A NEW bankruptcy law is moving through the lower house of India’s parliament. Even before its possible passage, the balance of power between the country’s lenders and their corporate borrowers is shifting.

The Reserve Bank of India is ordering banks to declare problem assets and clean up their books. That means rather than pretending all is fine and lending well- connected borrowers the money to pay interest, banks are now refusing to ‘evergreen’ loans to clients. The new bankruptcy law will further strengthen their clout.

“In this country we had capitalism without exit,” says one senior finance ministry official. “It was an unsavoury mix of state capitalism, crony capitalism and limited entrepreneurial capitalism. With the transparent auction of natural resources, crackdown on non-performing assets, the new bankruptcy law and our efforts to boost the entrepreneurial ecosystem, we are transforming capitalism in India.”

This being India, these steps are not without controversy. Many analysts fear the clean-up will squeeze the economy’s momentum and now is an inopportune moment to force such a reckoning.

In the past, banks’ share prices (with the exception of the most careful lenders such as HDFC) have been depressed by fears of unacknowledged problems. Now, they will be hurt by increased provisions and write-offs.

Others make the opposite argument.

They say these changes mark a turning point, rather than merely a starting point, in cleansing lenders’ balance sheets and that the worst is behind the sector. It is possible that such optimism, however, could be premature.

The truth of the matter is that there’s never an ideal time for difficult reform

Even if overhauling bank balance sheets should lead to a renewed willingness to lend, it isn’t clear how much demand for credit exists within the broader economy.

The private sector is cautious, given the high level of corporate borrowing costs.

With the interest rates on some corporate loans running as high as 14pc, there are few projects that meet that high hurdle. Last week’s cut in interest rates by the RBI won’t do much to bring down the high cost of capital in India. Other factors beyond the cost of debt also matter.

For years the supply of electrical power was a big constraint for the economy. Now supply is less of an issue, but demand remains weak. Similarly, the railway ministry reports that freight revenue is being hurt by slowing growth in sectors including coal, iron and steel.

That suggests that even as the banks force asset sales on troubled corporate borrowers, it is possible the assets will not fetch as much as a few years ago. For the first time, founders of cash-strapped infrastructure companies have been forced to sell investments.

For example, Jaiprakash Associ­ates, one of the more indebted companies in the country, has sold its cement assets to the better-capitalised Aditya Birla group. The cement plants are top quality. But other assets might prove less attractive. “Many groups are asset rich but cash flow and earnings poor,” says the head of one local investment bank. “Will the earnings power go up or will the asset valuation go down?”

The truth of the matter is that there’s never an ideal time for difficult reform.

Loan books of the banks - particularly public-sector ones - are in a poor state. Analysts say that, historically, banks have sometimes failed to conduct due diligence of their own, assuming if one big lender gave a borrower a loan, they would have done their homework.

Now, as the government seeks to pass bankruptcy legislation and the RBI insists banks clean up their bad loans, the big question is: what does this entail for the future?

One bright light is the prospect of other players aiming to expand in India. Some investors, whether locals such as Edelweiss, or foreign ones such as private equity group KKR, are developing their credit business based on hopes the government will clean up the bad debt problem.

If the banks can follow through and keep their books clean of bad loans, equity investors will follow. At least that’s the hope for the sector.

henny.sender@ft.com

Published in Dawn, Business & Finance weekly, April 18th, 2016