‘A strategic inflection point is a time in the life of a business when its fundamentals are about to change. That change can mean an opportunity to rise to new heights. But it may just as likely signal the beginning of the end.’

– Andrew Grove,

founder and former CEO, Intel.

 

NATIONAL crises – and there is more than one in India right now – redefine the relationships between the state, citizens, civil society, business and markets. We are in the middle of a public health crisis brought about by the Covid-19 virus, which made its appearance in March 2020; we are also facing a crisis on our borders with China, after a relatively quiet period of nearly three decades.

A third crisis has been brewing in India’s cauldron of economic problems that has been heating up for a while. The economy has been slowing over the last five years, and we have an elegantly named ‘twin balance sheet’ problem: an excessively leveraged corporate sector that is mirrored by a very stretched financial system.¹

Since the 1980s, politics has been the visible hand in India’s financial markets. It is evident in regulatory design, through changes in bankruptcy law, the presence of politically connected firms and the impact of political uncertainty on investment. This essay examines state-financial sector relations in India, situated against the global context of financial crises and bailouts.

Is there anything special or uniquely different about the financial sector compared with other business-state relationships? Estimating the extent of influence the financial industry or its representatives have on policy – either in formulation or in content – is an important lens to view the current non-performing loan (NPL) crisis in Indian financial markets.

The spectrum of state-capital relations in the financial system can be analysed by looking at a powerful and commonly used instrument: the bailout. From the Great Depression in the 1930s to the present day, the bailout gives us an unique perspective on the political economy of finance.

 

‘When the government makes loans or gives subsidies, what it does is tax successful private business, to support unsuccessful private business.’

– Henry Hazlitt,

journalist and author

 

Many states in the United States passed laws on debt moratoria (i.e., bank loans) in the early 18th century. In the 1930s Great Depression, debt moratoria were legislated for farmers’ mortgages. In a very large economic downturn, a significant number of firms and individuals could force legislatures to enact laws to protect borrowers from foreclosure.²

From protecting borrowers, crisis response evolved to protecting institutions. Following the 2008 Global Financial Crisis (GFC), the US Treasury Department coordinated the Troubled Asset Relief Programme (TARP), that helped financial institutions avoid bankruptcy and closure. Political influence was clearly visible in directing TARP monies to weaker banks.³

In his The Creation and Destruction of Value, historian Harold James describes the political controversy surrounding the 1931 bailout of the Austrian bank Creditanstalt, which he suggests escalated the Depression and contributed to the rise of the Nazi movement. Political factors influenced bailout decisions in Germany for example; capital injections into stressed savings banks were influenced by local politicians.⁴

In Europe after the GFC, the UK nationalized banks, Spain consolidated the savings banks, and Germany created a good bank/bad bank model; in all cases, they used taxpayer funds. In the post-crisis years, political differences of opinion prevented substantive progress on much needed reform; the EU did set up three new regulatory agencies, but until 2012, when the idea of a banking union was introduced, the logjam persisted.⁵ Even now, work on the banking union is incomplete.

 

Outside of the US and Europe, consider the experience of Hong Kong and Singapore. The Hongkong Exchange Fund (set up in 1935) and the Singapore Currency Fund (1938) were essentially sovereign wealth funds (SWFs) set up to deal with currency crises. In the mid-1970s and the mid-1980s, they were used as intervention reserve funds; they compensated the banks foreign currency losses. In the property market crises of the 1980s and 1990s – banks were overexposed to the property market then – these funds were used to inject capital into the banks, under government direction.⁶

SWFs have been used in the Middle East economies too. The Kuwait Investment Authority bailed out the Gulf Bank; similarly the Qatar Investment Authority injected more than $3 billion in four Qatari banks. The Abu Dhabi SWF bailed out Dubai World, a port real estate company. In the 2015 rouble exchange rate crisis, Russia’s SWF injected capital into banks.

 

Bailouts in China are unique. In May 2019, the People’s Bank of China (PBoC) and China Banking and the Insurance Regulatory Commission announced the takeover of Mongolia based Baoshang Bank, the 37th largest among more than 4000 banks. In July and August 2019, they took over the Bank of Jinzhou and Hengfeng Bank. It’s not just the banks. In 2018, the Chinese government launched a massive effort to rescue China’s private sector, as the economic growth slowed, and excessive debt laden companies began to flounder. Banks were persuaded to lend 339 listed firms the equivalent of nearly $23 billion as loans against pledges of their shares.⁷

These are among a class called ‘zombie firms’, or ‘the walking dead’ of the corporate sector: highly indebted, financially stressed, and not making enough profits to sustainably pay debt service. Some clear trends emerged in a study of loans from 2000 to 2016 made by national and local banks, when collated with the terms of office served by local Chinese Communist Party (CCP) Secretaries.

