Think Tank

India’s Financial Sector: What Ails it and the Way Forward

Professor Jayanth Varma, Indian Institute of Management, Ahmedabad

Bogged down by rising NPAs, India’s PSU banking system has been dysfunctional for years. However, until the IL&FS crisis broke a few months ago, businesses had barely felt the impact, because NBFCs had been filling the resultant lending vacuum. Today, at a time when private investment is just starting to revive, there is a real danger of systemic liquidity problems. At the same time, the stress on corporates has spread beyond a handful of sectors, and the fiscal space for public infrastructure spending has shrunk. All considered, India faces a serious investment squeeze. It may also see major headwinds if China – which has been on an unsustainable, over-leveraged path for years – experiences a financial crisis. That said, the news for India is not all bad, with several positives emerging in the financial system in the last few years.

A fair amount of good news…

The banking system has probably provided for all existing NPAs

Amidst all the bad news surrounding the Indian financial sector, there are a number of bright spots. Most obviously, banks, having endured years of pain, have now more or less recognised all of the NPAs that currently exist. This raises hope that banking system will soon be back on its feet – though it does not preclude the possibility of fresh NPAs cropping up. The badly-needed Insolvency and Bankruptcy Code (IBC) has also started to have an impact, though arguably, more should have been done on the liabilities side, rather than simply writing down assets.

A recovery in corporate investment and profit may be in sight

Another positive is an incipient recovery in corporate investment and profitability. In the lead-up to the Global Financial Crisis, when everyone expected years of double-digit growth, businesses overinvested in India across the board. When growth slowed, they ended up with huge excess capacity, creating corporate stress, and causing investment to stall. However, no investment drought can last forever. Even at growth rates of 6-7%, India has managed, in the last 10 years, to absorb most of its excess capacity. The upshot is that firms are starting to regain pricing power, implying that profitability as well as investment will perk up, purely driven by cyclical factors.

The global economy is in a ‘Goldilocks scenario’

For several years, the world economy has been poised on a knife’s edge. Growth has been neither so fast that interest rates and crude oil prices will rise inexorably, nor so slow as to tip it into recession. Today, America continues to grow, though its momentum is weakening, while Europe and Japan are seeing a down-trend. Up until a few months ago, the US Fed was moving to aggressively hike rates, but it has now retreated, providing some relief to the EMs.

Robust domestic institutional flows have propped up the equity market

Historically, India’s stock market has been hostage to FIIs. When they buy, prices and the Rupee go up, but when they sell, both go down. However, a decoupling has occurred in the last few years, with domestic flows replacing FIIs. Month after month, money has poured in, not just in the form of mutual fund SIPs, but also from the NPS and EPFO, both of which are required to invest a share of their incremental funds in equity. As a result, the market has held up even as FIIs have either sold shares or stayed away.

…but the downside risks are massive

Corporate stress is spreading beyond a few trouble sectors

More than balancing out the positives are several down-side risks, which together point to an impending squeeze on investment. First and most critically, corporate stress, which was until recently confined to a handful of sectors, is spreading:

  • Aviation: While everyone is focused on the problems of Jet Airways, the entire industry is losing money. Operating profit is negative, and there is huge over-capacity. The issue originated at Air India, which, with its near-bottomless access to resources, continued to buy planes even while making losses. Over-capacity has driven down airfares, in some cases, to levels below 2nd-AC rail fares. Clearly, this is unsustainable.
  • Telecom: Reliance Communication is only the most visible stress-point for an industry where the major players continue to lose huge amounts of money.
  • MSMEs: The entire MSME sector is stressed, hit by demonetisation and then the GST. Their problems were papered over by massive credit flows, both from NBFCs and via the Mudra scheme. Worryingly, estimates suggest that 50-80% of Mudra loans – which are typically approved without due diligence and hardly any collateral – may be non-performing. Now that fresh credit is drying up, it will be harder for borrowers to roll over their old loans. This will drive up delinquency rates.
  • Property developers: Since 2008, developers have been sitting on huge unsold inventories. For a while, they were financed by NBFCs, but these flows have now stopped, raising the likelihood of new NPAs. Other investors – most importantly, PE funds – are unwilling to step in, given that they see viability only in commercial property and affordable-housing projects.
  • Overleveraged business groups: Even the healthy parts of a diversified conglomerate can get dragged down by issues in just 1-2 group companies. This is what may be happening today with ADAG and Reliance Communications, but it is equally true of several other groups. A possible solution, albeit counter-intuitive, is for promoters to sell off the healthy assets – which will command strong prices – to settle their NPLs.

A credit squeeze in the financial system

The NBFC crisis was only the trigger for a long-overdue credit squeeze. It originated in asset-liability mismatches, which, though common to the entire financial system, were taken to an extreme by NBFCs. They were, for instance, financing 30-year loans with 90-day money. In fact, it is a miracle that the problem did not show up sooner. A liquidity crisis in the financial sector is very different from one in the ‘real economy’. In a well-run company that produces goods that the market wants, a liquidity shortfall does not necessarily become a solvency problem, and the business can chug on for years. In contrast, for a financial company, the dividing line between the two is extremely thin, and balance-sheet stress (which goes to the very heart of their operating model) can create a solvency crisis in a matter of weeks. A vicious cycle can quickly shape up as asset-side issues spill over to the financial side. An additional problem is that, whereas the RBI can quickly step in to bail out banks, NBFCs are a step removed from the central bank’s purview.

Fiscal stress will dampen public investment spending

A third, critical drag on investment is a rising fiscal deficit. India’s political economy is such that, each time the state needs to shrink the deficit, it is not subsidies, other dole-outs, or government salaries that are cut, but capex. The problem is particularly acute today, because after 10 years of sub-par growth, few of the benefits have trickled down to the middle classes, let alone the poor. This creates enormous pressure for populist spending, and there is simply not enough money to fund both, large infrastructure projects and, say, a universal basic income scheme. Nor can the Centre currently spend large amounts, as it could have 3-4 years ago, to recapitalise the banks in a meaningful sense. With the entire political system broadly in alignment on what to prioritise, India will see compressed public investment spending, regardless of who comes to power.

Net-net, India will experience an investment slowdown

All considered, India is headed for an investment squeeze. The public sector has no fiscal room to spend. The private sector is seeing incipient demand, but its access to credit is limited, while foreigners have, at least since last year, been net sellers of Indian assets. In the short term, then, investment is unlikely to pick up. This will impact India’s medium-term growth prospects, because growth is a function of investment – and a slowdown in capex today shows up in the GDP numbers two years hence. Breaking this vicious cycle will require focused, exogenous action.