Chapter 4 - The Festering Twin Balance Sheet Problem

Transcription

1 Chapter 4 - The Festering Twin Balance Sheet Problem India for sometime has been trying to solve Twin Balance Sheet Problem (TBS Problem) - which in simple terms can be put as over leveraged companies and bad loan encumbered banks-using a decentralised approach wherein the banks have put in charge of the decisions. The problem of NPAs (Non-Performing Assets) has festered further as in February 2016, banks reported that NPAs had soared to such an extent that they had overwhelmed the operating profits and hence the net income of the banks had taken a beating. The investors started fleeing the public sector bank shares as a result the market capitalisation of these banks came down (at a point, the market capitalisation of the 24 public sector banks was equal to that of HDFC bank!) It has been observed that whenever there is an economic crisis, the NPAs soar but since there was no economic crisis in India (contrary India was growing at the largest growth rate!), then what can explain this sudden surge in NPAs-one explanation is the Asset Quality Review (AQR) of RBI, following which the banks had to clean up their balance sheet. Nevertheless the NPAs kept on creeping upwards and reached 9% of the total loans by September 2016 (double to what it was a year ago) and more than 75% of these NPAs were in the public sector banks (gross NPA of PSBs has reached 12% of their total advances). On the other hand as per Credit Suisse, reported that 40% of the corporate debt was owed by companies which had an interest coverage ratio of lesser than 1 (the ratio basically represents what is the capability of a company to repay the debt, lower the value more difficult for the company to repay the debt) which meant that they did not earn enough to pay the interest obligation. Hence it is beyond any doubt that the in India both- the banks and corporate sectors-are under stress. The NPA ratio (as a percentage of Gross loans) for India is one of the highest in the world. Usually it has been seen that during the periods of boom, the corporations over expand, leaving them with obligations that they cannot repay and end up defaulting on their debts which will have a i pa t o the ala e sheet of the a ks. Ha i g said so I dia does t see to ha e tra ersed this path as there were prudential restrictions which kept the banks from expanding their credit and capital controls prevented undue recourse to foreign loans. The high NPAs usually derail the growth but in case of India this has not happened as there have not been cases of bank runs, no stress in the interbank market, and no need for any liquidity support from the time the TBS Problem has emerged in The explanation for this is 1. Bulk of the NPAs are concentrated in the public sector banks 2. These are ultimately backed by the government As a result the creditors have complete confidence in the banking system. That being said the TBCP experience has been puzzling in India and this chapter will try to answer 4 sets of questions 1. What went wrong?

2 2. What explains TBS syndrome with Indian characteristics 3. Is the strategy sustainable 4. What needs to be done In the beginning it was thought that the TBS problem was minor and would be resolved with growth but over the time it has been realised that the growth will not solve the problems of the stressed firms and on the contrary the problems of the stressed firms may imperil growth 1. What went wrong in the mid 2000s the GDP growth rate of India was high and was inching towards a sustainable double digit number? As per the expectations the corporates started making huge investment decisions (the investment-gdp ratio had soared 11 percentage points to reach 38% by ). These decisions were supported with huge growth in terms of non-food credit flow from the banking sector (between FY2005 to FY2008, the nonfood credit doubled), there was huge inflow of capital (in FY2008 it reached 9% of GDP). All of this added to the debt of non-financial corporations and with this these firms abandoned their conservative debt/equity ratios and leveraged themselves. Soon the negatives started creeping in the form of costs shooting over the budgeted levels (as there were difficulties in securing environmental and land clearances), the forecast revenues collapsed because of GFC, projects that were implemented with the forecast of double digit growth had to face half the level of growth. The situation worsened as the financing costs increased, firms that borrowed domestically had a setback as RBI increased lending rates to control double digit inflation and the firms that had borrowed from outside suffered because of depreciation of rupee. All these cumulatively squeezed the corporate cash flow which led to debt servicing problems. By 2013, nearly a third of corporate debt was owned by companies which and interest coverage ratios of lesser than 1 (IC1 companies) and by 2015 it has increased to 40% 2. What explains TBS syndrome with Indian characteristics India followed a standard path to the TBS problem as there was a surge in the borrowing, leading to overleveraging of the firms and that led to debt servicing problems. Having said so in other countries such as USA post GFC and Japan post the bubble burst in 1990s suffered from the stagnation of growth rates on the contrary in India high growth rates and high NPAs are running parallel. It seems I dia has de eloped its o ersio of TBS hi h has ee referred to as Bala e Sheet S dro e ith I dia Chara teristi s. The possi le e pla atio s are a. The unusual structure of banking system where there are stringent prudential norms b. India suffers from severe supply constraints-such as infrastructure-so when the investment increased, India invested in the infrastructure (such as power plants, roads, airports, ports etc) as a result of which there was ample room for growth even though there was a GFC (in comparison, the US boom was based on housing construction which was far less useful after the crisis)

