From Business World of 20 February 2005.
Why debts go sour
After the
Manmohan Singh boom ended in 1997, enormous debts of banks and government
financial institutions (FIs), whom I shall call stupid lenders (SLs), went
sour. Reserve Bank framed rules about when bad debts had to be recognized, and
how banks might go about settling with bad debtors. The banks did not settle,
as they could not come out of cover-your-ass syndrome. They complained that
courts took too long and that BIFR helped the defaulting borrowers; so the
government set up debt recovery tribunals (DRTs) and manned them with pliant
retired civil servants. But DRTs found banks as often at fault as their
debtors. If they ruled against debtors, the latter could appeal to higher
courts. Altogether, the tribunals did not bring the SLs the billions that the
government had hoped.
Then the government brought the misnamed and unjust
Securitization Act. In the absence of securitized debt market it has nothing to
do with securitization. And disposal of securitized paper in the absence of
regulatory clearance for investment by FIIs remains a far cry. However, it
enables government-owned SLs – and no other creditors – to take over secured
assets of bad debtors, and realize their dues without intervention by the
judiciary system.
Anyway, this Act has been in operation for some time,
and some SLs have taken over some assets. Not much is known about the outcome.
But it will fail just as surely as BIFR and DRTs, for the market value of the
seized assets will be just a fraction – generally between 1/3 and 1/5 – of the
debts; and if those assets are sold, their sale will bring down the market
value further.
The high personal tax rates till 1991 ensured that no
new entrepreneur could accumulate much wealth legitimately. Together with relatives
and friends he might raise maybe ten crore. But beyond that he had to borrow.
And the government had nationalized the lenders; so he had to go and borrow
from SLs.
SLs did not lend working capital, leaving the gap to
be tied up later; and they charged interest on their loans even in the initial
period when a project was under
implementation. The entrepreneur had to bring his own money for these
requirements besides his stipulated contribution the SLs insisted on. But if he
did not have enough, he had easier options. He overstated the value of his
machinery and equipment, got a bigger loan and used it to cover his
contribution.
Even then, loans were often insufficient; so the
entrepreneur had to go to the capital market. But the regulations governing
IPOs required him to show profits for three years. How could a new entrepreneur
show profit even before he had stabilized production? He showed the loans from
SLs as having been spent on machinery, made a counter-entry in sales, and thus
cooked the balance sheet to show profit. There would be fictitious plant and
equipment on the asset side, matched on the liabilities side by fictitious
reserves. The company might survive, succeed and grow, in which case the
fictitious assets might eventually be written off from profits. But then it
might not: It might go sick, and its debts would become bad.
The Indian economy has been subject to cycles, and
each cycle has left a swathe of failed companies and bad debts. The biggest
wave was the last one in the 1990s. The Manmohan Singh boom created enormous
euphoria, investment went into all wrong industries because protection was
high, and SLs lent like mad. A slump followed after 1997, companies turned
turtle, and the loans given to them went bad.
If my model of the process is right, there are hardly
any assets to seize, and the Securitization Act is doomed to fail. But there is
a way out. That is to find entrepreneurs to turn around the taken-over
businesses, and to engage them on terms that would reward success, such as
venture capital funds use with new entrepreneurs. The business would belong to
the SL or an asset reconstruction company. Initially, the entrepreneur would
get a salary, and most of his profits would go to the financier. But the more
profit he makes, the more he would keep; and once the financier has recovered
what he planned to, he would turn over the business to the entrepreneur. The
entrepreneur could well be the erstwhile bad debtor himself.
If properly run by an honest manager who is not too
greedy, this could be a great business – so good that I would be prepared to
invest in a mutual fund that financed it. Let a hundred Bad Debt Funds bloom!
