Is India Sliding Into A Banking Crisis?

India may well be quietly sliding into a banking crisis. The revealed non-performing loans (NPLs) are over $50 billion but could be as high as $200 billion — just under 10 per cent of GDP and rising. If the banking problems are handled badly and if the global factors worsen, India could be headed for a full-blown banking crisis, and the rupee could appreciate to 80 against the US dollar or even higher.

The finance minister was under pressure to sacrifice fiscal consolidation for growth. That he did not is good, because with jittery global markets, the fiscal space he would have gained would have quickly eroded if portfolio outflows led to a weaker rupee. A weaker rupee has negative fiscal effects.

Unfortunately, Budget 2016 was unable to maintain the momentum on public investment we saw last year. The government hopes to get more public investment through public-private partnerships and by urging PSUs to invest more. It also hopes to raise more funding through the bond market. But all this remains uncertain. 

The budget allocation of Rs 20,000 crore to deal with stressed assets is minuscule. A quick clean-up may require a level of funding which only an IMF programme could provide but which the NDA government may not like to take on politically - especially when it has touted India as the best performing global economy. But without a quick clean-up genuine recovery will be inordinately delayed.

Perhaps, the festering problems of the banking and corporate sectors would have been recognised earlier had we not been seduced by upward revision in the new GDP figures. With the gross investment rate in 2015-16 falling below 30 per cent of GDP for the first time since 2006-7, and with many physical indicators slowing down, the need to review the new GDP numbers becomes acute. If India’s GDP is growing at around 7.5 per cent then with a net investment rate of around 25 per cent of GDP, the incremental capital output ratio is under 4 — an unbelievably low number for a developing economy with large infrastructure. This means the economy is growing much slower than indicated by the new GDP growth rates.

India is now growing on one engine: private consumption; private investment, exports and public investment are unlikely to increase in 2016-17. In 2015-16 much of the decline in oil prices was captured by the government to meet its fiscal deficit target of 3.9 per cent of GDP. Had this oil windfall been passed on to consumers the boost in private consumption would have helped economic recovery.

Going forward, the RBI could help by lowering interest rates, which may not increase investment but would boost private consumption. A good monsoon, larger allocations for the rural sector would also help increase rural demand. But if the recovery remains tepid for another year, the NPL problem will only grow larger.

India must remember that the 1997 Asian financial crisis was exacerbated by tight monetary policy, forced on by IMF conditionality. The RBI is right in pushing the banks to come clean on their NPLs but must lower interest rates and ease liquidity in the system.

The government is in no position to cover the fiscal costs of a swift banking sector clean-up. So it hopes to rely on bank consolidation and mergers. But this approach can work for one or two banks, not the entire public banking sector. If the NPL problem continues to grow and the recovery remains weak, India could slowly slide into a crisis just like we did in 1991. Perhaps then and only then will we get the vital structural reforms that are badly needed to boost the economy.

The NDA government did not create these problems; it inherited them from the UPA. But by delaying the banks’ clean-up it risks delaying the recovery and ending up into a larger crisis than was warranted. Time to bite the bullet.