India: Modi opens a new front

Market analysis - 5/30/2016

The country is still not regarded as business-friendly. The reforms in the government’s Insolvency and Bankruptcy Code are meant to expand the capital market

The Indian economy has generated average real GDP growth of 6.5% in recent years. Yet the government is struggling to make significant headway in the area of structural reforms and this is preventing the country from realising its huge potential. Infrastructures by and large continue to creak, the labour market lacks flexibility and the financial markets need to be developed and opened further to international investors. When Narendra Modi became prime minister in mid-2014, it was hoped he would be able to make deep inroads with reforms, since he had gone on record as wanting to see India among the 50 business-friendliest countries in the world. Investors cheered this goal by bidding up the Bombay stockmarket, sending its valuation multiples soaring.

Subsequent events have reminded observers that Modi's party does not wield a majority in the upper house of Parliament, where its bills often run into opposition. For example, the government's flagship reform, a national goods and services tax that could boost GDP growth by 2%, has yet to be adopted. 


However, the recently adopted Insolvency and Bankruptcy Code should breathe new life into India's reform movement. It is meant to speed up the settlement of insolvency cases involving both companies and individuals. India has a sad history when it comes to settling and recovering on non-performing loans, an area where it still stands 130th in the country ranking compiled by the World Bank (see right-hand chart above). Insolvency proceedings drag on for an average of 4.3 years, with a recovery rate of just 25.7%. This is well shy of international standards. As a comparison, in China the process takes an average of 1.7 years, with a 36.2% recovery rate. The cumbersome nature and snail's pace of debt collection in India has so far been due to archaic legislation, some provisions of which had not been revised since colonial times. This has actually encouraged debtors to drag their feet. 

The new code, due to be signed into law in the coming weeks, will make it possible to settle insolvency cases in 180 days. During this period a committee of creditors will decide how to act on a payment default, i.e. by restructuring the debtor company's liabilities or by winding it up. Creditors will moreover be classified, with senior debt taking precedence over subordinated claims. Moreover, insolvency cases will henceforth be overseen by bankruptcy courts, replacing the slower regular courts that have handled these matters up to now.  

All this should have positive repercussions on India's business climate by evening the balance of power between lenders and borrowers and by strengthening confidence on both sides. The Insolvency and Bankruptcy Code broadens the range of alternatives available to distressed companies, which will now be able to change their capital structure or reschedule their debt. This new-found flexibility should stimulate free enterprise at the local level.


From a more practical standpoint, dealing with bad loans quickly and effectively will not only reduce the portion of non-performing assets in banks' balance sheets but also increase the supply of credit. At present nearly $150 billion of Indian banks' assets are at risk (representing 10% of their combined loan books, including restructured assets). This weighs on their profitability and, worse, blocks resources that could be used to finance productive projects. The end result is a tepid investment cycle where money needed for infrastructure spending is in short supply.

The new code is also meant to help diversify the sources of credit available to borrowers, who are now 60% dependent on bank loans. The authorities' objective is to encourage greater financing in the bond market and provide easier access to credit for smaller firms, which are often turned down by banks because of the higher credit risk involved.

Now the fanfare over the new legislation is fading, we should bear in mind that a whole ecosystem needs to be created. Setting up bankruptcy courts, training specialists and setting up databases to catalogue delinquent borrowers will all take time, meaning that the impact of the reform will only come in the medium/long term. Moreover, the recapitalisation of state-owned banks will be subject to the government's budget restrictions.

Unlike China, however, India is developing a coherent process to address non-performing loans, a problem that is taxing its banking system. The Reserve Bank of India has set its sights high with the objective of weeding out and fully provisioning bad loans by March 2017. This clearly marks a major step towards expanding the country's capital market, a vital effort in its economic development.

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