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.
MODERNIZING COMMUNISM
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.
