Eco Survey
Chapter 4: FESTERING TWIN BALANCE SHEET SYNDROME
· Public sector Banks reported in Feb 2016 that nonperforming assets (NPA) had soared, to such an extent that provisioning norms had overwhelmed the operating earnings of the banks resulting in poor balance sheets.
· As a result, net income had plunged deeply into the red.
Reasons for NPA:
· Normally, NPAs soar when there is an economic crisis, triggering widespread bankruptcies, examples being East Asia during 1997-98 and the US and UK in 2008-09.
· The RBI had conducted an Asset Quality Review (AQR), following which brought the clear picture of NPAs in the bank.NPAs reached 9 percent of total advances by September --
double their year-ago level.
Other features of NPA:
· Bad loans were concentrated in PSBs only. More than four-fiths of the non-performing assets were in the public sector banks, where the NPA ratio had reached almost 12 percent.
· India was suffering from a “twin balance sheet problem”, where both the banking and corporate sectors were under stress.
· At its current level, India’s NPA ratio is higher than any other major emerging market (with the exception of Russia), higher even than the peak levels seen in Korea during the East Asian crisis.
REASONS for twin Balance sheet syndrome:
· Corporations over-expand during a boom, leaving them with obligations that they can’t
repay. So, they default on their debts, leaving bank balance sheets impaired, as well.
· This combination proves devastating for growth
· The hobbled corporations are reluctant to invest,
· Those that remain sound can’t invest much either, since fragile banks are not really in a position to lend to them.
· However, this was not the India’s case. Though India boomed during the mid-2000s along with the global economy, it sailed through the GFC largely unscathed, with only a brief interruption in growth before it resumed at a rapid rate.
· Indian companies and banks had avoided the boom period mistakes made by their counterparts abroad. They were prevented from accumulating too much everage, because prudential restrictions keeping bank credit from expanding excessively during the boom and capital controls prevented an undue recourse to foreign loans.
The question then is what went wrong?
· The origins of the NPA problem lie in decisions taken during the mid-2000s. During that period, all world economies were booming, India’s GDP growth had surged to 9-10 percent per annum.
· Everything was going right: corporate profitability was amongst the highest in the world, encouraging firms to hire labor aggressively, which in turn sent wages soaring
· Firms launched new projects worth lakhs of crores, particularly in infrastructure-related areas such as power generation, steel, and telecoms, setting off the biggest investment boom in the country’s history.
· Within the span of four short years, the investment-GDP ratio had soared by 11 percentage points, reaching over 38 percent by 2007-08.
· This investment was financed by an astonishing credit boom, also the largest in the nation’s history, one that was sizeable even compared to other large credit booms internationally.
· In the span of just three years, running from 2004-05 to 2008-09, the amount of non-food bank credit doubled.
· There were also large inflows of funding from overseas, with capital inflows in 2007-08 reaching 9 percent of GDP. All of this added up to an extraordinary increase in the debt of non-financial corporations.
· As double digit growth beckoned, firms abandoned their conservative debt/equity ratios and leveraged themselves to take advantage of the perceived opportunities.
· But just as companies were taking on more risk, things started to go wrong. Costs soared far above budgeted levels, as securing land and environmental clearances proved much more difficult and time consuming than expected.
· At the same time, forecast revenues collapsed after the GFC; projects that had been built around the assumption that growth would continue at double-digit levels were suddenly confronted with growth rates half that level.
· The financing costs increased sharply. Firms that borrowed domestically suffered when the RBI increased interest rates to quell double digit inflation. And fims that had borrowed abroad when the rupee was trading around Rs 40/dollar were hit hard when the rupee depreciated, forcing them to repay their debts at exchange rates closer to Rs 60-70/ dollar.
· Higher costs, lower revenues, greater financing costs — all squeezed corporate cash flow, quickly leading to debt servicing problems.
· By 2013, nearly one-third of corporate debt was owed by companies with an interest coverage ratio less than 1 (“IC1 companies”), many of them in the infrastructure (especially power generation) and metals sectors.
· By 2015, the share of IC1 companies reached nearly 40 percent, as slowing growth in China caused international steel prices to collapse, causing nearly every Indian steel company to record large losses.
What Explains the Twin Balance Sheet Syndrome with Indian Characteristics?
· India did indeed follow the standard path to the TBS problem: a surge of borrowing, leading to over leverage and debt servicing problems.
· What distinguished India from other countries was the consequence of TBS.
· Even as Indian balance sheets have suffered structural damage on the order of what has occurred in crisis cases, the impact on growth has been quite modest.
· TBS did not lead to economic stagnation, as occurred in the U.S. and Europe after the
GFC and Japan after its bubble burst in the 1990s.
· To the contrary, it co-existed with strong levels of aggregate domestic demand, as reflected in high levels of growth despite very weak exports and moderate, at times high, levels of inflation.
