In India, the number of non-performing loans (NPLs) is growing. The central government has a number of tools at its disposal to remedy the scale of the problem, and Prime Minister Narendra Modi will use the situation as an opportunity to exert greater central authority over the financial system. This Deep Dive will discuss the economic difficulties facing Indian banks and interpret these financial challenges in light of Modi’s overarching political strategy to increase centralization of command.
- NPL growth affects both corporate profitability and banks’ balance sheets; if this issue is not resolved, it could threaten economic growth because the availability of credit will be reduced, causing a decrease in investment.
- NPLs are a real challenge for India but not an insurmountable one; furthermore, the banking system is not at catastrophic risk.
- To date, solutions to the NPL situation have been characterized by a lack of political coordination, which Modi intends to exploit to assert greater influence in the country’s financial system.
In India, both corporate borrowers and banks are struggling due to the growth of non-performing loans. When borrowers cannot repay what they own on a loan – either in part or in full – that loan becomes non-performing. NPLs exacerbate a company’s financial distress since the company must then devote additional cash toward paying down debt rather than investing in operations. At the same time, NPLs deteriorate bank finances. As loan repayment becomes less certain, the bank is forced to write down the value of the loan, which hurts the bank’s profitability in the short term and its financial viability in the long term.
Indian Prime Minister Narendra Modi and leader of the Bharatiya Janata Party waves during a rally in support of state assembly candidates in Varanasi on March 4, 2017. SANJAY KANOJIA/AFP/Getty Images
Since Geopolitical Futures has forecast a decline in India’s GDP growth in 2017, but not a collapse, this Deep Dive will explore the extent of NPL risk in India’s financial system, explain why it’s probably not catastrophic, describe the solutions available to the government and explore the solutions’ potential effects. The most likely outcome, establishing a “bad bank” to acquire non-performing assets with existing banks being forced to take losses on this bad debt, will be accomplished through increased government intervention in the banking system.
Indian banks have until March 31 to complete a full review of assets to recognize non-performing loans according to a set of standards established by the Reserve Bank of India (RBI) rather than using standards set by each individual bank. In his attempt to further consolidate central authority over what is currently a decentralized economy, Prime Minister Narendra Modi will use the banks’ prior lack of coordination and failure to solve the NPL problem as an opportunity to step in and force cohesion among actors in the political economy.
Genesis of NPL Growth and Impact on Investment
India experienced double-digit economic growth between 2000 and 2008, which generated positive expectations and drove credit expansion primarily to corporations and infrastructure projects. While India was not as heavily impacted by the 2008-2009 recession as many Western countries were, it was not left unscathed either. Despite the oft-written motto “past performance is not a guarantee of future returns,” banks frequently lend based on a company’s historical operations. Lenders forecast a continuation of strong growth, and banks began to extend credit based on less aggressive forecasts when growth proved to be weaker than expected. The result was a decrease in new loans. Reduced economic growth also shifted expectations for loans that had already been made, increasing the risk of write-downs.
Despite steady moderated growth in domestic consumer spending, goods and services exported by India fell from 24.3 percent of GDP in 2008 to 20.6 percent of GDP in 2009, driven by weak global consumption following the 2008 crisis. While India’s economy is not as heavily dependent on exports as other economies that we’ve previously identified, due in large part to the domestic consumer demand that accounts for approximately 60 percent of the Indian economy, revenues were still negatively impacted by the drop in global demand for imports.
A declining currency also impacted Indian companies’ ability to repay debt. In 2008, one dollar bought approximately 40 rupees, whereas today it buys approximately 65. While the depreciating currency helped exports recover (until 2014, when falling commodity prices again caused exports to decline), a cheaper currency also meant increased costs for Indian companies that purchased goods abroad, because these goods (especially commodities) are frequently denominated in dollars. Slimmer margins led to a decline in corporate cash flow, which made it more challenging to service debt. Furthermore, a weaker rupee relative to the dollar made servicing debt more difficult for companies that had taken out foreign loans during the years of expansion. Indian banks that had lent to companies holding foreign debt were exposed to this risk since additional debt makes it harder for companies to repay domestic bank loans.
