that decisions by public-sector bank managers would be the object of investigation … made the writing down or writing off of loans— absolutely vital to any solution—virtually impossible. … To a certain extent, this situation occurred because a series of RBI initiatives allowed a form of ‘extend and pretend’, postponing repayments to a day of reckoning far in the future. It was only in 2015, two years into Raghuram Rajan’s tenure, that the RBI started pushing banks to come clean on the magnitude of the problem, under its AQR…. 

It is, of course, nonsensical to blame Raghuram Rajan for the growth slowdown and for banks failing to extend more credit after 2014. If the RBI had not initiated the AQR, there would have been even further delays in tackling the NPA problem; the fraud would have continued, and the cost of cleaning up the mess would have continued to rise…. 

Counterfactual exercises are always risky. But it is interesting to speculate on what might have happened if the RBI had undertaken the AQR much earlier. It’s possible that the government might still have balked at providing the necessary resources, especially as the fiscal position in those years was still tight and the government was trying to reduce the deficit. But perhaps not. After all, the problem is fiscally not that expensive. A rough calculation suggests that it requires a maximum of 3-4 per cent of GDP, which is small compared to the government’s resources, and the typical emerging market banking crisis of 10-20 per cent of GDP. 

Even if the government had balked at the cost, the RBI could have initiated a negotiating dynamic with the government that might have helped move things forward. For example, the RBI could have said, ‘We put up some of the resources from our own balance sheet, as other central banks have done in the wake of the global financial crisis. In return, you bite the bullet on creating the conditions for writing down debt or even creating a bad bank.’ The RBI, sadly, missed a Draghi-esque (Mario Draghi, governor of the European Central Bank) ‘do whatever it takes’ demarche of determination, which could potentially have changed the entire dynamic around the TBS challenge.

Of Counsel: The challenges of the Modi-Jaitley economy

Author: Arvind Subramanian 

Publisher: Penguin Viking

Price: Rs 699

Pages: 336

Reproduced with permission