Finance is often defined as the lubricant that keeps the economy going. When finance fails, the real economy sees an impact. The latest example of this is the sharp decline in the auto sector, which is reported to be staring at 10 lakh job losses.
The crisis that has hit non-bank financial companies (NBFCs) has triggered a downturn in the auto sector.
While increasing liquidity, lowering interest rates and recapitalising public sector banks can ease immediate difficulties and increase credit growth, we will not get a dynamic and competitive financial sector without legislative and regulatory reform.
What went wrong for the auto sector
The auto sector was heavily dependent on NBFCs for financing dealers and customers. When NBFCs found it difficult to borrow money from banks or by selling bonds to mutual funds after the IL&FS crisis, they could not further on-lend to their customers.
Auto buyers were unable to buy cars, dealers were unable to hold inventory. A sharp pile up in inventory levels have been reported post-Diwali.
Cuts in production have followed the build-up of unsold cars, and there are reports about shutdowns in car manufacturing plants and ancillary industries.
The real estate sector had also seen a decline due to difficulties in finance. Post-demonetisation, the sector, which was heavily dependent on cash, has seen both builders and home-owners unable to borrow.
Real estate had reached sectoral lending limits for most banks. While it may be argued that to some extent this was a correction, and that the black money that was funding a real estate bubble was unhealthy and would have burst at some point, the failure of formal well-regulated finance to step in resulted in a long recession in the sector. This was a labour-intensive sector where millions had been employed in the boom years.
Before that, infrastructure had seen a collapse due to the failure of suitable finance. Bank financing is ill-suited for funding long-term infrastructure projects because of the maturity mismatch that borrowing short and lending long creates. However, the Indian financial system is largely bank-dominated and banks were encouraged to lend to public-private partnership (PPP) infrastructure projects.
Infrastructure growth that had been financed using bank financing got into trouble as delays in project implementation led to loans turning NPAs. Banks became risk-averse. The few large infrastructure companies that were eligible to win contracts became unattractive for further lending. The consequence has been a drying up of bank financing to infrastructure companies and an overall decline in new infrastructure projects. With the limited ability of the government to invest, this has meant a decline in the overall pace of construction in infrastructure.
Similarly, as is well known, the global financial crisis triggered off a decline in GDP in the US first, and then in many other advanced countries. This spilled over onto the rest of the world, and we saw a slowdown in the world economy.
How can finance sector be fixed?
One kind of response to the above difficulties in finance is to recapitalise banks, allow borrowers to restructure loans, ease liquidity, lower interest rates and pray that the problem in that sector gets eased. However, as we have seen over and over again, these short-term fixes leave fundamental weaknesses in the financial sector and the economy unaddressed. As a result, this approach is not sustainable in the long run.
While there is no doubt that this would ease the situation in the short run, it is important to understand that such easing can only be a palliative and cannot be a substitute for financial sector reform.
As has been understood for some time now, the 1991 liberalisation had undertaken reform in the real sector, but had left the financial sector unreformed. GDP growth at a rate of 7 per cent per annum means that economic activity doubles every 10 years. Since industry was liberalised, the increase in economic activity was largely in the private sector. Yet, the government kept a tight leash on the money it had access to, through its ownership of the banking system, regulatory controls over lending, and the use of the public sector banking bureaucracy. Lending decisions were often driven by political considerations.
Banks that do not make good decisions and make losses are repeatedly given taxpayer money so that they can continue lending. It is almost as if banking is a political service meant to fulfil the obligations of the government or provide bank employees jobs, rather than a critical instrument of resource allocation in the economy.
The regulator failed to develop an ecosystem in which private entities would be given bank licences while creating mechanisms like a resolution corporation to protect customers.
India’s uncompetitive financial system whose growth depends on repeated taxpayer bailouts needs to be replaced by a competitive financial system with various markets including private banks, bond markets and well-governed public sector banks.
Many studies and expert committee reports have shown the way forward. This government has the time horizon, the numbers and the political confidence to undertake bold reform, increase competition to public sector banks, bring back the Finance Resolution and Deposit Insurance bills, and take serious steps to improve governance in public sector banks, in addition to the short-term quick fixes it needs to bring them back on the table.
The author is an economist and a professor at the National Institute of Public Finance and Policy. Views are personal.