Buoyant Indian markets mask banking sector woes
Lack of progress on cleaning up bad loans contributes to stagnant credit growth
India has become a tale of two halves.
The first half, and the one which has received the most attention since Prime Minister Narendra Modi's stunning 2014 election victory, has been the resilience of India's financial markets.
Despite numerous external shocks, including the turmoil that followed the surprise devaluation of China's currency in August 2015 and the upset victory of Donald Trump in last November's U.S. presidential election, investor sentiment toward India has held up remarkably well.
Over the past three years, Indian equities have risen nearly 7% in dollar terms, compared with an almost 1% decline for emerging market stocks overall. The Indian rupee, moreover, has been one of the most stable developing-market currencies. Since the peak of the "taper tantrum" in August 2013 following the U.S. Federal Reserve's unexpected decision to start scaling back asset purchases, the currency has strengthened 2.5% against the dollar. The Malaysian ringgit and the Indonesian rupiah, by contrast, have fallen 31% and 19% respectively.
In government debt markets, the yield on 10-year rupee bonds has fallen from more than 9% at the end of 2013 to just below 7%. According to JPMorgan Chase, foreign investors purchased more than $4 billion of Indian domestic debt in March, surpassing the previous monthly record set in January 2015.
The second half of the India story, which has been eclipsed by the first, is the persistent deterioration in Indian bank asset quality, in particular that of state-owned lenders which still account for nearly three-quarters of sector assets.
According to the International Monetary Fund, India's economy expanded a brisk 6.8% last year, outpacing China and cementing the country's status as the world's fastest growing major economy. This growth was led by private consumption.
Investment, which has slowed sharply since mid-2015, is now contracting because of excess capacity in key industries, including metals and mining, construction and infrastructure. This in turn has contributed to a build-up of corporate debt.
With the corporate sector accounting for 40% of bank loan portfolios, a "twin balance sheet problem" has emerged and has been allowed to fester. Overleveraged companies and banks encumbered with bad loans have created a dangerous feedback loop that has proved difficult to break. This predicament has given rise to the world's highest share of stressed assets -- nonperforming loans, assets under restructuring and unrecognized stressed assets. These together represent nearly 17% of outstanding loans, according to the Indian government. Four-fifths of these are held by public banks.
The good news is that the Reserve Bank of India has forced lenders to start cleaning up their books. An asset quality review launched in December 2015 by then central bank governor Raghuram Rajan "has led to a considerable uptick in the recognition of nonperforming assets," according to a review of the Indian economy published by the IMF in February. Just as importantly, India's parliament passed the country's first national bankruptcy law last year, which should help speed up the debt-recovery process.
The bad news is that while recognition of problem loans has improved markedly, the debt resolution and bank recapitalization processes have made little headway. Both are vital to restructuring and reducing leverage in the corporate sector, putting India's banks on a firmer footing and restoring credit growth. Loan growth in real terms is now negative and is the lowest it has been for 23 years, according to government data.
The nub of the problem is the reluctance of Modi's government to grasp the nettle of banking reform.
A proposal outlined in the finance ministry's annual economic survey in January by Arvind Subramanian, Modi's chief economic adviser, for setting up a state-run "bad bank" would overcome most of the obstacles currently plaguing loan resolution and remove bad debt from the books of the public lenders but has received short shrift from the government. On May 2, the deputy head of Niti Aayog, the government's policy planning body, said the creation of a bad bank could "easily result in the loss of valuable time," even though previous efforts, which favored a decentralized and market-based approach, have failed.
The government has shied away from providing more funds to recapitalize the state-dominated banking sector, fearful that this could create a disincentive for public lenders to improve their governance standards.
In the annual budget announced in February, the government said it would inject $1.5 billion into the state banking sector in the year to March 2018 as part of a four-year, $11 billion recapitalization program. Yet Fitch, a credit rating agency, claims the sector needs as much as $90 billion in fresh capital to meet so-called Basel III capital requirements.
Investors have shown no signs of losing confidence in India's banking sector, mainly because rot is concentrated in state banks and government resources are more than adequate to rescue the lenders if necessary. But a dangerous disconnect has emerged between the bullishness in the markets and the increasing fragility of an economy in which the debt-laden private sector has stopped investing.
Indeed, the persistence of the twin balance sheet problem is indicative of Modi's patchy reform record since he took the reins of India's economy. Even his boldest initiative -- the overnight cancellation of 86% of India's banknotes in November in an effort to stamp out corruption and push more businesses into formal channels -- remains the subject of intense debate given the disruptive and far-reaching nature of demonetization.
For those investors who have piled into Indian assets because of expectations of comprehensive reforms, the parlous state of the country's banking system should be reason enough to be more cautious.
Nicholas Spiro is a partner at Lauressa Advisory, a specialist macroeconomic and property consultancy in London.