India, the world’s fastest growing large economy, is slowing: There has been a visible deceleration in activity in the past six months. It started with slowing sales of autos and some durable goods and has spread from there. Airline traffic growth is down; companies are now saying sales of consumer staples such as soaps and detergents have begun to weaken, too. Even as the hunt for reasons for the slowdown begins, the main culprit appears to be a familiar one: the still largely government-owned financial system.
The issue is that there isn’t enough money in the economy. For much of the past two years, distributors and retailers of consumer products have been warning of a growing lack of liquidity. At first, policymakers largely dismissed their concerns. The government’s late 2016 decision to withdraw most currency from circulation temporarily, and the introduction the following year of a nationwide goods-and-services tax, made it hard to decipher signals on economic momentum. Plus, liquidity, as the central bank measures it, generally looked stable: Banks were still parking funds with the Reserve Bank of India overnight.
Now that the GST is more than a year old and the effects of demonetization have faded, the growth numbers are less distorted by base effects and the slowdown is becoming more obvious. So is the lack of liquidity: For the past two years, growth in money supply, as measured by M3, has lagged GDP growth; the M3-to-GDP ratio has declined sharply from 85 percent to below 80 percent. Though aggressive purchases of government bonds by the RBI have caused base money or M0 (much of which is currency in circulation) to grow at 16 percent in recent months, it is still about 1 percentage point of GDP lower than its level before demonetization.
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Obviously, the engine that converts the 28 trillion rupees of base money (M0) to the 154 trillion rupees available as broad money (M3) is malfunctioning. The bottleneck is in the financial system. Money gets created when loans are given and, even though bank credit growth has accelerated in the past few months, aggregate credit growth is still far too weak.
A reluctance to privatize the financial system is to blame. State banks continue to dominate the sector, controlling some two-thirds of banking assets. They also accounted for nearly 90 percent of the non-performing assets from the last lending boom. While all sides of the political spectrum acknowledge the need for reform, governments have shied away from selling off state lenders outright, preferring to reform the sector by stealth. The hope has been to slow the growth of state-owned banks and allow privately owned rivals to gain market share. In another 15 or 20 years, the theory goes, the sector would effectively have been privatized. A similar strategy worked for the telecom and airlines sector, after all.
The problem is that state banks continue to have a very large role in the economy. As they slow, they drag down the economy, too; private-sector banks simply can’t grow fast enough to make up the difference. For a time, non-banking finance companies could help: Shadow banks were responsible for nearly a third of incremental loans in the system over the past three years. But, since September last year, when a funding crunch forced them to focus on survival, credit growth in the system has slowed.
After elections, the next government should not dodge the need for more radical reforms. If state-owned banks are asked to start growing again, the risk of future bad loans goes up. On the other hand, if nothing changes, the economy will remain sluggish. While both major political parties have talked of consolidating state lenders into about half a dozen larger banks that should be easier to administer, more ambitious reforms will almost certainly be necessary — at the very least, to remove them from the government’s direct control.
Other factors may also be contributing to the current slowdown in demand. The raises for government workers mandated by the last pay commission have started to dwindle in their impact, for instance. And, the central bank’s Monetary Policy Committee could certainly help matters by cutting rates faster, especially since the RBI’s own inflation forecasts for the next 12 months are lower than its 4 percent target. Lower rates can help bring down bond yields and provide some stability to the non-banking side of the financial system.
But rate cuts are no panacea. If the economy is to start growing again, the government may have to take an ax to state banks, not a scalpel.
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Neelkanth Mishra is co-head of Asia-Pacific Strategy and India Strategist for Credit Suisse.
RBI every time reducing their lending rates to banks, not going to boost economy, in fact the banks getting lowest interest rates from RBI, not passing it on to their customers taking loan. The banks performance should be closely monitored by RBI and necessary powers should be given to RBI to take action against non performing banks.
The problem of sluggish growth is attributed to slow bank credit growth. Even if this is presumed to be true, the bank credit has to be viewed in two broad categories- Big ticket and field level Loans (both Retail, Agri and MSME). The first one has most definitely slowed down largely due to the risk aversion by bank management which is understandable because the experience of being helpless with regards these big ticket lending is evident with the NPA crisis. None of the fast-track mechanisms including the latest NCLT & Bankruptcy and Insolvency Code, apart from the existing mechanisms of DRT, SARFAESI etc have helped the situation. With no apparent recourse mechanism to failed credit how is the bank management expected to lend aggressively is beyond me. The conservatism is justifiable as a prudent risk taker. Secondly, the field level credit has seen a growth in the last year as admitted by the author himself. But then again this growth is largely restricted or constrained not due to the bank’s inability to take credit decisions but more so because of non compliance of market/Public to tax structures and framework. This restricts bank’s ability to lend only upto the declared tune of business by the borrower where as the actual requirement is not shown on paper leading to a mismatch between demand and legally declared turnover (reduced to avoid tax liability). The PSBs are stuck in between. Prudence in lending is as important as being aggressive in the growth story.
I had posted the suggestion in 2014 that all PSBs – barring SBI, perhaps – should be privatised. That remains true in 2019. I have a sinking feeling that I will be posting a similar message in 2024 as well …
“A reluctance to privatize the financial system is to blame.” Spot on. Loss making farmers refusal to quit farming, loan waivers are partly responsible for non privatisation coz government banks are needed by shameless socialist governments to give doles. Socialist Modi is NPA
“A reluctance to privatize the financial system is to blame.” Spot on. Loss making farmers refusal to quit farming, loan waivers are partly responsible for non privatisation coz government banks are needed by shameless socialist governments to give doles.
The learned author has made some strong analytical points– lending leading to credit growth, etc. However, there are a few areas he has overlooked– a bad loan problem for the banking system automatically implies that there is a similar sized problem on the corporate balance sheet (in case of India currently). These firms were large borrowers in the system and unless the over-leverage at these firms is sorted, incremental credit demand is hard to come by. There is no mention of how this problem is supposed to be sorted. Second, associated issue at hand is that most of the over leveraged corporates are in the private sector, it is not too clear how privatization of the financial sector will lead to better outcomes- clearly the private has not covered itself with glory in the non-financial sector space.
Finally, any capitalist economy undergoes periods of excesses which lead to unsustainable debt (either in corporate sector and/or retail sector) and build-up of bad loans at banks. This requires intervention by the governments and central banks to get the system going. A true measure of a system’s sustainability is the fiscal burden imposed on the economy (as % of GDP). If this metric is used the level of costs imposed on the Indian economy over the past 10 years averages to ~1 of GDP, which is amongst the lowest in the world. Some of this analysis is missing in articles on the bad loan problem in India.
Prime reasons for the persistence of the bad loan problem in India is the wide-spread perception that bad loans implies either corruption or incompetence. This narrative has a debilitating impact on decision making and hinders risk taking (which is the foundation of a capitalist system). It will be helpful, if the media debate takes a more nuanced view of the problem at hand and rather than fall into the fallacy of looking for simplistic solutions, where none exists