Indian banks, and consequently the entire banking system, have managed to attract criticism on the back of rising non-performing loans (NPLs)—to the extent that any mention on Indian banking in the global arena is mainly regarding NPLs and restructured loans. The inherent strengths of the retail deposit backed banking system and a two-century-old track record of no bank failures have receded into the oblivion. Let us examine whether the so-called NPL crisis is really a crisis situation.
To understand NPLs we need to understand what major asset classes contribute to NPLs. The key NPL components can be classified into three broad asset categories: (1) cyclical industries, (2) infrastructure and (3) single name exposures or concentration risk.
Cyclical industries (moderate to low risk): Loans to cyclical industries account for nearly 60% of the total bank loans in the system. With the economic boom that India experienced during 2004-10 and attendant euphoria, the industry saw new capacity build up, overseas acquisitions and, of course, hunger for testing new derivative instruments. Unfortunately, a lot of it came on the back of debt and not counter-weighed by promoter equity. There were underlying assumptions of GDP floor rates of 6% or so and lower growth rates were assumed to be unthinkable. Demand from demographic profile of the population was overestimated. All in all, the margin of error left was very limited. Come 2011, the eurozone crisis strikes, export demand begins to taper off and NPL saga begins. High leverage across most industries, rapidly falling free cash flow (FCF)—those industries that grew faster than system average have higher NPL—and stretched working capital cycle simply accelerated the NPL build up. The key was lower demand and inability to pass on increased costs.
Today, the eurozone is poised to come out of depression. Export demand is beginning to pick up, especially in the textile sector. Auto and auto ancillary are likely to see increased demand on the back of 4%-plus agriculture growth. Cement, steel, construction being laggards will take a couple of quarters more to react. Corporates have taken a cue and have ploughed back profits, sold some assets, reduced debt