Many outstanding NPLs were originally lent to fund infrastructure projects such as airports, roads and ports. While many of these projects are not currently profitable, infrastructure gives businesses the scaffolding necessary for growth. Infrastructure also provides a positive public benefit that isn’t captured in the project’s financials. India previously lacked abundant developed infrastructure, and the ability for businesses to utilize this new infrastructure during the financial crisis allowed for investment and growth that, in part, shielded India from the global recession’s effects. Stalled infrastructure projects and completed projects that aren’t profitable could become viable in the future if sufficient economic growth occurs, which means that they are not necessarily terminally unprofitable. Stalled projects can also be restarted and used to repay the loans against them and generate cash flow once they are completed.
Despite India’s relatively low level of corporate debt compared to other countries, these challenges have led to a growing creep of NPLs. RBI’s official NPL ratio (non-performing loans as a percent of total loans extended) was 7.5 percent for 2016 compared to 2.2 percent in 2009. However, the Indian Ministry of Finance estimated in its annual economic survey that if poorly performing but as-of-yet unrecognized assets were included, the current NPL figure would jump to about 16.6 percent.
Doom and Gloom?
At first glance, a 16.6 percent NPL ratio may seem catastrophic, especially given that Geopolitical Futures has predicted a collapse in Italy’s banking sector predicated in part on an NPL ratio of 17 percent. However, there are some key differences between India and Italy. First is a matter of scale; the NPL ratio measures non-performing assets compared to total assets outstanding. This ratio provides a sense of bad debt relative to total debt, but it does not communicate the absolute size of total debt. Simply put, there’s a lot more debt in Italy than in India relative to the size of each country’s economy. According to the World Bank, private-sector debt in Italy was 88 percent of GDP in 2015 compared to 52 percent in India. The difference in central government debt was even wider, with Italy’s government having incurred debt worth 135 percent of GDP compared to India’s 50 percent.
Second is the degree of freedom the governments have in solving their NPL problems. Italy does not have complete control over its own monetary policy and instead depends on the European Central Bank, which sets policy for multiple nations at once. This prevents Italy from printing money and devaluing its currency to increase exports and cheapen the cost of its debt. India, however, is not handcuffed by an external regulatory body and can therefore enact this type of measure.
Third, European Union rules require that bank creditors must take losses before a government can spend taxpayer money to bolster bank finances. The Indian government, on the other hand, owns a large part of the banking system and can therefore intervene more directly in the financial system.
Fourth, as will be discussed in greater depth below, the amount of capital needed to buy India out of its NPL crisis only represents a small portion of the Indian central bank’s total reserves. Fitch, a credit rating agency, estimated that approximately $90 billion is needed to recapitalize the Indian financial sector; this is equivalent to only a quarter of the $360 billion in reserves held at RBI. Italy’s central bank reserves, on the other hand, do not come close to the amount of capital necessary to resolve the NPL crisis via a buyout. Italy holds approximately 360 billion euros in bad debt, more than twice the value of its 143 billion euro central bank reserves.
Lastly, growth expectations for Italy are far lower than those for India. India’s strong domestic market can grow its way out of the NPL problem, assuming the government takes steps to remedy NPLs now so that they do not pose greater risks in the future. Additionally, India’s GDP is projected to grow by approximately 7 percent in 2017 compared to 1 percent in Italy. Italy has no hope of growing its way out of its problem.
India’s Public Banks
India’s banking system is characterized by a high degree of public ownership of banks. India’s NPL position must therefore be understood in the context of the role that public sector banks (PSB) play (and have played) in India’s economic history.
