Throughout human history, debt has delivered mutual gains to borrowers and lenders alike. But not always. Debt delivers crises as well, not just to households and corporations, but also to sovereign states. India is no exception - recall the foreign exchange crisis of 1991.
As the world edges into 2016, we worry about a host of ticking debt bombs: China's is the biggest but least likely to blow up; Greece's is the smallest but most likely to blow up.
India's non-performing debt is dominated by government-owned bank loans to privately-owned infrastructure projects. The loans are not going to bring down the country's banks, but they are clogging up their balance sheets. They are at a 13-year high and loan growth is near a 20-year low. They contrive to restrict credit to small and medium enterprises that are India's potential for prosperity of an entrepreneurial middle class.
What is overdue in India is a clear and simple bankruptcy code. Parallel to this is a dire need for broad and deep domestic debt markets as a source of business borrowing beyond banks. The Strategic Debt Restructuring scheme - a procedure whereby banks can sway debt for equity - has been implemented. A bankruptcy bill has now been introduced in the Lok Sabha. But development of debt markets has a long way to go, albeit government debt is at last becoming tradable.
When dealing with bad debt it is crucial to bear in mind three principles, which I have dubbed "Paradoxes of Debt". They are:
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When debt turns sour, it is better to forgive and forget. More precisely, with optimal write-offs, both creditors and debtors can be made better off. This paradox holds for private debtors as well as sovereign debtors (that is, for company and country debtors), as long as they are simply illiquid rather than insolvent. Sovereign debtors are never insolvent in the long run because they have the power to tax.
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When sovereign debt turns sour, belt-tightening (austerity) is generally a bad idea, not a good one. Because countries can never be insolvent in the long run, it make sense to keep them alive rather than starve them. This could be called "The Principle of the Golden Goose": When it is ill and stops laying golden eggs, the farmer is wise to feed it well and wait for it to recover rather than slaughter it for supper.
In the language of macroeconomics, deficit or even money-funded growth is usually wiser than forcing repayment of bad debt on schedule. The debt-to-GDP (gross domestic product) ratio is better brought down by increasing GDP than by repaying debt.
What are the lessons for India?
Paradox 1 suggests that a new bankruptcy code is crucial. Indeed, the draft code looks sound, emphasising, as it does, three principles: a) Ranking of borrowers according to "seniority", with the ex ante understanding that junior creditors may never be repaid; b) Relegation of decisions about attachment of collateral and/or write-offs to bankruptcy courts rather than reliance on very slow and ad hoc passage through regular courts; c) Broadening of sources of credit beyond the banks to debt markets. The latter is crucial. It has already begun with the introduction of tradability to government debt, but the domestic market for commercial debt is still in its infancy.
Paradoxes 2 and 3 also contain lessons for India. The current debate about a sound upper limit for the fiscal deficit is premised on a fear that deficits will accumulate to unsustainable debt. But India's deficit, at 3.8 per cent, is modest, and its sovereign debt-to-GDP ratio is not high by international standards. Moreover, the newly-permitted tradability of government debt will lower borrowing costs.
On balance, I would argue in the upcoming Budget for upper-limit fiscal stimulus, given potential contagion from slow growth in China, Europe and even the US, and also because India's GDP growth is still well below inflationary capacity. And though deficits are already largely funded through the debt market, I would argue for lowering the current requirement that banks invest 21.5 per cent of their Net Demand and Time Liabilities in government bonds. This would encourage them to lend more freely to the private sector. The government's plans to speed up approval of infrastructure projects are wise and welcome, and should inject stimulus more quickly than waiting for the banks to cleanse their balance sheets of bad debt.
(Based on remarks delivered at a seminar at IDFC Institute in Mumbai)
The author is Professor Emeritus at Simon Fraser University in Vancouver, Canada. He specialises in sovereign debt resolution, and has lectured and advised in India since 1982
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