The banking sector in India is likely heading into a trap. That the trap is not one of its own making is a small mercy — the looming problem looks quite unavoidable. A combination of coincidental factors, most of which aren’t in control of the banking sector, could soon lead to a situation where banks have the liquidity to lend but find it difficult to get borrowers. At a time when global growth is falling sharply and India’s isn’t picking pace either, a slowdown in bank credit delivery is the last thing we need.
Let’s take a look at what has been happening in the banking sector over the last decade or so. The non-performing assets (NPA) situation had already started deteriorating in the final years of the United Progressive Alliance (UPA) government. The real picture of indiscriminate lending during those years was not quite clear. It took the Reserve Bank of India’s (RBI) 2015 Asset Quality Review to really uncover the true nature of the NPA situation the banking sector had been saddled with.
The findings were alarming: Gross NPAs as a percentage of banks’ advances rose to 11.5 per cent in March 2018, an unsustainably high level. This is what led to the first aspect of the trap the banking sector is walking into. In response to the NPA crisis, the Narendra Modi government forced banks to change their lending behaviour drastically, and the latter themselves became extremely wary of lending to corporates. They began shifting their lending to personal loans. A thousand smaller loans are far less risky than a handful of large corporate loans, the reasoning went.
Even though the NPA situation is far better now and banks are once again profitable, the trend of decreased lending to the industry has continued.
Changing role of banks
As this analysis by ThePrint shows, the share of credit to industry as a proportion of overall credit by banks and financial institutions has been shrinking. The share of credit to the personal loan category has been growing commensurately. Looking at the other side, corporates have been increasingly raising their funds from the debt market by issuing bonds and debentures rather than taking loans from banks and other financial institutions.
The banks’ role as a source of private sector funding–mostly used for capital investment–is changing. Banks are now driving a different engine of growth: Personal consumption. There are largely two reasons behind this. First, incomes have unquestionably shrunken over the course of the pandemic. While many have faced outright salary cuts, even those who have seen these being reversed have faced a fall in their real incomes because inflation has been eating away at the value of their money. And so, personal consumption has increasingly been financed through loans.
As for the banks, while the recent festival period and the higher demand for cash have meant that liquidity in the system has been temporarily tight, this should soon revert to the recent normal where banks have been quite comfortable, liquidity-wise. Government investment–a major driver of liquidity–is likely to pick up in the fourth quarter of this financial year as it usually does. The festive season’s impact on cash withdrawals will also likely cease come January.
Rising inflation and interest rates
The other problem, now well-entrenched, is inflation. The Modi government has been going blue in the face saying most of India’s inflation woes are imported. That is, global inflation, especially in energy prices, is spilling over into India and leading to uncomfortably high prices here as well. In fact, such is the severity of the problem that the RBI’s Monetary Policy Committee (MPC) recently drafted a letter to the government explaining why the 6 per cent upper limit for inflation had been breached for three consecutive quarters (or nine months).
Although the contents of the letter will remain secret for as long as the government deems it so, they aren’t likely to surprise. Inflation in India is high largely because of skyrocketing oil and gas prices driven by the war in Ukraine and the depreciation of the rupee against the dollar.
However, what this has meant is that central banks around the world–including the RBI–have had to increase their interest rates sharply. Last week, the US Federal Reserve raised interest rates for the fourth consecutive time by 75 basis points (bps). The Bank of England, too, last week raised its rates by the largest amount in 30 years, and the European Central Bank raised rates by 75 bps in October (the same as in September). For the uninitiated, a basis point is a standard measure for interest rates and other percentages. So, 75 basis points means 0.75 per cent and 100 basis points equals 1 per cent.
The RBI, for its part, has raised rates by 190 bps across four hikes since April 2022. The global scenario and persistent inflation mean that some hikes are likely in the near future as well, though not as drastic. What this means is that loans have been made more expensive, while deposits have become more remunerative. In other words, it is increasingly a good time to put money in the bank and an increasingly costly affair to take a loan.
So, taken together, what do we have? Banks are finding that their avenues for lending are more curtailed than they used to be since corporate loans are no longer a focus area. Instead, they are focussing on personal loans. Banks also have comfortable liquidity, so they have the funds to lend. However, interest rates are rising and loans are becoming more expensive. With incomes still strained, those who would usually take personal loans will increasingly be feeling the pinch of higher interest rates and the attraction of leaving money in the bank.
Unfortunately, there’s no visible way out of this conundrum. Growth isn’t strong enough to encourage corporates to go back to taking bank loans, and inflation isn’t going anywhere, so interest rates will remain high. This means the engine of private consumption won’t fire any time soon. This is dismal news for the Indian economy. Hopefully, finance minister Nirmala Sitharaman and her team can think of something innovative in the upcoming Budget.
Views are personal.
(Edited by Humra Laeeq)