Seemingly suddenly, India’s economy has taken ill. The GDP numbers are worrying enough, but the disaggregated data are even more distressing. Production of consumer and investment goods is falling. Indicators of exports, imports, and real government revenues are in negative territory, or close to it. Clearly, this is not an ordinary slowdown. It is India’s Great Slowdown.
The government and the RBI have been trying vigorously to bring the economy back to health. But the standard remedies for getting out of the current predicament aren’t working. Monetary policy is stymied by a broken transmission mechanism, which impedes the pass-through of cuts in policy rates to lending rates. And the scope for fiscal stimulus is limited since fiscal deficits are already close to double-digits (when properly measured) and larger bond issues will only further crowd out the private sector, by pushing up already-high interest rates.
In a recent paper, we argued that the Great Slowdown stems from a balance sheet crisis that arrived in two waves. The first wave — the Twin Balance Sheet crisis, encompassing banks and infrastructure companies — arrived after the global financial crisis, when the world economy slowed and infrastructure projects started during India’s investment boom of the mid-2000s, began to go sour. These problems were not addressed adequately, causing investment and exports, the two engines propelling rapid growth, to sputter.
The second wave came from the collapse of a credit boom, led by NBFCs, and centered on the real estate sector. The collapse owed to the recognition that the boom involved unsustainable financing of a rising inventory of unsold housing. As a result, the economy now confronts a Four Balance Sheet (FBS) problem — the original two sectors, plus NBFCs and real estate companies.
What then can be done to address the FBS? We propose a comprehensive plan in our paper, including a new asset quality review (AQR-2) to get a more honest recognition of the magnitude of stressed assets, and further strengthening the IBC. Here we focus on one idea, namely the creation of special resolution mechanisms for two sectors: Real estate and power.
These special mechanisms are needed because even a strengthened IBC will not be suitable for certain types of cases, notably those where social considerations are as important as commercial criteria, where public subsidies of one kind or another are inevitable, and where coordination across government is critical. The real estate and power sectors fulfill these criteria.
Consider first the real estate sector. In most residential cases, developers have funded their building partly through pre-selling, that is by requiring prospective owners to pay in advance for their promised flats. So when builders go bankrupt, prospective owners are left with neither money nor flats. It is obvious that the plight of these individuals cannot be ignored — a point underscored by the Supreme Court. But, it is equally obvious that they will not be well served by the IBC.
For a start, it is unclear how the prospective owners could be represented on the creditors’ committee. And, even if a way could be found, it hardly seems acceptable to ask them to wait for years, only to receive a small fraction of the money that they paid, and perhaps even nothing at all. It would seem far better to provide them with a speedy settlement, with a guaranteed minimum fraction of the amount that they paid. But this will require a government mechanism, most likely with government subsidies, since recovery rates from builders are likely to be very low.
The stressed power-sector assets pose another major quandary. Unlike most assets, private power firms cannot be easily sold, since they are incurring heavy operational losses and their prospects are highly uncertain. Even the public sector power producers have been reluctant to take them. But neither can they be liquidated. Although, supply currently outstrips demand, and the plants are only operating at half capacity, eventually the gap will close. And, technologically and environmentally, these power plants are good assets, in many cases better than the fully-utilised plants.
The essence of the problem, the reason there cannot be a private sector-led solution, is that the viability of power assets is inextricably entwined with government policies. For example, demand for power depends on whether the state electricity boards are financially strong enough to buy the power that the public is demanding. Similarly, demand for the stressed assets depends on the pace at which the government, Centre and states, phases out much older, environmentally inefficient public sector plants. As a result, the government would need to be heavily involved in any solution to this sector’s problems.
Consider how a bad bank for the power sector might work. The first step would be to take these loans, exceeding Rs 2.5 trillion, off the books of the banks, for that would free up balance sheets and management attention, allowing banks to focus again on their core business of supporting economic growth.
Once removed, the assets will need to go somewhere. A few of the plants could probably be sold off, once their debts are reduced to manageable levels. But most of the plants would need to be ‘warehoused’ until they can be returned to the private sector. To do this, the government could create a holding company, which would purchase the assets and manage them.
Essentially, the holding company would operate like a public-sector asset rehabilitation agency (a “bad bank”). The holding company would buy power companies at prices based on the recommendations of independent parties, such as investment banks, which would take into account a special regulatory regime that the government would establish for these assets. Importantly, this regime would include pre-announced levels of subsidies.
Such an open, ruled-based procedure would allow the transaction to be seen as fair by all stakeholders: The holding company, banks, and perhaps most importantly, the public. In addition, fair prices would give the holding company some chance to make a profit in the long run as power demand increases. And, the prospect of profits, in turn, might induce private investors to provide some of the capital that the bad bank would need, thereby alleviating the upfront cost to the government.
One may then ask what the holding company would do with the assets. The ultimate objective would be to sell the plants back to the private sector. In fact, this objective should be built into the charter, which should state that the purpose of the holding company is to sell off the assets within five years, after which it would be dissolved. To realise this objective, the holding company should endeavour to reduce uncertainty, especially by securing long-term contractual arrangements for coal inputs to be supplied by Coal India and output to be purchased by state electricity boards. Once this is done, and as demand for electricity grows to the point where the plants can operate at somewhere close to full capacity, the appetite for these assets will gradually revive, at which point they could be sold.
Of course, bad banks are not magical solutions. They will take some time to establish, and will require difficult political choices, in particular about how to allocate the costs amongst creditors, promoters, homeowners, and taxpayers. But, equally, something needs to be done: The nation cannot allow vital power plants to continue to deteriorate, operationally and financially. And, by now, all the alternatives have been tried and found wanting.
The Great Slowdown is upon us. Two bad banks to resolve the Four Balance Sheet problem might be one critical element of the solution.
This article first appeared in the December 20 print edition titled ‘India’s Great Slowdown’. Subramanian is former Chief Economic Adviser to the Government of India and Felman is former IMF Resident Representative to India
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