India’s Big Government

by Vivek Kaul

  Table 11.3(c): Segment-wise Gross NPAs of the State Bank of India.

  Source: Analyst’s presentation (2015-2016), State Bank of India.

  This is the broad trend observed across banks, with corporates/ industry bringing in the maximum amount of bad loans.

  As can be seen from Figure 11.1, the gross NPAs due to bank lending to industries as a whole stood at 11.9 per cent of their total loans as of March 2016. At the same point of time, their corresponding stressed assets stood at 19.4 per cent, i.e., one-fifth of the loans given out by banks to industry are now in trouble. They have either turned into bad loans or been restructured.

  The question is: Why has this happened? Why has such a huge proportion of loans given to one particular sector turned bad? One explanation lies in the fact that much of this borrowing was carried out during the go-go years before 2011, when the Indian economy was doing well and had been growing at greater than 8 per cent per year.

  Figure 11.1: Asset quality in major sectors for all banks over the period March 2012 to March 2016.

  Source: RBI supervisory returns.

  In this scenario, the promoters of companies borrowed and their companies expanded at a rapid rate. As often happens in good times, banks were also more than happy to give out loans. Nevertheless, when the tide turned post-2011, promoters found it difficult to repay their loans.

  But this is just a part of the explanation. A major reason for banks ending up with such a huge amount of bad loans from industry lies in the fact that crony capitalism flourished during the second term of the Manmohan Singh government. As the Financial Stability Report of June 2016 points out: “A risk profile of select industries as… [of] end March 2016 showed that [the] iron and steel industry had high leverage as well as interest burden. [The] construction, power, telecommunications and transport industries also had relatively high leverage.” High leverage refers to a situation wherein the debt of the company is very high with respect to its equity, or, basically, the capital that the promoters have put into the business.

  The sectors with high leverage are basically sectors where the crony capitalists ruled the roost during the Manmohan Singh government years. An excellent example here is that of Lanco Infratech. As on March 31, 2014, the company had total loans amounting to Rs. 34,877 crore. Against this, the company had a shareholders’ equity of Rs. 1,457 crore. This means that the company had a debt-to-equity ratio of around 24. Not surprisingly, for the period of the three months ending on September 30, 2014, the company had an operating profit of Rs. 317.23 crore and financial costs of Rs. 773 crore.

  Now compare this to what business schools teach in their basic financial management classes: Anything beyond a debt-to-equity ratio of 2:1 is risky. And here, Lanco Infratech had a debt-to-equity ratio of 24:1.

  To put it in a simple way, the situation is similar to when an individual approaches a bank for a home loan for a home priced at Rs. 50 lakh. The bank agrees to give a home loan of Rs. 48 lakh and the individual needs to put in only Rs. 2 lakh from his side (which is essentially what equity is) to buy the home. This would lead to a personal debt-to-equity ratio of 24:1.

  Of course, no bank would do this and would, instead, ask for a down payment of at least 20 per cent of the home price, or Rs. 10 lakh in this case. In fact, it is interesting to look at the home loan-home value ratio of SBI. The average home loan-home value ratio of the bank as on March 31, 2015 had stood at 53.1 per cent. This dropped to 52.9 per cent by March 31, 2016. Hence, it is safe to say that, on an average, SBI gives home loans which are around half the value of the home that is being bought by the borrower. But the same prudence doesn’t seem to have been followed by banks when it came to lending to corporates.

  Getting back to Lanco Infratech, what the figures clearly tell us is that the banks giving loans to this company did not do so with any due diligence or were simply under pressure to hand out the loans. This is not surprising, given that Lanco Infratech’s founding Chairman, L Rajagopal, was a Member of Parliament from Vijaywada on a Congress Party ticket in the fifteenth Lok Sabha between 2009 and 2014.

