India will solve its banking crisis – but what happens then?

The non-performing asset (NPA) problem in India’s public-sector banks (PSB) is severe, yet the current debt resolution framework is appropriate for resolving the problem. The strict and time-bound bankruptcy resolution and recapitalisation framework should be enough. 

" A return to sustained 8 per cent-plus growth - well within India's potential - is unlikely to be realised any time soon.”

At the same time it would be overly optimistic to assume lending will return with vigour. The international experience suggests credit availability declines even after banks are fully recapitalised. The pace of economic growth is compromised as a result. India is unlikely to be an exception.

The recent improvement in credit growth is confined to the household and services sectors and the buoyancy in capital markets is not broad based. The composition of growth is also likely to be different from the pre-banking crisis period. 

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India’s economic growth trajectory is likely to be weaker and more heavily driven by household consumption and government spending. Private sector investment activity is likely to remain subdued. Overall, a return to sustained  8 per cent-plus growth - well within India's potential - is unlikely to be realised any time soon.

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How big is it?

India’s investment cycle before the global financial crisis culminated in a severe bad-loan problem among local banks.

In the lead up to the crisis the Indian economy witnessed a sharp jump in the investment-to-GDP ratio with spending in capital-intensive sectors. The underlying project economics were based on unrealistic assumptions of sustained strong growth, speedy approval and exchange-rate stability.

At present, India’s NPAs amount to 11.6 per cent of the banking system’s total loans. Roughly 80 per cent of these NPAs reside in the 21 PSBs which in turn account for 70 per cent of the system’s assets. The NPA ratio for PSBs was 15.6 per cent at end-March 2018, significantly higher than 4 per cent and 3.8 per cent respectively for privately owned and foreign banks.

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Resolving the NPA problem has been an iterative process, entailing experimentation with initiatives such as extension of loan maturities and debt for equity swaps. The most recent framework, however, marks a significant step forward in our view. ANZ Research estimates the bulk of the NPAs should be resolved over the next 12 to 18 months.

The recognition of the true level of NPAs was an important first step, along with the legislation of a modern bankruptcy law, which assigns a hard timeline to creditors and borrowers to mutually arrive at a resolution. The hard timeline is a significant development as it replaces a plethora of laws which had resulted in interminable delays in resolving cases.

Considering the scale of the NPAs, an inevitable corollary of these measures is deterioration in the capital ratios of several banks.

The final aspect of the framework is the recapitalisation of PSBs. Whether this recap plan is sufficient or not will depend on the recovery rate on the sale of underlying assets. ANZ Research estimates the breakeven recovery rate at 28 per cent.

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And then?

So what happens when banks’ capital levels return to better health? Unfortunately it does not herald a return to a fully normal credit environment, in our view. International experience suggests the credit-GDP gap remains negative for a considerable period of time even after banks are recapitalised - and any economic recovery, at least initially, will be a ‘creditless recovery’.

Although the origins and nature of banking crisis tend to be different across economies, slower credit growth in the post-resolution and recapitalisation period has been a common feature.

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While an analysis of the Asian experience is naturally dominated by the Asian Financial Crisis (AFC), there are numerous examples of banking sector ‘crises’ which are much less explosive and which nevertheless have pervasive had economic effects.

Will India be different? There is some optimism about the near future – bank lending has already turned the corner and non-banking channels of intermediation, including capital markets, are alive and kicking.

The details, however, suggest a more circumspect approach. While credit has somewhat picked up it has been driven by lending to the household and services sectors. Lending to underleveraged households tends to be a common refuge of stressed banks in emerging markets. Credit to the corporate sector, which drives the capital spending India acutely needs, remains suppressed.

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As well, international experience suggests the composition of output tends to be different after a banking crisis. In general, investment spending is the component of GDP that is invariably weaker, particularly investment in the non-tradable sector.

In contrast, because the Indian rupee has been fairly stable, if not overvalued, in real terms, export-led growth is less likely. ANZ Research expects economic growth to be led by household consumption, with some possible support from government spending.

Household consumption is gradually but consistently turning up alongside a recovery in rural incomes, complemented by the government’s infrastructure spending program. High-frequency indicators such as auto sales and ‘currency in circulation’ provide confirmation.

Overall, ANZ Research believes household consumption is set to become a larger driver of growth, complemented by some limited support from public spending. Private investment, the most-important driver of growth from a medium-term perspective, will remain constrained.

Richard Yetsenga is Chief Economist and Sanjay Mathur is Chief Economist, Southeast Asia & India at ANZ