WHAT does a financial crisis look like? The 2008 crash is fresh enough in our memories to provide an adequate answer: Stock markets crash, fortunes are lost overnight, memorable photographs are taken of desperate or anguished financiers, and the great and the good meet solemnly to preserve what they can of a financial system suddenly rendered unimaginably fragile. By these standards, both aesthetic and objective, India is not going through a crisis. After all, what these characteristics have in common is the quality of rapidity: the crisis is upon you before you can prepare, and reaches its culmination almost before you are aware of it.

And yet, even though the Indian economy seems to be undergoing no such fast-moving stress, it is nevertheless in the throes of a slow-motion financial crisis. Its financial system – comprised not just of commercial banks but also of non-banking financial companies or NBFCs – is suffering through a constriction of lending and investment. In India, policy making is gradualist, reform proceeds at a glacial pace – but so do some crises.

The nature of this crisis is agreed upon by all parties, even if they disagree about causes and consequences. India’s state owned banks, which control over 70 per cent of the sector, are burdened down by non-performing assets – loans which have gone bad and are not being repaid. A study early in 2018 found that such bad loans had grown by 56 per cent in 2016, and then by 135 per cent in the two years after that. The exact number of ‘stressed’ assets – loans on banks’ books that already are or may turn bad – remains uncertain. But, officially, non-performing assets as a percentage of all banks’ advances were more than 11 per cent in March of 2018. For public sector banks, that percentage was 14.6 per cent. (This statistic has marginally declined since then.) This does not include the many loans that are at risk but do not need to be officially classified as non-performing.

What, precisely, lies behind this problem? The answer to this question is politically fraught. The political opposition, led by the Congress party, argues that the current National Democratic Alliance government has allowed the problem to linger and balance sheets of banks have turned adverse on its watch. For its part, the government disclaims all responsibility, arguing that the loans that went bad were handed out in the tenure of the previous Congress-led government – implying also that they were the product of corrupt dealings, possibly with the connivance of politicians. More neutral observers, such as former Reserve Bank of India governor Raghuram Rajan, construct a relatively nuanced and objective narrative to explain what happened – one which is, perhaps, closest to the truth. In the years prior to and immediately following the global financial crisis of 2008, banks went on a lending binge. Prior to 2008, in the boom years of the first term of the United Progressive Alliance, banks bought into India Inc’s rosy expectations of growth and returns, and lent them vast sums on that basis. These expectations were naturally belied; the crash came and corporate earnings fell sharply.

But the government reacted to the crash on a war footing: it cut taxes, increased spending and, yes, instructed banks to keep lending. Thus instead of unwinding their exposure to risky and possibly unprofitable projects, banks – supposedly with the intention of fighting a possible recession – increased their lending to such projects and to dubious promoters. When the government’s money and patience ran out, the banks were left with loans that were made prior to 2008 and then renewed after – but which had very little chance of being repaid.

 

And so from causes to consequences. A full ten years after the end of the UPA-I boom, the after-effects of this over-lending are still constraining economic growth. Banks that have too much bad debt on their books are banks that feel short of capital – and thus become banks that are unwilling to lend to new projects, especially those with a modicum of risk. For that matter, companies that already owe a great deal to banks are not willing to take on more debt, for fear of further burdening their balance sheets.

Given the joint impact of these two related sets of stressed balance sheets, former Chief Economic Advisor Arvind Subramanian called this the ‘twin balance sheet’ problem. If banks don’t want to lend and companies don’t want to borrow, then capital does not circulate – no investment is made. In real terms, no new factories are built, too few enterprises are begun, too few risks are taken. And without new factories, new enterprises and a little risk, it is impossible to get growth.

The consequence of burdened bank balance sheets is economic anaemia: stagnant, too-slow GDP growth. The financial crises familiar from memory and movies wipe out percentage points of GDP overnight; this financial crisis is more insidious, keeping GDP for years on end from growing the way it should. Some heart attacks are swift, some less so: If the arteries of finance are clogged, growth has a heart attack – even if the patient takes a long time to realize it.

 

How can the arteries of finance be cleared, and health restored to the economy? History provides few answers of use. There have been occasions in the past in which India’s state controlled banks were in fact weighed down by even greater loads of bad debt than they are at the moment. In the early part of this century, for example, they emerged from a period of slow growth and tight monetary policy with NPAs as a higher proportion of their advances than currently. But, on that occasion, no targeted solution needed to be devised; no bank-specific surgery was required. The business cycle turned, growth worldwide increased, funds flowed into India, and the magnitude of the mid-2000s boom was such that banks began to look healthy in spite of taking no action to address their sickness. No such revival in growth or financing looks likely to save public sector banks this time around.