  In fact, the senior journalist Shekhar Gupta wrote in The Indian Express in February 2014 that Rajagopal’s companies got new loans of Rs. 3,500 crore against an equity of Rs. 239 crore, with a leverage of around 14.7:1. Twenty-seven banks were involved in bailing Rajagopal out.633

  Figure 11.2: The debt-to-equity ratio of IVRCL over the past 15 years.

  Source: Author’s calculations based on the annual reports of the company.

  Another good example of extremely high leverage is a company called IVRCL, which is into construction. The company was in the news when a part of a flyover that the company was building in Kolkata collapsed on March 31, 2016. Figure 11.2 shows that the leverage of the company has exploded over the years, which, as on March 31, 2015, had stood at 12:1.

  Raghuram Rajan explained this situation in a November 2014 speech when he said:634

  The reason so many projects are in trouble today is because they were structured up front with too little equity, sometimes borrowed by the promoter from elsewhere. And some promoters find ways to take out the equity as soon as the project gets going, so there really is no cushion when bad times hit. Lenders should insist on more real equity up front, and monitor the project closely to ensure it stays in. Promoters should not try and finance mega-projects with tiny slivers of equity.

  This is precisely what had happened.

  The promoters had very little skin in the game. A research report brought out by EY and titled ‘Unmasking India’s NPA issues: Can the banking sector overcome this phase?’ made the same point as Rajan. It said that while corporates kept blaming the weak economic scenario for their bad loans, “periodic independent audits on borrowers have revealed diversion of funds or wilful default, leading to stress situations”.635

  In fact, Lanco Infratech and IVRCL are just two examples of promoters borrowing much beyond their repayment capacity. There are several other such promoters. Over the past few years, the stock brokerage firm Credit Suisse has been bringing out a series of reports titled The House of Debt. The October 2015 version of the report lists many groups which are highly indebted. The report tracks the total debt of 10 Indian business groups which have taken on around 12 per cent of the total loans of the Indian banking system. These groups are the Adani Group, the Essar Group, the GVK Group, the GMR Group, the Lanco Group, the Vedanta Group, the Reliance ADAG Group, the JSW Group, the Videocon Group and the Jaypee Group.

  The report makes several important points:636

  a) The loans given to these business groups amount to 12 per cent of the total bank loans. Furthermore, they amount to 27 per cent of the corporate loans given out by banks. Over the past eight years, the loans of these 10 business groups have gone up seven times. This rise in pace slowed down and, in 2014-2015, the increase was 5 per cent.

  b)The interest coverage ratio of these business groups was at 0.8 in 2014-2015, down from 0.9 in 2013-2014. The interest coverage ratio essentially points to the ability of a company to keep servicing its debt by paying interest on it. The ratio is calculated by dividing a company’s earnings before interest and taxes (its operating profit) during a given period by the total interest it has to pay on its outstanding debt during the same period.

  Typically, companies need to have an interest coverage ratio of at least 1.5 to be considered in healthy financial territory. In this case, the ratio is just 0.8. An interest coverage ratio of less than one means that the company is not earning enough to keep paying interest on its outstanding debt. Hence these groups are not earning enough to pay the interest on their total debt, leave alone the total principal.

  The trouble with any average number is that it does not give us a complete picture. The interest coverage ratios of several groups are well below the average. The GMR Group’s is at 0.2, the GVK Group’s is at 0, the Lanco Group’s is at 0.2, the Videocon Group’s is at −0.3 (this basically means that the company ha
s made an operating loss over the given time period), and the Jaypee Group’s is at 0.6. These business groups are in a very bad situation when it comes to the ability to keep servicing their respective bank debts.

  c)Given that the interest coverage ratios of these firms are in such a mess, it is not surprising that they are already defaulting on their debts. As the Credit Suisse analysts point out: “Rating agencies have now assigned the default ‘D’ rating to ~ 5-65 per cent of [the] debt for these groups.”637

  d)These highly indebted business groups have tried to repair their balance sheets by selling assets in order to repay their debts. This hasn’t helped much, given that, in certain cases, the assets that they had to sell were essentially the ones bringing in the money for the company in the first place.

