1. Demonetisation: Liquidity problem may worsen bank NPAs as SMEs face crisis of repayment

Demonetisation: Liquidity problem may worsen bank NPAs as SMEs face crisis of repayment

The surprise demonetisation resulted in an extraordinary amount of funds available to banks, albeit for a short period.

Published: December 27, 2016 6:40 AM
demonetisation, banks, non-performing assets, (AQR), RBI, GNPA The surprise demonetisation resulted in an extraordinary amount of funds available to banks, albeit for a short period. (Source: PTI)

The surprise demonetisation resulted in an extraordinary amount of funds available to banks, albeit for a short period. However, demonetisation will affect the banking sector in terms of non-performing assets (NPA), particularly in the context of last week’s bimonthly Monetary Policy Statement. Last year, in the August-November period, a special inspection was conducted in the form of an asset quality review (AQR) with the aim of asset reclassification. The former RBI governor, Raghuram Rajan, was committed to cleaning up the balance sheet by the end of FY16; banks were given the last two quarters of FY16 to do asset classification, which resulted in an increase in NPAs in FY16 of 79.7%.

In the four quarters since September 2015, banking sector gross non-performing assets (GNPA) increased sharply from R3.51 trillion to R6.73 trillion. Many large lenders bore record losses, like SBI (R1.6 trillion), PNB (R0.57 trillion), and Bank of India (R0.52 trillion). The recent demonetisation will slow the pace of rising NPAs.

However, once the economy returns to normalcy, there may be a rise in NPAs, and a fresh cycle would emerge. According to the Financial Stability Report published in June 2016, the GNPA ratio rose sharply from 5.1% in September 2015 to 7.6% in March 2016; and, if the macro situation deteriorates, it may rise to 9.3% by March 2017. Given the negative impact of demonetisation on economic activity, it could manifest in the balance sheets of banks, and a similar rise in NPAs can be anticipated. Following demonetisation, there has been a huge influx of funds into banks, which have been lending to RBI under the reverse repo option, mostly the variable reverse repo option.

Currently, the fixed reverse repo rate is 5.75%. It is expected that, due to the excess funds available with banks, the reverse repo rate will converge to the repo rate. This can be a huge boost for banks, at least in the short run, as they can gain from the interest rate spread of around 1.5 to 2%.

However, Bloomberg data highlights that RBI has around R5.2 trillion outstanding in the reverse repo option. The amount deposited in banks has already crossed around R13.11 trillion. Hence, banks will have to resort to other tools. To tackle the plethora of deposits, there are four conventional monetary tools—cash reserve ratio (CRR), reverse repo auctions, open market operations (OMO), and market stabilisation scheme (MSS). Of these, the CRR is preferred the most by RBI, since it does not have to pay any interest on the amount deposited.

Earlier, RBI imposed an incremental CRR of 100% for all deposits they received between September 16 and November 11. Under the OMO and the MSS, government securities are issued to soak up liquidity. The OMO is more useful if the action is targeted for a long-term plan but, given the huge liquidity with banks, it suffers from the supply constraint. Since the policy rate was unchanged in the fifth bimonthly monetary policy for FY17 on December 8, investment is not expected to pick up due to subdued demand—despite the extraordinary amount of funds available with banks.

The slowing of economic activity, and less liquidity with the public and firms, will hamper the Make-in-India initiative, which has a lot of start-ups which are now faced with money crunch. Small- and medium-sized enterprises and a high percentage of start-ups (excluding e-commerce start-ups) have already experienced a slowdown in funding and expansion.

The liquidity crunch will also delay outstanding investment projects, and might actually lead to an increase in NPAs, as small and medium-sized enterprises cannot repay loans. RBI accepts that there would be a “loss of growth momentum” in the economy following the government’s surprising recall of high-value notes. While it has kept the policy rate at 6.25% and the CRR at 4%, it has reduced its gross value added forecast for FY17 to 7.1% from 7.6% earlier. But it has also said that the incremental cash reserve requirements will be discontinued with effect from December 10.

Instead, to absorb the excess liquidity, a mix of MSS issuances and liquidity adjustment facility will be used. Earlier, analysts and economists widely expected the Monetary Policy Committee (MPC) to reduce the policy rate by 25 basis points to counter the possible contractionary impact of demonetisation.

The sentiment had already soared after manufacturing PMI decelerated sharply in November. Therefore, it was expected that RBI Governor Urjit Patel and a newly formed MPC would cut the rate by at least 25 basis points to account for the impact of demonetisation and arrest the downside risk to growth. A good monsoon has already kept food inflation in check. Given the drop in retail inflation to 4.2% and in wholesale inflation to 3.39%, RBI’s objective of containing consumer price index inflation at 5% by Q4 of FY17 seems easily attainable.

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RBI expects that demonetisation would result in a temporary reduction in inflation by 10-15 basis points for Q3. Hence, a rate cut would have boosted the sentiments in the economy and maintained the inflation target. So what could be the reasons for maintaining the status quo? According to RBI’s MPC, the effect of demonetisation will be transitory and food inflation might re-emerge in the winters. Also, since the Organisation of the Petroleum Exporting Countries (OPEC) has agreed to cut production, there may be a rise in crude prices in the future and in its volatility, thereby feeding into inflation. Anyway, RBI’s mandate is to maintain inflation at 4% (+/- 2%). Since the policy rate will remain unchanged for at least another two months, the reduction in the overall investment rate will reduce the potential growth of the economy.

To counter the effects of a contractionary monetary policy and the recent demonetisation, the government should come up with some measures of fiscal stimulus to increase activity. An expansionary fiscal policy will help increase investment and bring the economy back on track, but the fiscal space for stimulus is limited. Pravakar Sahoo is professor, Institute of Economic Growth, Delhi. Bhavesh Garg is researcher, Indian Institute of Technology, Hyderabad.

Views are personal.

Authored By: Pravakar Sahoo & Bhavesh Garg

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