Wednesday, October 15, 2014


Goa is a fun place; no wonder well heeled institutions hold meetings there. At one of them in January 2001, I had an argument with Nachiket Mor, who spent his working life in Industrial Credit and Investment Corporation of India except for some initial years when he helped farmers grow mushrooms. The liberalization of the 1990s brought competition to ICICI, so it is no wonder he was less enthusiastic about the reforms than I was. I continue to think that the supply of equity in India is insufficient; that is a major reason why this country teeming with entrepreneurs had done so poorly in business, especially in developing a corporate culture. This column was published in Business Standard of 23 January 2001.



At a recent Invest India conference in Goa, I said that communism failed because it tried to create economies in which there was all debt and no equity. Output in real economies was bound to fluctuate; someone had to bear the brunt of the fluctuations. In capitalist economies, the shareholders took most of the risk and enjoyed the rewards. In a communist economy, the state bore all the risk. But it did not get all the reward, for its agents – the managers and workers of state-owned enterprises – had an incentive to siphon off the rewards. Maybe there was a solution to this problem that clever economists could work out; but before they could do so, communism had collapsed.
That is too bad; but perhaps the economists have been born. For at the conference, Nachiket Mor of ICICI argued that Indian industry was in trouble because of the import duty reductions following the reforms; if only the duties had remained at 110% plus, there would have been no problem. And the companies were not really in such trouble; it was the press that spoiled their image by ill-informed, ill-timed flash reports. And suppose the press were half-right and the businesses were in poor shape; so what? Ninety per cent of the businesses financed by a venture capitalist failed; he made enough money on the rest to cover all his losses. So why should Indian banks and financial institutions be expected to avoid non-performing assets? NPAs were an inherent part of the lending business.
Because they had been made so paranoid about nonperforming assets, they overfinanced triple-A companies and starved small businesses of funds. The security they bought thereby was illusory, for triple-A companies were few, and the lenders unconsciously took on concentration risk. Many of those companies produced a single product like steel or cement, which added to the risk. Companies themselves were no good at assessing risk; they planned on the assumption that current conditions would continue forever. CRISIL had rated no more than 1500 companies; not more than 5000 companies were creditworthy. There were no data on migration rates between ratings. Companies’ debt capacity depended on their riskiness; so many of them were not worthy of further borrowings. Foreign financial markets imposed discipline on companies that raised money abroad and they had to make a credible case on the basis of solid accounts; but their numbers were even smaller.
According to him, banks and FIs faced unfair competition from mutual funds. The latter institutions had no minimum capital; they could lend all they borrowed, whereas banks and FIs had to set aside capital and put their funds to various unremunerative uses such as directed lending and lending to feckless government enterprises.
The principle is to write off expected losses and to provide capital against unexpected losses. On this principle, the probability of loss should be built into interest rates: the higher the likelihood of default, the higher should be the interest rate. In India, interest rates are biased in three ways. First, the rates paid to depositors are too low; they subsidize banks, FIs, and borrowers. Second, maturity premia are too low: long-term rates are not sufficiently above short-term rates, so lenders keep their funds in short-term investments, and long-term finance is not available for lending. That is why institutions end up giving five-year loans from three-month money. The solution would be to short loans; but that is not possible in India. Finally, risk premia are too low; the rates charged to risky borrowers are not sufficiently above those charged to safer borrowers. As a result, there is too little money available for lending to risky borrowers; too much is thrown at safe borrowers.
In these conditions, ICICI is feverishly compiling credit ratings, and assembling migration tables. On their basis it fixes risk premia. It bases its prime rate on market rates; since they change from hour to hour, it too changes its rates – once a week. The idea is to match lending rates to borrowing rates all the time, and to match interest rate differentials to risk profile.
I do not have much difficulty with this view as a micro view of the environment in which ICICI operates - although I hope its borrowers do not get to know that it thinks of itself as a venture capitalist and is blithely reckoning on losing 30-40 per cent of the money it lends. If they come to hear of it, the figure might get close to 100 per cent. If Nachiket Mor is right to think that it is very risky to lend to big triple A companies, ICICI may build up a great business lending to small and obscure businesses – provided they get on to its credit ratings and migration tables.
What I find less acceptable is the view, held by Ajay Shah, that the debt-equity ratio does not matter. To him, as long as businesses are transparent and their financial instruments are liquid, it makes no difference whether they raise debt or equity. The risk of default on debt will be anticipated and will have been provided for in interest rate differentials. The small investor who has lent to only one company that defaults may be wiped out; too bad he did not work out credit ratings and migration tables. But the solution is to persuade him to invest through ICICI. ICICI will work all these things out for him, invest his money like a venture capitalist and get him fantastic returns.
What are these returns? I lent ICICI money at 18 per cent in 1996. It has to repay me in the next fortnight; it is offering me 11-odd per cent for not taking back my money. Suppose its own spread is a fantastically low 1 per cent, and it aims to earn 12 per cent. If it expects a 40 per cent default rate, it will charge borrowers 20 per cent; if 80 per cent, it will charge 60 per cent. These are lower limits.
At these rates, it will not get much business, for other banks and FIs are charging less. And they are charging less because they the government has bailed them out from bankruptcy before and will again. That is the condition under which the debt-equity ratio does not matter. For then the funds lent by government financial institutions are debt only in name; in reality, they carry the full risks of equity, and earn its reward. In fact, Ajay himself has recently calculated the huge subsidies the government implicitly gives banks by insulating them from bankruptcy.

If this government guarantee were removed, interest rates would come to reflect risk premia. At interest rates of 30-60 per cent, many more people would be prepared to lend to small and risky businesses. And if they had a proposition that promised 60 per cent, they would not go to a bank; they would go to a venture capitalist, for he would take the chance of earning 60 per cent on equity. That is why if the government, the chief distortion in the financial markets, were removed, the overall debt-equity ratio would come down.