In the absence of this deus ex machina, the Reserve Bank of India devised various schemes to force banks to address their stressed balance sheets. Banks, their critics claimed, would be happy to ‘extend and pretend’ forever – in other words, to keep on lending a little to borrowers to keep them in business – ‘extending’ their indebtedness – while ‘pretending’ that the loans would some day be repaid.

 

But as early as 2016 the limitations of this approach were already clear. In that year, the government’s Economic Survey suggested that policy towards banks be governed by ‘four Rs’: recognition, recapitalization, resolution, and reform. In other words, there were four steps to a sustainable and healthy banking sector. First, recognition: the banks should stop pretending that all their loans were good and close to repayment, and recognize which of them were stressed. As with alcoholics, the first step to a cure is admitting you have a problem. Second, recapitalization: the government would have to put money into the banks it owned, so that they would look secure destinations for people’s savings in spite of having a large number of bad debts on their books. The extra capital would outweigh the freshly recognized bad debts. Third, resolution: the assets associated with the bad debts would have to be addressed – sold off, recon-figured, or shut down. Essentially, the file would have to be closed one way or the other. And, finally, reform: changing how banks were run and administered to ensure that the problem of bad loans did not recur.

Of these steps, only the first was followed through with any energy and commitment – and that not because the banks were convinced of the necessity, but because the RBI gave them no opportunity for further malingering. Under Rajan and then under Urjit Patel, the RBI forced many hidden bad loans into the open – explaining the rapid growth in stated NPAs quoted earlier in this article. Nor did the RBI let up – in February of 2018 the RBI issued a controversial ‘zero tolerance’ circular that insisted that any loan the repayment of which was overdue even by a day must be classified as delinquent. As we shall see later, this energy itself was sufficient to cause a major political backlash.

Recapitalization, in contrast, was undertaken half-heartedly. Many independent observers expected that the cost of recapitalization would strain government finances – requiring it to shell out a significant percentage of a year’s GDP and thus an even greater fraction of that year’s taxes. But instead the government tried some clever financial engineering. It said that Rs 2.1 lakh crore would be injected into the banks – but only Rs 18,000 crore of that would actually come from the government. The rest would be borrowed in one way or another, including through issuing tens of thousands of crores worth of what would be called ‘recapitalization bonds’.

 

Resolution, meanwhile, was given a shot in the arm by the Narendra Modi government’s most significant financial sector reform: the introduction of the Insolvency and Bankruptcy Code. This created a process by which a loss-making company could either be revived or shut down and its remaining value – land, financial assets and so on – distributed among its creditors. An auction mechanism for stressed assets would ensure that the creditors would get the highest possible return on their investment; and the creation of a committee of creditors would ensure both that nobody would either suffer more than anyone else and that nobody would be held uniquely responsible for the decision to shut down or revive a company. Previously, many public sector bankers were concerned about the legal or anti-corruption implications of any bad loan related decision; the new bankruptcy code helped set some of those concerns to rest.

 

Finally, there was reform: and here the government was slowest to act. This was because the only real reform possible was one which was politically unpalatable. India’s public sector banks have repeatedly shown themselves to be unreliable, and susceptible to political influence, lobbying and bribery. As conduits of finance and evaluators of commercial risk, they have revealed themselves to be inadequate over and over again. And yet there is little political appetite for privatizing even one state controlled bank. Without private sector control and private sector discipline, no real reform is possible.

Here the Reserve Bank of India stepped in again. It recognized that, even if reform (read privatization) of individual public sector banks was impossible, reform of the sector as a whole was another thing altogether. It thus imposed on the worst public sector banks – the ones with truly egregious amounts of bad loans – a framework of constraints it called ‘prompt corrective action’ or PCA. The idea behind PCA was that these troubled banks would have to immediately focus only on cleaning up their balance sheets – i.e., on resolution. Only if they succeeded in that would they be allowed to resume the normal functions of a bank and, in particular, to start lending again. Naturally, the effect of this over time would be to either clean up the sector or, more likely, to cause the worst parts of the public sector banks to shrivel up and die because they could no longer lend. The public sector would eventually occupy a smaller share of the overall banking sector and reform would be accomplished in spite of the government, not because of it.

 

By the first half of 2018, when the RBI had stepped in to speed up both recognition of bad loans and reform of the bad banks, the effects of stringent action against public sector banks were already causing political problems for the government. Its reaction was to turn the RBI itself into an adversary.

In defending public sector banks against stringent RBI regulation, the government was not acting purely out of ideological motives. Earlier dispensations – particularly Congress-led governments incapable of criticizing Indira Gandhi’s bank nationalization – might have taken on the RBI out of fidelity to socialist dogma. But the NDA, while not particularly sympathetic to free market ideals, had specific and very immediate political reasons for questioning the RBI’s decisions.