Lending to zombie firms in the last year of service of a Party Secretary increased by 228 per cent, while lending to non-zombie firms shrank by 87 per cent. Influence is also selective: Party Secretaries can put pressure on local banks to lend to these zombie forms, but their ability to similarly influence national banks was limited.⁸ Lending to zombie firms boosted economic performance in the short-term, but ironically, does not appear to have helped Party Secretaries’ chances of promotion or move up the party ladder.

 

Bailouts are not dependent on economic conditions, but on the political setting and institutional arrangements within the country in crisis. They also vary depending on the relationship between banks and policymakers, all of which raise four questions. First, what was the desired objective of the bailout? Second, what were the mechanisms used, and to what effect? Third, what were the costs involved and how were they distributed? Fourth and lastly, what were the outcomes?

In North America and Europe, the fear of contagion from failing banks forced governments to introduce a mix of policies; they issued guarantees to reassure depositors, recapitalized banks, provided liquidity support and examined at mechanisms to take toxic assets off banks’ balance sheets – like TARP in the US.

 

Costs varied. In 2009, expenditure crossed $1 trillion in the US, and $718 billion in the UK. Deborah Lucas, director at the MIT Golub Center for Finance and Policy, estimated the fair value of costs for the US at $498 billion.⁹ In Ireland, the expenditure at $614 billion for the bailout was 230 per cent of GDP. But the net costs of the bailout were much lower; in many cases, guarantees that were part of the bailout, for example, were never executed. Ireland’s crisis finally cost 22 per cent of GDP.¹⁰ France and Denmark spent much lower than committed, and actually made a small profit.

SWFs are typically rainy day funds (to be used to stabilize exchange rates in times of economic uncertainty), financed by simply absorbing excess money from exports or external income. Between 2005 and 2015, they grew from $895 billion to $5.865 trillion.¹¹ One estimate puts it even higher, at $11-14 trillion. In the 1980s, the Hong Kong Exchange Fund provided an estimated $2 billion in bailouts.

In 1999, China – whose banking system like India’s is dominated by state owned banks – set up four asset management companies (AMCs) to buy non-performing loans (NPLs) from four state owned banks that originally had them, to address capital adequacy concerns.¹² The first round of NPL transfers between 1999 and 2001 was the equivalent of $170 billion at face value, but recovery rates were inadequate: only 21 per cent. In 2004-05, another $125 billion in NPLs were transferred to the AMCs, but this time at a discount negotiated by the PBoC. More transfers followed in other years.

The cost of China’s bailout were met by capital injections ($100.3 billion), foreign equity participation ($11.7 billion) and NPL write-offs ($380 billion).¹³ The distribution of the costs of $494 billion was divided between the banks (15 per cent as write-offs), monetization by the PBoC (43 per cent) and an increase in implicit public debt (42 per cent).

Against this backdrop, consider the choices before the government and regulators in India to resolve the NPL crisis, and that is dependent on India’s political context. The government sits on both sides of the table: it both owns most of the banking system, regulates it and is itself a significant borrower. The resultant constraints and limits on the scope for action demand a fresh scrutiny of state-capital relations.

 

‘While communism is the control of business by government, fascism is the control of government by business.’

– Robert F. Kennedy

 

The evolution of the state-financial sector relationship in India falls into three stages: before 1969, from 1969 till 1991, and after 1991 to the present day. Before 1969, industrial development and growth were primary concerns. The 1943 Bombay Plan, put forward as a guiding document to economic policy after independence, included central planning, a mixed economy, protection for certain industries and public investment in heavy industry as elements. This aligned with Jawaharlal Nehru’s priority of a strong state.¹⁴

 

In 1969, then-Prime Minister Indira Gandhi nationalized the banking system; in July that year, she told Parliament that ‘the purpose of nationalization is to promote rapid growth in agriculture, small industries and export, to encourage new entrepreneurs and to develop all backward areas.’ Some saw it a political move to squeeze business houses that supported her opponents while also broadening her political base.¹⁵

It also put the government squarely at the centre of the financial system. Since banking access was not widely available in large parts of India, the free market was perceived ‘as being unable to optimally allocate resources over time, that is, for investment because of the myopic nature of the market.’¹⁶ Nationalizing the banks allowed the government to combine its developmental agenda with a ‘directive’ role.

