This Union Budget would be announced in the backdrop of the unprecedented pandemic, which has completely changed the economic landscape. This is the first instance when India has seen a decline in GDP numbers since the country began publishing numbers in 1996. The world has already accepted the fact of declining economic performance in every region, and the markets have already factored in the impact of such decline on the fiscal deficit of respective countries. So, a high fiscal deficit would not surprise the Indian Investors. Despite the higher expenditure and lower revenue this year, the government of India is expected to limit the fiscal deficit to 7%. The optimism on tax collection and the government’s aggressive estimates of disinvestments and non-tax collections are the key reasons highlighting that government will try to limit the fiscal deficit. The economic recovery has also surprised pleasantly, and GDP is expected to turn positive in Q3 of 2021, after the massive decline of 23.8% in Q1 of 2021.
As nominal GDP is expected to grow at around 15%, the government is likely to expect a surge in tax collections. However, expenditure will continue to remain high. The government will try to support the economic recovery by increasing public expenditure, boosting demand, and supporting industries that generate high employment. There is a very high cost that the government will incur to support nationwide COVID-19 vaccine programme and build supporting healthcare infrastructure.
At the same time, the government will try to control the fiscal deficit as much as possible, as increased government borrowing will have a crowding-out effect on the private sector due to high real interest rates. So, the government might project an improvement in of 150-200 bps in fiscal deficit for FY2022 as compared to FY2021. So, the fiscal management of the government can high rely on privatization and off-balance-sheet borrowings.
The Covid-19 pandemic has caused significant disruptions to the business and livelihood of common man, so the focus of Union Budget would be to soothe and support the economy with a special focus on the common man. Government via budget would try to focus on investments that directly help in job creation and therefore infrastructure, construction and significant incentives for high employment generating sectors (like textile, affordable housing, MSME, etc.) are key areas, which may get priority focus. The current account is also expected to be back in deficit in FY22 as growth returns and imports pick up and global trade normalizes.
Key Sectors to look out for
The government will focus on developing infrastructure (Roads, Water and Affordable housing). Such infrastructure would give economy earning/employment stimulus. The government can also extend PLI schemes to spur manufacturing. Some initiatives can be taken to support the urban poor especially from the disruptions in the MSME sector. So all in all, Real Estate, Construction, Infrastructure, and Railways are some key sectors which may become the focal point of the upcoming budget.
FY21 was very disappointing in terms of disinvestment as the government only collected INR161 bn through disinvestment as against an ambitious target of INR2.1 trn set by the government. Some of the high profile disinvestment which was supposed to happen this year did not happen. So disinvestment in Life Corporation of India, Air India, BPCL will be pushed for FY22 as these could not happen this year. This implies that the disinvestment target in the upcoming budget could revolve around INR1.6 trn.
This budget would be really important from the perspective of our country’s sovereign ratings. Most of the rating agencies are expected to revisit their assessment of India in Q1. Most of the rating agencies rate India a notch above junk, Fitch and Moody’s have both assigned a “negative” outlook for India. The next key step which will determine whether rating agencies will upgrade or downgrade the outlook will be fiscal dynamics as presented in the upcoming Union Budget.
The broad themes to watch for are as follows:
Overall government is expected to have a greater reliance on assets sale to keep spending at elevated levels while still managing to consolidate in FY22. The proper trade-off between ambition and credibility, as it related to long term fiscal consolidation path, will be an important macro determinant for rating agencies. The nominal GDP is expected to achieve significant acceleration, and to support it the further government will improve its outlays in different sectors.
Once again, talks for the creation of a bad bank are back in India as commercial banks set to witness a spike in NPAs, or bad loans, in the wake of the contraction in the economy as a result of the Covid-19 pandemic. Currently, loans in which the borrower fails to pay principal and/or interest charges within 90 days are classified as NPAs and provisioning is made accordingly.
What is a Bad Bank?
