Finance to the fore

Business Standard, 6 April 2020

The epidemic, and the responses to it, have created stress for a lot of firms. A sound financial system will put out a lifeline for some. The financial system has to understand the changed environment, and triage in allocation of capital. Efficiency in capital allocation means that not all firms should be saved. This drama will consume a good slice of the firms of India in 2020 and 2021. We also have to worry about the state of health of parts of the financial system.

When a bomb goes off in a coffee shop, the task of the first responders is to triage. The injured at the scene are classified into three categories : those that will not make it, those that are going to be okay, and those where medical resources can make the biggest difference. This classification focuses scarce medical resources upon the places where the highest gains are available.

This may appear cold and cruel. But if we spread medical resources equally after a terrorist attack, this will result in an inferior outcome.

When a natural disaster like Covid-19 unfolds, this damages many firms. Recent work by Sane and Sharma has shown that under certain assumptions, about a quarter of large Indian firms do not have liquid assets that can fill the breach for a 30 day interruption of revenue. When such an interruption of revenue takes place, these firms require external capital to survive.

Finance does the triage: of allocating the capital to the places where it will have the highest marginal product. Some firms are not going to make it, and putting capital there is like putting good money after bad. Some firms need more capital, but not badly enough to pay a high rate of return. It is the middle zone -- the firms where survival and success is likely to come about, but only if new external capital is brought in -- that a capable financial system should devote itself to. The best corporate financial deals are available to financiers when they are putting capital into a sound firm, where this capital will make a difference of life or death.

This seems like a dramatic moment, but this task is not too different from the role that the financial system always performs. Finance is the brain of the economy; it looks at alternative uses of capital and is supposed to pick the ones where capital yields the highest performance. The financial system constantly turns down certain proposals for equity and debt capital.

In the firms that require capital to survive, there will be a flurry of activity in lining up this capital. They will reach out to multiple lenders or equity investors and try to sell a good story about how their firm is the right one that should get an investment.

For the firms who are short of cash, this drama of survival and finance will absorb their energy. This will take attention away from business building initiatives. They will tend to lose market share. In an ordinary year, holding more cash generates a drag on the return on equity, but when such difficulties arise, the policy of keeping more liquid cash has its benefits.

A good financial system is one where capable firms are consistently able to easily obtain external capital at all times. In India, some large firms, with good performance, are well known and trusted in the financial system and are able to obtain external capital at will. For most firms, the Indian financial system works poorly. Many firms can obtain capital in good times, but there can be difficult hiccups in bad times. Hence, most firms in India have an incentive to hoard liquidity. Another interesting feature is that the firms who have access to external capital beocme financiers to the constrained firms in their ecosystem, and thus become financial intermediaries, to the firms where their knowledge is actually very strong.

In India today, the financial system that is responding to this natural disaster unfortunately has many difficulties. When there is an economic downturn and many borrowers get into trouble, this inevitably impacts upon the banks that have lent to them. We may see a turn for the worse in the stress in the Indian financial system, in 2020. Many banks and NBFCs are stressed and worrying about their own future.

These problems will limit the extent to which banks and NBFCs are able to bring energy and capital into looking for opportunities to place capital. The combination of capital controls, financial regulation, taxation and enforcement agencies has made operating in India daunting for foreign capital, and has resulted in a small scale access to foreign capital. For many securities, the financial markets are illiquid and have pricing discrepencies.

In the best of times, financial capital is a scarce resource, and the financial system rations this out between multiple claimants. At present in India, finance is more constrained than usual. This creates a greater shortage of capital.

For a given amount of financial capital, there is the question of allocative efficiency. Will Indian finance be able to put capital into the right places? There are many concerns about how this will work out. The working of many financial firms and markets is distorted by the policy environment. Many employees of financial firms have no incentive to actually understand which firms are sound and to direct capital to them.

What will happen to the firms that get rationed out by Indian finance? Perhaps their existing shareholders believe in the firm in a way that arms length investors do not: They will do a rights issue to bring in new equity capital. Many individuals in India will rearrange their portfolio in order to invest in these rights issues. Some firms will try to survive by tightening their belts, by eliminating many expenditures which appear inessential in the short run, but this has an adverse impact upon productivity and market share in the medium term. Finally, some firms will throw in the towel, and sell off the firm: either to a large player in the industry or to a private equity fund.

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