But other factors also played a role, including the unusual structure of the economy.
· India has long suffered from exceptionally severe supply constraints, as the lack of infrastructure has hindered expansion of manufacturing and even some service activities, such as trade and transport.
· These constraints were loosened considerably during the boom, as new power plants were
installed, and new roads, airports, and ports built.
· As a result, there was ample room for the economy to grow after the GFC, even
as the infrastructure investments themselves did not prove financially viable.
· So, the legacy of the historic mid-2000s investment boom was a curious combination of both TBS and growth. In comparison, the US boom was based on housing construction, which proved far less useful after the crisis.
· And in any case, the US never suffered from severe supply constraints.
· Perhaps the most important difference between India and other countries, however, was the way in which the financial system responded to the intense stress on corporations.
· In other countries, creditors would have triggered bankruptcies, forcing a sharp adjustment that would have brought down growth in the short run (even as the reconfiguration of the economy improved long run prospects). But in India this did not occur.
Instead, the strategy was, as the saying goes, to “give time to time”, meaning to allow time for the corporate wounds to heal. That is, companies sought financial accommodation from their creditors, asking for principal payments to be postponed, on the grounds that if the projects were given sufficient time they would eventually prove viable.
· Initially, this request seemed reasonable. For a start, the “giving time to time” strategy
had worked well in the previous business cycle, during the early 2000s.
· At that time, nonperforming loans had also reached high levels, but they then subsided a few years later when demand picked up and commodity prices recovered.
· It seemed sensible to assume the same might happen this time too, because India would eventually need the infrastructure capacity that was being installed.
· Accordingly, banks decided to give stressed enterprises more time by postponing loan repayments, restructuring by 2014-15 no less than 6.4 percent of their loans outstanding
· They also extended fresh funding to the stressed firms to tide them over until demand recovered.
· As a result, total stressed assets have far exceeded the headline figure of NPAs.
· To that amount one needs to add the restructured loans, as well as the loans owed
by IC1 companies that have not even been recognized as problem debts – the ones that
have been “evergreened”, where banks lend firms the money needed to pay their interest obligations.
· Total stressed assets would amount to about 16.6 per cent of banking system loans – and nearly 20 percent of loans at the state banks
Is the Strategy Sustainable?
· In principle, a financing strategy can indeed be sustainable.
o Accelerating growth would gradually raise the cash flows of stressed companies, eventually allowing them to service their debts.
o The inherent dynamism of the Indian economy would carry the impaired companies and banks along with them
· The Indian economy could still grow out of its balance sheet problems.
o Under the “containment” scenario, the NPAs would be limited in nominal terms as a share of the economy and a proportion of bank balance sheets, since GDP is growing at a nominal rate of more than 10 percent.
o In that way, the twin balance sheet problem, while never being explicitly solved, could simply fade away in importance.
· Stressed companies are consequently facing an increasingly difficult situation. Their cash flows are deteriorating even as their interest obligations are mounting – and if they borrow more, this will only cause the gap to widen further.
· In some cases, companies have tried to “square the circle” by selling off some of their assets. But this has sufficed mainly to buy them time, since selling off assets provides immediate revenues but leaves firms with less income to service their debts in the future.
· The aggregate financial position of the stressed companies consequently continues to with losses (roughly, the excess of interest payments, depreciation and taxes over EBIT and asset sales)
· The situation in the power sector illustrates these problems the best.
· At the same time, corporate stress seems to be spreading. For much of the period since the Global Financial Crisis, the problems were concentrated in the large companies which had taken on excessive leverage during the mid-2000s boom, while the more cautious smaller and midsize companies had by and large continued to service their debts.
· However in second half a significant proportion of the increases in NPAs – four-fifths of the slippages during the second quarter – came from mid-size and MSMEs, as smaller companies that had been suffering from poor sales and profitability for a number of years struggled to remain current on their debts.
· Countries with TBS problems tend to have low investment, as stressed companies reduce their new investments to conserve cash flow, while stressed banks are unable to assume new lending and this seems to be happening in India, as well.
· To cushion the impact on the overall economy, public investment has been stepped up considerably, but this has still not been sufficient to arrest a fall in overall investment.
· In the short run, the economy can continue to expand briskly on the back of consumption, with firms fulfilling demand by using the capacity that was built up during the boom years.
· TBS is taking a heavy toll on the health of the public sector banks.
o At least 13 of these banks accounting for approximately 40 per cent of total loans are severely stressed, with over 20 per cent of their outstanding loans classified as restructured or NPAs.
· Banks around the world typically strive for a return of assets (ROA) of 1.5 per cent or above. But Indian public sector banks are much below this international norm. In fact, their ROA has turned negative over the past two years.
Read more download file.......
