By Mihir Baxi
The world’s largest democracy recently hit a few economic speedbumps. The removal of large denomination cash notes from circulation last November is manifesting itself in a slower quarterly growth rate, while the Goods and Services Tax (GST) reform that took hold earlier this month is suffering from poor implementation and is being called overly complicated. The rate of job creation is falling precipitously, with a little more than 100,000 jobs having been created in 2015, which is made worse by the fact that one million Indians enter the labor force every month. No efforts have been made to reform restrictive labor laws, or to make it easier to do business. India is a young, populous, and industrial country whose once revered growth potential is now lacking a propitious outlook
However, in light of the grand schemes that often succeed in engendering populist political support, a largely ignored, deeply troubling fiscal problem looms. The prevalence of non-performing assets within the Indian banking system is one of the heaviest lags on the country’s economy. With about $180 billion in bad debt – amounting to 9.1 percent in terms of non-performing loans to total gross loans, and 16.6 percent in terms of stressed assets to total loans – Indian credit is at more risk than any other country among its peers with similar level of per capita GDP.
Much of this problem came to light last year, after the Reserve Bank of India (RBI) – motivated by reports of inappropriate asset classifications, misleading accounting practices, and growing investor uncertainty – mandated the conduction of an asset quality review throughout the banking sector. The value of non-performing assets between December 2015 and December 2016 was found to be underreported by more than half. In fact, bad loans rose by more than 80 percent within the Indian banking system in the 2016 fiscal year. Even though this had been calculated in real terms – not having accounted for any new loans – the now public record of the proportion of stressed assets held onto by banks forced a consideration of potential remedies.
The disclosures of stressed assets called into question the true value of bank capitalisation, and the 2016 rallies in banking sector stock prices. As one would expect, bank shares dropped in light of the quality review disclosures. Any efforts that banks do end up taking to clean their books and reduce their stressed asset ratios will be based on the knowledge that much of the Indian banking sector is indeed overvalued.
The RBI asset quality review also uncovered a nebulous divergence within Indian banking – between private and state owned banks. State owned banks, on average, have a non-performing loan to total loan ratio of close to 11 percent, which is much higher than the 3.2 percent average ratio of the six largest private banks. State owned banks today can be seen as tools for government policy, not operating under the same incentives as their private counterparts. The inherent fragmentation of the Indian banking sector, as noted in a McKinsey report, is supplemented by its unsophistication on risk and efficiency metrics.
Historically, Indian banks have been owned and operated directly by the government. The economic liberalisation in the 1990s allowed room for private and foreign firms. However, state owned entities currently occupy more than three-fourths of the banking sector, leaving little room for private banks to operate and profit.
The privatisation of the Indian banking sector is seen by many as an inevitability during the first decade of the 21st century. Such calls have thus far been repudiated by advocates of state ownership, who cite the performance of state owned banks in the aftermath of the Great Recession as evidence of the government ownership model’s success.
A cursory glance would lend support to this hypothesis. Most of the profits made by private banks leading up to 2008 were wiped out during the crisis, while state owned banks did not suffer as heavily. CDS spreads for private versus state owned banks were viewed as equally risky leading up to the crisis, but in the aftermath of the crisis the latter were viewed as healthier. The deputy governor of the RBI, Dr. Viral Acharya, wrote about this in a 2011 paper. While deposit growth slowed throughout the sector, private banks saw sharper declines in deposit growth, and worse performance during the crisis period among state owned and private banks with the same levels of exposure and vulnerability to market risk.
A perfunctory glance is not enough, however, to see the whole picture. It seems that the primary reason for the performance of state owned banks, and their simulacrum of relative health, was the access to government guarantees. Before and during the crisis, state owned banks in fact looked more risky than private ones in terms of vulnerability to a crisis. Their moral hazard of being immune to market risk due to government backing helped boost deposit rates in the immediate aftermath of the crisis. It can be noted that the legal precedent of this moral hazard is the Indian Bank Nationalisation Act of 1969, which explicitly guarantees government support to state owned banks in the fulfillment of their obligations, even in the event of insolvency. A flight to quality from private to state owned banks in the face of a crisis should not be surprising, given the assumption of government support.
After the crisis passed, private banks with the same levels of risk as their state owned counterparts performed better, substantiating the claim that the superior performance of state owned banks during the crisis period was in fact a function of government guarantees. More recently, while some private banks have seen increases in their stressed loan ratios, state owned banks are far more vulnerable and impuissant to this problem.
