Briefing 13 August 2018

Can Modi clean up crony capitalism in India’s banking system?

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Over the course of 2018 and 2019 the Indian economy is expected to grow at an annual rate between 7.4% and 7.8%, according to the IMF. Not only is this rate of economic growth significantly higher than that expected from China, but India is also predicted to become world's most populous country by 2022. Given these figures, one might expect a greater interest from international investors than has so far been the case. Historically, labyrinthine and slow-moving bureaucratic procedures have combined with corruption and protectionism to deter many global players from investing heavily in India. The situation has not been helped by the fragmentary nature of the federal system, which has often made it surprisingly difficult to do business across the borders of India’s various different states. The Modi presidency set out to change this landscape but one persistent problem has been the tightly-woven relationships between banks, corrupt politicians, and certain leading businessmen. This led to a reluctance to deal with defaults and non-performing loans that had built up to an enormous problem by the time Modi took over in 2014. Untying the knots of crony capitalism seen in these banking relationships is key to improving India’s overall business climate and to reducing corruption. In the light of a forthcoming Indian general election in Spring 2019 we examine how Modi is doing and what opportunities this is producing for global investors. A lopsided banking landscape Since India’s independence in 1947 its banking industry has been dominated by state-owned banks which lent out large sums, sometimes at the discretion of ruling politicians, to businesses controlled by influential families or businessmen. Private sector banks only started taking shape and gaining strength after India’s acceptance of globalization in 1991; since then, they have surpassed several of their public sector peers in size, competitiveness and profitability. Some had investors, such as global institutional players, whose concern for corporate governance helped them fend off political pressures when making key banking and underwriting decisions. Despite this, both private and public sector banks have suffered in the most recent banking downturn. This began in 2011-2012 when corruption scandals surrounding the allocation of coal blocks and 2G telecom licenses came to light, resulting in a number of these being cancelled by the Indian Supreme Court. Some companies had borrowed large sums of money on the basis of these coal blocks or telecom licenses and suddenly lost the collateral on these loans. It transpired that a number of them had invested the borrowed money in real estate instead of coal mining or telecom services as they had claimed. The fallout of bad banking decisions The investigations and subsequent charges continued up to 2015 and uncovered numerous bad loans in the banking systems, not just in the mining and telecom sectors. Even today, Indian banks, both state-owned and private, are still talking about finding the bottom of the bad loans cycle in their quarterly investor calls. This, coupled with a weak economic cycle for a number of businesses, including the metals and power sectors, caused a domino effect for most large Indian banks leaving them over-leveraged and under-protected from defaults. The result: a series of defaults, restructurings and a glut of bad loans which eventually totalled over USD 150 billion cumulatively. Banks tried to avoid reckoning with the scale of the problem by not making provisions for bad loans, taking write-downs, suing borrowers for recoveries, or – in some cases - even acknowledging that defaults were taking place. The Reserve Bank of India steps in It was only in 2013, when Raghuram Rajan became the Governor of the Reserve Bank of India, India’s banking regulator, that the situation changed. Amongst a number of initiatives that he introduced to bring the Indian economy back on track were banking reforms. To begin with, the Reserve Bank of India started enforcing monitoring and recognition mechanisms for bad loans and those which were likely to turn bad. Bankers were forced to acknowledge cases where borrowers failed to make payments on their loans for 30 or 60 days. After 90 days of non-payment, a loan would be provisioned for by terming it a non-performing asset. This enforcement started demonstrating the poor asset quality that the majority of the Indian banks had on their

