India’s financial system resets

India’s non-performing assets (NPAs) increased at the start of the last decade due to the natural turnaround in the business cycle, but also because much of the underwriting was done on the basis of due diligence political rather than commercial. As we entered a strong dollar cycle globally from 2011-12 to 2020-21, the chickens came home to roost with the pandemic as the last kick.

A new reformist and anti-crony government in 2014 ironically made matters worse in the short term. Inflation targeting, the Insolvency Bankruptcy Code (IBC), the Real Estate Regulatory Act and the Goods and Services Tax have added to the uncertainty, although they have been long-term growth factors.

We also overstated the checks and balances on public sector lending, and some good creditworthy companies entered the spiral of illiquidity even as many underlying frauds were exposed. Credit growth stagnated and the NPA ratio deteriorated, with the ratio of non-performing loans to gross loans crossing around 10% in 2018, a figure last seen in 2002. Despite some fiscal and monetary easing before Covid- 19 (circa 2019), it was clearly not enough.

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A whole way of doing business has been reset as India Inc has been forced to embrace digitalization and formalization more thoroughly. The previous mechanism of inflating bills, setting up projects without real equity and, if things went wrong, the sovereign footing the bill, was no longer viable. Likewise, siphoning large sums from minority shareholders no longer made sense now due to better transnational vigilance as well as limits on huge cash spending at the national level.

Demonetization resulted in a lot of money entering the banking system, but some of the benefits were wasted for two reasons. One of them, then Reserve Bank of India Governor Urjit Patel, let the rupee grow disproportionately in 2017-18 without seeing through inflationary pressures, which severely hurt exports and to industry. Rather, it should have built up reserves. Second, increasing top personal income tax rates in 2019 was another stick, when a carrot was needed to improve compliance.

However, bold actions outnumber mistakes. Corporate tax rates have been cut and a slew of aggressive reforms have continued throughout the pandemic. India’s unified payment interface has gone global and the equally revolutionary idea of ​​account aggregators will lead to the use of tax and payment metadata for better analytics and hence cheaper credit and more widespread. India is the world leader in public digital goods, and China’s recent crackdown on closed data gardens is a hat trick. Sooner or later America will follow, despite all the entrenched lobbies.

But, in the here and now, bank balance sheets remain degraded. IBC has led to some obvious gains, and we now even have a prepackaged version for micro, small and medium businesses. The idea of ​​not having a bad bank immediately was based on avoiding moral hazard – if banks know they will be bailed out by buying their worst assets at reasonable or no haircuts, they will not. no incentive to be diligent. It’s a valid fear, but right now we’re on the other end of the spectrum – economic and financial sadism and masochism.

The pandemic has given us the opportunity to get off to a good start, and we must seize it with both hands. Already, lower bond yields have partially fixed bank cash flows to some extent (lower yield means higher bond prices). If we are to build trillions of dollars of infrastructure over this decade, then we will need everyone on the bridge – development finance institutions, capital markets (INVIT, REIT where the government is also liberalizing) and , of course, a healthy private sector. and public banks.

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A consortium of banks coming together and creating an Asset Reconstruction Company (ARC), the government giving a limited guarantee for the paper (security receipts) that this National Asset Reconstruction Company Limited (NARCL) will issue, could well be exactly what as the doctor ordered. The CRA will remove nearly $ 30 billion of NPA from the system in two phases, and since said debt will be owned by a single entity, subsequent resolution through IBC will likely be faster. The government guarantee is a reasonable amount of $ 4 billion, is limited in time, may not even be used, but it is absolutely essential. This may be a more efficient use of capital than more direct bailouts, although this is not excluded. Depending on how it goes, we may need to readjust a bit.

Healthy financial intermediation, for example, allows young people who are rich in human capital but not in financial capital to borrow from those who have it. It enables the poor and the neo-middle class to move up the real estate ladder while systematically building a portfolio of stocks and reducing risk through insurance.

India cannot fully copy the Anglo-American model of capital markets first because financial literacy remains an issue here (and indeed around the world), nor can we copy the Asian model. Eastern and Continental European banks with close ties to industry and unions because our society and politics is much more heterogeneous.

Fortunately, we don’t have to choose – while we learn from everyone, we will create our own path based on our genius, away from bogus binaries, and let others discuss the Indian financial model. And this model has just received a big reboot over the past few months.

Harsh Gupta Madhusudan is the author of A New Idea of ​​India and an investor by profession

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