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Here is what’s common between the fastest growing large economy in the world and its predecessor: Today, both India and China are struggling with balance sheet issues in the corporate sector and have a banking system that is saddled with a large proportion of bad loans. India has gone the way of allowing banks to convert loans into equity. And China is expected to follow a similar approach. But there are problems with this approach.

As the International Monetary Fund (IMF) recently pointed out in a technical note on how the Chinese could proceed on converting debt into equity or securitizing them, these tools are not comprehensive solutions and can, in fact, worsen the problem by allowing non-viable firms to operate. India’s experience bears this out, at least in part. On paper, conversion of loan into equity will reduce the debt burden of companies and the subsequent sale of shares will help banks recover money at least partially—a plausible plan. The reality has proved to be somewhat different.

In June 2015, the Reserve Bank of India (RBI) allowed banks to take a controlling stake in indebted companies under the Strategic Debt Restructuring (SDR) scheme. The Joint Lenders’ Forum, at the time of restructuring the debt, has to incorporate the condition of converting loans into shares if the borrower is unable to attain visible progress over time, thereby acquiring majority stake in the company. The banks are then expected to sell the shares in the stipulated time to a new promoter.

Banks did exercise this option in a numbers of cases but are finding it difficult to change the management or find buyers, and are now reported to be going slow. The central bank earlier this year relaxed the scheme’s norms in a reflection of the difficulty that the banks are facing. According to a recent note by Religare Capital Markets, banks have used this option in 17 cases. But its analysts estimate that a 60-80% write-off would be required to make the SDR cases viable. Banks may also have to refinance these companies.

There are a number of practical issues here because of which the scheme is unlikely to totally address the bad debt problem. For instance, taking control and changing the management or the promoter will work only if they are the real problem, which may not necessarily be the case. RBI governor Raghuram Rajan recently said in his reply to the Public Accounts Committee of Parliament that the overall economic downturn is the real cause for the rise in bad debt. It is possible that because of changes in the business environment, a large number of companies are not able to generate enough cash to repay loans. In such cases, changing the promoter is unlikely to work. Also, value destruction in many cases has been so intense that the conversion of a very small part of debt into equity will give a controlling stake to banks, but will not be sufficient to reduce the debt pile.

The basic issue is this: Why will someone buy businesses that are overburdened with debt and are unable to generate cash even to service loans? Note that these are companies where, in most cases, restructuring of debt has not worked. The scheme can perhaps work if the debt burden is reduced significantly and the business is made viable again. But here, it runs the risk the IMF cautions against—of kicking the can down the road and enabling fundamentally unsound businesses, Rajan’s diagnosis notwithstanding. This is quite aside from the infeasibility of banks having to take massive haircuts—not easy for public sector banks where bad loans are mostly concentrated, as is evident from the failed auctions of pledged assets.

Another problem for state-run lenders is that the government lacks the fiscal space to freely capitalize banks, which will be necessary if non-performing loans are to be fully recognized and judiciously written off. Until that happens, banks will be reluctant to lend even to productive businesses, which will affect economic activity.

Will the Strategic Debt Restructuring scheme solve the bad debt problem? Tell us at views@livemint.com

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