Arvind Subramanian, in his latest paper, argues that India is facing a Four Balance Sheet challenge.
In the paper titled “India’s Great Slowdown: What happened? What’s the way out?”, Subramanian, along with IMF’s former India head Josh Felman, discuss the reasons and possible remedies for India’s current economic slowdown. Arguing that India’s “growth is feeble, worse than it was in 1991 or indeed at any other point in the past three decades,” both Subramanian and Felman state that the economy is headed for an Intensive Care Unit.
Subramanian discussed the twin balance sheet challenge in great detail in the Economic Survey of 2016-17. Here’s how the malaise spread for it to eventually become a four balance sheet challenge within the span of a couple of years.
Twin balance sheet
Twin balance sheet problem was a result of India’s over-leveraged companies and bad loan-saddled public sector banks. During the boom period of mid-2000s, state-run banks kept on lending while the corporate sector — especially infra companies — saw a period of robust growth fuelled by easily available credit.
“In the span of just three years, from 2004-05 to 2008-09, the amount of non-food bank credit doubled,” noted the Economic Survey of 2016-17. But as the economy hit a snag because of policy paralysis in the UPA era, the unravelling began.
Problem with the company balance sheet
India Inc binged on a diet of easily available credit from state-run banks, taking on more risks and accumulating more debt on their books. But as clearances for land and environment started showing signs of delay and financing costs began to climb, debt servicing became an issue for companies.
“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,” noted the Economic Survey of 2016-17.
The problem with banks
The failure on the part of the infrastructure companies to service debt reflected in the stress that started to accumulate on the balance sheets of state-run banks. As per the Economic Survey, in 2016, “more than four-fifths of the non-performing assets were in the public sector banks, where the NPA ratio had reached almost 12 per cent”.
This resulted in banks becoming more cautious in lending. The NPA problem resulted in more stringent norms of classification of bad debt by the RBI and a number of state-run banks landing up under the RBI’s Prompt Corrective Action (PCA) norms.
Triple balance sheet problem
When banks refrained from lending in the wake of their struggle to contain NPAs, NBFCs became major lenders. This credit flow not only boosted investment but private consumption as well.
But the collapse of IL&FS in September 2018 sent shockwaves through the entire financial system. The inability of the shadow lender to service debt led to a ripple effect, further constraining the ability of banks to push credit.
Nomura’s chief economist Sonal Verma said that the triple balance sheet problem which now includes stress in the balance sheets of NBFCs, has further choked credit in the system.
Four Balance Sheet challenge
In his latest paper named ‘India’s Great Slowdown’, Arvind Subramanian mentions the new ‘Four balance sheet challenge’. The Four Balance Sheet challenge includes the original two sectors – infrastructure companies and banks, plus NBFCs and real estate companies.
The author states that “in this situation, the standard remedies are no longer available. Monetary policy cannot revive the economy because the transmission mechanism is broken. Fiscal policy cannot be used because the financial system would have difficulty absorbing the large bond issues that a stimulus would entail. The traditional structural reform agenda — land and labour market measures — will not address the current problems”.
Subramanian acknowledges, in his paper, that the trouble came to the fore only after the unexpected collapse of the NBFC behemoth IL&FS. It carried a debt of Rs 90,000 crore on its books. Post the IL&FS crisis, the markets began taking note of the wider issues that plagued the shadow banking sector.
“What the markets discovered was profoundly disturbing. Much of the NBFC lending had been channeled to one particular sector, real estate. And that sector itself was in a precarious situation,” reads the research paper.
NBFCs were a major participant in financing the real estate sector’s growth. The paper says, “Historically the bulk of formal sector real estate funding was provided by banks, but in recent years most of the incremental lending has come from NBFCs, so much so that by 2018-19, NBFCs accounted for about half of the Rs 5 lakh crore in real estate loans outstanding.”
But, when demand tapered, debt servicing by builders became difficult and the NBFC balance sheets started accumulating stress resulting in what became a four balance sheet problem.
Finally, the 6-point action plan
To resolve the Four Balance Sheet problem, Subramanian and Felman prescribe a six-point remedy:
1. Launch a new asset quality review to cover banks and NBFCs (Recognition)
2. Make changes to the IBC to better align incentives (Resolution)
3. Create two executive-led public sector asset restructuring companies (“bad banks”), one each for the real estate and power sectors (Resolution)
4. Strengthen oversight, especially of NBFCs (Regulation)
5. Link recapitalization to resolution (Recapitalization)
6. Shrink public sector banking (Reform)