Bad Bank is a financial institution that takes over the non-performing assets and other illiquid assets of banks so that the banks are left with clean books. Such a mechanism helps a bank segregate its good assets from bad ones, making it easier for it to raise capital by issuing equity or debt or both. The segregation of toxic assets helps generate confidence among potential investors who can then examine the financial health of the lender with greater clarity. Further, by transferring sour loans to a bad bank, lenders can prioritize financing businesses, while letting a specialized institution such as Asset Reconstruction Company (ARC) focus on maximizing loan recovery, which is generally sponsored by the government.
Where did the idea of bad bank come from?
Originally, the idea was first proposed in the 1980s by the US-based Mellon bank. In 1988 it resorted to the creation of a bad bank i.e., the Grant Street National Bank which was dissolved in 1995 upon serving its purpose.
In India, the Government set up the Industrial Reconstruction Corporation of India (IRCI) in April 1971, under the Indian Companies Act mainly to look after special problems of sick units’ and provide assistance for their speedy reconstruction and rehabilitation, if necessary, by undertaking the management of the units and developing infrastructure facilities like those of transport, marketing etc. In 1984, GOI passed an act converting the Industrial Reconstruction Corporation of India (IRCI) into the Industrial Reconstruction Bank of India (IRBI) which failed. All bad loans were kept aside in one bank and nothing came out of it. The problem with this type of mechanism was that assets were transferred at book value, which basically moved it from under one government pocket (Public Sector Banks) to another government pocket (IRBI).
According to Bloomberg Quint, the government created a Stressed Asset Stabilization Fund in 2004 when IDBI was converting to a bank. The SASF basically structured as a bad bank and helped IDBI swap funds of about Rs. 9,000 Crore.
Further to that, after the 2008 crisis, various banks from all over the world like Bank of America, Citigroup, Swedbank, etc. took on this idea and are one of the renowned banks today. A number of countries like Belgium, Ireland, Indonesia, Germany and others have set up bad banks in response to the financial crises over time. But in India, a bad bank has not been set up; rather, private asset reconstruction companies (ARCs) have been buying NPAs from various banks—and 29 ARCs are in the business of buying bad assets but the model has not yielded desired results. ARCs act merely as recovery agents because they lack the bandwidth to reconstruct any company under stress which is sold as going concern. The efficacy of the ARC model is under question. The CVC, some time ago, submitted a report to the government after examining cases above Rs 50 crore that were sold to ARCs between 2013-14 and 2017-18 by PSBs. The report mentions that, in at least 48 cases, assets were sold to ARCs below the realizable value of the security. Besides the accounts which were sold as going concern, the value of stocks and equipment were not factored in while fixing the reserve price. Setting up a bad bank, undoubtedly, is a way forward in such conditions.
How serious is the NPA issue in the wake of the pandemic?
The RBI noted in its recent Financial Stability Report that the gross NPAs of the banking sector are expected to shoot up to 14.8% of advances by September 2021, from 7.5% in September 2020. Among bank groups, the NPA ratio of PSU banks, which was 9.7% in September 2020, may increase to 16.2% by September 2021 under the baseline scenario.
The K V Kamath Committee, which helped the RBI with designing a one-time restructuring scheme, also noted that corporate sector debt worth Rs 15.52 lakh crore has come under stress after Covid-19 hit India, while another Rs 22.20 lakh crore was already under stress before the pandemic.
The panel led by Kamath, a veteran banker, has said companies in sectors such as retail trade, wholesale trade, roads and textiles are facing stress. Sectors that have been under stress pre-COVID include NBFCs, power, steel, real estate and construction.
Banks and other financial institutions are the key drivers of economic growth, as they are the formal channels of credit. As things stand, lenders, particularly the state-owned ones, are saddled with massive bad loans. This has made them risk-averse and eroded their capacity to lend to help spur economic recovery from the shock of the covid-19 pandemic that has roiled the world. Banks will find it tough and exorbitantly expensive to raise capital from the market if the asset-quality trajectory remains uncertain, delaying and even jeopardizing, economic growth.