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books. Cosy relationships between bank bosses and businessmen which helped borrowers push the proverbial can down the road started to wane and loan recovery proceedings started to be initiated. The battlefield moved from the banks to the courts with both lenders and borrowers suing each other, clogging up the already over-extended legal system. Myriad existing laws replaced with a single bankruptcy law In parallel with Narendra Modi’s victory in the 2014 Indian elections the non-performing assets issue reached its peak. The banks’ balance sheets were in a precarious position due to the non-performing loans, a lack of ability to raise new funding for continued business, and the unwillingness of the government to recapitalize banks when they made bad lending decisions. A number of recovery mechanisms or laws were tried, including the SARFAESI1 Act, the Corporate Debt Restructuring (CDR) scheme, Strategic Debt Restructuring (SDR), the Sustainable Structuring of Stressed Assets (S4A) schemes, and the Joint Lenders Forum. Some of these were misused, failed to work and eventually had to be repealed or abolished. Until 2015, banks used the CDR, SDR and S4A schemes in conjunction with the Joint Lenders Forum, albeit reluctantly as all of these schemes involved converting a large part of debt into equity, getting all the lending consortium members to agree upon a resolution scheme and seeking an alternative management structure for businesses that had often been family-owned for generations - a process that the families themselves often tried to prevent or sabotage. Eventually, the Finance Ministry established the Bankruptcy Law Reform Commission, which in 2016 formulated a single code of law, the Insolvency and Bankruptcy Code (IBC) for the resolution of stressed or defaulted loans. The Insolvency and Bankruptcy Code The Insolvency and Bankruptcy Code (IBC) mandated that on a weekly basis all borrower entities in default with an exposure of more than INR 50 million had to be reported on. Banks also had to act quickly to resolve the biggest defaults; they had to come together to work out a resolution plan as soon as a default happened. If this was not done within 180 days the account had to be referred to the bankruptcy courts. The IBC set up two levels of bankruptcy courts, the National Company Law Tribunal (NCLT) and the National Company Law Appellate Tribunal (NCLAT) and set a time frame of 270 days to resolve bankruptcy cases referred to these courts. Some delayed results So, how has the new regime worked in practice? Since the introduction of the IBC, over 750 cases have been lodged with the insolvency courts to be judged upon and resolved. Initially, despite the mandated deadlines for recognizing defaults in 180 days and resolving them in the subsequent 270 days, it took until the start of June 2018 for the first resolution of an already recognized default, when Vedanta Limited took over ailing Electrosteel Steels by paying its lenders INR 54 billion against its outstanding debts of INR 142 billion and offering them a 7.5% equity in the newly structured business. Existing equity investors’ capital was eroded by 98%. Another resolution was that of Bhushan Steel, taken over by Tata Steel where lenders took a haircut of 27%. More such cases are in the pipeline heading slowly but steadily towards resolution, including Essar Steel, Monnet Ispat, Amtek Auto, Alok Industries, Ruchi Soya Industries and Jaypee Infratech. In cases where the lenders do not accept the bids for resolution by potential suitors, the companies are liquidated. Businessmen who have been accused of wrongly obtaining loans have been hit by lawsuits and face prosecution and possible arrest.

1 The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act - https://www.drt.gov.in/pdf/Act-s/SARFAESI%20Act.pdf

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One of the unintended side effects of the introduction of the IBC was that controlling shareholders or ‘promoters’ of family businesses, which had defaulted on huge loans saw an opportunity to buy back their businesses at a significant discount from the banks to whom they had defaulted earlier. The government acted quickly and introduced a clause in the law which barred promoters or entities connected to them from bidding for their own companies. The fear of losing control over their companies prompted nearly 2,100 promoters to settle their dues of over INR 830 billion to banks before the banks would initiate resolution action under the IBC against their companies. An opportunity for distressed debt investors While the stressed assets market looked attractive to seasoned distressed debt investors globally even before the IBC was introduced, most of them were daunted by the complicated and prolonged legal battles involving acquisition of distressed debt in Indian companies. Another problem faced by investors even today is the lack of liquidity in the debt markets which are yet to open their doors to global investors who have the size and risk appetite to buy, hold and trade large tracts of debt. Since the introduction of IBC, though, several global investors looked at the Indian markets with more interest. Private equity major Blackstone acquired a controlling shareholding in the International Asset Reconstruction Co Private Limited, while KKR & Co obtained an approval to establish its greenfield asset reconstruction company in India. Apollo Global set up a joint venture with ICICI Ventures to start its stressed asset investment outfit AION Capital, while the Quebec pension fund Caisse de Depot et Placement du Quebec bought a 20% shareholding in Edelweiss Asset Reconstruction Company. Canada Pension Plan Investment Board (CPPIB) set up a joint venture with India’s Kotak Mahindra Group to invest a USD 525 million fund in stressed assets; Bain Capital tied up with India’s Piramal Enterprises to invest up to USD 1 billion; and Brookfield Asset Management partnered with India’s largest state-owned bank, the State Bank of India, for another USD 1 billion stressed assets fund. In Conclusion India’s huge USD 150 billion pile of distressed debt is starting to be resolved, following the introduction of the IBC, and this is also untying some of the corrupt relationships that had grown up between the politicians, the banks, and a number of prominent businessmen. This process has created some significant opportunities for global players, although the international money invested so far actually remains quite low when compared with the overall size of the distressed debt sector. As we move towards the next electoral cycle in India, it will be important to see whether the pressure to resolve the NPL issue – and to clean up India’s overall business environment and corporate governance – is maintained. If a subsequent government, whether led by Modi or anyone else – should relax this pressure, then India could easily slip back into the kind of crony capitalism that created this problem in the first place. Current signs suggest that the Modi government is well-positioned to make a comeback, albeit not with an absolute majority as it did in 2014. It has been fairly successful in avoiding any allegations of corruption, unlike the previous tenure of the Indian National Congress-led United Progressive Alliance. Should Modi be re-elected, his focus is likely to move on to trying to tackle corruption in the bureaucracy, where it remains a significant problem. Modi would also hope to have more success in future in privatizing some of the many businesses still owned by the state; the recent high-profile failure of the Air India privatization process was symbolic of the overall lack of success of the privatization efforts thus far. To some extent, though, the political outlook does not change the economic prospects that India offers to investors over the next three to five years or so. In an era of trade wars, India remains relatively uncorrelated with other emerging markets (and developed markets) and is demonstrating growing domestic consumption due to its own demographics, fuelling economic growth from within.

