Twin balance sheet problem

Note4Students/Syllabus Mapping: GS3

The Economic Survey 2015-16 for the first time highlighted the weakening balance sheets of public sector banks and that of some large corporate houses as one of the most critical short-term challenges for the Indian economy and an impediment to economic recovery. Terming it as ‘Twin balance sheet challenge’, it is clear that the TBS problem is the major impediment to private investment, and thereby to a full-fledged economic recovery. Undoubtedly, this makes it a hot topic for 2017 CSE Mains in the context of Indian economic challenges that need immediate attention.

 

What is this Twin Balance Sheet Problem?

The twin balance sheet problem refers to the ballooning of debt on the books of corporate entities and the estimated Rs10 trillion of stressed assets that have piled up at banks because of the inability of borrowers to repay.

Thus, TBS is two-fold problems for Indian economy which deals with:

  1. Overleveraged companies – Debt accumulation on companies is very high and thus they are unable to pay interest payments on loans. Note: 40% of corporate debt is owed by companies who are not earning enough to pay back their interest payments. In technical terms, this means that they have an interest coverage ratio less than 1.
  2. Bad-loan-encumbered-banks – Non Performing Assets (NPA) of the banks is 9% for the total banking system of India. It is as high as 12.1% for Public Sector Banks contributing to four-fifths of the total NPAs. As companies fail to pay back principal or interest, banks are also in trouble.

 

Concerns  around this TBS issue

Corporate Sector Banking Sector
  • Gross capital formation by the private sector has come down sharply over the past three years. The Gross Fixed Capital Formation has declined from 34% in 2011-12 to 27% in 2016-17 which indicates stalled investments in the economy.
  • More than four-fifths of the non-performing assets are in the public sector banks, where the NPA ratio had reached almost 12 percent.
 The corporate investment is in the doldrums right now. New data from the Centre for Monitoring Indian Economy shows that new project proposals in the June quarter were at their lowest level in three years.
  • 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.
  • New data from the Centre for Monitoring Indian Economy shows that new project proposals in the June quarter were at their lowest level in three years.

 

  • 40 percent of the corporate debt it monitored did not earn enough to pay the interest obligations on their loans.
 The capital adequacy ratio of six banks is likely to fall below 9% in a severe macro stress scenario, dragging the system-level ratio down to 11.2% by March 2018 from 13.3% as of March 2017.
 While corporate debts are rising, the economic survey noted that their profits are low and the situation is forcing the firms to cut investment and preserve their cash flow.  The latest edition of the regulator’s Financial Stability Report (FSR), released on Friday, said a severe credit shock is likely to impact capital adequacy and profitability of a significant number of banks.
  • At least 13 of these banks accounting for approximately 40 per cent of total loans are severely stressed

 

What are the reasons for this issue?

  1. The origins of the NPA problem dates back to the decision taken during the mid-2000s.
  2. During this period for the first time in the country’s history, 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.
  3. Firms made plans accordingly. They 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.
  4. Within the span of four short years, the investment-GDP ratio had soared by 11 percentage points, reaching over 38 percent by 2007-08.
  5. This time saw extraordinary increase in the debt of non-financial corporations.

Work in Progress- yet visible shortcomings!!

RBI has deployed several mechanisms to deal with the stressed asset problems, of these mechanisms that are particularly notable. Success of schemes, however, has been limited. There are several reasons why progress has been so limited:

Poor Loss recognition: – The Asset Quality Review (AQR) was meant to force banks to recognize the true state of their balance sheets but banks kept on ever greening loans.

Coordination Issues: – The RBI has encouraged creditors to come together in Joint Lenders Forums, where decisions can be taken by 75 percent of creditors by value and 60 percent by number. But reaching agreement in these Forums has proved difficult, because different banks have different degrees of credit exposure, capital cushions, and incentives.

Lack of Proper incentives: – The S4A scheme recognizes that large debt reductions will be needed to restore viability in many cases. But public sector bankers are reluctant to grant write-downs, because there are no rewards for doing so. To address this problem, the Bank Board Bureau (BBB) has created an Oversight Committee which can vet and certify write-down proposals.

Massive Capital Constraints: –The government has promised under the Indradhanush scheme to infuse Rs 70,000 crores of capital into the public sector banks by 2018-19. But this is far from sufficient.

IBC in nascent stage: The new bankruptcy system is not yet fully in place, and even when it is, the new procedures (and participants) will need to be tested first on smaller cases.

Severe viability issues: – At this point, large write-offs will be required to restore viability to the large IC1 companies (those companies whose earnings do not even cover their interest obligations).

Lack of teeth in private Asset Reconstruction Companies (ARCs)

Many ARCs have been created, but they have solved only a small portion of the problem, buying up only about 5 percent of total NPAs. The problem is that ARCs have found it difficult to recover much from the debtors. Thus they have only been able to offer low prices to banks, prices which banks have found it difficult to accept.

Strategic Debt Restructuring (SDR) scheme

Under this creditors could take over firms that were unable to pay and sell them to new owners. Only those projects that have started commercial production can take advantage of this scheme

Sustainable Structuring of Stressed Assets (S4A)

Under this, creditors could provide firms with debt reductions up to 50 percent in order to restore their financial viability. Unlike CDR, S4A does not allow the banks to offer any moratorium on debt repayment; they are also not allowed to extend the repayment schedule or reduce the interest rate.

Way forward:

  1. TBS problem can be resolved by taking a four step path that involves – recognition, recapitalization, resolution and reform.
  2. First, there needs to be a readiness to confront the losses that have already occurred in the banking system, and accept the political consequences of dealing with the problem.
  3. Second, the PARA needs to follow commercial rather than political principles. To achieve this, it would need to be an independent agency, staffed by banking professionals. It would also need a clear mandate of maximizing recoveries within a specified, reasonably short time period.
  4. The third issue is pricing. If loans are transferred at inflated prices, banks would be transferring losses to the Rehabilitation Agency. As a result, private sector banks could not be allowed to participate – and then co-ordination issues would remain – while private capital would not want to invest in the Agency, since PARA would make losses.
  5. A rekindled optimism on structural reforms in the Indian economy, along with implementation of GST and diligent implementation of Bankruptcy Code will play supporting pillars.

Conclusion:

The twin balance sheet problem is a serious drag on credit growth. The setting up of a centrally-assisted rehabilitation agency will help in taking difficult decisions which the public sector banks are unable to take. The past mechanisms of resolving this problem in the form of decentralized approach have failed. There is no point of delaying this problem because the delay is very costly for the economy as impaired banks are scaling back their credit while the stressed companies are cutting their investments. Time is opportune to create a centralized agency called Public Sector Asset Rehabilitation Agency (PARA) akin to that of East Asia adopted during their crises period. The centralized agency in the form of PARA would allow debt problems to be worked out quickly as highlighted in this year’s Economic Survey.

 

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