One of the more perplexing things about the Indian business landscape is that even as cost of capital has fallen sharply over the past 20 years (the 10 yr Govt bond yield which was 13% in 2013 is now 7%). Indian corporates now borrow less than they did in the past. In this insightful piece, noted economist, Ajay Shah, explains why this has happened and why this does not bode well for India: “Borrowing by large Indian firms has greatly subsided. While this makes managers of firms feel safe, it is not healthy for the Indian economy. Debt is a disciplining device, and it helps ensure that managers run hard, which is good for shareholders and society. Borrowing improves return on equity, which is good for shareholders. Indebted firms go bankrupt, which is part of Schumpeterian creative destruction. An economy where large firms have little debt runs the risk of being less dynamic. Shareholders and boards need to reopen the discussion on optimal firm leverage.”

Mr Shah helps us understand the massive scale of deleveraging in India: “From the early days of economic reform, the Indian non-financial corporate sector has retreated from borrowing. Their debt-equity ratio was highest at 1.85 in 1991-92. In the latest data, for 2021-22 it stood at 0.89 and it is likely to have dropped further in the following year. It generally makes sense to represent the balance sheet on market-value terms. In this, the re-pricing of debt yields little change, and net worth is re-priced at market capitalisation. Once this re-pricing is made, the magnitude of debt that is now present is minuscule. When we look into the industry structure of the debt, it is really found in only a few industries like electricity: Leverage in most industries is at astonishingly low levels.”

So, what happened? Why has India Inc because averse to borrowing? Mr Shah’s article does not contain an answer to this question. What the article does do however is explain why the commonly touted factors (used to blame falling debt levels) do not stack up: “There has been much discussion about why this grand phenomenon took place. Explanations include: Low demand owing to the macroeconomic environment with low investment, low demand owing to fears of bankruptcy costs, and low supply owing to fears of bank employees (which spread from public-sector to private-sector bankers through a Supreme Court ruling in 2016 about the scope of the Prevention of Corruption Act). It can be argued that firms are recoiling from the problems that were experienced with high leverage. It must be noted that the peak leverage seen (debt:equity ratio of 1.85) was a while ago (1991-92) and any extremes of short-term responses should have subsided.”

So, what can we do? What can be done to get companies to borrow again? Firstly, Mr Shah’s says that Board Directors have to step up and do their job properly: “Solving this problem is primarily up to the dominant shareholders of firms and the boards that represent them. This reasoning needs to feed into the better working of boards. When boards do not exert their oversight on corporate financial structure, there will be a bias in favour of inefficient levels of gearing. There are now myriad situations in India where the chief executive officer is not a dominant shareholder. In such situations, the shareholders and board members need to push in favour of non-zero leverage.”

Secondly, he says (and so do CEOs of India’s banks), the bankruptcy process needs to be relooked at because “The bankruptcy process works poorly and imposes an unreasonable level of costs.”

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