The default jolts from the Infrastructure Leasing and Financial Services (IL&FS) conglomerate continue to reverberate through the system. As immediately implied by the unusual statement jointly issued by the Reserve Bank of India (RBI) and the State Bank of India (SBI) on Sunday, 23 September, to soothe the markets, IL&FS is too connected to fail.
This episode happened just when the tanking rupee seemed to be stabilizing, just when a current account deficit (CAD) projected at 2.4 % of gross domestic product (GDP) for the current year had been talked through as not unduly threatening, given the size of external reserves, and just when the flight of footloose jewellers from Default Street looked to be tapering off.
Credit rating agencies had lagged behind bond market participants on evaluating IL&FS debt instruments. The capital market regulator, Securities and Exchange Board of India (SEBI), actually held a meeting with rating agencies, urging them to take cognizance of bond spreads. Further complicating the problem is that the parent holding company, of what is a large unwieldy group of subsidiaries, is not listed and, therefore, not subject to SEBI disclosure requirements.
However, three of the subsidiaries are listed, and they have notably not defaulted so far. The regulatory gaze of the RBI is confined to non-banking financial companies (NBFCs) taking deposits from the general public, in which category neither the holding company nor its subsidiaries belong. The holding company is registered with the RBI as a core investment company (CIC), and one of the subsidiaries as a systemically important, non-deposit taking NBFC (ND-SI-NBFC), but any regulation going with these categories is administered at best with a light touch.
While we pick up the pieces, it is fruitful to look at what the episode reveals about the structural defects in the Indian financial system, which underlie rating and regulatory failure.
The first of these is the oft-mentioned feature of the group, that it had marquee names on its masthead. Although the erstwhile IL&FS board was completely replaced by the government on 1 October, the larger structural problem remains in other companies, other boards. Marquee names are a huge problem in India, because they hold on tenaciously to their positions, and call for surrender in a hierarchy.
There are very sharp youngsters in the financial sector, who I suspect are restrained from standing up to stalwarts at the top of their reporting hierarchy. This may not be an Indian so much as an Asian shortcoming. There is the well documented case of Korean Air disasters in the late 1990s, where the co-pilot could not presume to correct the pilot’s error even when he knew they would all die from it.
The further problem with marquee names is that simply having them on a company board relaxes due diligence procedures among lenders. Cozy rating, cozy diligence and cozy lending are not a matter of related parties alone (although that too), but of the signalling power of a name or names on the masthead of a borrowing entity.
The second defect is the peculiarly Indian phenomenon of seemingly privately-owned entities, in which substantial stakes are held by the public sector. With this, the private entity transfers risk to the public exchequer, and engages in far riskier behaviour than if the capital being played with was entirely privately-owned. Large equity stakes in IL&FS were held by the Life Insurance Corporation (LIC, the publicly owned insurance behemoth) and public sector banks such as SBI and Central Bank of India, alongside private investors, both foreign (Orix Corporation and the Abu Dhabi Investment Authority) and domestic (Housing Development Finance Corporation). Although the annual reports of SBI and LIC may report equity exposure to other entities in some corner, there is now a desperate need for this information to be given in a centrally collated place.
The reporting requirements under the Fiscal Responsibility and Budget Management (FRBM) Act of the central government do not call for information on equity contributions and lending by cash-rich publicly-owned parastatals such as the LIC. Nor, needless to say, does it carry this information on public sector banks. If this information were given in a matrix array as part of the Union budget documents, in terms of both the stock of equity held in other (public and private) commercial enterprises, as well as the flow addition in the reporting year, we would have, for the first time, some sense of the financial stakes of the public sector as a whole in private companies like IL&FS.
The third defect in the system is the widely-known phenomenon of delays in payments from government departments to companies for work executed or products supplied. In the particular case at hand, the National Highways Authority of India (NHAI, an autonomous agency of the Union government) was in default of payments due to IL&FS for works executed. The amount claimed is in dispute and the arbitrator is expected to mandate only a fraction of the claim as actually due. This is a dispute between a fully publicly funded entity (NHAI) and a company to which the public sector has sizeable equity and debt exposure.
FRBM legislation at both central and state levels has gone seriously astray. The key words in the legislation—responsibility and management—have been interpreted to mean just deficit or public debt targets. FRBM legislation does not carry any provision whatsoever for protection of budget provisions as passed in the demands for grants by the Parliament. All expenditure flows are necessarily tranched, but there are no clear dates for tranches due, and no provisions for penalties if due dates are crossed by a certain permissible number of days. When payments are due, and a department or autonomous undertaking like NHAI has itself not received the funds with which to pay an outside contracted supplier like IL&FS, the usual procedure is to find fault with the quality of work done or goods supplied. If the work was indeed substandard, the penalties leviable should in principle have been laid down in the contract, such that the sums owed in both directions are known clearly in advance. Had there been a fully specified contract of that kind in place, there would have been no cause for delay in the payments due.
This latest financial jolt came in the face of a widening external CAD, which has raised issues about the structural defects in the real economy. On the balance of trade, there is finally some econometric evidence presented in the latest annual report of the RBI for 2017-18 that disruptions in domestic supply chains following demonetization did indeed result in a surge in imports replacing domestic industrial inputs.
The report terms this phenomenon ‘reverse import substitution’, as this is the reverse of the import substitution that we tried to do during the socialist era. The exercise, in an extremely painstaking way, isolates the impact of demonetization amid the whole host of overall macroeconomic factors, including exchange rates and domestic price conditions, which together determine the ratio of imported to domestic industrial inputs.
The regression results show that there was indeed a sizeable and statistically significant ramp up in imports of industrial inputs during a defined post-demonetisation period. It also finds that post-goods and services tax (GST), from October 2017 to May 2018, there was a decline in import intensity, although a much smaller effect, suggesting that the earlier import thrust had not been fully reversed by May 2018.
What is more worrying than the demonetization impact, which could in principle be entirely reversed, is the coefficient of a term in the estimated equation showing the ratio of imported inputs going up in response to growth in domestic industrial output more generally. This is about the demand for industrial inputs skewing more in the direction of imports than domestic supply (not the same as the income elasticity of demand of imports in aggregate, which throws together imports of final goods and inputs into the same pot). The report attributes this to “constraints on domestic availability".
It is, however, not entirely clear whether the study covers all industrial inputs or just raw material inputs. If the latter, then constraints on domestic production of iron ore would be an example of an explicit domestic constraint (whether imposed by the judiciary or the executive). But if it extends also to produced inputs like steel, a “domestic availability constraint" suggests that it is just much easier for an industrial unit to import than to get delivery on a domestic order. That is a far more serious and debilitating phenomenon, pointing as it does to widening trade deficits going forward, since supply constraints cripple export growth as well.
This is consistent with recent work by Pranjul Bhandari in which she finds that aggregating across exports of goods and services, domestic constraints accounted for half of the decline in export performance over 2014-18 and much more in goods alone.
A more recent overlay, in the form of the failure of the GST machinery to adequately refund tax credits to exporters, can be treated in principle as a transitory factor. Even if GST gets its house fully in order, and exporters receive their refunds in time, there remains an abundance of structural factors limiting export growth.
The flip side is that the Indian economy can soar if structural constraints in both financial and real sectors are removed. The need of the hour is to recognize and remove them. Posting higher tariffs on imports will achieve nothing at all, other than maybe to afford some transient fiscal relief.
Indira Rajaraman is an economist.