3 c. In other countries, if the financial system was under such a huge stress then the creditors would have triggered bankruptcies leading to reduction in growth but in case of India, the banking sector has provided restructuring of the loans and other facilitative measures which have not had a great impact on the growth. The banks ha e follo ed the approa h of gi e ti e to ti e strateg allo ore ti e for the orporate ou d to heal a d e ergree i g here a ks le d o e to the fir s which is needed to pay interest rate obligations) 3. Is the strategy sustainable The problem of NPAs may get resolved under two scenarios a. Phoenix Scenario the higher growth would increase the cash flows of the stressed firms thereby allowing them to service their debts b. Containment Scenario limit the NPAs in nominal terms, once done they would shrink as a share of economy and a proportion of bank balance sheets as GDP is growing at a nominal rate of more than 10%. In this scenario they would fade away from importance For some time the second scenario was a possibility as the EBIT (Earnings Before Interest and Tax) of IC1 companies was over Rs Cr per quarter, this has come down because of deterioration in infrastructure companies to Rs Cr per quarter by These companies have subsequently been forced to borrow in order to continue their operations. (The debt of the top 10 stressed companies has tripled in the last six years). With this their interest obligations have also climbed rapidly. Starting from second half of 2016, a significant proportion of increase in the NPAs has come from mid-sized MSMEs. As smaller companies they have been suffering from poor sales and profitability for many years and this trend is likely to continue into The corporate stress is spreading along with stress on the power generation companies and on the MSME sector. In short the stress on the corporate sector is not only deepening, it also widening. There is another reason why the economy may not grow out of its debts, as it will have an impact on the investment scenario (the firms do not invest in new projects and banks will limit their lending). The private investment which was soaring in mid 2000s has contracted. Although the public investment has been increased, it has not been able to arrest the fall of the overall investment. In the medium term this needs to be reversed. Impact of TBS on Public Sector Banks (PSBs) a. At least 13 of these banks accounting for 40% of the total loans, are severely stressed b. 20% of these 13 banks have been classified as restructured or NPAs c. With ROA (Returns of Assets) turning negative, the investors are pulling back their investments in the shares of PSBs and as a result the share prices are declining d. The PSBs have responded to this situation as follows i. They are scaling back their lending (although some slack has been taken up by the private sector, there is limitation on what the private banks can do). As a

4 result the total credit to corporate sector has been decelerating steadily and is the lowest in the 23 years. The reduction of credit outflow has been uneven across the economy i.e. has remained stable in agriculture sector and has expanded in the household sector. ii. The PSBs in order to compensate for their NPAs have increased their interest margin rates. The gap between the average term deposit rate average base rate has widened to 2.7 percentage points (December 2016) from 1.6 percentage points (January 2015) This taxes good borrowers hence some of the borrowers have migrated to capital market (bond market and commercial papers). This migration has both advantages (growth of capital market) and disadvantages (banks are left with risky borrowers; MSMEs will be stuck with banks). Impact of TBS on power sector a. Some of the setbacks such as lack of supply side factors and infrastructural bottlenecks have led to cost overruns in the new power plants (50% on an average) b. PLF (Plant Load Factor actual production as a share of capacity) has decreased from 62% to 59.6% c. Merchant tariffs in the spot market have come down from Rs 4/kwh to Rs 2.5/kwh To sum it up, the financing strategy has worked in the last eight years but the stress assets are concurrently increasing which means that there is a need to address this debt problem or else there is a danger of this derailing the growth 4. What needs to be done RBI in the past few years, has introduced many mechanisms a. The 5/25 refinancing of Infrastructure Scheme: Under the scheme the lenders were allowed to extend the amortization periods to 25 years with interest rates adjusted every 5 years. The scheme is aimed at improving the credit profile and liquidity of the borrower while allowing the banks to treat these loans a standard in their balance sheets. Since the repayment period has been extended, the borrowers have found difficulty in repaying the interest which has led to evergreening thereby aggravating the initial problem b. Asset Reconstruction Companies (ARCs): Introduced SARFAESI Act (2002), with the objective of resolving the problem of the loans and reduce the burden on the banks. Initially the ARCs were paying very less amount to the banks on purchasing the NPAs, which was modified in 2014 and the payment was increased but so far only about 5 percent of total NPAs at book value were sold over and The problem is that the ARCs have not been able to recover much from the debtors c. Strategic Debt Restructuring (SDR): Introduced by RBI in June 2015 to provide an opportunity to banks to convert debt of companies to 51 percent equity and sell them to the highest bidders (subject to authorization by existing shareholders). An 18-

