Vicious cycle: slowdown, NPAs feeding off each other

The economic slowdown is largely attributed to the recent government policies of demonetisation and faulty introduction of Goods and Services Tax (GST). Most importantly, the growing concern is that there is a continued deterioration in the asset quality of Public Sector Banks (PSB) in recent times.

The concern is because economic growth is largely dependent on the timely flow of credit to different sectors of the economy, and in a bank-dominated financial system like India, that depends highly on the soundness of banks. The Reserve Bank of India’s Financial Stability Report 2017 observes that with high risk of accumulating Non-Performing Assets (NPA), the profitability and efficiency of public sector banks is fast declining, and this will have a negative impact on economic growth.

Former RBI governor Raghuram Rajan had expressed concern over the problem of bad debt in PSBs and emphasised the need to clean up the NPA mess to make credit available for economic growth. But the RBI report highlighted, based on the baseline macroeconomic scenario, that NPAs are going to increase from 9.6% in 2016-17 to 10.02% in the financial year 2017-18. This is now a vicious cycle: the economic slowdown is causing an increase in NPAs, and the high level of NPAs is forcing banks to hold back on credit and slowing down the economy further.

Further, the recent State Bank of India research report candidly said that the “economic slowdown is real, not just technical,” as the GDP growth rate in the June quarter fell to 5.7%, the lowest in three years. The industrial and agricultural sectors continue to show sluggish growth due to lack of public and private investment.

The growth rate of the industrial sector has hit rock-bottom at 1.61%, agriculture sector at 2.34% and the service sector is at 8.72%. Adding fuel to the fire, with demonetisation and high rates of GST, consumer demand is fast dwindling, which has a negative impact on the real estate and consumer goods sectors. The ‘Make in India’ initiative and the effort to double farmers’ income have yielded no result so far and remain mere rhetoric.

Even though the government has allocated a huge amount in the Union Budget for these sectors, in reality, gross fixed capital formation is very low as 28.5%. Debt in public sector banks and excessive defaults by the corporate sector have added misery to the economy. Further, what’s missing in Modi’s “mega offers” is equitable distribution of growth, or inclusive growth, for the long-term stability of the economy. This is evident from PSB lending patterns.

Public Sector Banks and their lending play an important role in economic development. They accounted for 70.63% of deposits and 68.13% of the total credit by the end of March 2016. At the same time, PSBs also accounted for 88.24% of the Gross NPAs as on March 2016, which was then already a serious threat to the banking system. Aggressive lending without due diligence and monitoring and writing off huge bad debts of the corporate sector have had their visible share in decelerating economic growth. Sector-wise credit outstanding of commercial banks shows that industry accounted for the largest share, 41.71%, in the total outstanding credit whereas agriculture and allied activities account for 13.49%.

The burden of NPAs for public sector banks is also mainly due to excessive corporate financing, which constitutes about 59% of the total borrowing from banks alone, rather than from the capital or debt markets. This clearly shows that a huge credit exposure to industrial and corporate sectors has resulted in accumulation of NPAs in public sector banks. This is also an indicator that sluggish industrial growth has impacted on loan repayment. The poor growth of industrial and agriculture sectors is dangerous as they may create more bad loans for the banks and further slowdown economic growth.

These evidences also expose PSBs’ favoritism towards corporate financing and their failure to follow sound banking principles in managing public money. Public sector banks experienced a steep decline in profitability in the post-recession period, which came down from 1.03% in 2008-09 to -0.2% in 2015-16, and further deteriorated to -0.24% in 2016-17. This trend is developing into a potential systemic risk for the financial system and economic growth. Paradoxically, private and foreign banks are making huge profits in India. Private sector banks recorded increasing trend in profitability from 1.13% in 2008-09 to 1.68% in 2014-15. The main determinants of NPAs in public sector banks are: operating efficiency of the bank, capital adequacy, GDP growth rate, and interest rate.

Debt recovery mechanisms have proved to be ineffective in containing the problem of bad debts in recent years. There are suggestions for public spending for recovery of the economy. This may prove costly, unless it is substantiated or supported by real growth of the sectors as it will further impact on the repayment of loans.

Economic slowdown maybe a feature for several months going forward as there is no drastic policy measure in place to reverse the trend. The problem of PSB debt burden is that excessive dependence on the banking sector for industrial credit and corporate finance, which clearly point to the need to develop the corporate bond market. Corporate bond markets can diffuse excessive pressure on the banking sector in corporate financing and reduce the high risks of NPAs and high fiscal deficit.

(Dr. Krishna Raj is professor and Dhananjaya K is Research Scholar, Centre for Economic Studies and Policy, ISEC, Bengaluru)