Further, it allowed the government to appropriate a significant amount of public savings to meet its own borrowing needs, using reserve requirements. Then, it set credit growth targets for agricultural lending, small scale industries and selected sectors of the economy: directed lending. Broadening access to finance through the banking system became a lever for political advantage and political patronage.

The first 14 nationalized banks had 80 per cent of the branches, 83 per cent of deposits and 84 per cent banking system assets. As economist S. L. Rao out it, ‘the country’s banking system became a playground for political interference with loan "melas" and loan write offs, and consequent decline in the quality of assets of the banks and financial institutions.’¹⁷ Another six were nationalized in 1980.

 

In 1991, following a balance of payments crisis, it became clear that the state’s capacity to advance the development agenda would not be enough. Once the liberalization process was set in place, the bureaucracy became more open to including business, based on ‘mutual dependencies’.¹⁸ Generating capital for development needed an enabling regulatory environment; reopening banking to the private sector became part of post-1991 policy mix.

The post-1991 period also coincided with greater participation in politics by businessmen and industrialists. Consider representation in Parliament. In 2014, the Lok Sabha had 143 MPs who classified themselves as businessmen in a 543-member house; in 2009, under the Congress-led government, there were 121. That’s a quarter of the Lower House. The Rajya Sabha or Upper House had 29 businessmen members in 2014, and 38 in 2009.

Vijay Mallya is a particularly interesting example. As a Rajya Sabha MP, he served on three Parliamentary committees: the Consultative Committee on Civil Aviation, the Standing Committee on Chemicals and Fertilisers, and the Standing Committee on Commerce. He had business interests in all three sectors.

Newspaper reports have documented how his businesses – almost all of which got into trouble – were treated favourably by industry regulators, benefited from his influence as an MP over policymaking, and from the patronage of 17 banks who lent him more than a billion dollars that remain unpaid. When the default became imminent, they didn’t move against him quickly enough or declare him a ‘wilful defaulter’ until it was too late, and he had moved to the UK. He wasn’t the only one who used his political influence.

Writing in Business Standard – a business daily – in September 2018, Mihir Sharma, now a Bloomberg Opinion columnist, pointed out that as long as the government owns the banks, bankers will follow signals from politicians on how to lend. The question he asks is whether politicians are responsible for the current pile-up of bad loans and the enormous strain on bank capital.¹⁹

 

‘What is maximum governance, minimum government? It means government has no business to be in business.’

– Narendra Modi,

Prime Minister of India

 

Which takes us to the question ‘how did we get here?’ with reference to the NPL crisis. The answer is, a combination of factors. Excessive growth in credit and indebtedness preceding and during the GFC, the economic slowdown that followed, poor bank practices and governance, and an ineffective judicial and legal system for resolving debt contract disputes.

But first, let’s examine the scale. At the end of 2018, the gross NPAs in the banking system amounted to Rs 11.20 lakh crore.²⁰ Large borrowers accounted for 52 per cent of bank loan portfolios and 80 per cents of NPLs. From FY15 to FY18, banks wrote off Rs 2.17 lakh crore of NPLs, bad debts from just 543 borrowers.²¹ The government recapitalized the banks with Rs 2.11 lakh crore in 2018.²²

Compare that to the Rs 4.7 lakh crore in farm loan waivers in a decade.²³ announced by at least 10 states and the central governments. These losses are borne by governments, not the banks, over a period of 3-5 years. Even the character of agricultural lending is changing. Large loans have become the norm.

 

Agricultural loans above Rs 10 lakh amounted to 4.1 per cent of total agricultural credit in 1990; it became nearly 24 per cent in 2011. In response to an RTI request, the RBI revealed that in 2016, public sector banks had given just 615 accounts Rs 59.581 crore in agricultural loans, or roughly seven per cent of total credit to agriculture; this pattern and level have been in place since 2007.²⁴ Many of these loans were given from urban branches, such as Mumbai. Corporate entities could borrow for agricultural purposes too.

 

None of which would have been possible without politics driving credit allocation decisions. ‘Directed lending’ is where social welfare maximization met profit-maximization head-on. The authors of a book on banking crises – Fragile by Design – expressed it best.

