A prescription to fix the Economic Mess

Alright, we heard you. In today's newsletter we will focus on the remedial measures prescribed by Arvind Subramanian in his recent paper and once again try to condense all that information into a 3 minute read. Wish us luck.

Note: We will refer to Arvind Subramanian simply as AS in the story.

The Story

The remedies are broadly divided into two lists: The Negative list and the Positive list.

Let’s start with the negative list for now.

Monetary Policy: This one is a no brainer. The Reserve Bank of India has been cutting interest rates in the hope that banks would follow suit and offer cheaper loans to their customers. This should work well in theory. RBI cuts its interest rate. Banks can now borrow at cheaper rates. So they start lending at lower interest rates as well. Everyone’s happy.

Unfortunately, that isn’t happening today. Despite repeated rate cuts by the RBI, lending rates in banks have stayed put. AS argues that this phenomenon is a byproduct of risk aversion that’s rampant in banking circles right now. Considering that most banks have found themselves in a precarious situation (because of the bad loan epidemic) they are seeing red flags everywhere. So despite being on the receiving end of RBI’s generosity, banks are simply too scared to cut rates. Instead, they are more focused on shoring up their reserve buffers i.e. a cash cushion that can protect you during a financial downturn.

AS also goes on to argue that forcing banks to offer cheap loans won't help either. Banks aren’t cutting rates not because they are greedy. They are not doing it because they are under significant stress already. You can’t blame them for not wanting to take on more risk. So yeah, this scheme is very inefficient.

Next on the negative list is — Fiscal policy.

Now some people believe that an easy fix for us right now is to make sure the government spends mad money in an attempt to kickstart economic growth in this country.

But there's a problem. The government has already been spending large amounts of money by taking on even larger amounts of debt. Now I know that the government keeps harping about how it’s not a total spendthrift, but AS contends that this bit is completely untrue.

The government has been hiding its debt burden for a while now. Most notably by forcing government-owned entities (like NHAI and the Food Corporation of India) to borrow on the outside and fend for themselves. But here’s the thing. The only reason these entities can borrow any money at all is because everyone knows that the eventual repayment is guaranteed by the government. So technically this borrowing is also government borrowing but its simply not included in the tally (fiscal deficit).

So no, the government doesn’t have any room to spend any more money, because it can’t borrow any more. In effect, this plan won’t work.

What might work, however (according to AS) is a combination of the famed 5R’s (with blessings from the government of course)

R=Recognition, R=Resolution, R=Regulation, R=Recapitalization, R=Reforms

5Rs. Get it?

Recognition: The first step is to understand the true scale of the problem. AS argues that it’s time for the RBI to go snoop around and see if the Banks and NBFCs have something to hide. Be thorough, be diligent and leave no stone unturned. It’s time to check the financial statements again so that we can know for sure if there’s another bad loan problem festering deep within.

Resolution: Once we know the true scale of the problem, we need an effective resolution mechanism. AS mainly focuses on the IBC (The Insolvency and Bankruptcy Code)— a relatively new piece of legislation that was brought in to make willful defaulters pay up or go home. His main contention is that there have been unnecessary delays in forcing these bad apples to settle their unpaid dues.

So for the IBC to work well, we need less interference from courts. We need to ensure government-owned banks have enough incentives to take defaulters to task and something in there for defaulters to act in good faith.

Then we need to set up a new bank — a bad bank of sorts, to take on the remaining bad loans. Loans that are unlikely to be resolved or paid back in full. We take these loans away from the public sector banks and put them in a separate entity whose sole aim will be to get rid of the collateral backing the loans. This way, banks can get back to their job without having to worry about the bad assets and the new "bad" bank can work its magic and get rid of what’s left.

Regulation: We also need the RBI to closely monitor NBFCs from here on in. You can’t let them off the leash any more. They are one of the main reasons why we are stuck in this current predicament and we need effective regulation that can prevent them from perpetuating another crisis.

Recapitalization: AS also argues that while the government has been infusing funds into public sector banks (to make them healthy again), they’ve still been ineffective in managing the bad loan epidemic. One way to sort them out is by only infusing funds into banks that show improvement. This way banks will have an incentive to work for the money.

And finally…

Reforms: Public Sector banks aren’t very good at risk management. They’ll screw up one way or another. So the best way to address this problem is by allowing private players to own a majority stake in some of these banks. This way, banks will actually have an incentive to eke out a profit and maybe they’ll be more prudent whilst extending loans in the future.

Also, any plan will inevitably fail if we don’t have the means to track progress i.e. Any prescription/diagnosis can be offered only when we understand the pulse of this country. But if we are working with a broken heart rate monitor we aren’t going to do a good job at it. So its time for the government to set up independent agencies within the legislative framework to collect and interpret data (economic indicators mostly) so that we know how best to tackle the issues at hand.

And as such, it is perhaps the most opportune moment to quote AS one last time — “As we measure, so we are”.

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