Dilemma of Public Vs. Private Bad Bank
If majority stakes of a bad bank are with the government then it would render the bad bank with issues of governance and capitalization as Public Sector Banks.
If majority stakes are with private companies then it could invite criticism of Favoritism and Corruption if the loans are not priced appropriately when traded to a bad bank.
What has been the stand of the RBI about resolving stressed loans?
Viral Acharya, when he was the RBI Deputy Governor, had said it would be better to limit the objective of these asset management companies to the orderly resolution of stressed assets, followed by a graceful exit. He suggested two models to solve the problem of stressed assets in consideration with the above dilemma-
First what kind of loans will be taken over? Will only those loans that have turned stressed due to the economic distress stemming from the COVID-19 pandemic be included? Or will loans extended to firms in sectors like power and real estate, which had soured even before the pandemic had hit, also be brought into its ambit? Considering that banks have in the past been reluctant to decide on the extent of haircut they were willing to take, how will the prices at which these loans are transferred to the bad bank be determined? Who will absorb the losses? And will the new entity be professionally managed, operating at an arm’s length from the political dispensation? Or will political considerations influence decision making?
What has been the stand of the Government for setting up a bad bank?
To the extent that a bad bank will take sour loans off the balance sheets of banks, it is a good idea. However, the Centre isn’t smitten by the idea as yet. After all, there exist several private asset reconstruction firms that buy bad loans at a discount. The government has significantly capitalized state-owned banks in recent years and pursued consolidation in the PSU banking space. In the last three financial years, the government has infused equity of Rs 2.65 lakh crore into state-owned banks. Also, the Bankruptcy Code, though not perfect, has helped in higher recoveries. There is also the question of a moral hazard that a government-funded bad bank can create by allowing reckless lending to continue. There is also the fear that it ends up as another case of throwing good money after bad.
Will a bad bank solve the problem of NPAs?
Despite a series of measures by the RBI for better recognition and provisioning against NPAs, as well as massive doses of capitalization of public sector banks by the government, the problem of NPAs continues in the banking sector, especially among the weaker banks. Having a Bad Bank will complement other measures taken by RBI & government to clean up banking sector. In the coming months, as and when the COVID-related stress pans out, proponents of the concept feel that a professionally-run bad bank, funded by the private lenders and supported the government, can be an effective mechanism to deal with NPAs. Many other countries had set up institutional mechanisms successfully such as the Troubled Asset Relief Programme (TARP) in the US to deal with a problem of stress in the financial system in the wake of 2008 financial crisis.
Banks and other financial institutions are the key drivers of economic growth. However, many borrowers may find it difficult to service their loans, requiring lenders to set aside capital to cover those losses. A bad bank can free them up to start lending. However, adequate measures need to be put in place so as to overcome the pitfalls of bad bank
The use of government spending and taxation to influence the economy of a country is termed as Fiscal Policy. Whenever the government decides on what goods and services to purchase, on the transfer payments to distribute, or what taxes need to be collected, it is engaging in fiscal policy. The primary economic impact of any change in the government budget is felt by particular set of groups, for example, an income tax cut raises the disposable income of an individual. However, the general focus of discussions on fiscal policy deal with the effect of changes in the government budget on the overall economy. Although changes in taxes or spending that do not affect government revenue may be termed as fiscal policy and may have an impact on the aggregate level of output by changing the incentives that firms or individuals face, the term “fiscal policy” is usually used to describe the effect on the aggregate economy of the overall levels of spending and taxation, and more particularly, the disparity between them. At a macroeconomic level, changes in fiscal policy can have a major impact on:
• Aggregate demand
• Savings and investment
• Income distribution
• The distribution of resources and money supply
• The business cycles
• Tax rates
In the globalized economy, fiscal policy also has an impact on exchange rate and the trade balance. During fiscal expansion, the rise in interest rates due to government borrowing attracts foreign capital and investment. In their attempt to get more Indian currency to invest, foreigners bid up the price of the rupee, causing an exchange-rate appreciation in the short run. This appreciation makes imported goods cheaper in India and exports more expensive abroad, leading to a decline in the merchandise trade balance. As a result, imports increase and exports decline, and foreign investors acquire ownership of Indian assets (including government debt). However, in the long run, consistent government deficits and the accumulation of external debt can lead foreigners to see Indian assets as risky and can cause a deprecation of the exchange rate from a subsequent fall in future investments.
