NPA clean-up suggests higher inflation

The bad loans problem in Indian banking has to be handled with firmness, creativity and pragmatism, says the RBI Governor. The Chairman of the Banks Board Bureau says that two large public sector banks could be merged in the coming fiscal once a clean-up of bad loans has run its course. The deadline for a creative and pragmatic clean-up, therefore, seems to be the next six months of this fiscal.

But, how can a clean-up of a mess, that itself is yet to run through its course, be completed in the next six months? A RBI Deputy Governor in an August 30 speech says that there is potential for some more pain. Therefore, one can only conclude that the RBI Governor and Banks Board Chairman’s idea of clean-up is something else than is commonly understood. Their idea seems to be that it (clean-up) is over once the bad loans are partitioned into sustainable and unsustainable portions (as per the S4A scheme). The unsustainable portion is to be designated as banks’ equity investment in the borrower companies.

But our idea of clean-up is that whether you classify it as a loan or equity investment — the asset should generate returns for its holder. This means the debtor (borrower) should be able to service his capital fully with his operational earnings. In a sample of some 3,000 companies, Credit Suisse in a recent update says that 40 per cent have interest coverage (IC) of less than 1 (interest coverage ratio is the ratio of earnings before taxes and interest as a proportion of interest payouts). It is only slightly higher than 1 for the rest. (An IC of 2.5 is considered acceptable). Therefore, for the bulk of the sample, only piecemeal debt servicing is being done. For the NPAs, of course, there is no debt servicing.

It is only when hitherto non-earning assets turn into earning assets that we can say that a clean-up has been achieved. And that can likely happen only over the next two to three years. Indeed, the equity stakes that banks may be forced to take in borrower companies can potentially turn dud (unsaleable!) if too much of the current debt pile is re-designated as equity, but companies are still not able to achieve IC of more than 1. That is, unsustainable turns to supposedly sustainable but again becomes unsustainable!

The key issue, therefore, is companies should be able to service their capital — equity or debt. They will be able to do that only if their operating revenues exceed their expenditures. An IC of less than 1 shows a gaping mismatch between operating expenditures and revenues.

This mismatch can be eliminated only if there is much higher inflation in the goods (and services) that the debt-laden companies are selling. That is, these companies should get much stronger pricing power than they have currently so that they are able to inflate the value of their sales. (Sales growth is very weak now — even negative as the accompanying chart shows).

The inflation in revenues should be higher than the inflation in expenditures.

Overall, then, a neat solution to the bad debt crisis is to generate much higher inflation in the overall economy. To be sure, at first glance, this inference may seem off-the-mark. Particularly so now, since a re-jigged monetary policy framework for the RBI is supposed to make inflation scarce in the ensuing period!

But inflating away debt is an age-old solution to a debt crisis. The prime example is India’s fiscal history itself — the overall public debt as a fraction of GDP has fallen from 85 per cent in the early 2000s to the 65 per cent levels now — mainly because of the sharp increase in the prices component of nominal GDP.

At the global level too, inflating away debt is a time-tested technique. The most recent example is provided by the sharp fall in delinquency rates on US residential mortgages in the past few years — from their highs following the housing crash of 2008-09. So, what aided the sharp fall in the delinquency rate on residential mortgages? The key driver is the significant recovery in housing prices as the charts show. After falling nearly 40 per cent from their peaks in 2006, US home prices are now up nearly 30 per cent from their lows. That has incentivised debt repayment and delinquency, is therefore falling.

Hence, there are only two ways to reduce debt burdens: default on it outright; lower its real value through high inflation.

The search then will be for the channels through which we can generate higher inflation. A much weaker Indian currency is an obvious candidate here. India’s RBI may also have other tricks up its sleeve.

The writer is a Chennai-based financial consultant