  Take the case of the Jaypee Group. The group has sold assets, and these sales are expected to bring in Rs. 22,000 crore. The trouble is that these assets contributed 59 per cent of its operating profit during 2014-2015. What has not helped is the fact that many projects in the power and road sectors have had cost over-runs due to delays in completion. Some projects have had cost over-runs of 20-70 per cent.

  It is also worth mentioning here that the owners of a bankrupt company have no real incentive in acting in the best interests of the company. This is a point that the Nobel Prize-winning economists George Akerlof and Robert Shiller make in their book Phishing for Phools – The Economics of Manipulation and Deception.

  As they write: “If the owners of a solvent firm pay themselves a dollar out of the firm, they diminish the amount they can distribute to themselves tomorrow by that dollar plus its earnings.” Hence, owners of a solvent firm have some incentive to not take out money from it. But that is not the case with the owners of an insolvent (or bankrupt) firm.

  As the economists write: “In contrast, if the owners of a bankrupt firm take an extra dollar out of their firm, they will sacrifice literally nothing tomorrow.” And why is that? “Because the bankrupt firm is already exhausting all of its assets paying all those Peters and Pauls [read as ‘banks’ in the Indian case]. Since there will be nothing left over for the owners, they have the same economic incentives as Genghis Khan’s army as it marched across Asia: what they do not take today, they will never see tomorrow. Their incentive is to loot.”

  This also explains an oft-repeated business wisdom in India about many Indian firms becoming sick but no Indian industrialist ever going that way. As Rajan put it in a November 2014 speech:638

  … [Across] much of the globe, when a large borrower defaults, he is contrite and desperate to show that the lender should continue to trust him with management of the enterprise. In India, too many large borrowers insist on their divine right to stay in control despite their unwillingness to put in new money. The firm and its many workers, as well as past bank loans, are the hostages in this game of chicken.… The promoter threatens to run the enterprise into the ground unless the government, banks and regulators make the concessions that are necessary to keep it alive. And if the enterprise regains health, the promoter retains all the up-side, forgetting the help he got from the government or the banks – after all, banks should be happy they got some of their money back! No wonder government ministers worry about a country where we have many sick companies but no ‘sick’ promoters.

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  Crony capitalism explains only one side of the messy story of the PSBs. There is another side to it, which can be explained through what economists call the ‘principal-agent problem’. This essentially refers to the problem of motivating the agent to act on behalf of the principal. Problems arise when the agent wants to act in his own interests rather than the interests of the principal.639

  How does this apply in this context? As Vijay Joshi writes in India’s Long Road: “The government also suffers from a ‘principal-agent’ problem. Its functionaries (legislators, bureaucrats) may pursue their own agendas rather than act in public interest. They may shirk their duties or feather their own nests. They may make deals that benefit special-interest groups at the expense of the general good.”640

  This is precisely what happened in the case of the PSBs, where a nexus was formed between the managers who ran the banks and the politicians, who forced these managers to give loans to crony capitalists.

  In fact, the EY report referred to a little earlier pointed out that the nexus went way beyond just the managers, politicians and crony capitalists. The report cited a survey carried out by EY, in which 64 per cent of the respondents believed that the bad loans of banks resulted primarily because of lapses in the due diligence carried out by the banks before the loans were sanctioned.641

  The report went on to suggest that lenders (i.e., the banks) relied on many third-party agencies, like surveyors, financial analysts, engineers, etc., in order to carry out the due diligence. These third-party agencies played an important role in assuring the financial information of the borrower, the work completion status of a project, the application of funds, etc. The entire system was manipulated. In fact, in some situations, the borrowers even managed to get the reports drafted in ways that suited them.

  I wrote a column about the EY survey and got a very interesting response from someone who had an insider’s perspective of how the loan processing and disbursal process of a PSB actually works. He gave me two examples of the loan disbursal system being manipulated. This ultimately led to several banks ending up with bad loans.