Fiscal policy also alters the burden of future taxes. During an expansionary fiscal policy, the government adds to its stock of debt. Since it will have to pay interest on this debt (or repay it) in future, the expansion today puts an additional burden on future taxpayers. Just as the government can use progressive taxation to transfer income between different income classes, it can run budget surpluses or deficits in order to transfer income between different generations as well.
Does Fiscal Policy Actually Work?
In the past, several countries have introduced packages of ‘fiscal stimulus’, by increasing the government spending or lowering taxes in order to boost demand and bring their economies out of recession. As a result, one could expect a certain degree of agreement within the economists on the effectiveness of fiscal policy. But nothing could be farther from the truth.
Ethan Ilzetzki and colleagues conducted a study on government spending and GDP of 20 high-income countries and 24 developing countries. Through this study, the team could derive estimates of the fiscal multiplier – a dollar increase in GDP caused by a one dollar increase in government spending, far more accurately than previous studies. The results showed that in high-income countries, an increase in government spending of 1% of GDP causes an immediate increase in GDP of 0.4% - a fiscal multiplier of 0.4. This implies a significant degree of ‘crowding out’ of private investment cause by the fiscal expansion. This means that, government fiscal activity is to some degree, discouraging private sector investments. On the other hand, in developing countries, the team found a fiscal multiplier of – 0.2. This means that fiscal economic activity fully crowds out private economic activity, indicating a decline in GDP in response to increase in government expenditure. This means that expansionary fiscal policy has a negative effect on GDP of developing countries.
Several other studies also show how response of Central Banks affect the implications of a fiscal expansion. In countries where Central banks are devoted to maintain a stable exchange rate, respond by lowering interest rates in response to an increase in government expenditure during the two years following a fiscal stimulus. This reinforces the fiscal stimulus and allows for the large fiscal multipliers. On the other hand, central banks which have an inflation target in mind, tend to increase interest rates. This is aimed to counteract the inflationary pressures caused by the fiscal expansion and increased aggregate demand. This however offsets the stimulative impact of fiscal policy and leads to the negligible effects of fiscal stimulus for countries with such a monetary policy. For policy-makers, these results indicate that the interaction between fiscal and monetary policy is a crucial determinant of the effects of fiscal stimulus.
Economists also note that the ability of fiscal policy to affect the output levels through aggregate demand dies off over time. The higher aggregate demand as a result of an expansionist policy, eventually translates only in higher prices and does not have an effect on output at all. This happens as the level of output in the long run, is determined not by demand but by the supply of factors of production i.e., capital, labor, and technology. These factors of production provide a “natural rate” of output around which business cycles and macroeconomic policies can cause only temporary fluctuations. Any policy measure to keep output above its natural rate by boosting aggregate demand policies will only lead to accelerating inflation. This gets accentuated with the “crowding out” of public credit as private firms do not invest in labor and technology to boost output. Not just this, expansionary fiscal policy can also alter the natural rate, and, ironically, lead to the long-run effects of fiscal expansion being opposite of the short-run effects. Expansionary policies will lead to higher output today, but will lower the natural rate of output below what it would have been in the future. Similarly, contractionary fiscal policy, though lowering the output level in the short run, will lead to higher output in the future.
