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Fiscal impact of bailouts

Ila Patnaik

Finance Minister Jaswant Singh appears to have a clear political mandate. He must win the support of middle class voters regardless of the fiscal cost. And, if he does want to go Yashwant Sinha's way, he must take his mandate very seriously. So first, he addressed the tax measures proposed in the Budget. Then, it was the turn of the Unit Trust of India.

As a result, last week the finance ministry announced a huge bailout package for UTI. Reports suggest that similar bailouts for the Industrial Finance Corporation of India and Industrial Development Bank of India are to follow. The coming months will, no doubt, see public money being unashamedly used for pursuing the FM's political agenda.

The fiscal costs of these bailouts will be enormous. Moreover, these will not be merely the numbers that are currently floating around such as the Rs 14,000 crore (Rs 140-billion) figure for the UTI bailout. The future fiscal costs of these bailouts will be much higher.

This is because bailouts create moral hazards for public sector financial institutions, including PSU banks, who will believe that mismanagement goes unpunished. They will now be convinced that they have unlimited claims over public money. Indeed, after these bailouts, the size of the government's internal debt should be measured including its guarantees to public sector banks and financial institutions. This clearly raises the level of public debt sharply.

That is why it is extremely short-sighted for a finance minister to have such bailouts even as options for supporting public sector financial institutions. He should have found less harmful ways of supporting small investors.

Moreover, these measures do not come with any serious attempts to reduce the cost of government guarantees to public sector institutions in the future. For instance, a common thread across UTI, IFCI and IDBI lies in their non-performing assets.

What is worse, most of the major NPAs in India are not limited to any one lending entity. For years, banks and financial institutions had a mechanism called 'consortium lending', whereby a consortium of lenders would give loans to a given firm. The NPAs of UTI, IFCI and IDBI are all likely to be present on the books of PSU banks.

It is thus possible that some PSU banks will go bankrupt in the years to come, owing to these same NPAs. The government might well choose to organise a bailout for these entities also. This adds up to a picture where the NPAs of the country have a substantial fiscal impact, through the mechanism of government bailouts.

It is believed that the NPAs of UTI are roughly Rs 5,000 crore (Rs 50 billion). IFCI has roughly Rs 10,000 crore (Rs 100 billion) and IDBI has Rs 20,000 crore (Rs 200 billion). The exact numbers are hard to estimate because many bad loans tend to be misclassified under the existing regulations. But approximately these three entities alone have roughly Rs 35,000 crore (Rs 350 billion) of NPAs.

If these loans and bonds were to be sold, part of the money can be recovered, which would clearly reduce the burden on the exchequer. Admittedly, the values of these loans or bonds in the market would, of course, be only a fraction of the Rs 35,000 crore (Rs 350 billion). But, even if it is 10 to 15 per cent, as in the case of similar auctions in China, it would reduce the fiscal cost by Rs 3,500 to Rs 5,000 crore (Rs 35-50 billion).

The value of an NPA depends on the perception of the buyer of the stock of loans or bonds about the money that can be recovered. The government could have contained the future fiscal impact of the current bailout by improved mechanisms for creditors to enforce their claims on loans or bonds that have defaulted.

With an improvement of the probability of recovery of loans the amount for which the NPAs could be sold would have increased and consequently the fiscal impact of the bail-out could have been reduced.

The legal and institutional mechanisms in India fare poorly when it comes to empowering creditors. The control of a limited liability company, where the shareholders lose control of the company when they are unable to meet debt obligations, should swiftly pass to the creditors. They should then be able to auction off the company and recover some of their money. For all practical purposes these mechanisms do not exist in India.

A recent ordinance has improved matters for creditors, but only for secured credit - i.e. for situations where a loan is backed by an asset as collateral, such as a car loan. But most of the debt of banks is unsecured credit. And, the recent ordinance is irrelevant for this. And, even for secured credit the ordinance can have only limited impact.

It entails an eight month wait after default before creditors can take action. The ordinance also leaves possibilities open for nuisance lawsuits, which can derail debt recovery. Hence, even in a well-defined situation, where a loan is backed by specific collateral, creditors in India cannot recover their money easily.

However, even this ordinance was followed by enormous hue and cry from industrial lobbies. This was not surprising as many large companies figure prominently in the list of defaulters.

Fortunately, Mr Jaswant Singh did not succumb to their pressure, as was feared when he took over as FM. Now, if instead of supposedly 'supporting' the financial sector by the bailouts, he had gone ahead on improving creditors rights, he might have done a lot more good.

But perhaps all is not lost. After all, even if UTI was a political compulsion, thanks to the large number of unit holders, there is no similar reason to bail out IFCI and IDBI. There are only a very small number of voters who would benefit from the money that would be spent.

So there is still time, Mr Singh. Stop, reconsider and minimise the damage you propose to do. And, if the money you save on these bailouts is better spent on public goods such as clean drinking water, you may even buy more votes than you would by rescuing IFCI and IDBI.

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