The writer, former Governor of the Reserve Bank of India, is the author of “ Overdraft: Saving the Indian Saver ”
India’s economy is experiencing the worst contraction in decades due to the coronavirus. But even if the threat of the virus fades, India’s medium-term growth prospects will be hampered by two policy reversals predating the pandemic. Both have systemic consequences.
The first is a return to high tariffs – an outward move that will affect productivity. The second is the challenge to the 2016 bankruptcy code – an internal policy that will lead to inefficient credit allocation.
Over the past four years, the Indian government’s reliance on higher tariffs has intensified, in a policy unmistakably reminiscent of the 1970s. Decades of bipartisan support that enabled previous administrations to reduce tariffs India’s 10 percent non-agricultural products were ruled out. And a quarter of a century of respectable export growth has been dismissed without debate.
While the government explicitly promotes protectionism, the opposition parties implicitly support it by remaining silent. They see no benefit in defending an open trade regime.
The results of island trade policies are well known from India’s turbulent past – higher prices, substandard products, low productivity, and self-fulfilling export pessimism – leading to pressure for additional protection. Somewhat contradictory, since 2019 India’s capital account has been liberalized further for external financing, including volatile Category. Together, this adds up to an incongruous economic policy.
A little-discussed potential outcome is that other countries will push back Indian services exports – an area in which the country has shown a lasting comparative advantage. The days of “heads I win, tails you lose” in business relationships are over. It is not inconceivable that some countries could retaliate by imposing taxes on the provision of cross-border IT solutions.
The second policy error is the dilution, by the government and the banking regulator, of the Framework of the Insolvency and Bankruptcy Code 2016 and associated regulations. A good rule-based, time-bound resolution has been released. Discretion is now at the rendezvous – and transparency has been compromised.
The definition of what constitutes a default was diluted in 2019, allow delinquent borrowers to extend business. Exposure limits for large borrowers, intended to mitigate concentration risk, have also been relaxed. The ad hoc regulatory exemption for specific sectors has also made a comeback.
There are many reasons why Indian politicians are reluctant to support market-based approaches. There is a lack of trust between the rulers and the governed. The suspicion that the system is rigged has remained difficult to overcome, even though India’s growth and outward orientation since 1991 has lifted hundreds of millions of people out of poverty.
This perception is difficult to counter in opaque credit markets, where crony capitalism has been operating for decades. A transparent, rules-based IBC was an opportunity to make it clear that defaulters can no longer hide in a regulatory and legal maze heavy with discretionary power. The code meant there was a credible threat that sponsors could lose businesses if they didn’t pay creditors on time.
The insolvency framework also rebalanced class interests, which should have been a plus for voters, and improved the allocation of capital.
Sadly, the government has chosen to undermine perhaps the most important structural reform of the past two decades. Now lenders, especially public banks, can once again allow recalcitrant borrowers to play with the system and owners to keep control of “zombie” businesses. Regulations are at the mercy of weak lenders and weak borrowers.
Currently, banks’ reporting of new non-performing assets is virtually at a standstill, due to Covid-induced abstention. The insolvency code has been on hold since the second quarter of 2020. Rather inexplicably, even borrowers cannot initiate a resolution process to recoup the value of failed businesses. But if accurate and consistent disclosure of balance sheets is done under a cloud, heightened risk premiums from the banking industry are inevitable.
The procrastination to fully tackle financial sector problems had contributed to India’s slowing growth before the pandemic: it had fallen to less than 4% in the first quarter of 2020. Effective investment finance requires credit is allocated and assessed according to the risk -adjusted returns. Further delays in unblocking the credit plumbing will have more serious consequences.