Did RBI just hint that Indian corporates have reached Ponzi stage of finance?

ARTS RAJAN
The Reserve Bank of India(RBI) releases the Financial Stability Report twice a year. The second report for this year was released yesterday (i.e. December 23, 2015). Buried in this report is a very interesting box titled In Search of Some Old Wisdom. In this box, the RBI has resurrected the economist Hyman Minsky. Minsky has been rediscovered by the financial world in the years that have followed the financial crisis which started with the investment bank Lehman Brothers going bust in September 2008.

So what does the RBI say in this box? “When current wisdom does not offer solutions to extant problems, old wisdom can sometimes be helpful. For instance, the global financial crisis compelled us to take a look at the Minsky’s financial stability hypothesis which posited the debt accumulation by non-government sector as the key to economic crisis.”

And what is Minsky’s financial stability hypothesis? Actually Minsky put forward the financial instability hypothesis and not the financial stability hypothesis as the RBI points out. I know I am nit-picking here but one expects the country’s central bank to get the name of an economic theory right. I guess given that the name of the report is the Financial Stability Report, someone mixed the words “stability” and “instability”.

The basic premise of this hypothesis is that when times are good, there is a greater appe­tite for risk and banks are willing to extend riskier loans than usual. Businessmen and entrepreneurs want to expand their businesses, which leads to increased investment and corporate profits.

Initially, banks only lend to businesses that are expected to gen­erate enough cash to repay their loans. But as time progresses, the competition between lenders increases and caution is thrown to winds. Money is doled out left, right, and centre and normally it doesn’t end well.

This is the basic premise of the financial instability hypothesis. In this column I will explain that the Indian corporates have reached what Minsky called the Ponzi stage of finance.  Minsky essentially theorised that there are three stages of borrowings. The RBI’s box in the Financial Stability Report explains these three stages. Nevertheless, a better explanation can be found in L Randall Wray’s new book, Why Minsky Matters—An Introduction to the Work of a Maverick Economist.

As Wray writes: “Minsky developed a famous classification for fragility of financing positions. The safest is called “hedge” finance (note that this term is not related to so-called hedge funds). In a hedge position, expected income is sufficient to make all payments as they come due, including both interest and principal.” Hence, in the hedge position the company taking on loans is making enough money to pay interest on the debt as well as repay it.

What is the second stage? As Wray writes: “A “speculative” position is one in which expected income is sufficient to make interest payments, but principal must be rolled over. It is “speculative” in the sense that income must increase, continued access to refinancing must be expected, or an asset must be sold to cover principal payments.”

Hence, in a speculative position, a company is making enough money to keep paying interest on the loan that it has taken on, but it has no money to repay the principal amount of the loan. In order to repay the principal, the income of the company has to go up. Or banks need to agree to refinance the loan i.e. give a fresh loan so that the current loan can be repaid. The third option is for the company to start selling its assets in order to repay the principal amount of the loan.

And what is the third stage? As Wray writes: “Finally, a “Ponzi” position (named after a famous fraudster, Charles Ponzi, who ran a pyramid scheme—much like Bernie Madoff’s more recent fraud”) is one in which even interest payments cannot be met, so that the debtor must borrow to pay interest (the outstanding loan balance grows by the interest due).”

Hence, in the Ponzi position, the company is not making enough money to be able to pay the interest that is due on its loans. In order to pay the interest, it has to take on more loans. This is why Minsky called it a Ponzi position.

Charles Ponzi was a fraudster who ran a financial scheme in Boston, United States, in 1919. He promised to double the investors’ money in 90 days. This was later shortened to 45 days. There was no business model in place to generate returns. All Ponzi did was to take money from new investors and handed it over to old investors whose investments had to be redeemed. His game got over once the money leaving the scheme became higher than the money being invested in it.

Along similar lines once companies are not in a position to pay interest on their loans they need to borrow more. This new money coming in helps them repay the loans as well as pay interest on it. And until they can keep borrowing more they can keep paying interest and repaying their loans. Hence, the entire situation is akin to a Ponzi scheme.

By now, dear reader, you must be wondering, why have I been rambling on about a single box in the RBI’s Financial Stability Report and an economist called Hyman Minsky.

In RBI’s Financial Stability Report the box stands on its own. But is the RBI dropping hints here? Of course, you don’t expect the central bank of a country to directly say that a large section of its corporates have reached the Ponzi stage of finance. And there are many others operating in the speculative stage of finance. Even without the RBI saying it directly, there is enough evidence to establish the same.

In the report RBI points out that as on September 30, 2015, the bad loans (gross non-performing advances) of banks were at 5.1% of total advances of scheduled commercial banks operating in India. The number was at 4.6% as on March 31, 2015. This is a huge jump of 50 basis points in a period of just six months.

