BackThe risks to stability are at the micro level
Why lower interest rates, new regulatory framework to deal with loan defaults and a robust secondary market for distressed assets are the three issues that will matter in 2016
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The manner in which private sector balance sheets are knocked into shape will be one of the most important economic themes of 2016. Three issues will matter above all—lower interest rates, the new regulatory framework to deal with loan defaults and a robust secondary market for distressed assets.
Let us first rewind to the middle of 2013. The Indian economy was a sitting duck during the emerging markets’ panic of those months. The breezy mismanagement of the Indian economy in the last few years of the United Progressive Alliance regime had led to a toxic combination of high inflation, a massive fiscal deficit and a record current account gap. These economic imbalances almost inevitably led to a run on the rupee, soon after the US indicated that its extraordinary creation of new money through quantitative easing would end.
The Indian economy is now far more stable than before, even though it is useful to remember that consumer price inflation as well as the general fiscal deficit is far above the emerging markets’ median. The return of economic stability is the main reason why the rupee was relatively stable in the months leading to the first increase in US interest rates since 2006.
But that does not mean all is well. The risks have shifted—from the macro to the micro. A combination of better fiscal management, interest rate hikes and the collapse of global oil prices helped India. The macro risks have receded. The main risks to economic stability are now at the micro level—the sticks of dynamite hidden in the balance sheets of large conglomerates as well as the problem loans in Indian banks. These are mirror images of each other.
The new Financial Stability Report released by the Reserve Bank of India in December pointed out that one-fifth of all listed companies have excess debt.
Earlier, investment bank CLSA had noted in an October report that the debt of 10 large conglomerates has increased seven times over the past eight years. They account for more than one quarter of all the corporate loans given out by the banks.
The standard measures of financial health such as interest cover and debt-to-operating profits do not paint a pretty picture. Many of these conglomerates that have gorged on debt are in areas where crony capitalism is rife, so there is political economy embedded in the problem of leverage. India is coming to terms with the costs of crony capitalism.
Such financial stress at the end of a credit bubble has almost been foretold in economic history. The key question next year will be how the problem will be resolved.
There are three important issues here.
First, can inflation decline further so that the Indian central bank can slash interest rates to an extent that it eases the ability of deeply indebted firms to service their loans?
Second, will the new regulatory architecture that is emerging be potent enough to ensure that the promoters have strong incentives to put company finances back on track or else lose control?
Three, will India finally see a robust secondary market for corporate assets that creditors have on their books, be it entire firms, specific units or loans sold at a discount?
The rights of creditors have weak protection in India, but that could be changing. Banks have already used the strategic debt restructuring option to take control of several companies, something that was inconceivable a year ago. Investment bankers are hopeful that such takeovers will be followed by deals to sell off the companies that the banks now control, either to other companies or special situation funds. Asset reconstruction companies are also expecting an increase in deal flow in the last quarter of the current fiscal year, as banks sell problem loans at a discount in order to present better financial data to investors in their annual accounts.
Indian promoters are feeling the heat. They have been caught in a pincer movement by a government that wants to attack crony capitalism and a Reserve Bank that does not want promoters to walk away from the mess they have created. It is against this backdrop that the new bankruptcy code is critical. Creditors can trigger insolvency proceedings against companies as soon as there is a default, as against the current system where borrowers can keep banks away till the company is either beyond salvage or money is siphoned off or both.
Why is all this important?
Most economists agree that the nascent economic recovery will lose momentum unless private sector investment picks up. Weak financials are one reason why companies are not in a position to invest in new projects. Excess capacity is the other reason.
The Narendra Modi government has been banking on public investment to drive the recovery till the private sector is ready, and it has switched spending focus from subsidies to capital expenditure. But there is no doubt that a sustainable recovery will need more robust private sector investment. And that is why the deleveraging of large Indian companies will be very important.
It is useful to remember that the splendid corporate recovery after 2004 was preceded by at least five years of painful restructuring. Companies shed assets, re-engineered their factories and cut debt. Their financial burden also got lighter after the collapse in inflation allowed the Reserve Bank under Bimal Jalan to slash interest rates by around seven percentage points.
No recovery is a carbon copy of the earlier one. But economists, investors and policymakers would do well to look at what happened in India in the early years of the century. The groundwork for the subsequent economic boom involved painful financial restructuring in corporate balance sheets. Will 2016 see some variant of this?
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