Slowly but perceptibly, we are moving into a different phase of the Covid crisis. The health situation remains serious, of course, precluding normal social interactions. But as the exit from lockdown starts, albeit slow in pace and differentiated across geographies, attention is beginning to focus on the task of reviving economic production. Warren Buffett famously said that only when the tide recedes can we see the jagged rocks. As the Covid deluge recedes, what jagged rocks are we likely to see? And what is the best way to repair the damage?
For some time, we have argued that production and growth have been held back by diseased balance sheets, afflicting key sectors of the economy. As far back as December 2014, we highlighted that the banking sector and infrastructure firms had come under financial stress, a problem we termed the Twin Balance Sheet (TBS) challenge. By December 2019, we documented that the problem had spread to the NBFC and real estate sectors, raising the number of stressed balance sheets to four.
Now, following the Covid-19 shock, red ink will be blotting balance sheets across the economy. For more than a month, firms of all sizes and sectors have been unable to sell their goods; many households have been unable to earn; financial institutions have been unable to collect on their loans; and the government has been unable to collect much tax revenue. The damage to all their financial positions has been severe, and will take a long time to repair.
How bad is the damage likely to be? Reports suggest that around one-third of industrial and service firms have applied for moratoria on their bank loans. If only a quarter of these deferred loans eventually go bad, then the stock of non-performing assets (NPAs) would increase by Rs 5 lakh crore. And this is a conservative estimate. Senior bank officials have been quoted as estimating that the stock of NPAs could increase by as much as Rs 9 lakh crore. In this case, we would be looking at NPAs of Rs 18 lakh crore, equivalent to around 18 per cent of current loans outstanding. For planning purposes, it is worth considering who will pay for such losses, if they do materialise.
At one level, the answer is simple: The shareholders of the financial institutions, which in most cases means the government. But this is where the ubiquity of the balance sheet problem comes in. When the TBS challenge first materialised, after the Global Financial Crisis of 2008-09, the government had a relatively strong balance sheet: Deficits were low, and the consolidated debt-GDP ratio, having fallen by 17 percentage points over the previous 7 years, stood at just over 60 per cent of GDP. So, fiscal room was available, allowing the government to recapitalise the PSU banks.
This time, the government’s financial position will be quite different. Central and state government deficits and debts will increase dramatically this year, as revenues, already slowing, have been decimated by the Covid crisis, while expenditures have increased. Add in a slowly recovering economy, and it becomes clear that the fiscal position will remain weak for some considerable time. As a result, the government will want to pass the burden onto the corporate and household sectors, in the form of higher taxes, more arrears, and possibly higher inflation. But these sectors will resist, for they have financial problems of their own.
It will be tempting in these circumstances to delay recognising the problem, pushing it into the future, for example by allowing banks not to classify bad loans as NPAs, and barring them from taking defaulters to the Insolvency and Bankruptcy (IBC) system. But this time, more than ever, this would be the wrong approach. The reason is that, in circumstances where no sector has a strong ability to bear a loss, it becomes imperative to minimise the size of that loss.
How can this be done? Broadly, in two ways. First, by preventing bankruptcies from occurring in the first place. To do this, banks will need to identify the firms that are viable, and lend them the funds they need to tide them over the immediate crisis. But banks are facing their own difficulties, and are reluctant to bear the risk of making such loans. So, the government might need to create a guarantee fund to support lending, as one of us has proposed.
Second, when firms do default, they need to be resolved as quickly as possible. Speed is necessary because the financial position of stressed firms tends to worsen over time. By definition, stressed firms have poor cash flows and can’t obtain much in the way of loans from banks. So, they don’t have enough money to fund their operations properly, which means that over time their underlying business deteriorates, destroying the firms’ market value. Consider what happened to now-famous House of Debt firms, the 17 large companies (excluding Essar Steel and the Adani group) that Credit Suisse long ago identified as stressed. In March 2010, their market value was Rs 3.1 lakh crore. A decade later, their value had fallen to just Rs 0.8 lakh crore, a loss of Rs 2.3 lakh crore or nearly 75 per cent. Accounting for inflation over this period, the real value of that loss is even greater.
As this example shows, while public attention focuses on the size of the NPAs, a much more important number is the recovery rate — the degree to which the banks can recover on these loans. And the only way to maximise the recovery rate is to sort out the bad loans speedily. If this can be done, and firms put back on their feet quickly, the economy will reap an additional benefit, since the resolved firms will be able contribute to the recovery.
To recapitulate, the Covid crisis is dealing a sharp blow to an already-struggling financial sector. But no sector is in a strong position to rescue the banks, since balance sheets across the economy are now impaired. That means the costs cannot be spread, they must be minimised, which in turn requires urgent action because delays severely erode the underlying value of assets.
A new approach is consequently needed. The immediate problems created by the crisis must be addressed, decisively and quickly. Then the attention will have to turn to addressing the pre-Covid legacy balance sheet problems, which have been intensified by the crisis. In the next column, we will suggest how both can be done.
This article appeared in the print edition of May 9, 2020, under the title ‘The economic malaise’. Subramanian is former chief economic advisor to the government of India and Felman is former IMF Resident Representative to India
(This is the first of two pieces by the authors)