A FEW weeks ago, the State Bank of India auctioned off $700m in the debts of the Hotel Leelaventure. The event was noteworthy for several reasons.

For a start, it gave rise to hopes that the banks are finally dealing with at least some of the non-performing debt that they have carried on their balance sheets for years.

Many bidders turned up, including at least one credible foreign investor, the special situations arm of the alternative investment firm KKR, represented by the asset reconstruction arm of Edelweiss Financial Services.

Edelweiss, a local securities company, controls one of about a dozen of these asset reconstruction companies (ARCs), which are the only groups licenced to participate in such auctions.

The Leela group has gorgeous hotels — it just has too little cash flow to support the debt incurred building them, with interest due for the fourth quarter about five times earnings before interest and taxes for the period, according to data from Credit Suisse.

In the past, there have been few auctions of bad debts and they have not been terrifically successful because of flaws in the process. Now though, that might be about to change

In the past, there have been few auctions of bad debts and they have not been terrifically successful because of flaws in the process. Now though, that might be about to change.

The Reserve Bank of India is soon expected to adjust rules on bad assets for the banks, adopting a carrot and stick approach. (In the past, if a bank sold assets below par, it often had to face a grilling from the menacingly named Vigilance Committee.) It will also modify rules governing these auctions, a small but vital step in the healing process.

If so, it would represent the sort of concrete but not terribly difficult step necessary for India to return to a more robust pace of growth and attract more investors and their money to the country.

“Bank stocks have re-rated with expectations of a turnaround of stressed borrowers,” analysts at Credit Suisse noted in a June research report. The data are still sobering, though. Fully 35pc of Corporate India has interest coverage of less than one for eight consecutive quarters, the report adds.

Both domestic and foreign private sector investment in India practically came to a stop before the May elections brought in a new government. Now, to take advantage of the new optimism, and for credit to flow and fuel growth, Indian banks need to repair their balance sheets and deal with about $60bn in problem loans.

But further reforms are needed for the banks to supply the credit Corporate India desperately needs. Today, Indian banks are capable of supplying less than half the $270bn bankers estimate is necessary to support a more robust rate of growth.

The ARCs show just how much change is needed. They must bid at par or close to it in most cases, putting up only 5pc of the face value of the debt in cash. (The rest depends on the amount that is ultimately recovered.) The ARCs are also barred from taking action that is too intrusive, such as removing management for at least six months, while in many cases the value of the assets drops. The bank meanwhile gets to transfer the loan to an investment account — at par.

“These arrangements are all about avoiding write-downs, and not maximising recoveries,” says the head of one foreign bank in Mumbai. “The rules make it hard to turn these companies round.”

Now, the RBI plans to make it easier for these ARCs to deal with the debts in a more proactive manner and to alter the 5/95 rule. As a result, KKR (through its special situations arm) is considering taking the maximum 49pc stake allowed to foreigners in one of the asset reconstruction companies, bringing both foreign capital and know-how to the process. KKR executives think India is one of the most attractive markets for its debt market expertise.

True, Indian companies have taken advantage of the continued buoyancy of the stock market to raise equity. But what has been raised is still small in comparison to the magnitude of the need. For example, GMR Infra­structure, with debts of almost Rs7,000bn, (making it among the most levered companies in the Credit Suisse universe) has raised a fraction of that in new equity.

Recently, government officials in the finance ministry have sent out feelers to at least a few international private equity firms to see if they have any interest in taking small stakes in public sector banks. But by and large, they do not.

Such steps are incremental. Clearly, India needs to do much more. It helps that there are neither bubbles in India yet, nor the sort of over capacity issues that plague China, and that sentiment, which is a huge factor in India, is positive.

Of course, reforming the ARCs is a small step, but India has not taken even such small steps in way too long.

Published in Dawn, Aug 4th, 2014