On September 21, the Sensex at the Bombay Stock Exchange (BSE) gyrated between its lowest and highest points, swinging 1,495 points. Although conclusive evidence is never available to explain why markets move this way or that, market pundits attributed the spectacular pirouette to the dire straits in which Infrastructure Leasing & Financial Services Ltd (IL&FS), a premier lender to many of the infrastructure projects undertaken in the public-private partnership (PPP) mode, finds itself. Share prices collapsed across the board, even in sectors completely unconnected to the IL&FS crisis, but the most dramatic collapse was reserved for the NBFCs (non-banking finance companies) sector and those focussed on housing finance.
Although the stock market did recover by the close of play, the sheer breadth and depth of the spike revealed several disturbing facets of the Indian financial system. The most important one was the rude revelation of the utter opacity of IL&FS’ operations. Indeed the day’s frenzy was driven by the fact that no one knew which company or institution would be dragged down by the unwinding of the IL&FS. The contagion was also perhaps triggered by fears that other NBFCs could have similar dud assets in their portfolios.
IL&FS is an unlisted entity. That in itself is a staggering factoid. Given the sheer size of loans it owes—more than Rs.1 lakh crore—being unlisted, it would have to reveal little to investors and regulators. IL&FS is not a bank since it does not take deposits. Instead, it borrows from banks, financial institutions and mutual funds. According to Nomura Research, almost two-thirds of its borrowings are from banks, mostly public sector financial institutions, including the beleaguered PSBs.
Shockingly, for such an opaque operation, IL&FS is merely the parent company. It has 24 subsidiaries, 135 indirect subsidiaries, four associate companies and six joint ventures. One subsidiary, IL&FS Financial Services Ltd, an NBFC, has already defaulted on payment of a short-term loan of Rs.1,000 crore to the Small Industries Development Bank of India (SIDBI). Some others are also reported to have defaulted in repayment of loans aggregating about Rs.500 crore. To cap it all, since NBFCs are not covered by the provisions of the Insolvency and Bankruptcy Code (IBC), there is no immediate recourse to initiating legal measures to recover whatever it can from companies that have borrowed recklessly to gamble on road projects, power plants, water treatment plants, all in the name of enhancing infrastructure capacities (see Table 1). Reports indicate that IL&FS Financial Services Ltd has loan repayments worth $500 million (Rs.3,600 crore) due in the second half of the current financial year, while it has cash to the tune of only $27 million (about Rs.194 crore). Not surprisingly, the credit rating agencies ICRA and CARE (Credit Analysis and Research) have downgraded its creditworthiness.
Andy Mukherjee, the well-regarded Bloomberg columnist, pointed out that the opacity of IL&FS’ operations meant that there was very little information on the true extent of the mess. This is what happened on September 21 when there was mayhem in the stock markets. Since mutual funds and other lenders feared defaults by the IL&FS Group, they may have rushed to exit from company stocks, which precipitated the market collapse. Moreover, there was no information about how much IL&FS owed to which entity. The speculative scramble hit all NBFC and housing finance company stocks and the orgy spread across the entire market, hitting even entities that were not even remotely connected to IL&FS and its line of businesses. Faced with this grim situation, IL&FS is reported to be planning an exit from some of its projects, but this would also be a complicated process because many of these involve other lenders, including banks already saddled with bad loans. Moreover, upon exit, IL&FS would have to accept a heavy discount on the loans, what goes by the name of a bankers’ haircut these days. Since many of these are projects that have been implemented in the notoriously opaque PPP mode, which are characterised by subsidies extended by the state and its institutions (by way of land, financial contributions or tax breaks), the extent of the impending losses is far greater than what is obvious.
Not surprisingly, Life Insurance Corporation (LIC), which is the biggest shareholder in IL&FS, is once again being summoned to act as the saviour to bail out the company. Incidentally, LIC, which functions much like a publicly-owned trust, is currently involved in bailing out the beleaguered IDBI Bank. The use of a public institution to bail out an entity whose collapse has been caused by large corporate borrowers acting recklessly in the certain knowledge that they bear no risk or responsibility whatsoever for their wildly speculative adventures reaffirms what is happening to the PSBs.
