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Economic Survey 2016-17 for IAS Prelims: The Festering Twin Balance Sheet Problem Part 3

Mar 1, 2017 18:17 IST

    Economic Survey on TBS problem Part 3

    As the data filtered into the public consciousness, it became clear that India was suffering from a “twin balance sheet problem”, where both the banking and corporate sectors were under stress. Not just a small amount of stress, but one of the highest degrees of stress in the world.

    Economic Survey 2016-17 for IAS Prelims: The Festering Twin Balance Sheet Problem Part 2

    Last year financial markets in India were rocked by bad news from the banking system. One by one, public sector banks revealed their financial results and banks reported that nonperforming assets had soared, to such an extent that provisioning had overwhelmed operating earnings.

    ECONOMIC SURVEY 2016-17 IMPORTANT QUESTIONS

    Here, we provide exclusive questions on twin balance sheet problem from the Economic Survey 2017 which can prove to be extremely helpful in IAS Prelims 2017 preparation.

    1. Consider the following statements regarding the gradual tightening of the credit constraint across the Indian economy:

    1) Total credit to the corporate sector has been decelerating.
    2) Household credit, where default has been minimal is also decreasing.
    3) Agricultural loans have also continued at a good pace, as they have been protected by the priority sector lending requirements.
    4) Real loan growth to MSMEs has increased due to various skilling programmes.

    Which of the above statements is true?

    a. 1 and 3
    b. 1, 2 and 3
    c. 1, 2 and 4
    d. 2, 3 and 4

    Answer: b

    Explanation:

    Public sector banks have responded to their difficult financial situation in the standard way. They have tried to protect their capital positions by minimising the new risks they are taking, that is by scaling back their new lending.  As a result, total credit to the corporate sector has been decelerating steadily. In real terms, such credit growth is now negative, the lowest it has been in 23 years.

    This gradual tightening of the credit constraint has been felt rather unevenly across the economy. Household credit, where default has been minimal and where private sector banks have a comparative lending advantage, has been expanding exceptionally rapidly, fuelling the growth of consumption. Agricultural loans have also continued at a good pace, as they have been protected by the priority sector lending requirements.

    But corporates and MSMEs have been hit severely. Real loan growth to MSMEs slowed significantly in 2014-15 and actually turned negative during the past two fiscal years. Meanwhile, loans to corporate in the stressed sectors remained buoyant for some time, in line with the strategy of keeping them afloat, but even for this group loan growth turned sharply negative in real terms during 2016-17.

    Union Budget 2017 Questions for IAS Exam

    2. Consider the following statements regarding the way the Public sector bank responded to the difficult financial situation. Which of the following statements is true?

    a. Public sector banks have tried to protect their capital positions by scaling back their new lending.
    b. Banks have tried to compensate for the lack of earnings from the non-performing part of their portfolio by widening their interest margins.
    c. Both (a) and (b)
    d. None of the above

    Answer: c

    Explanation:

    Public sector banks have responded to their difficult financial situation in the standard way. They have tried to protect their capital positions by minimising the new risks they are taking, that is by scaling back their new lending. Public sector banks have also responded to their stress in another standard way. They have tried to compensate for the lack of earnings from the non-performing part of their portfolio by widening their interest margins.
    Bank Rates analysis

    Some of the lending slack has been taken up by private banks, but there are limits to the extent that they can provide a substitute because the public sector banks (in aggregate) are much larger. It was only following the extraordinary influx of deposits consequent on demonetisation that public sector banks finally cut their lending rates by significant amounts.

    Economic Survey 2016-17 for IAS Prelims: Universal Basic Income

    3. The RBI has over the past few years introduced a number of mechanisms to deal with the stressed asset problem. Consider the following such mechanisms:

    1) The establishment of private Asset Reconstruction Companies (ARCs), in the hope that they would buy up the bad loans of the commercial banks.
    2) The Strategic Debt Restructuring (SDR) scheme was introduced, under which creditors could provide firms with debt reductions up to 50 percent in order to restore their financial viability.
    3) The Sustainable Structuring of Stressed Assets (S4A) was announced, under which creditors could take over firms that were unable to pay and sell them to new owners.

