“Look at the stars, look how they shine for you,” Coldplay

The news of the failure of ‘Yes Bank’ is now reasonably old news. There has been a spate of failures in banking in recent years. Banks like PNB have run into problems regarding ‘NPA’ . Nearly every bank in the nation seems to have a large pile of these ‘NPAs’. What are NPAs? In banking jargon, an NPA ‘is a loan or advance for which the principal or interest payment remained overdue for 90 days.’ (according to the Economic Times)

In simple terms, an NPA is a loan that isn’t paying off for a lender. ​​When people talk about India’s banking crisis, they talk about a massive pile of loans on the verge of a default. ​​Moreover, there are rupees 8.34 trillion failed projects for which companies are struggling to pay off their debts as of March-end 2021. By any definition, this is a massive number. Indias GDP is around Rs 135 trillion for some context. These numbers were enough to pique my interest. The loan crisis, while worsened by Covid, is much older than Covid.

Looking into the numbers further revealed exciting insights. The banking sector in India is one of the least profitable in the world. As a management student, you always look for anomalies. Anomalies are the language of the universe, the perfect means to understand the world, just like a tracker in medicine that works not by how it interacts with the body but with specific tissue.

It was this curiosity that led me down a rabbit hole. ​​We can learn much from the Indian banking crisis about disparate topics like culture, public policy, organizational structures, and the functioning of large systems. So what will we be talking about today? The three insights I had:

• The more we know about what’s happening in an economy, the more complex it becomes. Several factors that define the functioning of an economy are dependent on people’s perception of how things are likely to happen. Optimism or pessimism among people makes a real difference in terms of the growth and functioning of an economy.
• The growth of the Indian economy will boost by the presence of better business management and accounting software, better marketing outreach and recommendation for such software, and most importantly, more vital financial education of the populace in terms of the value produced by this software and the benefits of taking debt and the growth potential of the business.

Let’s go sequentially as all of these logically flow from each other. Let us first look at why growth happens. In economics, there is a term called potential GDP. The GDP is when all people of a country work for the appropriate number of hours to work sustainably for the future—the same for machines. When the GDP goes above this, the economy is overheating. It is not sustainable. The only way to bring sustainable growth is through better technology or increased productivity of citizens via education. These are the three ways in which change can happen. At a fundamental level, we have to increase the productivity of people. As such, how do we achieve this?

• Capital investment in Machinery
• The Invention of new technology
• Investment in education

These three require the investment of money in a concentrated manner. If 100 people have one-lakh rupees, each of them cannot build a factory. If they pool their resources, then one crore would be enough to do this. In an economy, this takes the form of debt or equity. We all put our money in the bank, which then lends out the large pool to enterprising people who can turn this into added value. Another way is by investing in stocks where the people go and invest in companies’ stock and essentially give them the money to invest in their enterprise.

Equity is riskier than debt and thus a weaker force in developing countries like India, especially when building new ventures. Now we go to the fundamental problem. How is debt given out? At what interest rate should it be given. Here we have a tradeoff. If the interest rate is low, we end up with higher inflation as more money flows in the market as debt is readily available. If the interest rate is high, there is less money in the market as it is more expensive to take debt, so fewer people take it. One interesting example is that of the steel industry in India. In a recent report by PWC, India has the second most efficient steel production in the world. Our mills convert iron ore to steel at one of the lowest costs in the world, second only to Ukraine. (Cheaper than China, Korea, Japan, and the US, all of whom are considered tech heavyweights) However, the steel we sell has a significant price disadvantage against steel from China, Japan, and Korea. Somewhere between 80–100 dollars per tonne is more expensive. It is a staggering cost gap and one of the biggest challenges in the steel industry. One of the biggest reasons for this paradox is the higher cost of capital in India. As the construction of most steel mills is on borrowed money, the higher interest rates are responsible for 30–35 dollars of the price gap. Infrastructure and transportation costs being the other significant component, and reducing the interests rates has real benefits for the development of a country. Ideally, you want to maximize the amount of debt you give out, provided you’re confident the deficit is likely to succeed. It means more investment and more growth. However, if there is more money in the economy, the value of money goes down. The prices of commodities go up.

So then the real pesky problem is inflation. But then why is inflation a problem. If people also made more money while costs went up, there would be no problem. As their incomes rise, the rising prices would not be a problem. Therefore if the loans we give out become productive and the money trickles down to the employees in these companies, we will see good inflation.

Therefore growth is a function of successful debt to an extent. ​​There is equity, but at least on this front, we can say that if more of our obligations are successful, the economy will grow better. And more and more debts are likely to be successful if we have more access to data. The odds of a bet paying off are great when one has more data on it. This is why platforms like Udaan build logistics and distribution systems for small businesses at meager profits. The plan is to use the fact that you handle distribution for millions of small businesses to collect data on how their business is going, how many sales they are making. You can lend intelligently with access to such data, and the likelihood of loans paying off is more significant.

Therefore we cover the first insight. Now we try to look at the Indian economy. One of the things that stand out is that the Indian economy is close to 50% informal. Close to half of the Indian GDP is in the informal economy. Close to 90% of the workforce in the country does not work in the formal economy. That is, they do not work for corporations or registered companies. This part of the economy is not measured or even included in the GDP. All we have are vague estimates of its size. The informal economy is heavily cash-driven – one of the main reasons it was heavily affected during the demonetization. Cash benefits the informal economy in many ways. It provides two advantages.

• It’s not taxable
• It has lower transactional costs and overheads at a small scale

As for point 1, it is hard to track cash. This part of the market is not under taxation for the most part. However, the lack of taxability comes at one high cost.

