Elements of the recovery

Business Standard, 06 August 2017

We have been in a sustained downturn from 2011 onwards. How will this end? It is instructive to look at the last difficult downturn, of the late 1990s. We roared out of the downturn through the exit of firms, improved productivity of firms, respect for policy makers and a global revival. This gives us a rough template of what it will take to get out of this slump. This time, we will fare better on the exit of firms, through privatisation, the bankruptcy reform, and the resolution corporation.

We had a credit boom in the mid 1990s. Banking regulation was faulty so the banks gave out bad loans, and we got a banking crisis. The Asian Crisis started in August 1997. RBI raised rates by 200 bps in January 1998, in order to defend the rupee, which harmed the domestic economy. There was an IT bust and then there were the 9/11 attacks. These problems ran from 1997 to 2002, after which India roared out remarkably well. The net sales of listed non-finance non-oil companies grew by 2.5 times, in real terms, from 2002 to 2007. This was average annual growth of 20% in real terms.

History does not repeat itself, but it sometimes rhymes. We had a credit boom in 2004-2008. Banking regulation was faulty so the banks gave out bad loans, and we got a banking crisis. RBI raised rates by 400 bps in 2013, in order to defend the rupee, which harmed the domestic economy. We are now in a rough spot. The sales of listed non-finance non-oil companies has negative growth, in real terms, from 2011 to 2017. The outlook for external demand is clouded by geopolitical risk through the rise of nationalism worldwide.

How did the dramatic turnaround of the economy occur last time? The first element of the story was the exit of firms. Thousands of firms went out of business. In those days, `going out of business' was not a clear bankruptcy filing. Thousands of firms either shrunk to an irrelevant size, or ceased operations. This helped reduce competition for the survivors.

The survivors sharply increased productivity. It was clear to the survivors that there was no easy option, that customs tariffs and the barriers to FDI were going to end. They focused on increasing productivity. A variety of metrics show the transformation of Indian firms in that period, with improved processes and improvements in management.

Policy makers had their back against the wall. There was candour about the difficulties of the economy, and this pressure was channeled into economic reforms. Teams were assembled and executed complex change in numerous areas, including : (a) Resolving the banking crisis; (b) The equity market reform; (c) The New Pension System; (d) The NHAI; (e) The telecom reforms; (f) A sustained pace of incremental tax policy reforms.

These teams went after deeper reforms and not superficial patches. As an example, the UTI crisis was followed by a 50/50 sharing of the burden between customers of UTI and the taxpayer, the old UTI Act was repealed, and the viable part of UTI was privatised. This permanently solved the UTI problem. Similarly, in the equity market reform, the old `badla' trading of BSE and the Calcutta Stock Exchange was ended, and derivatives trading began. This permanently put the Indian equity market on a sound footing. Similarly, in the telecom reform, control of Indian telecom was wrested away from DOT/MTNL/BSNL, with the entry of private and foreign telecom companies. This gave revolutionary and permanent gains.

These successes in reform were important in and of themselves. They were even more important in inducing hope. The private sector (in India and abroad) started looking at Indian policy makers with new respect. A team that can figure how to build highways might possibly, in the future, learn to build airports and railways too. A team that can figure how to build an equity market might possibly, in the future, learn how to build the Bond-Currency-Derivatives Nexus too. A team that executes the New Pension System might possibly, in the future, fix EPFO.

The world economy turned around after the 9/11 attacks, and experienced a good expansion till 2007. The stronger Indian firms were able to tap into external demand in this period, which helped demand conditions and optimism domestically. Indian firms graduated from cry babies demanding protectionism, to exporting and building MNCs.

Optimism is measured by the stock of `announced' projects, by the private sector, in the CMIE Capex data. This went up from Rs.5 trillion in 2003 to Rs.30 trillion in 2007. (It has declined to Rs.25 trillion in 2017.)

In summary, India roared back from 2002 onwards because of four things : exit of firms, productivity gains by survivors, respect for the policy establishment, and a global recovery. This gives us a rough template to think about how we can come out of the present slump. We should ask these four questions. Are weak firms exiting? Are the survivors sullenly waiting for redemption, or is a great pace of management effort afoot that yields productivity growth? Is the policy establishment respected for building and empowering teams who have deep domain knowledge and are pulling off fundamental solutions? Is the world economy bountiful in external demand, and are exports booming?

One element where things could work well is the exit of firms. The Insolvency and Bankruptcy Code is a half-done reform that could help significantly increase the pace of firm exit. The privatisation process can yield important gains in this regard. The exit of firms will free up labour, land and capital, which will give reduced prices of labour/land/capital, which will reduce the cost structure of the survivors.

`Zombie firms' are those that ought not to exist, but are kept alive on artificial life support by the government or by banks. They are selling goods and services at artificially low prices, which harms the profit rates of the healthy firms in their industry. The presence of zombie firms harms healthy firms. When the government pulls the plug on Air India, or when the banks pull the plug on companies that have been kept alive by additional bank credit, or zombie banks exit the banking industry, this helps increase prices and profitability of survivors. These gains can be obtained by pushing on four fronts: privatisation, IBC, Resolution Corporation, and reforms of banking regulation.

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