After India gained independence in 1947, the Indian government sought to take a more active role in the economy, believing that private distribution of capital would result in credit failing to reach those who needed it the most. The Indian economy was a socialist one during the first four decades following independence, and the government wanted tools that would let it play an active role in stimulating economic growth. In 1949, India nationalized the RBI, which had been established in 1935 during British colonial rule. The RBI was given regulatory control over Indian commercial banks that were still private at that time. Six years later, the government also nationalized the Imperial Bank of India, which became the State Bank of India in 1955 and remains the country’s largest lender. In 1969, Indira Gandhi nationalized 14 additional banks, arguing that banks – which had been privately held up until that time – should be used as a social tool to encourage economic development and elevate the poorest in the country. This move brought the total number of bank branches under government ownership to 84 percent and saw bank branch growth surge in the years that followed, especially in rural areas that previously did not have easy access to banking services.
Despite a phase of liberalization that began under the Congress government in the late 1980s, PSBs still remain India’s largest banks and today account for 73 percent of total assets in the Indian banking system as well as 80 percent of non-performing assets. PSBs also continue to make up the majority of lending activity.
Worse Than It Looked
Assuming that the stressed nature of some assets would be temporary following the financial crisis in 2008-2009, the central bank agreed to let banks momentarily avoid recognizing many loan write-offs. When it became apparent that reduced economic and project growth was long term rather than temporary, the RBI decided in 2016 to conduct an extensive Asset Quality Review (AQR) to ensure banks recognize non-performing assets in ways that would make their balance sheets comparable. (That is, the AQR would standardize rules rather than allowing each bank to use its own set of rules.) The review discovered that a number of non-performing loans were not classified as such. Recognizing these NPLs resulted in an 80 percent “increase” in bad loans.
Rather than recognizing bad debt, banks continually refinanced struggling borrowers to defer classifying the debt as non-performing, a measure that allowed the banks to avoid write-offs. (This practice is called “evergreening.”) Bank investors also faced uncertainty regarding bad loan classification and were unsure of the banks’ true financial positions. As a result, the RBI mandated that banks fully identify all non-performing bank assets, including unrecognized evergreen loans, by the end of March 2017.
The greatest risk India faces with its NPL crisis is that nothing happens – banks continue refinancing existing loans to avoid write-downs in the short term and NPLs continue to grow as the can gets kicked down the road. In this case, long-term economic growth would stagnate as credit becomes more limited and economic and productive project investment declines. In February, RBI Deputy Governor Viral Acharya spoke to the Indian Banks Association about the risk of India becoming another Japan – whose economy was crippled beginning in the early 1990s by overextension of debt, resulting in long-term stagnation – if measures aren’t taken to correct the NPL crisis.
To date, Indian banks have attempted to handle NPLs through what has been called the “decentralized approach.” This means that individual banks work with their borrowers one-on-one to find solutions to troubled assets, such as by restructuring or refinancing loans. All borrowers have a personal contact at their bank; when loan repayment becomes challenging, the borrower talks to this contact to work through the problem. However, this has proven ineffective so far as NPL growth has persisted.
Banks under financial distress face a choice: either raise more capital to meet reserve requirements as assets sour or reduce new lending to minimize losses from underperforming assets. While the reduction in new credit does not solve pre-existing bad debt, it does decrease the amount of business investment in the economy. Raising new capital has proven challenging since investors are concerned about the deteriorating position of PSBs. The alternative, decreasing the availability of credit to the market, has led to a decline in fixed asset investment, which risks damping economic growth. Further, the decrease in credit has impacted lending to small and medium-sized businesses and has therefore affected their ability to invest additional capital in their operations. Ensuring that credit remains available to smaller enterprises and individuals is not only politically prudent for Modi but also plays into his economic plans to sustain growth by encouraging investment by smaller businesses.
All potential solutions must be seen from two lenses: economic and political. Each has economic ramifications that impact the political situation in India. While several potential options are discussed below, Modi’s government will choose to adopt policies that further his overarching political plan of greater centralization of power. For this reason, the “bad bank” option will almost certainly play a role in resolving India’s NPL crisis.
One approach would be for banks to seize borrowers’ assets. However, most banks don’t like to do this. While borrowers frequently pledge collateral to give lenders additional assurance, lending institutions are not in the business of reselling assets. When banks are forced to do so, they almost always incur a loss. There is also the additional risk of poor political optics for a public bank that takes assets from “the people.” For these two reasons, this option is relatively unlikely to occur.