The first, and broadest reason for the government’s adversarial reaction was that investment and growth were failing to recover sufficiently. Had the banking crisis been addressed sooner – earlier in the NDA’s term perhaps – this would have been less of a problem. But, as the general elections of 2019 approach, the Modi government’s growth record does not look as good as it would like. If a significant revival is to be seen in time for the electorate to register it before voting, then banks must be encouraged to start lending at their regular pace even if they have not yet cleaned up their books.

The second reason is linked to the first ‘R’, and in particular the RBI’s ‘zero tolerance’ approach to the recognition of bad loans. One major consequence of this was that many power generation companies that were struggling to meet repayment schedules to their creditors were in danger of being declared non-performing assets and then forced into the bankruptcy process. This would throw the power sector into crisis and endanger one major promise on which the prime minister had campaigned in 2014: the provision of accessible, 24x7 electricity. The government demanded that the RBI ease its not-one-extra-day harshness when it came to recognition of bad loans by banks.

 

The third reason is linked to another ‘R’, reform, and in particular the prompt corrective action (PCA) framework. Under the NDA, public sector banks – always a crucial distribution channel for political patronage – had been given the additional responsibility of propping up, through lending, the small and medium enterprises that the government believed would create the jobs their voters want. Such smaller enterprises, devastated first by the demonetization of late 2016 and then further hampered by the botched roll-out of the goods and services tax in 2017, needed all the help they could get. The prime minister himself, meanwhile, pointed to the success of the MUDRA scheme of loans to smaller enterprises as the fulfilment of his promises in 2014 to create millions of jobs. But the PCA framework, under which many banks would find themselves unable to lend, naturally slowed this politically important expansion of lending to small and medium enterprises. Thus it was once again in defence of its electoral promises that the government felt it had to tackle the RBI’s harsh stance on bank reform.

And one last ‘R’, recapitalization, also had a role to play. The government is still searching for funds to transfer to public sector banks so that their balance sheets begin to look cleaner and they feel once again empowered to lend. Since there are other calls on the government’s tax revenue, it would like the RBI to hand over some of its own reserves for the purposes of recapitalization. The RBI is unwilling to do so – creating yet another point of dispute between Mint Street and North Block.

These four disagreements grew more and more stark as 2018 proceeded, and eventually led in December to the startling and unprecedented (in recent history) resignation of RBI governor Urjit Patel. In essence, the government is happy – for now – for public sector banks to stay locked into their slow motion crisis; the RBI, which has sought to end that crisis through firm action, is being forced into retreat.

 

For many successive quarter after the NDA took office, private investment – dependent greatly on bank lending – grew slowly, not at all, or even shrank. But the year 2018 began to see a gradual recovery in investment. Partly this might have been because of the global growth recovery, partly because the Indian business cycle itself was turning – but partly, perhaps, it was because banks recovered a certain confidence and began to lend a little more.

Yet the sustainability of this recovery is now questionable thanks to the government’s stymieing the RBI’s efforts to force an end to the bad loans crisis. In some sense, India is still living with the consequences of Indira Gandhi’s original sin of bank nationalization: once the financial system is turned into an instrument of state policy, then it will never be allowed to become fully healthy if that comes in the way of the political imperatives of the party in power.

To the crisis in banks must be added a newer emergency: the seizing up of lending by and to non-bank financial companies or NBFCs. These had expanded their lending to occupy some of the space vacated by troubled public sector banks. But, in late 2018, the best connected and most systemically important such NBFC, Infrastructure Leasing and Financial Services, failed to repay some of its loans on time. Investors lost confidence in the entire NBFC sector, and many individual NBFCs began running short of funds. There will be little support for infrastructure projects or for small and medium enterprises from NBFCs in the immediate future; and any hope that these ‘shadow banks’ would replace regular banks as the primary pillar of growth and investment in India has been dashed. Instead, another part of India’s financial architecture will need to undergo a painful and prolonged clean up. And, as it happens, the government would again like to postpone this pain, and the RBI would like to get it over with – yet another unresolved point of conflict between the central bankers in Mumbai and politicians in New Delhi.

 

If one artery is blocked, it must be cleared as soon as possible or others will also begin to be congested. Similarly, the failure to address the existing bad loans crisis before forcing banks to start lending again will likely cause yet another crisis to build up – sooner, perhaps, than most of us expect. Many believe that the small and medium loans that are being handed out under political compulsions will be the trigger for another crisis. Others argue that the unwillingness to allow power generation companies to fail, and to ‘recognize’ that they are now bad loans, is what will cause the next crisis. What everyone agrees on, however, is that without a healthy and active banking sector, the Indian economy will struggle to return to the high growth trajectory of the 2000s. A slow motion crisis may not be as photogenic or as exciting as the sort we saw in 2008 – but it can be as damning for a nation’s destiny.