New Insolvency Law - the govt is right, market is wrong

This was published in the DNA Opinion page on 29th of Nov, 2017

The recent changes to the Insolvency and Bankruptcy Code (IBC) through an Ordinance has brought into stark relief an enduring cliché — “good politics is not good economics”. Or at least, that is the dominant narrative of the market and the financial nomenklatura (let’s call it the finklatura) that cheerleads the market. Prima facie, the rationale of the finklatura is unexceptionable. 

The amended IBC essentially bars controlling shareholders (or promoters) of companies from bidding for their bankrupt companies that are being auctioned off via the NCLT (National Company Law Tribunal)-overseen process. In its original avatar, only those promoters deemed as “willful defaulters” were proscribed from bidding. Before this amendment came through, bidders in many of these cases before the NCLT included promoters (eg, Ruias for Essar Steel).

The politics of this is ostensibly simple — harsh measures against big business make for good optics and good messaging.

Economically, the finklatura asserts, it’s the other way round. Currently, there are 12 identified bankrupt companies that are before the NCLT for auctions that try to minimise the haircuts creditors (primarily banks) will need to take on the loans outstanding. In the short run, with promoters out of the process, bids are likely to turn less aggressive. There are multiple reasons for that. Most of the 12 companies are in steel, power and infrastructure sectors. To start with, all of these are industries where an enormous amount of local operating domain knowledge is critical to successful operations. Second, all 12 are large, complex enterprises — typically insiders have a lot better handle on the complexities of effective management. Put both factors together, and it is clear why existing promoters would have greater confidence in running these companies, and therefore bid more aggressively, compared to any other third-party bidder. The cherry on the cake —– structurally, all three are what economists call oligopolistic markets, i.e, industries with few operating players. In other words, in the best of times, there are relatively few viable bidders, and removing the promoter from the fray takes away a large chunk of active interest in the auction. 

Less aggressive bids, naturally, would cause the banks to accept a price that demands a higher haircut on their loans (initial market estimates range from 10-20 per cent higher haircuts in bids). This, in turn, would mean banks requiring more capital to clean up their balance sheets. Given that the recently announced bank recapitalisation plan is fully taxpayer-funded, this would check all the wrong boxes — higher public debt, higher interest rates, potentially even an expansion of the recapitalisation required, and all their downstream adverse consequences. The economic impact, therefore, is clear, that we have (yet again) sacrificed economic gains at the altar of politics. Or is it?

Let us examine the economics of it. There has recently been a great deal of excitement around Richard Thaler’s Nudge Theory (primarily driven by, as is usual for arcane subjects, by the Economics Nobel Prize awarded to Professor Thaler). 

Simply put, a Nudge is an act (or influence) that alters behaviour, while not precluding any options for the user. Now, a law is somewhat more than simply a nudge, it is perhaps more akin to a shove. From a signalling standpoint though, this shove makes for interesting potential outcomes. Fundamentally, a strong, almost unforgiving insolvency law sends a strong message to promoters across the board. The message fundamentally seeks to alter promoter behaviour. It does not preclude the option of promoters taking loans in their enterprises but puts the fear of God on ensuring prudence, analytical rigour and above all, integrity, in the utilization of loans. 

India’s promoters don’t fall sick, only their companies do — has been an oft-quoted, and sadly, accurate description of Indian capitalism. The spectre of promoters of distressed companies remaining in a saddle, infusing no additional equity, even as banks take large haircuts on loans — militate against a very fundamental definitional tenet of the market economy. Under that tenet, creditors are senior to equity shareholders over assets of a company.

In other words, creditors need to be repaid in full before equity-holders can own any assets of a company that has defaulted on servicing its loans. Seldom has this been honoured in its letter and spirit in India. The new law and the ongoing resolution process should, hopefully, establish the seniority of the creditor in the capital structure, for perhaps the first time in India.

All policymaking is political. In this case, the good politics of the law makes for good economic principles too. Ben Graham, the legendary investor, described markets as being a voting machine in the short term (tallying up stocks that are popular and unpopular) and weighing machine in the long term (assessing the substance). In the case of the new Insolvency law, the nomenklatura representing the markets is seemingly in its voting phase. Ironically, the vote-driven government seems to have “weighed” it in a lot better!     