5 month period was envisaged for these transactions, during which the loans could be classified as performing. But as of end-december 2016, two dozen companies have entered into negotiations, only two cases have been actually been concluded d. Asset Quality Review (AQR): RBI emphasized on AQR (because resolution of the bad assets require their recognition), to verify that banks were assessing loans as per the classification rules issued by RBI. Any deviations from such rules were to be rectified by March e. Sustainable Structuring of Stressed Assets (S4A): Introduced in June Under this an independent agency (hired by the banks) will decide on how much of the stressed de t of a o pa is sustai a le. The rest u sustai a le ill e o erted into equity and preference shares. Unlike the SDR arrangement, this involves no change in the ownership of the company. So the question arises as to why the progress has been limited? The reasons are a. The schemes are new and financial restructuring negotiations will take time b. The AQR was conducted so as to make the banks identify the true state of their balance sheets but the banks have continued to evergreening of the loans c. Although RBI promotes formation of the Joint Lenders Forum (JLF). The JLF model has hit certain roadblocks-arriving at a decision has become difficult (as it requires 75% value and 60% volume of creditors to take a decision) d. The reward framework is absent (for writing down of the loans) whereas there is an inherent threat of punishment because of presence of referee institutions. Now the Banking Board Bureau (BBB) has created an oversight committee which can vet and certify the write down proposals The road to resolution is full of obstacles and it is much more acute in case of large borrowers (are few in number but per borrower debt is very high) because of the following reasons a. To restore the viability of these firms the write downs required are huge b. Such high write down would reduce the cushion capital of the banks c. Larger borrowers have more number of creditors. These creditors need to arrive at a strategy which is very difficult d. The bank officials are not only worried about the referee institutions but are also worried about public attention So will the new bankruptcy code change the situation? The systems under the bankruptcy code are not yet fully in place and once implemented it has to be first tested with smaller cases and then the complex cases involving large borrowers can be taken up PARA (Public Sector Asset Rehabilitation Agency)

6 These difficulties raise a fundamental issue which points to the fact that the present mechanism is not working hence there is a need for centralised approach. One of the possible strategies would be to create PARA. The following are the features which point to the need of PARA a. The dis ussio so far has ee re ol i g arou d the a ks apital hereas the ai issue here is the bad debts of the firms b. Majority of the problem is because of economic features such as exchange rates, growth expectations etc going wrong c. Majority of the stressed assets are concentrated in small number of borrowers and the issue can be overcome by solving small number of cases d. Cash flows have reduced to a great extent in many of these firms so only alternative that is left now is to convert the debt into equity (as cash flows have come down so will be the capability to repay the debt) e. Large debtors have many creditors and it is very difficult to bring all these creditors on the same page f. Since the banks have been unable in resolving these complex cases, the burden has been postponed. With the delay the costs will increase so will the bad debts g. The pri ate ARCs ha e t had good out o es How PARA would be better a. The mandate of PARA could be to resolve complex cases b. Since there is centralisation, there would be no problems of co-ordination (previously there was decentralisation wherein each bank had to take its own decisions) c. The centralisation will also lead to setting up of proper incentives, by giving it a mandate of maximizing recoveries within a fixed period of time d. It would separate loan resolution process from worries about the bank capital How PARA would be set up the funds for setting up of PARA could come from a. Government issues of securities could stre gthe the go er e t s fi a ial position by resolving the debt issue and thereby reducing the amount that would be provided as compensation to the banks b. Capital markets if PARA is structured in a way that attracts the private sector to take up equity share, it would also help replenish the capital of the PSBs, if the government decides to bring down its holdings c. RBI RBI would transfer some government securities thereby increasing the capital of PARA. There would be no implications for monetary policy, since no new money would be created

7 Working of PARA PARA would purchase loans of large indebted firms from the banks and work them out-either convert debt to equity to sell the stake in auction or granting debt reduction-based on the professional assessments of value maximization strategy Once these loans are off the balance sheets of the banks, the government will recapitalize, thereby allowing the banks to focus on their core business-giving loans. Similarly once the firms have attained financial viability, they would focus on their operations, rather than on their finances and will be able to consider new investments. During the process certain costs/losses will rise and the bulk of it should be taken up by the government as the objective is to minimize the existing liability by resolving bad loan problem as quickly and as effectively as possible Setting up of PARA is not a panacea as the experience with the government set rehabilitation agencies has not been uniformly positive. There are certain issues that have bedevilled other agencies which need to be resolved to ensure smooth functioning of PARA a. There is a need to have readiness to confront the losses and accept political consequences as there will be accusations of favouritism if the loans are written off and allegations of strong government when the companies are taken over and sold. To minimize such allegations it is imperative that PARA is very professional which plans to maximize recovery value b. PARA needs to follow commercial principles (not political principles). To achieve this, there is a need for PARA to be independent agency (could be set up on the lines of GST Network) c. The pricing of the loans has to be market driven. It would prohibit from banks transferring their losses to PARA but on the other hand determining market price is difficult and time consuming The pre ious ear s E o o i Sur e had re o e ded 4Rs-Recognition, Recapitalisation, Resolution and Reform. Under the Recognition there has been the most progress in the last one year. RBI has announced AQR (Asset Quality Review) and as a result the banks have recognised higher number of NPAs which has eaten into the capital base of the banks Recapitalisation has to be provided by the banks and as such is not the need of the hour Resolution is the key issue because there is no guarantee that even after recapitalisation, the banks will be willing to increase their lending until they know what are the true losses, which can be gauged through resolution and on the other side the borrowers would be able to invest unless their financial position is rectified. Until this happens, the economic growth will be under threat There is a need for fundamental Reforms as it has not been seen that large share of portfolios of PSBs have turned NPAs twice in a decade. If the reforms are not implemented then the problem will recur again. But with TBS problem being solved there is a danger of

8 getting into the significant moral hazard problems, wherein the banks forget about the past and start lending indiscriminately again as the balance sheet has been cleaned up.