Bankruptcy code is a new deal between the state and businesses in India

Representational image | Bloomberg

It has shaken up the protection model. 

The Insolvency and Bankruptcy Code (IBC) isn’t just an antidote to the problem of companies not repaying banks. In the short-term, the implementation of the code can be seen as a system of recovering debts. In the longer term, the code reflects a fundamental shift in the way the Indian state approaches business and capitalism. We are moving away from a cosy relationship between existing businesses and the state, in which the state placed heavy restrictions and taxes on existing businesses on the one hand, and on the other, protected those businesses from failure. In New India, both entry and exit are essential.

Restrictions on businesses

The bad old days started with the expropriation of textile mills in Mumbai on the grounds of mismanagement. This trend continued till the late 1970s with the nationalisation of banks. The policy environment resulted in India being left with only a handful of large businesses. Their activities were heavily restricted on the one hand and their companies protected on the other.

The state enacted business-unfriendly legislation leading to high taxes and labour protection. Production, investment, expansion of capacity, imports and exports were all highly restricted. Permissions and licences had to be obtained for almost any activity a company undertook.

Protection for businesses

India enacted a series of laws and policies to protect existing businesses. Foreign competition was constrained through laws like Foreign Exchange Regulation Act (FERA) which prevented foreign companies from entering India. Within the country, laws like industrial licencing and the MRTP act would ensure that existing businesses did not face competition from other businesses or new ones. While taxes were high, there were generous exemptions for activities which only established businesses could undertake, such as R&D. Low-interest loans were provided to existing businesses with physical collateral.

India’s banking and credit culture was also an extension of the same economic model. If a business failed, it was a problem to be solved by the state. The state would make attempts to revive the business through various schemes and protect the interests of promoters.

Bank loans would be restructured, renegotiated and ever-greened as it were. The attempt was to never allow a company to go bankrupt. Protecting jobs was an oft-used excuse when trying to revive sick companies. In the India of industrial controls and restrictions, almost all business difficulties could be attributed to some taxation, industrial policy or law enforced by the state. There was no good reason to shut down one company and allow another to take its place.

The new ones would have performed equally badly. Bad performance was not due to the promoters or the management as much as it was a feature of the restrictive economic policy framework. Bankruptcy had little economic rationale.

Liberalisation removed restrictions

The liberalisation of the Indian economy removed many constraints under which business had to operate. The MRTP law was replaced with a more business-friendly Competition Act which does not prohibit companies from growing. Taxes were reduced. Many restrictive laws like the Aluminium and Cement Control Orders were relaxed. FERA was replaced with Foreign Exchange Management Act (FEMA), which made cross-border investments easier.

India joined the WTO, opening trade of many goods.

In today’s India, companies do not face as many restrictions as they did in the past. They can expand, invest, import and export as they like. Well-managed companies perform better and grow.

However, at the same time, companies have to face competition due to low tariffs, foreign companies and foreign technology. Badly managed or outdated companies fail in the face of competition. If new companies are allowed to enter markets, those that fail must also be allowed to die. If instead of a handful of incumbents, who can be protected forever, the economy consists of a large number of entrepreneurs entering businesses, they cannot be
protected the way the old ones were.

The economy cannot afford it. Promoters who cannot run businesses well have to lose their companies. Resources need to be reallocated to efficient firms all the time and cannot be stuck in unproductive use. Failing businesses cannot not be protected by the state. Loans cannot keep getting renegotiated bringing credit growth to a halt.

However, businesses in India are used to protection. Many business strategies were probably based on the assumption that the protections would continue or not be dismantled at such a fast rate. The IBC is a tectonic shift for the old guard in India. Most businesses have seen the endless renegotiation with banks and the alphabet soups of CDR, SDR and S4A.

It is not pleasant to wake up to a world with them suddenly gone. It is only rational for businesses to try as hard as possible to try to go back to that cosy world of protections.

Arguments to protect firms in the name of protecting jobs have started resurfacing in the new world. While the government has taken the bold step of bringing in a bankruptcy law, it must vigilantly protect it from slipping back into the old ways.

The IBC has many teething problems and institutional issues that need to be solved. The fundamental purpose of the reform and its economic rationale must remain the guiding principle to make any changes.

Shubho Roy is a consultant at NIPFP

Ila Patnaik is a Professor at the National Institute of Public Finance and Policy

This is the first of a series of articles the authors will write on law and economics in India.