1. As bank credit falters, how worried should we be?

As bank credit falters, how worried should we be?

Are Indian corporates credit starved? Looking at the recent trend in bank credit to industry and services, any one would tend to agree with such a notion.

By: | Published: March 29, 2017 5:07 AM
In a historical context, such a trend should have been alarming, triggering anxiety about the banking sector’s health and its ability to support business investment. (Reuters)

Are Indian corporates credit starved? Looking at the recent trend in bank credit to industry and services, any one would tend to agree with such a notion. It is common knowledge that Indian corporates rely heavily upon banks to finance their investments, whereas banks’ outstanding credit to these sectors has contracted by 2.2% in January 2017. In a historical context, such a trend should have been alarming, triggering anxiety about the banking sector’s health and its ability to support business investment. But we are living through two different narratives: one, that there isn’t much corporate demand for credit and banks should be able to finance that, whenever it revives; the other is that non-bank sources of funds have been mitigating the credit deficits to a large extent. Subscribers to the first narrative point out the high excess capacity in manufacturing, and believe the economy is driven by private consumption, manifest in robust growth of personal loan portfolios.

Supporters of the second narrative look at the strong growth in corporate bonds’ and some pockets of non-bank finance companies (NBFCs). It is quite possible that both narratives have some degree of truth. But concerns persist: Will banks be able to finance when demand recovers? Doubts certainly arise seeing their weak balance sheets, the rise in NPAs, especially of the dominant public sector banks. If not, will non-bank sources be able to fill the financing gaps? Here, we take a closer look at the emerging trend of resource flow to industry and services, excluding agriculture and personal consumption.

The accompanying table presents outstanding resource flows—bank credit, corporate bonds, commercial papers and ECBs, but doesn’t include financing by NBFCs as comprehensive sector-wise loan data isn’t available. Bank and non-bank funds are aggregated to get a better macro view; absolute magnitudes, and that scaled with respect to GDP, are both presented for a better sense on evolution of trends in the last four years. We believe a larger chunk of NBFC finance goes toward financing consumption, especially towards personal loan, and will not materially alter the macro picture. We must also flag that after 2013, RBI stopped providing a very useful, informative table containing total flow of financial resources to the commercial sector, which would have been handy for any such assessment.

Decline in bank credit not offset by pickup in non-bank resources

The broad picture is that the fall in bank credit is not offset by rise in non-bank funding. Total financial flows to commercial sector are substantially lower this year. The key takeaways are:

*Aggregate financial flows as percent to GDP are 3.6 percentage points lower this year (January 2017 over March 2014). The drop is far sharper, 3.9 points, relative to FY16. This update is supported by RBI’s own assessment in October 2016 (Monetary Policy Report: pg. 31) when it observed that that credit growth was sluggish in the first half of FY17, and also subdued were non-banking sources of funding for the commercial sector, foreign as well as domestic. Qualifying the impact of bad loan write-offs/sales to asset reconstruction companies and UDAY bond issuances, RBI said that after adjusting for latter, non-food credit flow in H1-FY17 (up to September 16, 2016) was at comparable levels as the previous year, while the total flow of resources to commercial sector was 15% lower.

*Non-bank resource shares in GDP rose 3.3 percentage points in January 2017 over March 2014. This is less than half the fall in bank credit/GDP, which plunged 6.9 points in this period. n The biggest drop in bank credit/GDP occurred this year (January 2017 over March 2016)—3.84 points, more than double the decline in previous year (March 2016 over March 2015).

*The 6.9 percentage point drop in bank credit/GDP is almost double the 3.6 point increase in two major nonbank sources of corporate financing, viz. bonds and commercial paper, relative to GDP.

*Corporate bonds/GDP too slowed incremental pace in April-December 2017, even as their share is 1.9 points higher over March 2014 ratio. Commercial paper issues have increased 1.7 points in the matching period, while their incremental pace is steadier.

Can corporate bond financing sustain?

With the entire buzz about corporate bonds as the emerging source of financing that may even displace the primacy of bank credit, what are the prospects? Two developments raise disquiet and scepticism that its strong growth will sustain. One, corporate bond defaults have risen sharply in 2016, as seen from the jump in non-performing asset portfolio of LIC, the biggest buyer of debentures and bonds. Recent reports show that LIC’s non-performing debt increased 40% in three quarters following banks’ NPA-recognition exercise directed by RBI; gross NPAs rose to 5.19% by December 2016 from 3.76% in March 2016. What is serious here is that defaulting firms in LIC’s debt-book are the same that are NPAs in banks’ loan books. This reflects contagion from loan defaults to defaults on coupon repayments (bonds) or from banks to the insurer.

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Note that LIC is also exposed to banks through equity holdings: at 9.21% average stake in public and private banks, it is the second-largest shareholder after the government, facing contagion risk from value erosion too; it can also be a source of market contagion in the event of large-scale sales. Setting aside financial instability risks, the pertinent issue here is that rising defaults are bound to trigger caution, meaning low appetite, risk-aversion and saturating demand for corporate bonds. Two, corporate bond growth has been supported by increase in FPIs’ buying limits ($51 billion), of which only R594 billion, or 0.4% of GDP, remains to be used. The scope for FPI purchases is thus limited, unless the cap is raised. Constraints of currency appreciation and the capital flows cycle, currently on a roll, govern such revisions.

Banks must recover quickly, resume lending

Given the evolving pattern of aggregate financial flows to commercial sector and question marks over sustainability of corporate bond financing, a standstill in NPA-induced stress and consequent lending freeze can be ill-allowed to persist. Contrary to common perception, alternate or nonbank sources of funding have not offset the decline in bank credit. These developments also coincide with the new framework for large borrowers from April 2017: banks have to make more provisions and assign higher risk weights for ‘specified borrowers’, viz. outstanding loan limits of R250 billion in FY18, R150 billion in FY19 and R100 billion at start of FY20. Banks need to recover quickly and resume lending.

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