“India’s twin balance sheet problem is over. We now have a twin balance sheet advantage!”

That’s what Finance Minister Nirmala Sitharaman said a couple of days ago. And it’s the same thing that RBI Governor Shaktikanta Das said last month.

So in today’s Finshots, we explain what’s this twin balance sheet they’re talking about and whether the problem is really over. But before that, a quick sidenote, if you're a recruiter or you know someone who is a recruiter with about 4+ years of experience, Ditto is looking to recruit a Talent Acquisition Specialist (Recruiter). If you're interested or know someone who is please click this link.

The Story

First, some background.

In the mid-2000s, India was going through a massive boom. The GDP growth was spectacular, companies were making truckloads of money, the stock markets were on a tear, and no one thought the music would stop. So businesses kept expanding. And they kept borrowing crores of rupees from banks to fulfill their ambitions. Banks were happy to lend massive amounts too — after all, the bigger the loans, the higher the income they make through interest. We witnessed a credit boom that was larger than ever. In just about 5 years leading up to FY09, the non-food bank credit doubled. The economic situation looked promising and no one shied away from taking risks.

But then, the music stopped. The global economy crashed and the promised economic growth vanished.

Indian companies were dragged into the mess too. People weren’t buying stuff like they used to and sales tanked. Infrastructure companies that had gone on a building spree were doomed. Also, many of these companies had borrowed from foreign markets. And when the Indian rupee fell in value, they suddenly had to cough up a lot more money to repay the loans. The debt was an albatross around their neck. And the first balance sheet was shaken.

Meanwhile, this cascaded to the Indian banks which had also lent money with reckless abandon. Companies began defaulting and bad loans ballooned. To put things in perspective, NPAs (bad loans) had reached about 12% of the gross loans that banks lent. And nearly 80% of these NPAs were on the shoulders of public sector banks (PSBs). The second balance sheet was in turmoil. Investors started losing their confidence in PSBs and started pulling out their investments. And the share price of these banks crashed so much that at one point, HDFC was valued as much as 24 PSBs put together!

And this problem festered because banks did something shady. They resorted to a practice called evergreening. Which meant that they simply kept extending new loans to the crippled corporate sector. Just so that they could say the loans were refinanced and wouldn’t have to call it out as a bad loan.

And India’s twin balance sheet woes continued.

To get out of this, we first needed to clean up the problem. Make sure there were no skeletons in the closet. So the RBI set up a massive review in 2015. It asked banks to come clean and declare their NPAs properly. And it was shocking to see the result — NPAs rose from a mere 4% in 2014 to over 11% by 2018.

We at least knew what we were dealing with now.

But declaring NPAs and writing off bad debts meant that the system was now starved of capital. If banks wanted to continue lending money, they first needed money to lend out. So the government stepped in. Between FY17 and FY21, it infused over ₹3 lakh crores to strengthen PSBs. It issued a special recapitalisation bond. The banks would subscribe to it using their deposits. And the government would give the money back to the bank in the form of equity.

It would spur a fresh round of lending.

But we had to do something with all the bad debts that banks were writing off, no?

So in 2021, we established a separate bank that would deal only in bad debts. Or rather, the recovery part of the bad loan equation. It was called the National Asset Reconstruction Company Ltd (NARCL). And this special bank would take over bad loans worth over ₹2 lakh crores from India’s banks. They’d then try and recover the dues. Basically, it would do the dirty work and it would free up the time for the regular banking system. Now it’s too soon to say if this is working out. But it’s still something.

And oh, we also had the big bang reform in 2016 — the Insolvency and Bankruptcy Code. When companies defaulted, the creditors could quickly take them to the bankruptcy court. Try and sell the assets of those companies and recover dues. And if we ignore the pandemic period and look at what the Economic Survey told us in 2020, the IBC helped recover 42.5% of bad assets. The recovery was just 14.5% under the previous law. Also, insolvency proceedings were completed in 340 days compared to 4.3 years earlier.

Meanwhile, the RBI also wanted banks to become more prudent. So it asked them to increase their provision, or the money set aside, once loan repayments are delayed. And of January 2023, the RBI mooted an idea to strengthen this even further — through an  Expected Credit Loss plan. Which means that banks will have to set aside money even when things are good. Like saving money for a rainy day. They’ll have to estimate whether the credit default risk is increasing. They’ll have to consider the historic default situation across sectors. Anticipate the future. And set aside money.

It’ll strengthen the banking system by a fair bit.

So yeah, maybe it was the result of all this that the NPAs of PSBs finally fell to around 6% in FY22. And they were able to triple their (net) profits to nearly ₹1.04 lakh crores over the last decade.

But what about the other twin — the corporate balance sheet? How’s that faring, you ask?

Well, apparently, the Indian corporate balance sheet is at its healthiest in 10 years.

In the past few years, most sectors have actually pared down their debt. Companies didn’t invest much money in setting up fresh capacity. Rather, they used their profits and extra balances to repay debt. They sold off assets that didn’t add much value to raise money too. They were deleveraging. In fact, an RBI report says that the debt-to-equity ratio of private (non-financial) companies fell from nearly 55% to 35% between FY15 and FY22.

And that’s a good thing because a healthier balance sheet means that they’re in a better position to expand their businesses now. In fact, the new project announcements from private companies are now picking up. It has jumped from ₹5 lakh crores in FY21 to a massive ₹26 lakh crores in FY23. Companies are ready to use their cleaner balance sheet to expand.

So yeah, it does seem like things have taken a turn for the better. And it’s no wonder the Finance Minister believes we now have a twin balance sheet advantage. Let’s keep our fingers crossed that it remains this way.

Until next time…

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