Another option is a bailout. The government has, to a certain extent, already initiated a limited bailout, pledging to inject 25,000 crore rupees (approximately $3.75 billion; crore rupees indicates 10 million rupees) into the banking system during the 2016-2017 fiscal year. (India’s fiscal year runs from April 1 to March 31.) Some 23,000 crore rupees (approximately $3.45 billion) already had been provided to a number of PSBs – including the State Bank of India, Punjab National Bank and Indian Overseas Bank – by the beginning of March 2017. Furthermore, an additional 10,000 crore rupees (approximately $1.5 billion) has also been allocated toward capital infusions for state banks in the 2017-2018 fiscal year. However, these are small figures relative to the $90 billion that Fitch estimates is required to fully compensate for outstanding NPLs in the banking system.
A longer-term risk arises with government bailouts: moral hazard. If bank managers believe they can capture profits while taxpayers subsidize losses, then a bailout will defer the problem rather than fix it as bankers resume the reckless lending practices that first initiated the problem. The RBI and central government would need to implement significant reforms to employ a larger-scale bailout without repeating the current situation. (Repeating recent history would not be attractive to Modi.) Since Modi is attempting to establish greater centralized authority, the optics of citizens paying for bank bailouts would threaten his future power base.
While moral hazard forms a sound economic base for establishing restrictions on bank bailouts, politics also matter. Steps are already being taken to establish a more stable financial system, such as reforms passed last year that will accelerate the bankruptcy process and grant banks a clearer path to establishing control over insolvent companies. This transfers risk away from the banking system and onto companies. It also improves banks’ financial positions and decreases the risk of a financial crisis that would require a taxpayer-supported bailout.
A third potential solution to the NPL issue has already been tried: the decentralized approach, mentioned above, in which each bank attempts to independently recover or restructure its NPLs. In the short term, banks are incentivized to refinance or restructure loans since bank managers don’t want to be forced to incur losses and, therefore, receive smaller bonuses. They do this by decreasing the loan’s restrictiveness, such as by redefining covenants or extending the tenure of the loan. This approach has led to little progress toward reducing NPLs on bank balance sheets. The failure of the decentralized approach to solve the NPL situation will provide an opportunity for Modi to step in and assert additional authority over India’s financial system.
The fourth solution involves creating what’s called a “bad bank.” This entity – which is often referred to as the Public Asset Rehabilitation Agency (PARA) – would purchase NPLs from individual banks. While the PARA would need to be well-capitalized to prevent the risk of losses, separating bad debt would divorce the task of restructuring from normal lending practices. Additionally, the PARA would specialize in restructuring. At the same time, selling non-performing loans would strengthen banks’ financial positions and make it easier for them to meet capital adequacy requirements and thereby attract new capital from investors. Fresh funding would strengthen banks’ balance sheets and reverse the downward trend in investment caused by credit contraction.
The PARA could also solve problems that have become evident with the “decentralized” approach. Rather than having individual banks work independently, a single entity would become responsible for the bad assets; this would eliminate the lack of coordination that has characterized restructuring attempts to date. Relatively few companies are responsible for a large portion of the bad debt – approximately 50 companies in India account for 71 percent of the debt owed by “IC1 debtors” (debtors with an interest coverage ratio below 1; these companies do not generate sufficient cash flow to service their existing debt obligations). Having the vast majority of bad debt concentrated in such a small number of companies would benefit an entity focused on restructuring, such as the PARA, since it would handle a relatively small number of accounts. It would also let banks continue to focus on what they do best – lending – while assigning the responsibility of NPL recovery to an entity with the means to hire restructuring specialists.
Since implementing the PARA would require increased coordination among several economic and political actors, which would need to be facilitated by the central government and which aligns with Modi’s goal of centralizing power, it is the option most likely to occur. In a previous analysis, Geopolitical Futures discussed Modi’s drive to centralize power. The fact that Modi will be moving from a hands-off, decentralized approach to a more active one regarding the NPL situation must be seen within the context of his broader political goals.
