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India must face up to bad debt menace

Rise in nonperforming assets threatens to derail economic growth

| India
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People queue to withdraw cash in Ahmedabad, India, on Nov. 27, 2016.   © Reuters

India, the world's fastest-growing large economy, is facing a financial double whammy. The value of nonperforming loans is high and rising, while the demand for credit is slowing, especially from the private sector, threatening to cut business investment and economic growth.

The value of banks' nonperforming assets rose to $120 billion in September, accounting for 9.1% of their aggregate loan portfolios, from 7.6% in March 2016. Overall stressed assets, including restructured loans, rose to 12.3%. State-owned banks performed even less well, with stressed loans climbing to 15.8%. Bank credit grew just 5.1% in the year to Dec. 23, the lowest in two decades.

NPAs do not generate interest for banks, which must make provisions for them. This drains liquidity and may lead to a downgrading of credit ratings. Worse, banks may be forced to write off the bad debt. Between 2013 and 2015, 29 state-owned banks wrote off 1.14 trillion rupees ($16.7 billion) of bad debt. In 2016, the State Bank of India, the country's largest state-owned bank, wrote off 70.1 billion rupees owed by 63 defaulters.

Such numbers, coupled with subdued credit demand, have adversely affected the profitability of Indian banks, while gross fixed capital formation, a key measure of investment, fell by 1.9%, 3.1% and 5.6% respectively in the last three quarters. This investment decline is likely to continue, and India may have to face lower economic growth as a result.

The rising rate of NPAs is largely due to a demand slowdown and delays in regulatory approvals -- in particular environmental clearances -- for projects, which has led to cost overruns and lower profitability than initially expected.

Just five sectors -- infrastructure and real estate, steel, textiles, power, and telecommunications -- account for three-fifths of all stressed loans. These are also the sectors most dependent on the government. Many companies in these sectors, particularly in infrastructure and steel, are fragile and could generate more NPAs.

On the other hand, banks are responsible for making bad decisions that have turned many of their assets into liabilities. For instance, there has been intense competition among banks to lure big corporate borrowers, which are easier to service and bring high bonuses for bank employees, but can be prone to payment defaults. The share of banks' overall loan portfolios and bad loans accounted for by large borrowers (those with loans of 50 million rupees or more) reached 56.5% and 88.4% respectively in September.

It does not help that bank staff generally lack the necessary skills to assess the technical and financial viability of complex projects. Since this is combined with laxity in credit risk appraisals and loan monitoring it is unsurprising that there has been an increase in subprime lending and bad loans. The third-party agencies that banks rely on to assess projects and collateral value are often under pressure from unscrupulous borrowers to support loan requests.

India's economic slowdown is in part to blame for companies' failure to repay bank loans. But underbidding for projects to beat competitors, the diversion of funds for non-sanctioned purposes and willful defaults by exploitative borrowers also help to explain the high rates of nonperforming loans.

The recent demonetization exercise, in which the government suddenly withdrew from circulation all 1,000 rupees and 500 rupees bank notes, has provided a temporary cushion for troubled banks, which have experienced a surge in deposits. However, slowing demand for credit will neutralize the benefits. Worse, banks have to pay 3% to 4% interest on these deposits.

Loan frauds

New Delhi has introduced a series of measures intended to deal with the bad debts problem. The most important is the enactment of a bankruptcy and insolvency code, which is expected to ensure quicker resolution of problem loans. It will also discourage loan frauds and the diversion of funds.

The government, the major shareholder in the state-owned banks, could consider recapitalization to boost the banks' balance sheets. However, recapitalization is at best a short-term measure for dealing with liquidity issues, and it might not work in an environment in which there is little demand for new loans.

Businesses have been slow to expand and reinvest because of concerns about lackluster consumer demand for goods and services. The bureaucracy that surrounds business in India can also deter investors. The government says it is committed to improving India's global ranking in terms of the ease of doing business, but it has not met with much success.

Many experts have floated the idea of setting up a specialized bank to take over bad debts. That would reduce banks' provisioning requirements and unblock capital flows. But there is a major problem: Given the size of India's bad loans, a "bad bank" would require huge capital resources to acquire them. That would be challenging for the government to finance, and may explain its reservations about the idea.

The central bank, the Reserve Bank of India, has also devised measures to help banks deal with bad loans. It allows troubled banks to explore the option of a so-called "scheme for sustainable structuring of stressed assets," known to bankers as S4A.

Under this scheme, the liabilities of borrowers are separated into sustainable and unsustainable debt, with the latter converted into equity. The equity stake is then sold to a new owner, who has the advantage of running the company with lower and more manageable debt. Banks could clean up a large portion of their loan books this way. However, they might have to take "haircuts" of up to 50% because the market value of the unsustainable debt would probably be lower than its book value.

Another possibility is strategic debt restructuring, under which a lender bank converts its stressed debt in a company into equity, acquires a majority stake and takes management control. However, an even bigger haircut is likely than under S4A. Indian banks are also inexperienced in running businesses. As a result, this form of restructuring has not taken off.

There are some things that banks themselves can do to offset bad debt. One would be to give more loans to small borrowers to reduce their reliance on large ones. Unless banks become more cost-effective, lending more money to small borrowers would reduce operating margins and profitability. Yet banks need to swallow this bitter pill if they are serious about curbing NPAs.

It is important to realize that unless the system of credit sanctioning and post-credit monitoring improves, bad loans will continue to proliferate. Loans should be given purely on commercial considerations. The government should have no influence over who gets a bank loan; such decisions should be made by banks after an independent assessment of loan proposals. Banks must also monitor how the loans are used, to ensure that the funds are not diverted from their original purpose.

Moreover, the RBI or the government should disclose the names of willful defaulters as a preventative measure. The RBI should also analyze which sectors are contributing most to NPAs, identify any systemic failures and suggest ways to help. Initiatives such as these are essential to stop the growing menace of bad loans turning into a crisis.

Ritesh Kumar Singh is a corporate economist and former assistant director of the Finance Commission of India.

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