The Fatal Lending

One of the chronic problems that our economy is plagued with is the magnitude of Non-Performing Assets (NPA) in state-owned banks. The Insolvency and Bankruptcy Code (ÍBC) began with a bang as the Reserve Bank of India (RBI) ensured that the twelve largest cases of default were referred under this law. However, four years hence, the corrosion being inflicted by the percentage of NPAs on the banking system refuses to abate. After a hiatus of a year on account of the pandemic, the gravity of the problem will only get bigger once the IBC code is revived soon.

Delving into the depth of insolvencies, one discovers that the malaise has afflicted nearly every other prominent business house that embarked on ambitious projects. Several promoters who set out to build large infrastructure projects in sectors such as steel, power, telecom, and infrastructure seem responsible for the turmoil. While the natural tendency would be to accuse the promoters of siphoning off funds or banks funding unviable projects; these beliefs are far from the truth. Admittedly, every delinquent loan has its own story. But, if the desire is not to repeat these outcomes, we ought to fix the actual problems. Is there a case for an ecosystem of financing large projects using the conventional lending approach, preordained to fail?

As an emerging economy, India still operates with a headline tax rate of over 30% and a borrowing rate that remains perennially over 10%. The combination of high taxes and interest rates increases the cost of borrowing dramatically when compared to developed economies. If one were to borrow INR 10,000 crores for a project, it should deliver an average top line of INR 25,000 crores per annum (i.e., two-and-a-half times the amount borrowed) with a 10% generation of cash, consistently over ten years. Only then will the project service the loan, pay taxes on income to generate free reserves and successfully repay it.

However, this dream sequence seldom plays out in real life, and eventually, almost all large debts wind up in the insolvency court. From the experience of the past two decades; only in the rarest of cases, would one find a company that has successfully discharged their loans from internal accruals. In a few instances, the debt initially raised is either replaced with new debt or infusion of equity. Then there are others who are still accumulating larger debt before the game of musical chairs can stop.

The story of a large steelmaking company that is still languishing in the insolvency court is a classic case study. At the outset, the bankers lent money to this company with an almost obscure promoter's contribution, which was little over 1% of the borrowing. This does not account for reserves that may have been overstated. Over a period of six years, the borrowing increased by over two-and-a-half times while the promoter's contribution remained stagnant. Alarmingly, the interest cost that began at 9% of the turnover kept rising and eventually peaked at 45% of the turnover by the end of the sixth year. Importantly, all through this period, the turnover trailed between one-third to one-fourth of the borrowing, way below the sustainable turnover threshold of two-and-a-half times as in the earlier example.

By the time the company stopped meeting its repayment obligations, thirty-five banks had lent money to this company. It makes one wonder that while this game of ‘passing the parcel’ was on, did no one realise the fatality of the outcome? Did the banks lend money to only account for interest income but wished away the eventuality that neither principal nor interest, would be recoverable? Interestingly, to this day, the project is viable and delivers excellent profits even as it waits for a new suitor mandated by the insolvency court. This could well be the story that must have repeated hundreds of times to create the monstrous NPA problem. The conventional lending to large projects with a long gestation period, saddled with the high-interest cost, is a killer proposition bound to bankrupt the borrower and the lender both. The government needs to step into re-capitalise the banks to keep them solvent or set up bad banks, and the hapless taxpayer has to shell out taxes to make that happen.

The obvious conclusion is that the entire ecosystem of lending with the expectation of high-interest rates and repayment is, outright, an unviable proposition and not the project. The long-term repercussions of a failed system of lending are multi-fold. It is a strong disincentive and a deterrent for private investment to flow in to set up large projects of the size that we are now seeing in bankruptcy. Lenders are reluctant to look at large project funding with the bucketful of bad experiences. With investment drying, the demand-supply equilibrium is broken, resulting in a price increase that has a spiralling effect on the economy. If it is a commodity business, the demand will end up being serviced by imports.

India's needs for financing infrastructure are unique and therefore importing wisdom from abroad is not the solution. Take the case of the Chinese Development Bank (CDB), which is undoubtedly the growth engine that has invested trillions in propelling the Belt-and-Road initiative. But the CDB is bankrolled mainly by the Ministry of Finance of China that possesses enormous muscle power. The examples of Japan and Korea also do not help as the economic factors are not comparable.

Till this fatality of lending is not set right, we will very likely miss a generation of investment in large projects, leaving an enormous, long-term impact on our economy.