Stressed Balance Sheets May Create Fresh Vulnerabilities; Why It’s Time To Revisit Key Banking Sector Reforms

Karan Bhasin

Aug 18, 2020, 12:23 PM | Updated 11:57 AM IST

Finance Minister Nirmala Sitharaman and RBI Governor Shaktikanta Das.
Finance Minister Nirmala Sitharaman and RBI Governor Shaktikanta Das.
  • It is important to look at instruments that can help restore the balance sheets of the private sector.
  • The relief should come in the form of cash transfers and the need for a bad bank that will do a deep cleansing of banks’ balance sheets in a single go.
  • The state of the Indian economy has been a concern over the last few quarters — more so, as our recovery from a growth recession got adversely affected by the Covid-19 pandemic which has resulted in an unprecedented economic slump.

    Chances are that by the time the pandemic gets over, we will witness the worst recession since the Great Depression.

    The key lesson, however, from the Great Depression was the realisation that deficits must be allowed to expand as economic activity contracts — as the move to balance budget by raising taxes further pushed countries into depression.

    This is important for governments to recognise and refrain from any attempts at increasing tax rates until the time economic activity resembles normalcy for a few quarters.

    This is also important as we have suggestions regarding introduction of wealth or inheritance tax. The move, as argued, will help redistribute income with the intention of helping the bottom of the pyramid and prevent from a significant increase in inequality caused by the pandemic.

    The problem, however, during recessions is to get growth back on track. Indeed, sharpening inequality will invariably cause stagnation in the purchasing power which will result in a slower pace of growth.

    However, that would be a different situation as we would be looking at structurally lower levels of growth.

    In contrast, what we are witnessing at the moment is substantial worsening of the balance sheets of private sector — including small businesses.

    To put things in perspective, our banks have been facing their own set of challenges due to the rampant lending which led to the increase in non-performing assets (NPAs). These troubles got compounded when our growth faltered in early 2010s and corporate balance sheets became weak.

    The problem that occurred due to the growth slowdown was that even the viable projects suffered as economic prospects weakened. The problems in India’s corporate sector, and in India’s banking sector spread over to the entire financial system when we tightened our monetary policy in 2018, culminating in the growth recession that started from September of 2018.

    The corporate tax cut of 2019 was thus a move which was intended to help restore health of corporate balance sheets, attract greater investments and put the economy back on track.

    However, the pandemic has further put stress on the balance sheet of companies, banks and financial sector participants.

    Moreover, with salary cuts across the spectrum, we are looking at a reduction in nominal incomes which would affect consumption demand in the foreseeable future.

    To make situations slightly tedious, we also have the small and medium sector which has witnessed a substantial deterioration in their balance sheets — the micro small and medium enterprises (MSME) sector had managed to maintain healthy balance sheets in terms of less leverage.

    This pandemic has left many firms with choice to either borrow extensively against existing assets or shut operations and wait for the economic activity to revert to the new normal post the pandemic.

    There are two important policy issues that are important to meet the objective of limiting the economic costs of the pandemic — first is restoration of balance sheet of companies even if it comes from a higher level of public debt.

    Deficit monetisation will invariably be a bullet that we may have to bite at some point, so it is important to look at instruments that can help restore the balance sheets of the private sector.

    This relief should come in the form of cash transfers and not in the form of equity or debt instruments.

    A big no to equity because we don’t want government to tell the private sector on how to manage, run or operate their businesses.

    Fundamentally, we must oppose government purchasing stake in private sector — but encourage them to sell stake in their own state-run enterprises.

    The second issue is of restoring the balance sheet of India’s financial sector participants — primarily banks and non-banking financial companies (NBFCs).

    The process of growth will ultimately improve the balance sheets — however, it will take time which necessitates the need for direct action towards improving balance sheets, going forward.

    Perhaps, we do need to revisit the possibility of one-time conditional cash injections for companies, especially small enterprises.

    The rationale is that these cash injections should be for companies that continue to operate as that will ensure that any cash injection would ultimately be compensated by the company paying direct taxes going forward.

    The costs of not providing cash injections which could result in firms shutting shop would be higher to the economy and for the government which makes it important to discuss this idea as we start the process of unlocking.

    Another idea that needs a revisit is the idea of a bad bank which could take over all the stressed assets post the pandemic and work closely with asset restructuring companies to recover whatever can be recovered.

    The need for a bad bank is to do a deep cleansing of banks’ balance sheets in a single go rather than waiting for the Insolvency and Bankruptcy Code (IBC) process to recover the money.

    It is important to remember that a bulk of private investments in India are financed through public sector banks, especially the investments made by MSMEs and this is what makes it imperative for us to restore them as swiftly as possible.

    The need to revisit some of these ideas arises from the aspiration of converting the pandemic into an opportunity for faster pace of growth which is only possible once both consumption and private investment cycle are positive.

    The steps taken so far have done well to limit the impact of the pandemic, however, what we do now can determine the pace of our recovery and likely growth rates for the coming few years which is why we must revisit some of these bold ideas.

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