The restructured loans of banks fell to 6.2% of total advances from 6.4% in March 2015.  A restructured loan is a loan on which the interest rate charged by the bank to the borrower has been lowered. Or the borrower has been given more time to repay the loan i.e. the tenure of the loan has been increased. In both cases the bank has to bear a loss.

The stressed loans of banks, obtained by adding the bad loans and the restructured loans, came in at 11.3% of total advances. They were at 11.1% in March 2015.
The numbers for the government owned public sector banks were much worse. The stressed loans of public sector banks stood at 14.1%. In March 2015, this number was at 13.2%. This is a significant jump in a period of just six months. The stressed loans of private sector banks stood at a very low 4.6% of total advances.

Let’s look at the stressed loans of public sector banks over a period of time. In March 2011, the number was at 6.6% of total advances. By March 2012, it had jumped to 8.8% of total advances. Now it is at 14.1%.

What is happening here? Banks are clearly kicking the can down the road by restructuring more loans, because many corporates are clearly not in a position to repay their bank loans. Why do I say that? As the Mid-Year Economic Review published by the Ministry of Finance last week points out: “Corporate balance sheets remain highly stressed. According to analysis done by Credit Suisse, for non – financial corporate sector (based on ~ 11000 companies in the CMIE database as of FY2014 and projections done for FY2015 based on a sample of 3700 companies), the number of companies whose interest cover is less than 1 has not declined significantly (this number was 1003 in September 2014 and is 994 in September 2015 quarter).”

Interest coverage ratio is essentially obtained by dividing the earnings before interest and taxes(operating profit) of a company during a given period, by the interest that it needs to pay on the loans that it has taken on.

In the Indian case, a significant section of the corporates have an interest coverage ratio of less than 1. This means that they are not earning enough to even pay the interest on their outstanding loans.

Further, the weighted average interest coverage ratio of all companies in the sample as on September 2015 was at 2.3. It was at 2.5 in September 2014. As the Mid-Year Economic Review points out: “Research indicates that an interest cover of below 2.5 for larger companies and below 4 for smaller companies is considered below investment grade.”

What this means that many corporates now are not in a position to even pay interest on their loans. They need newer loans to repay interest on their loans. They have reached the Ponzi stage of finance, as Minsky had decreed. Still others are in the speculative stage.

The RBI Financial Stability Report again hints at this without stating it directly. As the report points out: “Bank credit to the industrial sector accounts for a major share of their overall credit portfolio as well as stressed loans. This aspect of asset quality is related to the issue of increasing leverage of Indian corporates. While capital expenditure (capex) in the private sector is a desirable proposition for a fast growing economy like India, it is observed that the capex which had gone up sharply has been coming down despite rising debt. During this period, profitability and as a consequence, the debt-servicing capacity of companies has, seen a decline. These trends may be indicative of halted projects, rising debt levels per unit of capex, overall rise in debt burden with poor recoveries on resources employed.”

What the central bank does not say is that rising debt without a rising capital expenditure may also be indicative of the fact that newer loans are being taken on in order to pay off older loans as well as pay interest on the outstanding loans. The public sector banks are issuing newer loans because if they don’t corporates will start defaulting and the total amount of bad loans will go up even further.

In such a scenario, the public sector banks have also been helping corporates by restructuring more and more loans. By doing this they are essentially postponing the problem. A restructured loan is not a bad loan. Further, around 40% of restructured loans between 2011 and 2014 have turned into bad loans.

All this hints towards a large section of Indian corporates operating in what Minsky referred to as a Ponzi stage of finance. Many corporates are also in the speculative stage. And given that, it’s not going to end well.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on SwarajyaMag on December 24, 2015

Advertisements

About vivekkaul
Vivek Kaul is a writer who has worked at senior positions with the Daily News and Analysis(DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System , the latest book in the trilogy has just been published. The first two books in the trilogy were published in November 2013 and July 2014 respectively. Both the books were bestsellers on Amazon.com and Amazon.in. Currently he works as an economic commentator and writes regular columns for www.firstpost.com. He is also the India editor of The Daily Reckoning newsletter published by www.equitymaster.com. His writing has appeared across various other publications in India. These include The Times of India, Business Standard,Business Today, Business World, The Hindu, The Hindu Business Line, Indian Management, The Asian Age, Deccan Chronicle, Forbes India, Mutual Fund Insight, The Free Press Journal, Quartz.com, DailyO.in, Business World, Huffington Post and Wealth Insight. In the past he has also been a regular columnist for www.rediff.com. He has lectured at IIM Bangalore, IIM Indore, TA PAI Institute of Management and the Alliance University (Bangalore). He has also taught a course titled Indian Economy to the PGPMX batch of IIM Indore. His areas of interest are the intersection between politics and economics, the international financial crisis, personal finance, marketing and branding, and anything to do with cinema and music. He can be reached at vivek.kaul@gmail.com

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: