Fix credit growth to fix the slowdown

There is much hand-wringing over the slowdown in India’s GDP growth. The growth rate of 5.8 per cent in the last quarter of FY 2018-19, in particular, has set alarm bells ringing. Many believe the time has come for another bout of sweeping structural reforms. The responses required may well be more modest.

A slowdown in growth is not a huge surprise. Leave aside the turbulence in the world economy. We are in the midst of a banking crisis. It’s not a severe banking crisis (one where non-performing assets, or NPAs, exceed 25 per cent of all loans). And it’s not a classical banking crisis, that is, one where there are multiple banking failures. Ours is what the Economic Survey of 2016-17 called a banking crisis with “Indian characteristics”. One characteristic is that, despite a high level of NPAs in public sector banks (PSBs), none has failed.  

Because banks have not failed, the cost of the Indian banking crisis has been much less than in a classical crisis. The Indian banking crisis has merely meant a lower level of GDP growth than before the onset of the crisis. Although NPA levels at banks have started declining, the crisis is far from played out. On the contrary, the collapse of IL&FS in September 2018 signalled the spread of the crisis to non-banking finance companies (NBFCs). This is, perhaps, the most important factor in the current slowdown.

Thanks to a lack of capital and other issues at PSBs in recent years, NBFCs (and private banks) increased their share of the market. In 2017-18, NBFCs’ share of aggregate domestic resources for the commercial sector was 39.1 per cent. In 2018-19, the year of the IL&FS crisis, the share of NBFCs dropped to 26.6 per cent. This has impacted firms. 

The NBFC crisis has also seriously impacted retail lending. There are retail products in which NBFCs have had significant market share. In December 2018, the share of NBFCs in auto loans was 30 per cent; in loan against properties, 19 per cent. In Q4 of 2018-19, NBFC auto loans fell by 69 per cent relative to Q4 of the previous year; NBFC property loans were down by 47 per cent.

Banks have not been able to make up for the fall in credit provided by NBFCs. The accompanying table shows that in the fourth quarter of 2018-19, incremental credit from banks and NBFCs together fell by 17.2 per cent compared to the fourth quarter of 2017-18. The decline in NBFC credit was larger than that of bank credit.

 

Banks say they do not face enough demand for credit. We must understand why this is happening. In many retail segments, and especially in some geographical areas, banks lack the capability to substitute loans hitherto provided by NBFCs. Small and medium enterprises (SMEs) that have depended on NBFCs for loans cannot easily switch to banks to meet their requirements of credit. The decline in retail credit from NBFCs has led to cuts in production in sectors such as automobiles. This, in turn, means lower demand for working capital from banks. What appears to be weak demand for bank credit arises from a drying up of credit supply from NBFCs. 

Clearly, we need to fix credit growth if we wish to arrest the slowdown in GDP growth. In the short-term, NBFC lending is unlikely to revive strongly as the market is still sorting out the strong ones from the weak. The onus is on PSBs to find ways to significantly enhance credit to retail segments and SMEs to compensate for the drying up of credit from NBFCs. As PSBs regain market share, they will need more capital than has been provided thus far. The government must infuse the required capital — and at one go. 

How will the government find the necessary capital for banks while sticking to its fiscal deficit target? The Bimal Jalan Committee on the economic capital framework of the Reserve Bank of India (RBI) holds the key. It can recommend transfer of excess contingent reserves that can be used for recapitalising banks. Or it may recommend that excess revaluation reserves be extinguished. This would mean extinguishing some of the government debt held by RBI and opening up space for additional borrowings by the government. 

Some of the excess RBI reserves and an aggressive disinvestment programme may be used for increasing public capital expenditure. A small issue of sovereign bonds will help keep domestic bond yields low. India’s real interest rate remains among the highest in the world, so there’s scope for further reduction in the policy rate. 

Disruptive structural reforms are not the answer to the current slowdown. A strong credit push by PSBs, adequate recapitalisation of banks and counter-cyclical fiscal and monetary policies should do the trick.

The writer is a professor at IIM Ahmedabad.  ttr@iima.ac.in