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Opinion

India's twin balance sheets troubles

Post-demonetisation, the verdict on India's economic performance from reputed global institutions has seldom been unambiguous. However, the International Monetary Fund (IMF) was the first to lower India's gross domestic product (GDP) growth for the current fiscal to 6.6 per cent in its updated world economic outlook report a couple of months ago. This was at a time when the authorities and other cheer-leading public and private institutions were cocksure of India's growth clocking 7 per cent in 2016-17.

Now the ill-tidings is out with the IMF contending in its assessment of the Indian economy under Article IV discussion it held with its Executive Directors, the contents of which were released in Washington on Wednesday. Under Article IV of the Fund's Article of Agreement, the IMF holds bilateral parleys with members, usually every year with a staff team visiting the country to hold a discussion on the various economic issues. IMF staff team held extensive discussions in New Delhi, Mumbai and Kolkata in November last with the report completed in early January this year in Washington.

The Fund's Executive Board believes that post-demonetisation, the Indian economy faces near-term challenges, while its medium-term growth outlook remains favourable. It contended that the post-November 8, 2016 cash shortages and payment disruptions caused by the currency exchange initiative of declaring not legal tender high denomination currency notes of Rs 500 and 1000 have undermined consumption and business activity, posing "a new challenge to sustaining the growth momentum". This had come at a time when growth was bolstered by large and durable terms of trade gain and more recently by a favourable agricultural crop outlook and decennial civil servant wage revisions, propelling consumption as the driving force of the Indian growth recovery.

Investment, on the other hand, has contracted sharply even before demonetisation, in the first half of 2016-17 (April to September), reflecting excess capacity in the major industrial sectors and strains in financial and corporate sector balance sheets. As a consequence, India's growth is projected to slow to 6.6 per cent in fiscal 2016-17 to rebound to 7.2 per cent in fiscal 2017-18, due to transient disruptions, primarily to private consumption caused by cash shortages. The Fund hastens, however, to add that tailwinds from a conducive monsoon, moderate oil prices and continued progress in resolving supply-side bottlenecks, as well as robust consumer confidence would underpin near-term growth as cash shortages ease.

But for the investment recovery, the much-needed impetus for ensuring broad-based revival of the economy, the IMF foresees only a modest phase ahead with uneven spread across sectors. This is predicated on the occurrence of deleveraging and industrial capacity utilisation picking up soon. With temporary demand disruptions and increased monsoon-driven food supplies, inflation is expected at about 4.75 per cent by early 2017—in line with the Reserve Bank of India's inflation target of 5 per cent by March 2017. Supply side reforms, particularly in agriculture, continued fiscal consolidation and relieving impediments to monetary transmission remain crucial to retain low inflation in the medium-term, the Fund noted.

Even as the domestic authorities are flaunting figures for the success in containing the current account deficit (CDA) in recent years, the Fund raises a red flag on this front by presaging a widening of CAD to about two per cent of GDP over the medium as domestic demand strengthens further, and commodity prices, particularly oil and other farm produce like edible oil, gradually rebound.

On the financial front, while the policy ballast to clean up banks' balance sheets has led to a considerable uptick in recognition of non-performing assets (NPAs) among Indian banks, the Fund has not glossed over the enormous problem of proper provisioning and debt recovery which remain key challenges for banks. It said the public sector banks '(PSBs) aggregate provisioning coverage ratio continues to be low at 39 per cent as of the end fiscal year 2015-16, triggering travails about its sufficiency. It further noted that PSBs' loan recovery capacity remains weak and vulnerable, with efforts to counteract the rise in NPAs being met primarily through write-offs. Write-offs accounted for a 1.2 percentage point offset in NPA slippage rates in fiscal 2015-16 while loan recoveries accounted for only 0.6 percentage points, down from 0.8 percentage points a year earlier, underlying the urgent need for timely implementation of debt resolution reforms.

On corporate balance sheet woes, it said leverage levels generally remain high, with the debt of highly-leveraged firms (debt to equity ratios above 150 per cent) accounting for about a half of overall debt. Importantly, high leverage is focused and concentrated in certain industries—including metals and mining, construction and engineering, and transportation and infrastructure—which together hold a significant share of the system's debt-at-risk. The high debt-at-risk in these sectors—as high as 36 per cent in metals and mining—poses NPA slippage risks for banks. Without mincing words, the Fund cautions that "with the corporate sector accounting for about 40 per cent of banks' credit portfolios, the soundness of the banking sector and its ability to provide effective intermediation in the economy thus rest on the effective deleveraging and debt restructuring in the corporate sector".

The Fund pertinently points out that the slow deleveraging and repair of corporate balance sheets and the potential further build-up of new NPAs can have "detrimental effects" on the real economy by constricting the flow of credit to the productive segments that are in dire need for working expenses to keep the wheels moving. It said the need for capital preservation meant a marked slowdown in credit growth at PSBs, down to four per cent year-on-year as of March 2016 from an average of 11.7 per cent in the preceding three years. The Staff Appraisal report of the Fund justifiably argues that altogether, a larger-than-anticipated increase in new NPA formation due to shocks affecting corporates' debt repayment capacity—e.g., due to weaker demand in certain sectors or exchange rate or interest rate shocks—or PSBs' inability to raise adequate capital, could further dampen the provision of credit to the real economy and impair growth. Interestingly, the pre-budget Economic Survey released a day before the Union Budget on February 1 also spoke of the deleterious dangers of the twin balance sheets troubles—banking and corporate sectors.

Unless the twin balance sheets troubles looming large on the economy remain unaddressed, the high corporate leverage which magnifies banks' losses in response to shocks, which has already been a drag on domestic investment, would remain so for the foreseeable future. This is the message loud and clearly let forth by the world's lender of the last resort!

(The views expressed are strictly personal.)
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