How did the balance sheets get better?

Business Standard, 21 February 2022

A rise in stock prices is synonymous with an improvement in credit quality. There has been a remarkable rise of stock prices from April 2020 onwards. Synonymous with this is the improvement in credit quality of Indian financial and non-financial firms. For a very long time, the economy was tormented by `the twin balance sheet crisis', but now things are better. How did Indian banking get better? Three elements can be identified: banks are less important in non-financial firm financing, investment by non-financial firms is subdued, and some of the economic stress of the pandemic may have not yet played out.

The pandemic, at first, led to great consternation in the equity market, with a 40 per cent decline of stock indexes. The turning point for the S&P 500 came on 20 March 2020. The turning point for Nifty was on 3 April 2020. Both indexes have doubled from that bottom. This reflects a combination of strong profitability of the firms and low interest rates.

The balance sheet stress in the Indian financial sector and the non-financial sector has eased. With banks, some estimation methodologies show that the equity capital shortfall in banking, by late 2021, were back to the values seen in 2015-16: the surge of the pandemic period has been reversed.

In the non-financial firms, the overall average and median value of the interest cover ratio has improved significantly. This is made up of about a quarter of the firms, which are doing badly as before, and a top quartile of firms, where interest cover ratios are extremely sound, with low leverage and high profitability.

Metrics of credit stress based on information in the equity market show strong gains. With large private financial firms, in late 2019 about 17% of the balance sheet was under stress, this had declined to 13% in late 2021. With large private non-financial firms, in late 2019 about 25% of the balance sheet was under stress, this had declined to 12% in late 2021.

These are substantial gains. What changed? Two broad explanations mentioned above are gains in firm profitability and global stock prices. Let us drill deeper into Indian banking and its lending to Indian private firms.

Investment by private firms is sluggish, so there is a reduced requirement for financing. On average, the annual growth of net fixed assets (for large private domestic non-financial firms) in the 1991-2011 period was 18% (nominal) per year. In the years after 2011, this has dropped to 10%. This reduced pace of investment has held back demand for finance by firms, both for the purpose of investment and for the working capital requirements which would have arisen if there was high growth. This helped hold down borrowing from banks.

The share of banks in the balance sheet (of large private domestic non-financial firms) had peaked at 21% in 2008-09. This has declined steadily, to a value of 10% in 2020-21. So the firms were growing slower, and a smaller share of their (slowly growing) financing was coming from the banks.

These two forces tell us something about how Indian banking returned from the brink. Some banks went bust. The others wrote down bad assets year after year, retreated from lending to firms, and growth of the balance sheet overcame bad assets.

In the end, we have a healthier banking system, but we also have a banking system that is not doing much by way of firm financing. Bank lending now makes up only one-tenth of the balance sheet of private domestic non-financial firms. At its peak, banks and FIs put together were at 27.7% (in 1991-92).

What has taken up the slack, given the retreat of banks and FIs? Equity made up 22.4% of the total liabilities of private domestic non-financial firms in 1991-92, and has risen dramatically to its highest ever value of 39.43% in 2020-21.

Ordinarily, economists look at `the sources and uses of funds', where the change in total financing is apportioned to various sources and various applications. This helps in discerning changes in the flow, because the stock does not change too much. What is striking in the facts presented above is that the stock has changed. Bank+FI financing went down from 27.7% of the balance sheet to 10.8%. Equity financing went up from 22.4% of the balance sheet to 39.43%.

In the 1990s, when the great reforms of the equity market were underway with the establishment of SEBI, NSE and NSDL, it was hard to anticipate the sea change in corporate financial structure that was going to emerge out of this. Now, when we look back, we see the combination of success on the working of the equity market alongside poor policy achievements on banking and the bond market. A country fares better when there is more diversification, with a wide array of financing choices, so that weakness in any one element induces less harm for the economy.

Looking forward, there are two elements of concern. First, DM central banks have started raising interest rates, and this will reverberate through the global financial system. If RBI tries to defend the INR, this will require sharp rises in the domestic interest rate, which will roil the economy. Second, it is not yet clear that the harm caused in the pandemic, upon household and firm balance sheets, is as yet fully in the data. If bad news has been held at bay through restructuring and forbearance, this will trickle into the data in coming months and years.

Faced with this respite in the twin balance sheet crisis, the most important priority for reform should be methods for resolution. The bottom quartile of stressed private non-financial firms needs to go into the IBC and get rapidly resolved. The FRDI Bill is required through which stressed financial firms are smoothly and regularly put to sleep.

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