The latest Financial Stability Report (FSR) from the RBI has given the banking system a reasonably healthy bill of health. This is a significant achievement, given the stress of the previous decade, the shock of the pandemic and the associated economic downturn. However, improving bank finances is a half-full picture. It remains unclear whether the banking system is sound enough to provide the sustained credit growth needed for a strong economic recovery.
Two key indicators bear witness to the progress of the banking system. Successive waves of recapitalization have given banks enough resources to write off most of their bad debts. As a result, they were able to reduce their gross NPAs (non-performing loans) from 11% of total advances in 2017-18 to 5.9% in 2021-22. NPAs for industrial credit have been cut even more drastically, from 23% to 8.4%. Even after these large write-offs, most banks maintain comfortable capital levels.
This financial recovery has given banks the space to resume their credit-granting activity. During the decade the banks were in trouble, the growth of non-food bank credit had declined, reaching just 6% in 2020, its lowest point in six decades. Since then, credit growth has nearly doubled.
These are the visible signs of a healthier banking system. However, the broad aggregates mask a worrying picture, raising questions about the role bank credit will play in supporting GDP growth. The problem is that very few of these credits go to big industry or investment financing.
Consider first the sectoral distribution of credit. Over the past decade, banks have increasingly shifted away from providing credit to industry, favoring consumer lending instead. As a result, the share of industry in total bank credit fell from 43% in 2010 to 30% in 2020, while that of consumer credit fell from 19% to 29%. This trend continues – in the year ending March 2022, consumer loans grew by 13%, while industrial loans only increased by 8%.
The bulk of lending to industry has gone to small businesses (MSMEs), which have benefited from the credit guarantee scheme offered by the government in the wake of the pandemic. Growth in loans to MSMEs increased from 3% in 2020 to 31% in 2022. In contrast, loans to large industries have stagnated in nominal terms over the past two years, meaning that they have fallen sharply in terms real.
A related problem is that there have been few loans for private sector investments. Over the past year, bank lending to infrastructure has increased by 9%, compared to 3% in 2020, but this has been mainly fueled by public sector capital spending. Meanwhile, much of the lending to private industry took the form of working capital loans, necessitated by rising commodity prices, which led to a sharp increase in the cost of holding inventory.
Why are there so few large business investment loans? Both demand and supply factors seem to be at work. On the demand side, private sector investment has stagnated for almost a decade. The ups and downs of the mid-2000s burdened companies with excess capacity, giving them little reason to expand production facilities. Furthermore, the global financial crisis has shown the dangers of ambitious expansion backed by excessive borrowing, leading companies to conclude that it would be prudent to scale back their plans and instead focus on debt reduction. .
On the supply side, banks have learned similar lessons. During the period 2004-2009, the rapid GDP growth of the Indian economy was fueled by an unprecedented credit boom. Credit has doubled in the space of a few years, mainly thanks to loans granted to large infrastructure projects. Subsequently, many of these loans became bad, resulting in high levels of NPAs on bank balance sheets. Because of these financial problems, the banks were unable to extend much credit for a decade. Even when their health improved, they remained reluctant to lend to large-scale industrial projects, preferring instead to turn to smaller-scale, less risky consumer loans.
This situation of risk aversion on the part of companies and banks has not changed significantly during the post-pandemic recovery.
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On the positive side, companies seem to have finally used up a lot of their spare capacity. But on the negative side, the fundamental problems that led to the difficulties of the past decade have still not been resolved. There is still no framework that reduces the risk of private sector investment in infrastructure, certainly not in the critical and very troubled power sector. There is also no assurance for banks that if problems arise they can be resolved quickly, since the Insolvency and Bankruptcy Code has been plagued with delays and other problems. . Today, heightened global macroeconomic uncertainty, growing geopolitical tensions and uncertain recovery prospects for the domestic economy are likely to make matters worse.
In other words, a healthy balance sheet of the banking sector is a necessary but not sufficient condition for economic growth. The important question is whether banks and companies will once again be ready to take on the risk of investing in industry and infrastructure. And that seems unlikely unless there are deep structural reforms – of the infrastructure framework, of the resolution process and, indeed, of the risk management processes of the banks themselves. If these reforms do not materialize, shortfalls in credit, investment, and ultimately economic recovery and growth could persist.
The author is Associate Professor of Economics, IGIDR