Thursday, October 17, 2013

In an attempt to grow at a faster pace and acquire more assets, at times companies end up accumulating large amount of debt on their balance sheets. But as business conditions become unfavourable, debt servicing becomes a problem. Projects get stuck, cash flows get affected and interest payment becomes difficult. High debt significantly increases chances of default and bankruptcy. It also threatens the banking system which has lent money to large indebted companies. As the economic growth has slowed down significantly in India in the last few quarters, a large number of companies are finding it difficult to repay debt and are going for debt restructuring.

What is deleveraging?

  • The process of reducing the amount of debt on a company’s balance sheet is termed as deleveraging. 
  • In an interview, Raghuram Rajan, governor, Reserve Bank of India, while referring to large companies selling assets to reduce debt on their balance sheets said: “We need more of that.” 
  • Rajan further noted: “If the liquidity-strapped entities get financial space once again, they can then start bidding for projects; they can start fulfilling some of their past commitments.” 
  • The increased financial space and the ability to take up projects due to reduction in debt by large companies can also help start the investment cycle and push growth.

The big picture
  • The problem of excess debt is not restricted to just few companies at the microeconomic level. 
  • Excess borrowing and investment by companies, individuals and governments during good times becomes a major problem at the macroeconomic level when the cycle turns. 
  • As the economic environment becomes unfavourable and servicing debt becomes a problem, firms shelve investment plans, households attempt to reduce consumption and increase savings which further worsens the economic condition. 
  • Governments are also, normally, not in a position to increase spending for long to support the economic activity and are forced to cut expenditure. 
  • This makes the process of deleveraging extremely painful. When both the private sector and the government try to reduce debt at the same time, it affects economic activity and growth.
  • The last global financial crisis to a large extent was a consequence of excess debt. 
  • Large number of households and financial firms in the developed world borrowed excessively during good times and were caught on the wrong side of the fence when the cycle turned. 
  • It has been proven that excess debt in the system threatens financial stability.

The India story

Though some companies have excess debt on their books and non-performing assets are also on the rise, it is not yet a threat to the financial system.

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