Interest Rates: Stars Are Aligning, Not In The Direction Markets Hope!

This article was published by the Business World Magazine on the 26th of Nov, 2017

Interest rates are always in the news, but decibel levels on India's rates have gone up manifold since the last quarterly GDP growth print (of 5.7%) came out. The general refrain has been that India's rates, especially real interest rates (ie, net of inflation) are too high, and are adversely affecting growth and other macro outcomes like jobs. At the receiving end of most criticism has been the Reserve Bank of India (RBI), for not cutting policy rates aggressively. 

Unfortunately, like it is most of the times, the noise is likely to remain just that. Macro variables have not only vindicated RBI's stance on keeping rates steady, but also point towards marginal hardening of market yields.

To start with, the global monetary cycle, after years of easy money, is turning. Of the three major Central Banks (in US, Europe, Japan), two have embarked on a major unwinding of the Quantitative Easing (QE) that started after the global financial crisis in 2008, and injected trillions of dollars of liquidity in the global markets. At the same time, the global economy has started showing a coordinated upturn - IMF has recently upgraded its global growth forecasts to their best levels in five years. Global growth is expected to be 3.6% in 2017 (compared to 3.2% in 2016), driven by both developed markets (22% in 2017, compared to 1.7% in 2016) and developing markets (4.6% versus 4.3%). For well over a year, we have seen the goldilocks period in global growth since 2008 - with jobs, industrial production and global trade all moving up in tandem in a secular trend across the world. Both these factors, ie, unwinding of QE and strong global growth, together have meant that global interest rates are on their way up, limiting the headroom for Indian interest rates to decline from current levels.

India's macro variables on the other hand have started worsening at the margin. The key ballast for the economy in the last couple of years has been stable twin balance sheets (fiscal and trade) and low inflation, even as the economy settled to a low(er) growth equilibrium. The twin deficits have worsened. One, trade deficit is trending higher (averaging $12.6 billion in FY2018 compared to USD8 billion in the previous year). Two, fiscal situation of both state and central government have worsened, with farm loan waivers, state pay commission payouts, and now, the big bank recapitalisaiton plan (more of that later). To make things a little more interesting, inflation too seemed to have bottomed out, with more upside risks as global oil prices approach the USD60 level. In a nutshell, there is more at risk today for RBI to cut interest rates than many would have us believe.

The last piece in the interest rate jigsaw is the mega bank recapitalisation plan, funded substantially via a 1.3 lac crore Recap bond issuance. Ostensibly, this shouldn't expand the fiscal deficit - as many in the government, led by the Chief Economic Advisor have been at pains to explain. While "below the line" is the fashionable imprimatur of the Recap bonds, the impact of such definitions are optical rather than real. Effectively, the government (or some government institution) will issue bonds. While there might be adequate liquidity in the system to subscribe to these bonds, it expands the supply of bonds in the economy. In other words, it takes up the debt-GDP ratio, and skews the demand/supply dynamics for the bond market, adversely at the margin. At the end of the day, all bond (and equity) supply has to be financed by the same pool of financial (largely household) savings in the economy. Ergo, a large addition to the existing stock of bonds makes additional demands on the same pool, irrespective of the accounting treatment.

At the end, the real question is, does it matter? Will a reduction in interest rates by (say) 100 basis points kickstart the private investment cycle? When capacity utilisation in industry is running at mid-70% levels, the answer is almost obvious. In the last three year, the Indian economy has been marked by remarkable macro-stability in an increasingly uncertain world. By lowering rates today, is the marginal gain, in terms of higher potential growth, worth the risks of deteriorating macro? Historically, there has been very little correlation between interest rates and growth in India. Our growth challenges are elsewhere, in inadequate demand. Lower interest rates don't make for a good enough solution in the toolkit - the rates doves are barking up the wrong tree!

Moody's upgrade is a milestone in India's development journey

This was published in the Economic Times dated 20th Nov, 2017

In India’s argumentative ideas space, no news is good news. Therefore, the kerfuffle over the upgrade of India’s sovereign ratings by Moody’s (to Baa2, from Baa3) is entirely expected. For the partisan, it is a definitive validation of the government’s economic management. To naysayers, it is at best empty optics at a time when the economy is slowing down, at worst highly suspect on timing and credibility. Curiously, both miss essential woods for trivial plants.