However, fiscal policies are more often not guided by economic principles. Policy makers are often driven by votes which leads them to being enthusiastic about expansionary policies during recessions which are not matched effectively by contractionary policies during boom, primarily so as to not lose votes. Moreover, they can showcase the benefits of expansionary fiscal policy to their voters immediately, whereas postpone its costs (higher future taxes and economic growth) to the future.
Thus, the greatest obstacle, of using fiscal measures as powerful policy tools are not economical, but political.
A Special Purpose Acquisition Company or SPAC is a company solely formed with the goal of raising capital through an Initial Public Offering (IPO) and later use the capital raised to acquire and merge with an existing private company. These type of companies do not have any commercial operations of their own and are also known as “blank check companies”.
The founders of a SPAC company are generally experts in some or other industry and have a deep understanding of business. As these are a type of Shell Company the management is the key selling point for raising capital for these companies. SPAC may contact an investment bank to handle the IPO where the valuation focuses on the management’s history since there is no performance history of the company. The capital structure may include retail investors, institutional investors as well as founders share. Once the money is raised all the fund proceeds are held in an interest bearing trust account until the company identifies an acquisition target. There are two possibilities from here – first being that the management team finds and completes the acquisition within a specified time period (usually 18 to 24 months) or if no acquisition is made before the predetermined date, the SPAC is dissolved and the proceeds from the IPO are returned to the respective investors. In case the management needs additional funds for acquisition they may arrange for committed debt or equity financing, such as private investment in public equity. After this if the business combination is approved by the shareholders (not necessary) and the conditions specified in the acquisition agreement are satisfied, the SPAC and the target business will combine into a publically traded operating company. Here the ticker of the SPAC is changed on the exchange after the merger.
Comparison with the traditional IPO process
Technically the only business of a SPAC company is to acquire a private company and help them to go public. So the question raises that why would companies go via this path when they can opt for going through an IPO process themselves. Well there are various reasons why companies may opt for this process. Traditional IPO is a very extensive process which involves a lot of back and forth between the legal authorities, regulators and public authorities. This takes time and may hamper the firm’s objective of raising capital smoothly and efficiently. Private companies also go through a lot of public scrutiny while going through the IPO process and involves a lot of roadshows trying to get the investors interested in the company. Thus need to generate demand for the shares of the company for a successful IPO. This all involves a lot of uncertainty and companies like WeWork and Uber found this the hard way. Comparing this to SPAC, the IPO is already been done and it removes the financial uncertainties of IPO failures as well. Going through this process also reduces the time for the company to go public and reduces the public and regulators’ scrutiny. While it has benefits there are downsides to going public through SPAC as well. The investors who raised the capital may or may not be interested in the company after the acquisition and thus very difficult to get long term investors on-board. Secondly multiple sources have mentioned that SPAC is generally more expensive as compared to an IPO. The cost can go as high as three to four times you pay for an IPO and additional to this the founders might also get 20 percent of shares of the target company at a very cheap rate as compared to the price charged to the investors. Though with increased competition the underwriter fees has come down significantly in recent times. Further the amount of due diligence done on the target company is significantly less than what the Securities and Exchange Commission (in case of US) mandates for a regular IPO making investors wary about investing in such stocks.
Rise of SPAC
SPACs or similar entities have existed since decades now. In the 1990s these companies focused on technology and healthcare industry while it gained popularity in the oil and gas industry in the mid-2010s when the low commodity prices drove investors to management teams with experience on finding good mineral based companies. The number of SPAC IPOs and the capital raised via them has steadily increased since 2013 and 2020 has seen a sharp rise in SPAC IPOs.
Future of SPAC in India and regulatory Issues
SPAC have emerged as a promising means to raise capital and can help in public funding in offshore markets as well. This might particularly suite the Indian start-ups where the retail investors still have shown a very conservative approach. These also do not depend primarily on the private investments which might decline or dry up in the future. Though this brings huge opportunity for new businesses, Indian laws also need to be able to facilitate overseas funding or through domestic SPAC IPOs.
Some of the Indian acquisitions by SPAC are –