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India’s Loan Crisis: Lessons to be Learned

The Reserve Bank of India (RBI) has found itself under close scrutiny recently as a sharp divergence in Non-Performing Assets (NPAs) or “bad loans” reported by India’s state-owned banks plagues the Indian banking system, raising concerns over broader financial stability and inadequate regulatory diligence. The RBI defines a NPA as “a credit facility, in respect of which the interest and/or instalment of principal has remained ‘past due’ for a specified period of time” – generally 90 days or more. Put simply: when an asset ceases to generate income for the bank.

Of all of the major economies across the globe, the International Monetary Fund (IMF) has India currently tabled to lead all peers, overtaking China with annual real GDP growth of 7.4% expected this year, followed by 7.8% in 2019. Such an economic expansion has historically been fuelled by strong and sustainable credit growth that is generally correlated with a healthy banking sector, resulting from profitable asset creation within the economy (figure 1).

Figure 1. GDP vs Credit Growth – India

  

Source: BondAdviser, Reserve Bank of India (RBI)

However, India’s percentage of NPAs has increased by 4.0% over the past three years to 9.7% at the end of 2017 – second only to Italy (16.4%) amongst major global economies (figure 2). To provide context to the severity of the crisis, Australia’s total NPA ratio was just 0.9%, whilst China, which has been forced into injecting liquidity into its credit-driven economy, has recently maintained a reported ratio of 1.7%.

Figure 2. Bank Non-Performing Loans to Total Gross Loans

Source: BondAdviser, The World Bank

India’s high delinquency rates raise serious questions regarding the true asset quality of its Public-Sector Banks (PSBs) and the true causes behind the exponential increase in the value of NPAs (figure 3). The relatively slow pace of deterioration that occurred before 2015 has alarmingly been attributed to the PSBs’ reluctance to properly recognise bad loans, thus, artificially maintaining provisions at low levels and keeping published profits high. The almost sudden realisation of the severity of the country’s NPA crisis has seen state-run Indian banks post losses upwards of USD$8.6 billion YTD – a product of poor asset quality leading to lower interest income recognition, higher provisioning and higher recorded credit losses.  Naturally, this results in the deterioration of a bank’s profitability and regulatory capital which could well lead to multiple bank failures. If this persists, it could become a real threat to the financial stability of the country.

A key takeaway from India’s NPA woes is that it has largely been driven by capital-intensive industries such as energy, metals and telecommunications (~73% of total NPA’s in 2016-17 were derived from corporate and industry loans) resulting in an infrastructure bottleneck that is likely to drag on future GDP growth. Furthermore, given that 50% of India’s government-controlled banks have already been placed under the RBI’s Prompt Corrective Action (PCA) program that curbs lending and expansion, asset quality may deteriorate further as tighter regulations come into effect and the number of stressed loans in the all-important energy sector rises.

Figure 3. Value of Non-Performing Assets: India vs Australia

Source: BondAdviser, Bloomberg

In an effort to manage a banking sector that was on the verge of collapse under the weight of non-performing loans, the Indian government appears ready to further “bail-in” state banks through the implementation of the Financial Resolution and Deposit Insurance (FRDI) bill. The bill aims to establish a ‘resolution corporation’ with widespread powers to acquire and transfer assets or liquidate a financial institution in the event of probable failure.

It is encouraging to see emerging major economies stray away from the alleged mistakes of other countries (i.e. costly US government bail-outs during GFC) to develop and maintain a robust banking system while still fundamentally following capitalist policies.  This framework could become a model for other rapidly-growing countries to follow in the future and would likely improve overall stability in the global financial system.  However, we’re still convinced that the proof of the post-GFC banking system is in the pudding and ultimately depends on how many banks are failing, their size and interconnectedness.