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6 Things to Know About India’s ‘Twin Balance Sheet’ Problem

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22 Feb 2023

In its recent ‘Financial Stability Report’, the RBI spoke in detail about India’s ‘twin balance sheet’ problem. This, the RBI says, is the blip in an otherwise positive outlook for the Indian economy. “Weak investment demand, partly emanating from the twin balance sheet problem (a leveraged corporate sector alongside a stressed banking sector) is a major challenge,” the RBI report states.

So, what is the twin balance sheet problem all about? Let’s understand:

What Are Twin Balance Sheets?

A balance sheet is a statement of an institution’s assets and liabilities. This applies to both companies as well as financial institutions. Even the RBI publishes its balance sheet. But, the ‘twin balance sheet’ issue refers to the problematic balance sheets of Indian companies and banks—meaning, both the lenders and borrowers are under stress.

What’s wrong with company balance sheets?

Companies have too much debt and little money to repay. Simply put, they seem to have chewed more than they can swallow. As per the Economic Survey 2016-17 it was reported that around 40% of the corporate debt it monitored was owed by companies which had an interest coverage ratio less than 1. This is a worrying figure. The interest coverage ratio compares the loan interest payments with the operating profits. This helps you understand if the company can repay its loan interest using the profits it earns from its core business. If the figure is less than 1, it means the company’s operations do not generate enough money to even repay the interest, let alone the entire amount.

What about the banks?

A bank’s key source of profits is the interest it earns on loans. If a company fails to pay back interest on the loan, the bank loses its profit. Plus, the bank also loses the money it gave out as the loan. Here’s an example why: You deposited Rs 1000 with a bank. The bank then gave two loans of Rs 500 each. It expected to earn Rs 10 as interest from each loan account. Of those two loans, one defaulted. So the bank was left with just Rs 510—Rs 490 less than what it had. And unfortunately for the Indian banking system, 9.5% of the total loans turned out to be bad loans, as per RBI data. “More than four-fifths of the non-performing assets were in the public sector banks, where the NPA ratio had reached almost 12%,” the Economic Survey reported.

Why does this matter?

For an economy to grow, its banks have to be stable. Plus, its companies have to keep planning new investments and projects. Otherwise, there would be no growth. Currently, banks are not stable. Back in February 2016, banks reported that the amount of bad loans exceeded the total interests they earned as ‘operating earnings’, the Economic Survey said. This makes banks very risky. If depositors start withdrawing money, a bank could easily shut. At such times, banks start lowering the amount of money it lends. This means the new companies that want to execute new projects or investments would not have access to funding. Lower investments have been the key cause of India’s slow economic growth in the past decade.

What’s the scale of the problem?

Quite large, indeed. Back in 1997-98, East Asian companies went through a similar problem. It turned into a huge crisis that set the countries behind by a great extent. However, India’s bad loan problem is much bigger than the peak levels seen in Korea during the Asian crisis. Korea’s bad loans touched a peak of 8.9%, lower than India’s 9-12%. India’s bad loans have crossed more than Rs.8 Trillion.

Why does this happen?

It’s an easy mistake. When a country grows continuously for a period of time, companies plan a lot of investments and projects. It’s easy to over-estimate the profitability of such projects given the fast economic growth. However, economies go through cycles. When the economy stops growing fast, such countries struggle to make the projects profitable and thus, repay their loans. A similar story seems to have unfolded in India. The only difference is, the problem hasn’t affected the economic growth so far. This is because companies have other options like Non-Banking Financial Companies (NBFCs), Mutual Funds and the Capital market. However, the RBI warned that the alternatives aren’t enough to shield the economy from a banking crisis.