Banks need a two pronged strategy: Acting on NPAs alone cannot be the solver

The economy is no different than any business, it has assets and liabilities. If the asset side is growing at a phenomenal pace, the liability side is only a follower.

The assets must be deployed to give productive returns, that which would balance the liabilities. But there is always a matching problem and timing effects. Some of the growth could be organic but based on distortions in the market, that which could be transitory. Some of this could be the effect of short term trends that may not remain in the long term. Some of the positives could just be chance events or even economic bonanza earned not by merit.

The timing problems could be associated with gestation periods and assumptions of growth, which could move sideways. Some of the growth could be inorganic, but based on assumptions which may not hold good over a period.

Some of these problems could be solved by a plethora of instruments that banks have devised; but not all.

Never can the instruments replace the fundamental premise on which assets and liabilities are to be seen. If an asset is built that becomes a source of constant infusion of funds then it eventually fructifies into a label known as NPAs.

When the head winds appear on the asset side and it is not able to grow productively, the liabilities remain. Banks holding such assets have problem at hand. When assumptions go awry, such a problem could be catastrophic.

Some large economies have seen this happening, like Brazil. Some of the large oil economies are going to see this if fundamentals do not change.

The economy is no different. The good way to look at this problem is as follows.

Money in circulation precedes any growth of an economy. Bulk of this money moves into assets and creates the foundation of growth. The rest moves into goods and services, which fuels any economic activity. Some of it gets parked as excess reserves. The Central Bank tries to manage this supply of money through interest rate maneuvers, so as to see that too much does not move into goods and services that could raise price levels in the economy.

On the other hand if too much moves into non-productive assets, we have a problem at hand.

Money in circulation is a good measure of what is happening in the economy, but it cuts both ways. Too much money in circulation and not in productive assets could be troubling. Too little has the same problem. Let us look at some statistics first.

Monetary base M3 for India grew by a whopping $300 Billion in the last one year, which is a growth of 14%.

India’s current GDP which stands at $2300 Billion is growing by 7%. So monetary base grew by exactly twice of the rate of economic growth, which isn’t so bad after all. But what is important is that monetary growth precedes economic growth, it is not the other way around.

Gross NPAs in Indian banking system now stand at 7.8%, it is most likely to cross 8%.

So when we say that NPAs in India have grown by a whopping 3% YoY we are saying some of the monetary growth has moved into assets that are not creating value. If this is not fixed the chances of a cascade impact cannot be avoided that will impact growth surely.

On the other hand if bank lending into productive assets is stalled, fuelling further growth will be difficult.

It appears as a paradox or a circular argument. If banks are merely cleaned up by offloading some of these NPAs, it may look as if the system is cleansed. But the deeper implications would still remain.

Therefore selling such debt in exchange of equity is one step, but not the end-all of all actions.

Banks must find a way to deal with NPAs by actually seeing through the restructuring paradigm. It would mean taking the bull by the horn. It would mean running the business to see what it takes to turn it around.

But banks are not in the business of running businesses. But they better find out how to do this.