Financial stability

Developing a bond market should be among key policy priorities

Reserve Bank of India (RBI) Governor Raghuram Rajan has called for closer monitoring of the threat to banks from weakening corporate performance and thus the debt-servicing capabilities of leveraged business groups. Indeed, the proportion of bad loans held by large borrowers has risen to over 87 per cent and the gross non-performing assets (NPAs) of scheduled commercial banks as a percentage of their loans are now over five per cent. According to one estimate, banks in India have leverage of roughly 20 times. Losses of roughly five per cent of total assets should thus be sufficient to bring down a bank. Since the recovery rate for NPAs is roughly 20 per cent, all that bankruptcy requires is gross NPAs of roughly six per cent of total assets. Many banks in India are flirting with danger of this nature.

While bad news about banks can be hidden, bad news about borrowers is visible to all. Roughly a third of the overall corporate balance sheet is in firms which are not producing enough operating profit to pay interest. Banking regulation and supervision are about ensuring that matters do not come to such a pass. This requires tough rules about loss recognition and about adequacy of equity capital. It requires an effective supervisory system. The RBI, therefore, must ensure that banks are not allowed to hide bad news.

It must, however, be noted that India is not likely to have a dramatic banking crisis with PSU banks having a virtually unlimited government guarantee. Things have been held up in the past by three factors: a cartel of banks which pays low interest rates on current accounts and savings account, a steady injection of taxpayer money into banks, and high growth in the size of banking. With a sharp decline in nominal GDP growth, the third factor has been removed. Injections of taxpayer money into banks will become more difficult given the acute fiscal stress. The cartel of banks has been challenged by some new entrants and will become increasingly unsustainable given the activities of the Competition Commission of India. Hence, the ways of the past will not carry forward into the future. The strategy of weak regulation and supervision, coupled with hiding bad news, has been utilised in Japan and China. Japan got "lost decades" of bad economic growth as a consequence, and China is also on the early stages of that process.

Simplistic solutions involve putting in more taxpayer money. This is a poor use of taxpayer resources, much like putting taxpayer money into Air India is unwise. Fiscal constraints also rule out a resource outlay of the scale required. Solving this problem requires reforming regulation, enacting and implementing the new bankruptcy code, and reducing the government's stake in PSU banks. It appears hard for the government to muster the public administration capabilities required to achieve success on all three fronts simultaneously. On a horizon of five years, it appears unlikely that substantial progress will be made on all three fronts. For all practical purposes, slow growth in bank credit could hold back GDP growth in coming years. One tool through which policy makers can alleviate the pain, at least for the top 1,000 companies of the country, is by developing the bond market. However this also involves confronting political economy constraints, as was seen in the roll back of the bond market initiatives of Budget 2015.