    Which of the above statements is true?

    a. Only 1
    b. 1 and 3
    c. 1 and 2
    d. 1, 2 and 3

    Answer: a

    Explanation:

    The RBI has over the past few years introduced a number of mechanisms to deal with the stressed asset problem. Initially, the schemes focused on rescheduling amortisations to give firms more time to repay. For some time, the RBI has been encouraging the establishment of private Asset Reconstruction Companies (ARCs), in the hope that they would buy up the bad loans of the commercial banks.

    In that way, there could be an efficient division of labour, as banks could resume focusing on their traditional deposit-and-loan operations, while the ARCs could deploy the specialist skills needed to restructure corporate debts.

    In June 2015, the Strategic Debt Restructuring (SDR) scheme was introduced, under which creditors could take over firms that were unable to pay and sell them to new owners. The following year, the Sustainable Structuring of Stressed Assets (S4A) was announced, under which creditors could provide firms with debt reductions up to 50 percent in order to restore their financial viability.

    In principle, these schemes taken together might have provided a comprehensive framework for dealing with solvency problems.

    Economic Survey 2016-17 for IAS Prelims: Demonetisation To Deify or Demonize Part 4

    4. The capital requirements would nonetheless be large to resolve the bad loan problem. According to the Economic survey analysis, which agency will fulfil the capital requirement?

    a. The Government securities, foreign loans and the RBI
    b. The Government securities, Public investments and the RBI
    c. The Government securities, the capital markets and the RBI
    d. The Government securities, Private investments and the RBI

    Answer: c

    Explanation:

    The capital requirements would nonetheless be large. The part would need to come from government issues of securities. This would increase the debt stock, but could actually strengthen the government’s financial position if establishing PARA hastens the resolution of the stressed asset problem since doing so would reduce the amount that would ultimately be needed to compensate banks for the losses on the bad loans.

    The second source of funding could be the capital markets if the PARA were to be structured in a way that would encourage the private sector to take up an equity share. In addition, capital markets could help replenish the capital of the public sector banks, if the government were willing to sell down its holdings.

    A third source of capital could be the RBI. The mechanism for doing this is straightforward. The RBI would (in effect) transfer some of the government securities it is currently holding to public sector banks and PARA. As a result, the RBI’s capital would decrease, while that of the banks and PARA would increase. There would be no implications for monetary policy since no new money would be created.

    5. RBI is one of the most highly capitalised central banks in the world. Consider the following statements regarding the other uses of this capital according to the economic survey2017:

    1) For recapitalizing the banks.
    2) For recapitalizing a Public Sector Asset Rehabilitation Agency.
    3) For extinguishing debt to demonstrate that the government is serious about a strong public sector fiscal position.

    Which of the above statements is true?

    a. Only 1
    b. 1 and 3
    c. 1 and 2
    d. 1, 2 and 3

    Answer: d

    Explanation:

    The RBI is exceptionally highly capitalised and it is one of the most highly capitalised central banks in the world. So, it would seem to be more productive to redeploy some of this capital in other ways.

    Assuming that the RBI returns Rs. 4 lakh crore of capital to the government, it could be used in several good ways. Firstly, it could be used for recapitalizing the banks and/or recapitalizing a Public Sector Asset Rehabilitation Agency (PARA).

    Second, for extinguishing debt to demonstrate that the government is serious about a strong public sector fiscal position. The key principle that should be observed in this process is that the excess capital in the RBI, including that created by demonetisation, is a balance sheet or wealth gain and not an income gain. Hence, the uses to which this is put should be of a balance sheet nature.

    It cannot be emphasised enough that any strategy to use the excess capital must be done carefully that in no way undermines or circumvents the relevant laws. It must also be done with the full cooperation of the RBI to ensure that the RBI’s independence and credibility are in no way undermined.

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