There are, however, challenges to the PARA model. The first question is who would capitalize it. Since it would, by its nature, hold a number of troubled assets, it would need substantial capital reserves to prevent bankruptcy. If it is primarily owned by the government, the risk is that the PARA might not be able to offer the competitive wages that would allow it to hire the skilled restructuring specialists it would need. There is also the question of where the public capital would come from (likely the RBI) and what would happen if loans at the PARA continued to struggle.
A different set of problems arises in the event of private investor capitalization, whether or not the investor takes a majority stake in the bad bank. Since NPLs cannot guarantee the same surety of cash flow as unstressed assets, the NPLs will need to be sold at a discount to face value. If the discount is too great, banks will not be incentivized to sell the assets since doing so would require booking a large loss. If the discount is too small, however, it will be difficult to attract investment in the PARA since investors will assume that losses are being passed on to them.
There are already indications that Modi’s government will force banks to take write-downs. In mid-March, the State Bank of India (SBI) announced that it will implement a special one-time settlement program for farmers who received loans for tractor and farm equipment. SBI will take a 40 percent haircut on its debt for all borrowers that approach the bank before March 31, which is also the deadline for the bank to re-categorize its NPLs according to the RBI’s Asset Quality Review guidelines. Recently, India’s farmers have been particularly hard-hit as agricultural commodity prices have dropped and put a dent in India’s farm-based exports, increasing farmer suicides. In a related political move, during its campaign to win Uttar Pradesh, the Bharatiya Janata Party (BJP) promised to excuse farm loans and use local government funds to compensate banks for the losses they would incur. The pledge seems to have been effective since BJP won overwhelmingly in Uttar Pradesh. The politics of banking economics has already become a reality.
Public PARA Provisions
Given the public nature of India’s financial system and Modi’s political aims, it’s highly likely that the government will take an increasingly active role in resolving the NPL situation. Money to capitalize the PARA would need to come from somewhere, and the government has a few mechanisms at its disposal. For instance, the government could issue new securities and use this cash to directly capitalize the state banks. This initiative would not require the establishment of a PARA.
A second option would be to structure the PARA in such a way that the new entity itself could issue its own securities. The government could participate in its capitalization through purchasing these new securities.
A third possibility would be for the RBI to directly capitalize the PARA. In this scenario, the RBI would transfer securities to either the PARA or public-sector banks, or possibly to both. A direct transfer would have minimal to no impact on monetary policy – and therefore inflation – since the transfer would be in-kind and would not require printing new money.
The RBI is in a strong financial position and is well capitalized, so it’s likely that a direct transfer of securities will provide one source of funding for the PARA. As mentioned previously, Fitch anticipates that the banking sector needs approximately $90 billion in funds to compensate for its NPL position. As of February 2017, the RBI had approximately $360 billion in reserves.
These three options are not mutually exclusive and can be taken in tandem with one another. It is important to note, however, that even in a worst-case scenario, the RBI has more than enough capital to patch the banking sector’s NPL exposure. This minimizes the extent of the damage possible with the current iteration of the NPL crisis and differentiates India’s situation from Italy’s.
India’s relatively low level of corporate indebtedness belies the risk that stems from poor credit quality. At the same time, steady NPL growth has dampened investment and risks slowing economic growth. However, the absolute size of NPLs – while large relative to other countries – is not unmanageable, at least not yet. The RBI has more than enough reserves to bail out the banking system as it currently stands without printing money, and the government has taken an assertive stance in forcing banks to more aggressively recognize under- or non-performing assets.
Modi will take advantage of the lack of progress in working down NPLs to assert greater central government authority over the Indian economy. Although India has the economic resources to deal with the current state of its NPL problem, the challenge to date has been a lack of political coordination preventing a plan that can effectively deploy these resources. This deadlock will not continue, however. Based on the success of last year’s demonetization policy and the BJP’s resounding victories in the recent elections, Modi appears to have the mandate to exert greater control over India’s financial system and will likely move to further consolidate the central government’s influence.