A blog on financial markets and their regulation
How to bury zombie companies quickly
June 16, 2017Posted by on
Earlier this week I posted about the bankruptcy literature of the 1990s that sought to rely less on judges, administrators and experts and more on contracts and markets. As promised in that post, I now explore the implications of that framework for the widespread corporate distress in India today.
While much of the discussion on the Indian situation emphasizes the problem of bad loans in the banking system, the government’s Economic Survey rightly described it as a twin balance sheet problem encompassing problems in the balance sheets of the banking system and of the corporate sector. Of the two, I would argue that the problem in the banking system is the less serious one for many reasons.
- The overt problem is largely confined to the public sector banks and from past experience we know that these banks can run smoothly (without any run on the banks) regardless of how little capital they have. Indian Bank in the mid 1990s is a classic example of the depositors retaining their faith in the bank even after reporting a large loss that resulted in a negative net worth. These days, there is the issue of Basel norms, but strictly speaking, they apply only to internationally active banks. If the overseas operations of the unhealthy public sector banks are shut down or transferred to healthier ones, there is no technical bar on letting them operate with low levels of capital adequacy. By placing restrictions on their fresh lending, any moral hazard problems can be alleviated.
- Many observers believe that bad loans are not confined to the public sector banks, and that at least some private sector banks have a large but covert problem. But this issue can probably be addressed by imposing a large preemptive recapitalization on them.
India needs to move away from a bank dominated financial system, and some degree of downsizing of the banking system is acceptable if it is accompanied by an offsetting growth of the bond markets and non bank finance.
In my view, the problem of zombie companies is far more serious than the problem of zombie banks. There is overwhelming anecdotal evidence that these zombie companies are a major drag on the economy. For those who are not swayed by anecdotal evidence, an IMF working paper published this month demonstrates that the decline in private investment in India is linked to over-leveraged companies being unable to start new projects or complete ongoing projects. For India to achieve high growth, it is necessary to sort out these zombie companies.
Bankruptcy is the most effective way of putting an end to the zombie companies, and recycling their assets for more efficient use. Bankruptcy breaks the vicious cycle through which past debt acts as a brake on future growth. As Heidt put it: “Bankruptcy separates the past from the future … it takes the debtor’s past assets to pay its past creditors.”
Traditional bankruptcy processes may not provide an adequate solution to this problem because the number of companies involved is quite high and because India does not yet have enough trained bankruptcy professionals and judges to do bankruptcy on a massive scale. This is where I am fascinated by the idea in the bankruptcy literature of the 1990s of using markets instead of courts. This is much more scaleable in the Indian context because some Indian financial markets are reasonably deep, and the supply of funds in these markets is quite elastic because they are open to foreign investors.
My preferred solution is basically the same as the AHM procedure that I mentioned in my last blog post. In this approach, the government forces the banks to converts all their loans into equity, and also forces the banks to sell the resulting equity in the stock market within a tight time frame. The new shareholders decide whether to sell the assets or to run the business. In any case, with the debt completely removed, the company is no longer a zombie company, and even a partial or total liquidation would be a voluntary liquidation by the shareholders that does not require significant court intervention. The difficulties with this method are easy to surmount:
It assumes a well functioning equity market, but I think this is more reasonable assumption to make than that banks can suddenly figure out how to restructure all this debt, or that rating agencies can be trusted to provide useful guidance on this (Partnoy’s scathing piece last month should remove all doubts on the matter) or that an omniscient central bank can tell the banks how to restructure all the debt.
One “discretionary” question still appears to remain: how much of the old equity should be wiped before the conversion of the loans. In the original AMH procedure, this problem is solved using Bebchuk options: old shareholders are given the option to buy out the creditors pro rata. In most of the zombie companies, the Bebchuk options are unlikely to be exercised, and the old shareholders would be completely wiped out. Allowing the old shareholders to retain 5-10% of the expanded equity might be another possibility to make it politically more palatable.
The banks would take large losses in this process that could leave them poorly capitalized. I have already discussed this above. For public sector banks, the capital does not really matter, and for the private sector banks, the problem can be solved by imposing a preemptive recapitalization. The important thing is to downsize the banking system so that we do not get into this mess again.