• You cannot raise debt on unaccounted cash

Cash businesses have difficulty raising capital on the traditional markets as they often have minimal standards of accounting. The neighborhood vada pav vendor is unlikely to keep detailed accounts of his inflows and outflows of cash. And even if he did, the lack of bank transactions means he cannot prove any of this to the bank. The bank has no data on him. And as the bank has no information on his business, it cannot lend to him. Without lending, he cannot grow. His only option is to go to informal lenders. With higher risk, informal lenders charge higher interest rates, often in the 20–30 percent range and even higher. One of our professors in his classes emphatically stated that the standard rate for microlending by microlending firms that give small loans is at 22 percent for farmers. The informal rate from local moneylenders is likely to be even higher. Such high rates are not sustainable for any business to repay. Thus these people do not take loans, and growth stops. Farmers that often do take loans get stuck in debt traps and end up struggling to repay.

So essentially, If you are choosing to carry out your business informally as MSME, then you have one of the above two reasons. If you’re doing it because of reason 1, then you value saving taxes as worth more than being able to take debt. Why would anyone do that? Taxes are about 30 percent of profits. From a businessman’s perspective, you have to believe that the ability to take debt is worth more than 30 percent of your earnings to formalize your operations. This isn’t always true. For the vada pav vendor example, it may simply not be accurate. If he is a pessimist who does not believe in his ability to build a more significant business, what does he do with debt? But if the vendor were optimistic and ambitious, he would see the value in debt. If he believed he could succeed, he’d account for every penny and make sure it flowed through the bank. ​​In 3–4 years, he could take a loan on the credit he builds up, open a second cart, and eventually more. His level of belief defines the choice he makes here in the future. His practical experiences define it. Does he believe there is potential for a brighter tomorrow? Is he an optimist or pessimist? And this itself is characterized by a combination of the culture surrounding and the realities of the business environment. A vada pav vendor in Somalia is likely not to be considered a pessimist for thinking there is limited space to grow. This same logic applies to small manufacturing units and other such businesses. The outlook of all these small businesses affects the behavior of the economy as a whole.

If you think this is a minor factor, here is an interesting factoid. India had 42 million businesses in 2005, according to the economic census. Less than 1 million of them are registered companies. As mentioned before, this represents nearly half our GDP – . it employs 9/10 people in the country. The optimism or pessimism of the informal sector is likely to decide how much of it formalizes and how much value we can draw from it. When people talk about crorepati vada pav vendors with multiple homes, this is the economy they are referring. Thus we prove our second assertion. The outlook of people makes a massive difference to how the economy functions. Nearly half the economy cannot raise debt severely affects our ability to give out debt efficiently. A lot of well-run enterprises are excluded from the modern economy. These small businesses are often well-run enterprises that could do very well if they had better access to cheaper debt. The balance sheets of microfinance companies that lend to this sector, often at high-interest rates, reveal that they often have lower NPAs than significant banks. Less than 1.9% in Q2 of 2019, according to the RBI.

But what if it’s the second reason for using cash. What if they do it because it has lower transaction costs. This is another benefit of cash. It has lower transaction costs at a lower scale. Vadapav vendors don’t just use cash because it avoids taxes. It is also cheaper to deal in cash at these scales. You don’t have to deal with the costs of setting up card scanners for people who want to pay by card. You don’t have to give the bank a commission for every payment you make. You can pay your employees quickly and easily at the end of the day. They don’t need an internet connection to access their money. Something that is not always available. Something noticeable here is that many of these hurdles have become easy to deal with with the arrival of UPI. The new payment apps make much of this more accessible, and, thus, we see a lot of local vendors have Gpay QR codes for payments. It is easier to process payments this way, and it helps make businesses run smoother. We have thus seen increased formalization with the arrival of UPI. However, there are other overheads like costs of accounting. When you are running a formal business, inflows and outflows have to be kept track of. The business must have a robust accounting system that follows the complicated conventions of accounting. While this produces real value for businesses at a large scale, at a small scale, it has little value for the person-hours that it costs. And person-hours equal to the actual cost for businesses. We see some of this phenomenon at a larger scale when businesses are hesitant to go public, as it involves even more public disclosures. Meeting those disclosures means more documentation and a more detailed collection of data which costs money. Therefore overhead costs are a real problem. I was reading this interesting article about two startups, BukuKas and Buku Warang. BukuKas and Buku Warang are startups in Indonesia that provide free accounting software to small informal MSMEs, a big part of the Indonesian economy. One of the key ideas is that they want to change the behavior of small businesses to push them to carry out business more formally at a less increased cost to them. They are digitizing small businesses. Another benefit is that the data they collect from such software can be used to provide, among other things, credit to small businesses. Buku Warang is currently valued at $250 million.

Suppose we can provide better financial education, better means of formalization with lower transaction costs (Like UPI), and better awareness of these means. In that case, we can push further formalization in the economy. If we do not formalize the economies, we can get more data on it and lend increasingly to informal units through central banks than through NBFCs at lower rates than currently. And as we know now, data is gold in the new economy. It is at the heart of the growth that we see in the coming decade. Of course, while all these matters, let it not be forgotten that Infrastructure was the other major component of the cost for the steel industry. The cost of freight is much higher in India than in the different countries. Primarily due to less transportation supply than demand, in other words, an overloaded transport network. Fundamentally data will not do us much good if it just shows us that things are not good. That is unless we use it to improve things. Therefore all this must be supported by work on the fundamental things that support business—an excellent healthy environment with quality infrastructure that encourages businesses. Every little thing is a step in the right direction, and every significant step is an opportunity to take another.