Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

The big question: how India should deleverage

Steps taken by policymakers so far have not improved the situation as they were expected to

In his first press conference as governor of the Reserve Bank of India (RBI), Urjit Patel said that dealing with the bad loan problem would require skill and creativity. The banking regulator has tried a number of things in recent times in order to address the problem, but the situation has not improved as desired at the aggregate level for the banking system, which is struggling with toxic assets worth Rs6.3 trillion.

The new Fiscal Monitor of the International Monetary Fund shows that India is not alone in dealing with high leverage and its effects. At 225% of the world gross domestic product, gross debt in the non-financial sector, (including government, household and non-financial firms) is at an all time high. It is not only a risk for financial stability—high levels of debt in the private sector can also affect growth as indebted borrowers begin to cut consumption and investment.

Banks are also unwilling to lend in such conditions, which can, in some cases, increase the problem due to non-availability of credit. To an extent, this situation is currently playing out in India as investment continues to remain weak. Even though leverage in the Indian private sector is at a much lower level compared with other emerging market economies such as China, it is still a big financial stability risk. Also, unlike some of the other emerging market economies, which accumulated higher debt due to easier financial condition in the global market, private sector leverage in India is a consequence of the post-2004 credit boom and lax lending standards.

Policymakers in India understand the importance of getting out of this situation and have taken several steps in the right direction, but success has not yet been forthcoming. It is possible that India is unable to solve the bad debt problem because the government intervention has been limited. “...without government intervention, balance sheet repair often proceeds very slowly, because of coordination problems, market failures, and the inability of distressed banks to absorb losses," the Fiscal Monitor notes.

Government intervention can happen in multiple ways and depends on specific conditions and the availability of fiscal space. For instance, the government can intervene directly and extend financial support to households and corporations if the credit channel is not working, as the US did in 2008. It can also incentivize restructuring of debt, as Korea did in 1998-99. The government may also recapitalize banks or increase government spending in general to push economic activity and help reduce debt.

There are at least five broad lessons from past experience that can help India deal with the problem of debt.

First, although the government of India lacks fiscal space at the moment, lack of timely decisive action can result in a prolonged period of suboptimal outcomes which may end up increasing the cost of adjustment in the longer run, as has happened in Japan.

Second, the government and the RBI should incentivize companies and banks to clean up their balance sheets. This may not happen without a sound bankruptcy framework. Therefore, the implementation of the bankruptcy code is important, as it will help create an enabling ecosystem where bad assets can be disposed of more efficiently. It is being speculated that the government might create a bad bank to take over bad loans from commercial banks. Bad banks may have worked in other countries, but it’s a bad idea for India in the current circumstances. Most of the bad loans in India are concentrated in the books of public sector banks and pricing will be a big problem. Also, it could become a way to bailout crony capitalists. Shareholders of highly leveraged companies must share the pain of bad decisions, and any pragmatic approach by the government or the RBI should not become a free ride.

Third, the government should reassess the capital requirement of public sector banks. It is important that banks are adequately capitalized. It might be sensible in the short run to first recapitalize large and more efficient banks. This will not only increase return on investment, but will also start the flow of credit in the economy in a more meaningful way. In the medium term, the government can work on how state-owned banks can best be restructured so that the cost to the taxpayer is minimized.

Fourth, both the government and RBI should work in the area of improving supervision and oversight. It is important that the system be able to recognize the problem of excessive leverage in the private sector and concentration of bank exposure in particular areas in time.

Fifth, the government should create a fiscal buffer so that it has the ability to intervene if required. India has always had a high deficit bias which limits the government’s ability to take counter cyclical measures. If the government had the fiscal space, it would have easily infused capital in the banking system and moved on.

However, even in the current situation, it would do well to find fiscal space for capital infusion in banks that it owns. History shows that delays increase the cost and affect economic activity.

Thankfully, India is not in a situation where the government is forced to save banks or corporations from failing, as happened in Iceland, the US, and elsewhere in 2008. But it still has a difficult task of providing adequate capital to public sector banks with limited fiscal space. Ample scope to show skill and creativity.

What is the best way to tackle the problem of high leverage? Tell us at views@livemint.com

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