The NPA scandal
The PSBs registered their biggest loss in 2017-18, amounting to a combined total of Rs.85,369 crore. But this was only to be expected, given the aggressive push from the Reserve Bank of India and the Finance Ministry to “clean up” their balance sheets. After making provisions for losses in their loan portfolio amounting to Rs.2.7 lakh crore in 2017-18, which was an increase of 57 per cent over the previous year, there was no way their results could be rosy. By the end of the last financial year (2017-18), the gross non-performing assets (NPAs) of the PSBs amounted to Rs.8.95 lakh crore, a staggering 31 per cent increase in a single year. The total volume of “stressed assets”, loans that are categorised as NPAs or those that have been restructured, of Indian banks now accounts for almost one-fourth of all credit disbursed by the Indian banking system (see Table 2). Clearly, no banking system that is so stressed can remain viable, let alone be profitable. The Narendra Modi government’s approach has been to aggressively push the banks to first explicitly recognise the NPAs on their books and then actually set aside provisions for these bad loans that are not earning returns and initiate a distress sale of these assets invoking the provisions of the IBC. The last stage of that operation has been on for some months now, but the results are not savoury. Of the 12 projects (mainly large projects in steel and metals) that have been put through the first round for a settlement, only some have been resolved.
Three aspects of the process are particularly disturbing. The first pertains to the deep discount that buyers of the stressed assets have been offered. In effect, this means that while the original borrower goes scot-free after failing to repay, the new entrant to the project gets the asset at a much cheaper cost. It is evident that while two private investors (the one who exited after the default and the one who now acquires the same asset at a deep discount) gain from this process, the loss is borne entirely by the banks, mostly the PSBs. Surely, there is nothing to celebrate in this kind of solution to the problem. If anything, it suggests a gigantic scam in the Indian banking system, one that would put the Nirav Modi scandal or the Kingfisher scandal to a mere infraction in an ocean of sin.
The second aspect of this resolution process pertains to the manner in which it has been conducted, especially by allowing the original sinners (entities that have defaulted heavily in some of these projects) to participate in the bid for other assets. To ordinary citizens, it would appear morally outrageous to default on one loan while running to purchase another asset. This is what has happened in the case of the recent announcement of the acquisition by a consortium led by ArcelorMittal, the global metals conglomerate, of Essar Steel’s beleaguered assets. The consortium, which includes Nippon Steel and Sumitomo Metal, is to pay Rs.42,000 crore for the acquisition. Essar Steel owes Rs.45,000 crore to the banks. Only the fine print would reveal the true extent of the haircut. In fact, in the run-up to the bidding process, ArcelorMittal and its promoters quit their holding in Uttam Galva Steel and KazStroy Service (a Kazakh entity), both of which defaulted to Indian banks. But ArcelorMittal remains a shareholder in HPCL-Mittal Energy, which is implementing the Guru Gobind Singh Refinery, ostensibly based on funding from the very same banks they had defaulted to earlier. Incidentally, ArcelorMittal’s competitor for the Essar Steel bid was a consortium led by Numetal in which Rewant Ruia of the Essar Group was a part. The question that would arise immediately is: how is it possible for the government, regulators or banks to enforce discipline on a negligent borrower who is being feted and wooed as a non-resident Indian investor? The ArcelorMittal consortium’s acquisition would have to get final approval from creditors and the National Company Law Tribunal.
The third contentious aspect of the entire resolution process is the fact that it willy-nilly drives the concentration of corporate power, even as it bleeds the banks. The three major settlements made so far have resulted in the acquisition of distressed assets by companies that already have a substantial presence in their industries. Essar Steel’s acquisition by a consortium comprising multinational metals majors, Tata Steel’s acquisition of Bhushan Steel and the JSW Group’s acquisition of Bhushan Power and Steel all significantly enhance the monopoly power of the acquiring companies while diminishing competition. Whether that is an intended consequence of the entire resolution process is an open question.