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About Argo Associates Argo Associates is structured around a single overriding purpose: providing our clients with the information and intelligence that will allow them to navigate acquisitions, investments, disputes, or frauds in a clear-sighted and rational way, minimizing risk and maximizing opportunities. Information gathered may clarify the profile and background of key business people and managers; it could illuminate the operations of a company or demonstrate a history of fraud or mismanagement; or it could help our clients to assess the political situation in a given jurisdiction and how it may affect their investments or business operations. Headquartered in Hong Kong, Argo Associates assists clients across Asia and – through international partners – globally.

Intelligence Gathering “Intelligence” is central to making sense of the world and to decision-making. Argo Associates has developed a network of well-placed human sources across Asia and – through our partners outside Asia – globally. This network provides insights beyond what is available publicly – into leadership, operations, strategy, corruption, red flags, political connections and so on - and is supplemented by extensive research and analysis of publicly available sources – corporate filings, litigation filings, regulatory communications, media articles, social media postings and so on. In a world in which information is increasingly commoditized, high-level intelligence and analysis provides the insights that give our clients an edge over their competitors.

Fraud, Corruption and Disputes Our intelligence-gathering techniques and in-depth research and analysis have also helped our clients uncover frauds within their operations or in those of a portfolio company or recent acquisition. Our professionals have provided numerous reports for arbitration or legal proceedings to recover the proceeds of fraud. We have also assisted clients in tracing assets globally when bringing a high-value claim against a company or individual. In high-profile disputes we have assisted a number of top law firms in gathering information, evidence and intelligence in support of their clients’ cases.

Political Risk Our political risk work has developed naturally out of our intelligence and investigative capabilities. We see political risk as an important part of the evaluation of many investments, mergers and acquisitions, as well as a key element of commercial disputes in many markets. We have helped our clients look at political risk in a new way, not just in terms of the broad outline of potential political developments in various countries, but with a focus on the impact on their businesses. For example, will growing frictions between two countries lead to tariffs that could impact the specific sector in which a portfolio company operates? Or, how will rising protectionism in a country alter the possibility of a fair result in an ongoing commercial dispute? Frequently, politics is local as much as national and we understand the importance of drilling beneath the widely-circulated opinions to a real understanding of what is happening.

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Our Founder – Jason Wright Jason Wright is the founder and Managing Director of Argo Associates.

Prior to founding Argo, he was a Managing Director in Hong Kong for Kroll, the company that created the modern investigations and intelligence sector. Before moving to Asia seven years ago he worked for Kroll in Italy for five years and then briefly in London. While assisting clients on numerous transactions, investigations and disputes in Asia and Europe, particularly for private equity funds, banks, hedge funds and special situations investors, Jason has also specialized in the analysis of political risk, whether that has involved examining the role of local politicians, regulators and other stakeholders, or broader geopolitical concerns. Although he has managed projects across the whole Asia- Pacific region he has been particularly focused on Korea, China, and Southeast Asia, especially Indonesia, Vietnam, Malaysia and Thailand. Jason is a scholar of St. Catherine’s College, Oxford, having been awarded a Master of Arts (Oxon) in English Language and Literature, as well as a Master in State Management and Humanitarian Studies from La Sapienza University in Rome, Italy.

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