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Economic Survey: A Central 'Bad Bank' Can Rectify Stressed Assets
Wed, 1 Feb Pre-Open

Amid the hullaballoo of the Union Budget, the economic survey tends to go unnoticed. Yet this - the flagship annual economic document of the Ministry of Finance - deserves attention. It contains a lot of economic data for the year as well as solutions to the challenges facing the economy.

The Economic Survey 2016-17 stated that Indian banks should be recapitalised at the earliest and a centralised bad bank needs to be established to take over large bad loans.

This survey predicts that India may be unable to grow out of its debt problem, which would soon take a toll on economic growth. That's because stressed corporates are reducing their new investments while stressed banks are unable to take new lending risks.

An article in The Business Standard holds that the survey's solution that suggests that the government will have to prepare a massive bailout mechanism for indebted corporates. This would be achieved through the establishment of a Public Asset Rehabilitation Agency (PARA).

This means that the government would buy bad loans from banks and reimburse them for losses or recapitalize them. The PARA would essentially take charge of the largest, most difficult cases, and make politically tough decisions to reduce debt.

The bad bank concept is not entirely new in India. When IDBI Ltd converted into a bank in 2004, the government set up a Stressed Asset Stabilisation Fund to hive off its stressed and non-performing cases worth Rs 9,000 crore. This indicates that segregation of good and bad debt isn't enough to solve the bad debt problem. Though this creates a good balance sheet, it does not necessarily solve the ground level problem of recovery. It is also seen as a 'moral hazard' shielding banks from their own inconsistencies and failure to take proper precautions.

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A bad bank may have been a solution in other countries, however, setting one up in India will be more complicated.

So, will the tax-payer's money be used to bail out the big corporates? The survey says the government could compensate banks for their losses by selling them government securities, or the government could recover its money if PARA manages to recover some of the bad loans it has purchased from banks.

But the experience of Asset Reconstruction Companies and other schemes haven't proved effective. Most of the restructured loans have interest rates added to the value of the asset over the past few years. But these assets, in fact, have lost value even at the cost level.

Also, the Strategic Debt Restructuring scheme has been a limited success. It was observed in restructuring cases that borrower companies were not able to come out of stress due to operational/managerial inefficiencies.

Alternatively, the Survey suggests that PARA could be funded through government issue of securities and/or through equity capital provided through RBI. This reduces RBI's cost of borrowing bonds directly from the government. Raghuram Rajan had also wondered why RBI should not use its reserves to recapitalize banks.

  • Now, let us understand the rationale for not taking this back from the RBI and using this to buy back bonds. You could do that. Or you could trump it from every rooftop that you have so much in terms of assets with RBI. Why do we think it's useful for it to stay in the RBI? Because you need an entity in the economy which has a pristine rating. So, for example, if you want to do swap arrangements with other economies, you are better placed if you have a AAA-rated entity.

So the recapitalization of PSU banks is only a short term reprieve. The real problems are far from being resolved. Investors should take into account the sustainability of credit growth and asset quality instead of investing in banks looking to writing off bad loans with newly acquired funds.

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