Orgy fuelled by liberalisation
Even as NPAs smother the banking system, there is a massive surge of NPAs emanating from the power sector. According to a recent study by the Centre for Financial Accountability, the outstanding loans of a mere 34 power projects, 32 of which are privately owned, have a combined outstanding loan amounting to a whopping Rs.1.74 lakh crore. The operating companies are in the process of establishing capacities to the tune of 40,130 megawatt. Of this 24,405 MW has already been commissioned and 15,725 MW is in the process of being commissioned. More ominously, 22,422 MW of capacities have been established or are being established for which the entities do not have a power purchase agreement (PPA). What this means is that 56 per cent of the generating capacities is being established (or already established) without a guarantee that someone would buy the power. Given that even a small Indian retailer would know better than to stock without having potential buyers in view, it is hard to imagine what these “powerful” had in mind while venturing into such projects. Was the unstated guarantee that they would not be liable for their actions responsible for their conduct? Or, were they lulled into taking risks with someone else’s money, egged on by the certain knowledge that their adventure would be fully funded? Of the 34 projects, the same group is involved in 14 projects. The Lanco group has four, GMR two, Jaypee Group two, Adani Power two and the Essar Group two. Several of these groups have extensive industrial interests, and their NPAs are extensive. The legal fiction that companies may have common promoters but are somehow separate is what enables the serial offenders who have NPAs in multiple realms to get away while causing grief to the banks.
The former RBI Governor, Raghuram Rajan, currently Professor of Finance at the University of Chicago’s Booth School of Business, submitted a note to the Parliamentary Committee on Estimates on September 6 in which he provided an account of how the NPA build-up happened. Although Rajan has acquired a reputation for speaking his mind, and which appears to have added value in the current climate of intolerance, his statement of the problem is partial and misses key aspects of the banking crisis. In fact, as the RBI Governor, he was responsible for egging on the banks to resolve the NPA mess.
While that may not be wrong in itself, the fact is that it places the entire burden of the adjustment on the victim rather than the perpetrator, especially when such predators are busy chasing the next victim (another bank). The example of the power sector cited earlier is indicative of a much wider malaise in which banks are only one aspect of the problem, one in which the RBI and the government have had much to contribute. Just one example—the Kingfisher collapse—would suffice. It was the RBI’s decision to categorise airlines as an infrastructure industry that made banks increase lending to the beleaguered airline, even when it became evident that it was rapidly becoming a dud asset. The government had information at its command but did little to stop PSBs from lending more.
The liberalised norms for investing in power projects were directly responsible for the sharp increase in generation capacity. Egged on by a regime that guarantees a pass-through tariff (that loads cost directly into tariffs) plus a rate of return on equity, investors poured into new projects. Consider this: the generation capacity increased from 1.32 lakh MW in 2007 to two lakh MW in 2012, an increase of 51 per cent, and between 2012 and 2017 it increased further by 65 per cent. In an economy that is not growing or not visibly growing, this constitutes an excess capacity. This is what the failure by many of the new projects to initiate PPAs unmistakably means; this is also reflected in the growing volumes of power sales in the spot market, at lower prices. In reality, the NPA crisis is not a banking crisis at all, but one that has been engineered by a regime that has abandoned the approach of coordinated investment, what in an earlier time went by the name of economic planning, which treated projects not as a stand-alone investment but in a holistic manner.
Too big to fail
For all his straight talking, it would appear that Rajan’s position on the banks converges quite closely to the Modi regime’s plans for Indian banking. For that matter, it does not differ very much from the previous United Progressive Alliance (UPA) government’s vision. The thrust to cleanse the banking sector of the NPA problem is geared to ensure an environment in which it can be paraded for privatisation. It is clear to these advocates of privatisation that the banks, at least in their current shape, cannot be sold off, not even at a deep discount. This is exactly the same motivation that made Finance Minister Arun Jaitley push for the merger of three PSBs—Bank of Baroda, a large-sized bank; Vijaya Bank, a medium-sized bank with a relatively better NPA position; and Dena Bank, clearly the laggard in terms of its NPA position but one that is small in size. The idea seems to be to create a larger bank in which NPAs of the smaller bank can be made to appear insignificant in proportion to the size of the new entity.
Ten years after the great crash, it appears that the Modi regime has not learnt from the most essential truth of the crash: that size in finance is a recipe for disaster, not an insurance against a crisis. The amalgamation of banks would only create bigger risks. Size may reduce operational costs, but it certainly does not ensure reach, which is critical in a large and diverse developing country like India. What is the point in having an even bigger bank in Bengaluru when the bank is not in a position to reach the small farmer in Mandya in time?
Meanwhile, unmindful of these mundane concerns, the Great Indian NPA Scam rolls on in the sheltered corridors of power in Delhi.
The article, first appeared on the Frontline, can be accessed here.