NPAs & Structural Issues

The article was published in the Business Standard on October 4, 2017 and Organizing India Blogspot on October 5, 2017.

An aspect of financial services often overlooked is that they serve as second-order infrastructure, essential for commerce, industry, and daily living. A disruption in the financial sector slows everything by cutting productivity. Other reasons for decline, such as structural issues in power supply, telecom/broadband, and in farming, are accepted as part of the landscape. That is why devising corrective measures is not so simple. Setting aside political considerations, misattribution does not help in problem-solving. Resolution needs root causes to be identified and addressed.

Consider the example of the guillotine approach to non-performing assets (NPAs). Imagine if an inspection of water and sanitation in your locality were to result in the shutting off of the water supply because conditions are deemed unsanitary. There would be a scramble for sourcing water, while economic activity and productivity would tank. What if it were a metropolis, or the whole country?

This is what happened with the abrupt change in booking NPAs. From around 2.5 per cent between 2006 until 2011, they began to rise in 2012 (see Chart 1).

Public sector banks in particular responded to the government’s accommodative efforts after the 2008 crisis. As growth fell, NPAs rose, especially for long-gestation, regulation-dependent infrastructure loans. In 2015, the Reserve Bank of India (RBI) adopted a hard line as the economy was gaining momentum after slumping in 2014 to 6 per cent. Earlier, the RBI was faulted for allowing the ever-greening of loans. An abrupt change without a gradual coming to terms to manage cash flows resulted in a crisis.

Leaving aside malpractice/fraud, NPAs resulted from factors such as aggressive, unsustainable lending, regulatory delays, the domestic and global slowdown, and commodity price shocks, as when export duties were imposed in Australia and Indonesia on coal. Cash flows drive demand, and a weak economy can make or break a business.

Apart from crippling banking and financial services, the consequences of the NPA shock were enormous, especially for sectors such as iron and steel, construction, power, telecom, transport, and agriculture, with knock-on effects on MSMEs across sectors. Could a phased, more gradual, differentiated approach have yielded better results? Probably, just as when water supply fails, interim arrangements involving pipes, equipment and tankers have to be made to tide over the crisis.  For stressed loans, the requirements were for a differentiated approach to the category of wrongdoing, including overreach, and support for stressed sectors undergoing a downturn.   The need was and is to prevent disruption in cash flows from a systemic perspective, conserving employment and assets in untainted enterprises with the potential for recovery.  This also retains momentum and market sentiment to the extent possible.

Ways Out?

1. NPAs in the mid-90s were outrageously high. Yet, what followed especially after 2003 was high growth until the global financial crisis of 2008. The NPAs were reduced and ceased to be a problem (see Chart 1). One explanation is that banks did significant NPA provisioning from profits in bond trading, as interest rates on 10-year government bonds fell 8.1 per cent from 1997 to 2003. A booming economy from 2003 did the rest, although there were no changes in the underlying causes that led to the NPAs. Hence, bond trading could be a way out provided interest rates fall, and so could economic growth.
2. Regarding interest rates, the dilemma is of high rates for domestic savings because people save with banks in India, and for foreign investors in bonds, against low rates for consumer demand and for capital investment. Given our acute need for growth and misaligned real interest rates, this needs rectification (see Chart 2).
   
   
   
   
3. There’s a need to insulate banking from political influence, while ensuring rigorous procedures for evaluation and monitoring. Any system can be gamed, however, and to work well, players need competence, integrity, and the freedom to exercise both. Banks are not well suited for funding long-gestation infrastructure because their deposits are more short-term. This is an institutional and market deficiency that needs to be bridged through developing bond markets, and channeling long-duration funding from pensions and insurance.
4. There are compounding effects from imposing the Aadhaar/UID without the requisite connectivity, processes and safeguards, likewise the hasty imposition of the goods and service tax (GST). There is little doubt of benefits when properly applied, but that needs time and support for thorough implementation; meanwhile, the immediate need is for relief. Rescue measures are needed to lighten the burden of the GST and its reporting requirements on MSMEs (up to a higher ceiling?) over a long period. Interim solutions could be flat rates for a larger set, augmented by support for implementation.
5. Meanwhile, structural issues resulting in NPAs need to be fixed. Three obvious areas:

• Farming, with its large population, small holdings, outmoded practices, low productivity, and the issues around pricing. Pricing is an essential aspect, as are direct benefits, for example, subsidies through cash transfers depending on income. But simply increasing farm prices addresses only one aspect of a multifaceted problem. What’s needed is to change the way production and marketing are organised. Practicable strategies are needed for produce, perhaps like the approach in dairy farming for milk production and marketing. Systems need be designed (worked out) and implemented properly, with design elements to promote and safeguard honest, competent, disciplined behaviour.
• Telecom and broadband services need policies based on a complete change of mindset and market structure, such as shared networks and equipment including spectrum, protection from anti-competitive action, and revenue sharing instead of auctions.
• Electricity supply: Power generation and distribution are both stressed by low economic activity, while many states continue with lax practices of under-recoveries for electioneering.This cannot be resolved as long as profligacy and indiscipline continue.