Bad loans & nonperforming assets: why Raghuram Rajan is right to worry
- RBI Governor Raghuram Rajan recently said that the world may see a global economic meltdown like the Great Depression.
- This is a little extreme. The world hasn\'t seen a crisis like the depression of the 1920s and 1930s.
- Keynesian policies - greater public expenditure - is the way out. But Rajan knows it won\'t be enough.
The immediate threat
- Nonperforming assets of Indian banks have been piling up. Rajan has been flagging this for 2 years now.
- The rules give banks enormous powers over borrowers, yet they weren\'t able to recover debt effectively.
- Banks were then asked to adopt less harsh methods.
- Now banks often use obscure methods to recover a part of the loan and write off the rest. Concept of NPA gets muddled up.
The way out
- Rajan needs to appoint a committee to inquire into the shady practices of banks.
Raghuram Rajan does not lack confidence. He has been known to take on the world's best economists and carry his point. He is not easily upset. But recently, he has been sounding more like a Cassandra.
Speaking at the London Business School, a few days back, he warned the world that it might see a global economic meltdown like in the Great Depression. That is pretty extreme, for the world has seen nothing like the long and deep crisis of the 1920s and 1930s.
Global Depression: Rajan's apprehensions
Economists are taught that Keynes worked out a formula for preventing such depressions. Nations could prevent them by stimulating expenditure - giving incentives to investment, and if necessary, spending more than they received from taxes.
Rajan would not dispute that; but he would doubt if that would be enough, for two reasons.
First, Japan and the US tried out Keynesian policies when they faced severe downturns; they tried deficit spending, and reduced official interest rates to zero. But it did not work as well as they wanted.
Recently, Japan has tried to boost the impact of zero-interest policy by means of inflation; but that too has not worked.
Second, a policy of reducing interest rates leads funds to move out, and depress the exchange rate. That tends to increase exports and replace imports with domestic products; both tend to stimulate the economy. But the resulting improvement in the country's balance of payments worsens other countries' balances of payments and reduces their income and employment.
They would not like it, and to counter it, they would also try to depress their exchange rates. So policies of currency depreciation are contagious; and if they spread to enough countries, they can prove ineffective, and can do much harm to international trade and investment in the meantime.
This was the basis of Rajan's fear: that the world may slide into an incurable depression - or at least a depression that would require the appearance of another Keynes.
Closer home: Nonperforming assets
That is a gargantuan fear. If it materialises, there will be little that we or even our government can do. But there is another, less immoderate fear that is closer to home. Rajan has been warning for almost two years about banks' nonperforming assets and asking them to take corrective action.
That would seem an odd thing to do, for comprehensive corrective action was taken long ago. The government got worried about defaults by bank borrowers in the early 1990s. The 1980s was a great time for the Japanese economy. Its exports soared, and so did its export surplus. The money so earned was parked in Japanese banks.
They proved a cheap source of funds for Indian importers and industrialists, who borrowed abroad and parked the money with banks at home. The banks lent out the money; when the boom collapsed in 1989, they were left with a lot of bad debts. All they could do was to sue borrowers in civil courts; if they were lucky, the case would be listed after a decade or more.
Rajan has been warning for 2 years about banks' nonperforming assets, asking them to take corrective action
The government owned the banks, and was naturally protective of them. In 1993, it passed the Recovery of Debts Due to Banks and Financial Institutions Act. It created debt recovery tribunals - special courts that took only cases of banks against defaulting borrowers.
Corrective actions and safeguards
When the debt recovery tribunals followed the fate of all Indian courts and became overloaded, the government passed the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act in 2002.
Essentially, it gave banks the power to seize defaulters' assets without their permission and without getting into legal trouble, and created asset reconstruction companies - special companies that would pick up banks' bad debts and recover as much as possible from borrowers and their assets.
It also enabled banks to take over defaulting borrowers' businesses. With such draconian powers, how can the banks have nonperforming assets? If any asset dares to nonperform - if any loan is not repaid in time - the bank can seize the asset against which the loan is secured, sell it, and turn it into cash. It can even confiscate the borrower's business.
Then, the backfire
Why is the Reserve Bank unhappy despite the banks' overarching dominance over borrowers?
This is what seems to have happened. SARFAESI gave banks enormous powers. If they had used them too often, they would have scared borrowers to death, and destroyed their own lending business. So in 2002, the Reserve Bank issued a working paper, which basically told banks to use their judgment, and to try gentler ways of recovering loans before they threw the law at borrowers.
It probably backed up the paper with sermons to bank managers; at any rate, the banks took the advice to be nice to heart.
The Reserve Bank has been very reticent about what actually happened. But I thought of KC Chakrabarty, a rather unconventional deputy governor of Reserve Bank who resigned last year, three months before he was to retire, and joined the Indiabulls board as director.
A couple of years ago, he gave a talk to the Indian Banks Association. He compared the way banks dealt with bad debts in 2001-07 and in 2007-14. Let us call them periods I and II. An NPA is an asset turned bad; so we can analyse NPAs in terms of stocks and flows.
Banks began period 1 with Rs 600 billion in NPAs, and ended it with Rs 505 billion; they began period II with that Rs 505 billion, and ended it with Rs 1.93 trillion.
In other words, they reduced their NPAs in I, and increased them in II. In each period, they had an opening stock inherited, and an accretion during the period; they had to deal with the sum of the two. They dealt with 77% in I and 65% in II; they left 23% in I and 35% in two untouched.
Of the NPAs they tackled, they wrote off 44% in I and 40% in II; the figures are pretty similar. They carried into the next period 30% in I, and 55% in II; in other words, they left a much larger proportion untouched in II.
They recovered 42% of the money in I, and 34% in II. That leaves us 14% in I, and 25% in II. What did they do with these NPA accounts? They 'upgraded' them; in other words, they converted them from nonperforming into performing assets.
What is this upgradation? It obviously does not mean that they recovered the money; otherwise it would have been called recovery. It does not mean write-off. It means something in between.
They told the borrowers responsible for these NPA accounts: "Why don't you settle this little problem? Give us so much, and we will forget about the rest."
The bad debt was settled behind closed doors in the bank manager's office, and the borrower walked out, poorer for the settlement money he shelled out, but with his reputation intact.
What is upgradation? It's not recovery, it's not a write-off; it means something in between
And what did he do when he wanted to borrow again? He went to another bank - or to a so-called non-banking financial corporation. Maybe, even his first bank lent him more money. Briefly, banks began to treat defaulters more gently, more benignly in II.
Is this good or bad? It was good for NPAs: they went up 2.7 times in I, and 10 times in II. It put off delinquent borrowers less, and they went to banks with less fear - especially borrowers who were likely to default. And resolution of bad debts was much poorer in II: of the opening stock plus accretion, 23% were carried forward unresolved in I, and 35% in II.
What would worry me if I were Rajan is that the banks have muddled up the concept of NPAs. They have converted NPAs into PAs with non-standard, obscure tricks. Many of their borrowers must know that if they default, they will be able to strike a bargain with their banks, and no one will ever know that they defaulted.
So all the definitions and procedures that the Reserve Bank laid down to define NPAs are worth nothing.
Rajan needs to appoint another enquiry committee to investigate banks' shady practices. Who may chair it? Maidavolu Narasimham of course, if he is available at the age of 88. If not, Kamalesh Chandra Chakrabarty.