  The first case was of an unlisted entity in the luggage manufacturing business. The firm borrowed money from two big PSBs. The promoter of the company offered his equity in the company as well as land and the factory as collateral. This transaction took place in 2007. The valuation report by a third-party agency put the combined value of all the assets at Rs. 35 crore. Against these assets the banks gave a loan of around Rs. 27 crore. The promoter took this loan. He also borrowed Rs. 3 crore more from the banks.

  Later, another valuer was brought in to examine the value of the assets, and the value of the assets was then put at a much lower Rs. 19 crore. The old valuer was dismissed, but by then the damage had already been done. The bank had given out a loan of Rs. 30 crore against assets which were worth only Rs. 19 crore. Ideally, the situation should have been exactly the other way around, where the bank should have given out a loan of Rs. 19 crore against collateral worth Rs. 30 crore.

  The second case involved a listed company in the building materials space. The company came out with an initial public offering and was listed at a three-digit price. The price of its shares later crashed.

  The company took loans amounting to Rs. 325 crore from two big PSBs and one of the bigger new-generation private sector banks. The promoter did not stop at this. He borrowed more using his other listed entities as well. In 2013, he defaulted on the loans, citing slowdown in the construction activity sector.

  He ended up owing around Rs. 1,000 crore to the banks. The book value of the assets that the banks had as collateral was around Rs. 225 crore. The market value was expected to be in the region of Rs. 325-350 crore. The rest of the money was lent by the banks against shares, which, by the time the promoter had defaulted on the loans, had fallen to single-digit levels.

  In both cases, the banks ended up with losses. The point is that the crony capitalists and politicians could not have caused the damage that they eventually did without the support of the managers of PSBs as well as the third-party system which supports them.

  This is a classic example of the principal-agent problem at work. The incentives of the managers were not in line with public interest, which should have been to give loans which would be repaid and not defaulted on. The managers knew that if they did not listen to the politicians, they were likely to get transferred to a nondescript location, not get promoted and face other problems as well.

  Also, in the case of PSBs, salaries are paid on the basis of seniority, and there is no extra payment for performance. As Joshi points out: “In the public sector, managerial incenti
ves are blunted because all profits belong to the state.”642 On the other hand, private sector banks tend to issue employee stock option plans to well-performing employees. Hence, there is no incentive to go looking for an income beyond what one is paid by the bank.

  In fact, the principal-agent problem even came in the way of banks getting around to recognising bad loans as bad loans. It was in the interests of the public sector bankers to keep postponing the problem by not recognising bad loans as bad loans. This was done through restructuring problematic loans and giving out fresh loans to troubled borrowers so that they could repay their maturing loans. Of course, it was in the interests of the public sector bankers to keep hiding bad loans even though it wasn’t in the overall public interest. The first step towards solving any problem is to recognise that it exists, which clearly wasn’t the case here.

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  In the Financial Stability Report published by the RBI in December 2015, there was a very interesting section titled ‘In Search of some Old Wisdom’. In this section, the RBI resurrected the economist Hyman Minsky. Minsky has been rediscovered by the financial world in the years that have followed the financial crisis, which started with the investment bank Lehman Brothers going bust in September 2008.

  So what does the RBI say about this? “When current wisdom does not offer solutions to extant problems, old wisdom can sometimes be helpful. For instance, the global financial crisis compelled us to take a look at… Minsky’s financial stability hypothesis, which posited the debt accumulation by [the] non-government sector as the key to [an] economic crisis.”

  And what is Minsky’s financial stability hypothesis? Actually, Minsky put forward the Financial Instability Hypothesis, and not the financial stability hypothesis, as the RBI claims. The basic premise of this hypothesis is that, when times are good, there is a greater appetite for risk, and banks are willing to extend riskier loans than usually is the case. Businessmen and entrepreneurs want to expand their businesses, which leads to increased investment and corporate profits. In the Indian case, it also led to businessmen padding up project costs and siphoning off the money they had borrowed as loans.