First, the basic point – credit ratings, like most ratings, are predominantly an evaluation of the past, even though the objective is to provide guidance for the future. An upgrade is typically rare, especially so after the global financial crisis in 2008. It takes years of evaluation of policies (primarily related to macro-stability – debt-levels, sustainability of public finances, stability etc) before rating upgrades are done. In this case, the upgrade is especially creditable as it comes barely four years since India was classified as one of the “fragile five” economies, struggling with high twin deficits in fiscal and current accounts. To that extent, the current government deserves a lot of credit – it has privileged macro-stability over growth from its first day. It started with its first Budget, when the Finance Minister stuck with the deficit target set by his predecessor, a number that was received with much scepticism when it was presented by P Chidambaram. Since then, government has been a dogged “fiscal fundamentalist”, refusing any slippages even as growth plunged in the recent quarters. On the external account, a combination of luck (declining oil prices) and pluck (RBI ignoring shrill calls for massive reduction in interest rates), has kept the situation on an even keel.

Second, in many ways, this upgrade is merely a partial correction of a historical anomaly. Baa3, the toe-end of investment grade, clubs India with a bunch of countries with far worse macro-indicators. It’s a point that has been made repeatedly by Indian policymakers, most notably by Chief Economic Advisor Arvind Subramaniam in a section in the last Economic Survey. India’s structural strengths, eg, public debt entirely funded via rupee loans, all but a small part via local savings – were seemingly ignored while benchmarking on headline numbers.

Third, and most important point, is one of future signaling. What does it mean for India’s economic prospects going forward?

To start with, the sovereign rating is an estimation of the sovereign’s ability to repay its loans. An upgrade, technically, lowers the cost of borrowing for the sovereign. This is of limited practical utility to India, as the Indian government does not fund its deficits via offshore commercial bond markets. The entire public debt of India is funded via the domestic Rupee (INR) bond market, and foreign investor participation there is very small, and tightly regulated through quotas.   

Sovereign rating also serves as a benchmark for corporate entities domiciled in that country, as corporate ratings are (barring very exceptional cases) capped at the sovereign rating of the home-country of the corporate. Soon after the sovereign upgrade, Moody’s upgraded a bunch of Indian corporate entities (largely public sector companies). Over time, this has an impact on corporate ratings down the chain as well. While not automatic with a sovereign upgrade, a higher sovereign rating opens up fresh space for corporate upgrades too. This would result in reduction in cost of borrowing for Indian companies looking to raise financing from offshore bond markets.

Most important though is the optical macroeconomic signal. A ratings upgrade gives out a positive narrative on policy and builds incremental confidence in foreign investors. There are material benefits of the same, eg, in terms of incremental foreign investment pools from global Pension and Life Insurance firms that have minimum ratings criteria for investing. Typically, such incremental flows would tend to bid up Indian bond prices (both onshore and offshore) – we have already seen the first signs of the same in the form of dropping yields on government bonds. Higher bond prices, or lower yields, would tend to lower cost of funds – marginal for the government, but significant for corporate sector. Incrementally higher foreign flows tend to bid up INR too, making investments in a host of other Indian financial assets – equities, Real Estate – incrementally more attractive to foreign investors. It is especially propitious time for Public Sector Banks (PSB), that would find it easier to raise capital as part of the recapitalization plan announced earlier this month (PSB are expected to tap public markets to raise nearly 60,000 crores as a part of this plan). Lastly, as a net importer, a higher INR flows through as lower inflation into the economy, as imported goods become cheaper.

This isn’t an unmixed blessing. High levels of foreign flows resulting in rapid currency appreciation can result in loss of export competitiveness, with adverse consequences. South Korea’s meltdown in 1997-98 was at least partially due to a similar situation, barely a couple of years after it received a sovereign ratings upgrade.

In a nutshell, a ratings upgrade isn’t a major climax, nor is it much ado about nothing. It is a positive milestone, and quibbling about the size of the same is essentially narcissism of minor differences. But it is merely one milestone in India’s development journey, where there are miles to go before we can even think of dozing off!