Decoding Rajan’s letter on NPA: How bank balance sheets remained clean all these years

Revival of economic growth is crucial. The last thing Modi would want is to hand over the stewardship of the boat to those who nearly sank it in the first place.

 |  5-minute read |   20-09-2018
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Like all good economists, Raghuram Rajan chooses his words carefully.

The former governor of the Reserve Bank of India (RBI) recently wrote a 17-page letter on NPAs to the Parliamentary Estimates Committee. The majority of bank NPAs, Rajan wrote, were created between 2006 and 2008 during the UPA-I government.

Industrialists borrowed copious amounts from banks at high interest rates to set up large infrastructure projects, expand capacities and plough funds into new businesses.

rbi_092018010359.jpgEvery RBI governor (including Rajan) has based monetary policy on keeping inflation low. (Photo: Reuters)

Bird’s-eye view

After the global meltdown in September 2008, many of these projects turned sour.

When the global economy seizes up, high-interest debts become difficult to service. That was the genesis of the bank NPA crisis.

What did the RBI do?

Instead of lowering interest rates (as the United States Federal Reserve did) to reduce the cost to industry of servicing debt, it raised interest rates. That’s like sprinkling water on a drowning man.

Over the past decade, every RBI governor (including Rajan) has based monetary policy on keeping inflation low.

This is a good strategy for developed Western economies growing at less than two per cent a year.

It is a self-defeating strategy for a developing economy growing at over 7 per cent a year.

Caught in a pincer between a global economic slowdown and high interest rates at home, bank loans began to turn bad after 2008.

Large corporates found themselves in a classic debt trap: huge borrowings at high interest rates amidst an economic downturn.

Rajan had a bird’s-eye view of the growing bank NPA crisis. He was chief economic advisor to the government of India in 2012-13 before being appointed RBI governor in September 2013.

bad-loan-inside_092018010323.jpgThough bank loans made to several large corporates in 2006-08 had turned bad by 2013, the balance sheets of those banks did not classify them as NPAs.

P Chidambaram was finance minister at the time and also during 2006-08 when, as Rajan’s 17-page letter to MPs noted, the bulk of today’s NPA’s were created.

Now the story becomes murkier.

Though bank loans made to several large corporates in 2006-08 had turned bad by 2013, the balance sheets of those banks did not classify them as NPAs.

Rajan concedes in his letter that there was “evergreening” — banks rolling over bad loans and accumulated interest in the hope that industrial projects would be revived, corporate growth restored and the bad loans paid back.

What did the RBI under its new governor Rajan do?

By September 2013, when he took over, Indian economic growth had slowed to 5 per cent. Corporates were crying hoarse over high interest rates. And yet Rajan kept interest rates high, citing inflation as the main enemy that must be slayed.

Despite the red flags, the RBI did not crack the whip on banks to classify bad debts as NPAs. Evergreening continued. Loans continued to be rolled over along with interest. Bank balance sheets remained artificially clean.

Lack of transparency

In May 2014, the BJP-led NDA took charge of an economy run into the ground.

Inflation was still high despite the misguided effort to control it with high interest rates. GDP growth had plummeted. Banks had stopped lending to corporates sagging under the weight of high-cost debt.

On taking office, Prime Minister Narendra Modi erred by not publishing a white paper on this parlous state of affairs.

He conceded recently that he did not do so to avoid the risk of global investors fleeing India.

With hindsight though, transparency in 2014 would have added to India’s credibility, not led to capital flight.

Rajan’s letter says he informed the PMO of the looming (but as yet hidden) bank NPA crisis which had led to a steep fall in private investment.

The Modi government was initially slow to act.

In 2015, the RBI tightened rules to classify bad debts as NPAs within a set time frame. No more evergreening. In 2016, the Modi government legislated the Insolvency and Bankruptcy Code (IBC), its most significant financial reform.

Under the IBC, as Rajan says in his letter, promoters for the first time fear they could lose their companies. They have become serious about repaying their bank loans.

The new NPA classification rules have led to an explosion of hidden bad debts re-classified in bank balance sheets as NPAs.

As a result, banks have recorded huge quarterly losses. They have written off NPAs from their books that for years lay hidden under the “current loans” classification.

urjit_092018010428.jpgUrjit Patel reduced interest rates in 2016 and 2017 but depreciation of the rupee led the RBI to again start raising interest rates. (Photo: India Today)

Revival of economy

RBI governor Urjit Patel reduced interest rates in 2016 and 2017 after he took over from Rajan to help corporates lower their borrowing costs and revive private investment.

The depreciation of the rupee and the fear of capital outflows has, however, led the RBI to again start raising interest rates.

Inflation is now below the targeted 4 per cent. Interest rates should ideally dip to aid economic growth and spur private investment.

Instead, we are back to fire-fighting.

New RBI classification norms for NPAs and the IBC have ensured that bank NPAs have peaked and will now gradually decline.

However, as Rajan pointed out in his letter, the IBC could still be misused by canny promoters submitting artificially low bids for their own debt-ridden companies through proxy firms.

As Modi prepares to fight the 2019 Lok Sabha election, a revival of economic growth is crucial. The last thing he would want, after spending five tortuous years lifting a keeling boat out of the water, is to hand over its stewardship to those who nearly sank it in the first place.

(Courtesy of Mail Today)

Also Read: Why National Herald should be a Harvard Business School case study

Writer

Minhaz Merchant Minhaz Merchant @minhazmerchant

Biographer of Rajiv Gandhi and Aditya Birla. Ex-TOI & India Today. Media group chairman and editor. Author: The New Clash of Civilizations

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