‘The fact that the property-rights system underpinning banking system is an outcome of political deal making means that there are no fully "private" banking systems; rather, modern banking is best thought of as a partnership between the government and a group of bankers, a partnership that is shaped by the institutions that govern the distribution of powers in the political system… Banks are regulated and supervised according to technical criteria, and banking contracts are enforced according to abstruse laws, but these criteria and laws are not created and enforced by robots programmed to maximize social welfare; they are the outcomes of a political process – a game, as it were – whose stakes are wealth and power.’²⁵

Calomiris’ and Haber’s review of five countries – the US, Canada, the UK, Mexico and Brazil – says politics is integral to the banking business. Politics, they say, explains why Argentina had four crises in the last four decades, and Australia none. Or why since 1840, the United States had 12 systemic banking crises; Canada, none. Their book does not, however, have a satisfactory explanation of whether there was any politics in the origins of the 2008 GFC.

Government is the biggest borrower from the banking system in most economies, in need of financing perpetually. Governments also set the legal framework for banking activity, regulate banking behaviour and when a bank fails, arbitrate how losses are shared between borrowers, depositors, shareholders and taxpayers. Calomiris and Haber call it the ‘game of bank bargains’.

 

When the banking system is state owned, banks become the easiest and most convenient source to raise money from, and cheaply. The banking system also becomes a vehicle for channelling subsidized loans to important constituents or special interests. In India, 40 per cent of lendable resources have to go to ‘priority sector’ lending. In India, that accounts for 40 per cent of all lending to this day.

NPLs in Indian banks have been managed through capital infusions into bank balance sheets. In certain cases, the transfer of bad assets has been through a series of legal remedies in the form of debt restructuring schemes. Under the aegis of the Reserve Bank of India to either revive or dispose of the NPLs and the underlying physical assets. A second approach has been to transfer them to asset reconstruction companies or ARCs, of which there are currently six.²⁶ But the mechanism is still a work-in-progress in many ways.

When banks have been severely stressed, the government’s other approach has been merging weaker banks with stronger ones. Over the years, they have been brought down from 29 to 20. Now the government purposes to reduce them even further to just 10, through a series of mergers. The process has already begun.

Since 2014, the banking sector’s problems have been getting bigger but not better. Look at the latest raft of NPLs: barely 25 companies or industrial houses account for more than a quarter of all NPLs. The RBI, in its biannual financial stability reports, has highlighted the potential for fraud when NPLs are this high.

In the last six years, there has been a massive fraud in Punjab National Bank that will cost the bank over $1 billion, the near collapse of the up-and-coming aggressive private sector Yes Bank (which is being bailed out by the largest state-owned bank, State Bank of India), the collapse of an infrastructure lender (IL&FS), and sundry problems in others.

Separating the costs of bank-specific bailouts is difficult, since recapitalization has also been done as part of the compliance process with Basel III rules. Now, the ‘bad bank’ approach has been proposed, though details have been sparse. But the costs, as the Chinese example shows, can be massive.

 

Given the yet-to-be-estimated costs that the Covid-19 pandemic will impose on our already slowing economy, it is not just financial capital that the ministry of finance will have to think about, but the political capital that will have to expended to get people to bear it. So what can the government do? There are three options. One, it could accelerate the Indian Bankruptcy Code (IBC) process, and let market mechanisms work out solutions. This will be easy in some cases – as has been the case with several large companies – but court challenges could delay the process. Persisting with the IBC will be have political costs, which have to be traded off against lower financial costs and a credible, acceptable outcome.

Second – and here the political costs are higher – the government could use the NPL crisis to reduce the government stake in these banks in stages: first to 40 per cent, and then to 26 per cent. The government still controls the regulatory framework, and could achieve its socioeconomic objectives through that, and moral suasion. Third, the government could use a judicious mix of mergers and recapitalization to stabilize the system first, and then proceed with an accelerated set of second generation reforms that include the creation of a corporate bond market that shifts the risk of bad debts to public markets. This may well help the government build political capital.

 

There are structural questions that the government can address in the next stage of its reforms, which are all but inevitable. The biggest one is about incentives, operational and monetary. Banks should be able to negotiate reasonably about the value of collateral assets that they can sell to willing buyers as part of NPL resolution, without fear of punishment.

Across the system, regulatory actions have ensured a provision coverage ratio of 61.5 per cent across the banking system.²⁷ Developing an auction process to aid distressed asset sales would not be out of place; the government has done that on other sectors. These are not either/or options, but measures that have to be timed well, politically and strategically. That said, waiting for the right political moment shouldn’t be like waiting for Godot; that political moment must be created, if necessary. Given the opportunity costs of not doing anything, time is really money.

 

Footnotes:

1. Economic Survey of India 2017-18, Ministry of Finance, Government of India.

2. Patrick Bolton and Howard Rosenthal, ‘Political Intervention in Debt Contracts’, Journal of Political Economy 110(5), October 2002, pp.1103-1134.