The absence of risk causes state owned banks to extend credit to lenders who may not possess appropriate collateral or the ability to generate sufficient revenues for repayment. This is epitomised in the extension of credit to the energy, infrastructure, and telecommunications sectors – which are top-heavy on credit, and represent a large portion of the stressed assets within the banking system. A little more than half of the loans given out have been to large industrial companies (concentrated in the agriculture, steel, retail, and infrastructure sectors), accounting for more than 85 percent of the non-performing loans on the books of Indian banks. Given these facts, it should not be surprising that in light of the recent RBI asset quality review, state owned banks have contributed the most to the credit cycle slowdown. The rate of loan growth in India was 6 percent in June 2017, down from 9 percent just one year before that, and down from close to 15 percent in January 2014.
Some may attribute the lending slowdown to interest rates, which have been high as a result of the RBI’s efforts to curtail inflation. While it is true that cost of borrowing in India – especially in fixed income borrowing at the state and federal level – is remarkably high, blame cannot be placed solely on interest rates. Consumer price inflation is falling, and creditors should see this as a signal of lower interest rates in the near future. Attention should thus be turned towards the loans themselves, under what conditions they were made, and the entities to whom they were extended.
As a recent working paper on the Indian banking sector by the Bank of International Settlements found, well-capitalised banks tend to take on less credit risk; both private and state owned banks show a pro-cyclical response to credit growth; and the degree of pro-cyclicality of non-performing loans is larger for state owned banks than it is for their private counterparts. It was also found that a one percent change in the rate of loan growth is associated with a 4.3 percent change in the level of non-performing loans.
A number of the loans that are now classified as stressed were extended after 2008, when state owned banks were assumed to be in good standing, and confidence was high in the Indian economy’s growth potential. A large number of the projects initiated with money borrowed from state banks produced good returns, which prompted a willingness to accept higher risk on loans.
The slow global recovery, lack of due diligence, and the Indian bureaucratic sludge brought an end to an era of ‘irrational exuberance’, while the inability to generate returns on projects got many a borrower stuck in a debt trap. Bureaucratic burdens, ponderous judicial processes, as well as maladroit debt collection add on to the growing level of non-performing assets in the banking system. The RBI estimates that under the status quo, non-performing loans as a percentage of total loans may go up to double digits by mid-2018.
Unfortunately, policies such as the recent substantial loan wavers that have been offered to farmers across the country do not promote a healthy attitude towards credit and risk taking. In such cases, loan recipients are willing to take on more risk than they would under competitive market conditions, which discourages modernisation within the industry. Creditors face moral hazard wherein they have no incentive to review loan applications carefully, with the assumption that the government will bail borrowers out to gain political points. Further, state owned banks have an explicit guarantee of a government cushion, and face no market risks for making loans to unfit borrowers. These guarantees, of course, are in exchange for using state banks as a conduit for policies that help win political points, just as the farm waivers will undoubtedly do.
Some progress is being made. Bankruptcy courts have been established, albeit their ability to clear cases is untested, and a new law gives the RBI more power to resolve insolvencies. Serious solutions have been proposed and discussed. These include debt restructuring, the setting up of a bad bank to take on stressed assets, and new banking laws that would make capital recovery far easier. All of these proposals tackle the problem after the event of a crisis, while a sustainable fix to Indian banking requires policies and changes that tackle the core incentives faced by banks and borrowers. Under current conditions, the value of banks will continue to be questioned as stressed and non-performing assets become more prevalent. With no changes in risk free lending by state owned banks, and the crowding out of private banks, the entire sector risks becoming less profitable. This will have negative effects on the investment cycle in the Indian economy, not allowing it to meets its growth and employment potential. A short term fix is a government financed capital infusion, which, again, does not change the incentives under which actors participate within the banking sector.
A more viable long term fix, however, is a road towards the privatisation of currently state owned banks. Without the guarantee of a government bailout, banks are forced to pay greater attention to risk, and will extend credit to projects and industries that will not squander resources and will be able to generate healthy revenues. The current structure of the banking sector does not allow for this. The reversal of this structure, where a majority of private banks can allocate credit appropriately, and a small number of state owned banks that take on higher, government-guaranteed risk only when necessary, will have a cathartic effect on the Indian banking sector. This may well allow India to reach its high growth potential, but only if it is done while the country still holds a demographic dividend to exploit so as to make full use of its manufacturing and service promise.
The author, Mihir Baxi, is an economic analyst and researcher. His work focuses on international economic affairs.
Tweet at Mihir: @baximihir95
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