Thursday, November 21, 2019

The regulatory shock to the Indian economy

The demonetisation and Goods and Services Tax (GST) are commonly considered the two biggest negative shocks faced by the Indian economy in the 2016-8 period. They have been variously blamed for the economic slowdown, credit squeeze, and other ills afflicting the Indian economy today.

There is a third, perhaps a more important negative shock. This involves the administrative actions by way of enhancing oversight and enforcement of laws and regulations by the RBI in particular.

Three sets of actions in this regard assume relevance.

1. The RBI initiated the asset quality review (AQR) of all schedule commercial banks. It then initiated a process for early detection of stressed loans and their surveillance, by classifying them as Special Mention Accounts (SMA). It also then withdrew all the restructuring schemes and through its February 12, 2018 circular directed that all defaulting loan accounts had to be classified as stressed even for a day of default, and also mandated that bankers had to refer all accounts with over Rs 2000 Cr loans to the National Company Law Tribunal (NCLT) within 180 days of default. In order to initiate immediate corrective action on banks struggling with capital adequacy ratios, asset quality, and profitability, the RBI initiated the Prompt Corrective Action (PCA) framework.

The AQR and SMA made no distinction between the different asset categories of banks. Temporary defaults on large infrastructure projects with their innately cyclical nature, even for a day beyond the 90 day period, were to be treated on a par with those on personal loans and classified as NPAs with process initiated to recover the loans under the IBC. 

In addition to all these, the RBI adopted the Basel III capital adequacy norms, and that too with a higher capital buffer than required. This, at a time when banks were struggling under the weight of the rising NPAs, squeezed them even more. The credit taps just got turned off completely. 

2. The Insolvency and Bankruptcy Code (IBC) was promulgated to help resolve bankrupt businesses and recover debtors and investors capital. It introduced a paradigm shift into the process of dealing with defaulting corporates. It was a welcome reform. This was state-of-the-art regulation and a progressive and big-bang reform. It was believed then that the days of capitalism without exits was over!

It should have been eased into the system. Again, here too the RBI stepped in by mandating a zero-tolerance approach for defaulting borrowers through its SMA classification. Ambitious time lines were fixed for completion of the entire process of resolution, including the judicial stages.

In fact, at that time, I thought it was a good move by the RBI, since a paradigm shift often needed actions which shook up the system off deeply entrenched practices. But it clearly seems to have backfired, by squeezing too soon.

3. The spate of financial market scandals led to tax authorities initiating investigations and raids across the country and across business sectors. This was accompanied by the crack-downs on shell companies, tax evaders, and black money peddlers. Both the demonetisation and the GST accentuated this trend. All this empowered tax officials and created a culture of aggressive enforcement.

All the three cases mentioned above were associated with radical regime shifts. In all of them, the system moved quickly from one of permissiveness and abundance of slack to one where tight adherence to very restrictive requirements became the norm. Theoretically, all of them were progressive moves, attempts to emulate best practices which are the norm in developed economies.

But these were sledgehammers. And these sledgehammers from RBI, IBC, and tax authorities (black money, shell companies, evasion etc) all fell at the same time, and that too when the economy was weakening. This was perhaps the last straw which broke the camel's back.

As I wrote in an earlier post, using the sledgehammer is just as inappropriate as is ignoring the problem altogether. Both are easy responses for regulators and policy makers at the helm of affairs. Making change happen in a more thoughtful and calibrated manner is very challenging.

I am inclined to believe that when the history of the Indian economy for this period, perhaps even an important long-term inflection point, is written, then these three channels of regulatory shocks will occupy the central role. It may also be a good example of the limitations of technocracy, especially in central banking. 

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