3. Ran Duchin and Denis Sosyura, TARP Investments, 2012. Finance and Politics, University of Michigan, 2010. Lucas Puente, ‘Political Influence and TARP: An Analysis of Treasury’s Disposition of CPP Warrants’, PS: Political Science and Politics 45(2), April 2012, pp. 211-217.

4. Bo Bian, Rainer Haselmann, Thomas Kick and Vikrant Vig, ‘The Political Economy of Bank Bailouts’, SAFE Working Paper Series, Leibniz Institute for Financial Research, July 2017.

5. Nicolas Veron, ‘EU Financial Services Policy Since 2007: Crisis, Responses and Prospects’, Global Policy 9, Supplement 1, June 2018.

6. Jurgen Braunstein, ‘Understanding the Politics of Bailout Policies in Non-Western Countries: The Use of Sovereign Wealth Funds’, Journal of Economic Policy Reform 20(1), 2017, pp. 1-18. DOI: 10.1080/17487870.2016.1247705

7. Sun Yu and Zinning Liu, ‘China’s Bailout of Private Companies Fails to Halt Defaults’, Financial Times, 5 December 2019. https://www.ft.com/content/9f2f2370-15a1-11ea-9ee4-11f260415385

8. Qiuying Qu, ‘Zombie Firms and Political Influence on Bank Lending in China.’ Department of Economics, Columbia University, 2018.

9. Deborah Lucas, ‘Measuring the Cost of Bailouts’, Annual Review of Financial Economics 11, December 2019, pp. 85-108.

10. Emiliano Grossman, Cornelia Woll, ‘Saving the Banks: the Political Economy of Bailouts’, Comparative Political Studies, 11 June 2013.

11. ESADE Annual Report 2014. ESADE Institute for Social Innovation, Barcelona.

12. The four AMCs were ‘bad banks’ of four largest state owned banks: Industrial and Commercial Bank of China (Huarong), China Construction Bank (Cinda), Agricultural Bank of China (Great Wall), Bank of China (Orient).

13. Le Xia, ‘Lessons from China’s Past Banking Bailouts.’ Working paper, BBVA Research, Hong Kong, 4 March 2020.

14. Sarvepalli Gopal, Jawaharlal Nehru: A Biography. Harvard University Press, Cambridge, 1976.

15. Niranjan Rajadhyaksha, ‘The 1969 Bank Nationalization Did India More Harm Than Good’, Mint, 16 July 2019.

16. C. Rangarajan, Indian Economy: Essays on Money and Finance. UBS Publishers’ Distributors, New Delhi, 1998.

17. S.L. Rao, Economy and Business in India Under Reforms. Konark Publishers, New Delhi, 1996.

18. Pepper D. Culpepper, ‘Structural Power and Political Science in the Post-Crisis Era’, Business and Politics 17(3), October 2015, pp. 391-409.

19. Mihir S. Sharma, ‘Are Politicians Responsible for India’s Banking Crisis?’ Business Standard, 25 September 2018.

20. https://events.debtwire.com/npl-chart-of-the-week-china-india-have-more-npls-than-europe

21. https://www.news18.com/news/business/banks-lost-rs-1-76-lakh-crore-to-416-loan-defaulters-in-3-years-big-hike-in-write-offs-after-demonetisation-2340213.html

22. Srikanth Srinivas, ‘Rs 2.11 Lakh Crore Bank Recapitalization is a Band-Aid Solution: the Rot in the System Runs Deeper’, Firstpost, 27 October 2017. https://www. firstpost.com/business/rs-2-11-lakh-crore-bank-recapitalisation-is-a-band-aid-solution-the-rot-in-the-system-runs-deeper-4176837.html

23. https://www.businesstoday.in/current/economy-politics/farm-loans-worth-rs-4-7-lakh-crore-written-off-in-past-decade-report/story/393666.html

24. https://www.indiaspend.com/top-12-corporate-npas-cost-exchequer-twice-as-much-as-farm-loan-waivers/

25. Charles Calomiris and Stephen Haber, Fragile by Design: The Political Origins of Banking Crises and Scarce Credit. Princeton University Press, Princeton, February 2014.

26. Srikanth Srinivas, ‘On the Edge’, BW Businessworld, 23 July 2012. http://www.businessworld.in/article/On-The-Edge/08-11-2014-65079/

27. Reserve Bank of India, Financial Stability Report, 27 December 2019.