'Bad bank' and development finance institution are Modi govt's bad legacies

Over years, the two institutions will become agents of uncertainty as the government tries to make them work to avoid adverse criticism.

It's an unwritten rule, the world over, across time, that every good government must leave behind a bad legacy. The Modi government has not been the exception that proves the rule. 

It has created two bad legacies. One is the creation of a ‘bad’ bank. The other is reincarnating a development finance institution (DFI). A ‘bad’ bank takes over the dead loans of other banks so that their balance sheets are cleaned up and they can start taking risk and lending again. This is then the way Indian streets are swept--by moving the dirt from one side to the other. 

A development finance institution, an Indian peculiarity from the 1960s, lends money to high-risk, long-gestation projects. We had two till their massive losses forced the government to shut them down between 1999-2001.

So one must ask why governments repeat their mistakes. For two reasons: one, good people can promote bad ideas; and two, a refusal to understand the difference between risk and uncertainty.

For the last 60 years, because of endemic capital scarcity, our governments have focused on eliminating or reducing risk in the economy. Largely, Indian governments have chosen bad ways of doing this.

Thus central planning, price regulation, industrial licensing, government-directed and mandated credit were all bad ways. Indeed, a government-owned central bank was another bad way. The RBI had been private till 1949.

The economic point here is that while reducing or eliminating risk is a worthwhile objective, it has an obverse: it entails low returns. Eventually, this results in low rates of GDP growth. That is, no pain, no gain.

Meanwhile, uncertainty, which has now bobbed back into public policy consciousness, is the Siamese twin of risk. It looks the same but is completely different because while risk can be managed, uncertainty, by its very definition, cannot. For example, there is risk when you face fast bowling but you can manage that risk in a variety of well-known ways. But when the air is heavy there is uncertainty, too, as the ball swings by a degree. The air can’t be managed. 

This distinction was first made almost 100 years ago by an American economist called Frank Knight. 

Bureaucrats, risk and uncertainty 

Our bureaucrats have been entrusted with reducing risk and they have done an admirable job, but in the process they have also increased uncertainty because of the way in which they have reduced risk. 

The reverse is not true because uncertainty is sui generis. Thanks to this obsession with risk elimination, there is no certainty of policy, laws and rules in India. For example, the government thinks the more money it has, the more it can speed up growth. So it keeps tinkering with tax rates and tax policies just as a bowler alters his line and length. But in economies this effort ends up slowing down growth because it raises the risk for investments by increasing the uncertainty in the policy regime.

The only certainty

Over the next few years, both the bad bank and the new DFI will become important agents of uncertainty as the government tries to make them work to avoid adverse criticism. It will try to reduce risk and thus increase uncertainty.

That’s why, as far as the bad bank is concerned, the simplest solution was to just write off the 3 lakh crore it takes on its books. That isn’t unaffordable. As for the DFI, it has been allotted one lakh crore of capital from the exchequer. It now needs to look for five or six times more of that much--and also to find ways of dealing with the problems of public scrutiny. 

One can only wish both creations all the best. But luck can be scarce.