Funding Growth: India needs an optimal financial architecture

This could reduce the fiscal burden and enhance the role of the private sector in driving growth with lower overall cost of capital

However, it is critical that growth be driven by credit to the private sector rather than government debt.
However, it is critical that growth be driven by credit to the private sector rather than government debt.

By Ajit Pai & Gaurav Sharma

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Globally, debt has played a crucial role in driving GDP growth. Considering incremental debt to incremental GDP, India’s 5-year ratio for 2020, at 233%, compares favourably with China (421%) and the largest OECD economies. With debt still being relatively more accretive to growth than for most large economies, that India still has significant headroom for total debt is reassuring. However, it is critical that growth be driven by credit to the private sector rather than government debt.

Per the World Bank, India’s domestic credit to private sector, at 55% of GDP in 2020, is below the world average (148%), and lowest among Asian peers—China (182%), South Korea (165%), and Vietnam (148%). India’s government debt to GDP, 90% in 2020, is considerably higher than China’s (68%), South Korea’s (48%), Vietnam’s (46%) and the average for developing economies (64%).

High government debt to GDP has led to high cost of capital as the yield on government debt forms the basis of interest rates prevailing in the economy. Elevated government debt at high interest rates puts pressure on the fisc and drives overall interest rates up. Interest payments are estimated at ~24% of government’s total expenditure and ~49% of revenue receipts in FY23 (BE). Effective interest rates estimated to increase to 6.9% from 6.7% in FY22(RE) implies additional fiscal burden of >`1,100 crore. Recent trends of rising yields could potentially double or triple this. An optimal financial architecture would reduce the fiscal burden and enhance the role of private sector with a lower overall cost of capital. The three main sources of private debt—banks, NBFCs, and corporate bond markets—are sub-optimally utilised in India.

A critical factor dampening India’s economic growth has been the increasing gap between the demand and supply of credit to MSMEs, estimated at `20-25 trillion by the UK Sinha Committee in 2019. The Centre has targeted enhancing MSME contribution in GDP to 50%, in exports to 60%, and five crore additional jobs by 2025. Achieving these will depend on accelerating credit to MSMEs.

Two major deterrents have hindered MSME’s scaling and greater access to formal credit. First, priority sector lending for banks with sub-targets for micro and small enterprises (till 2015) and micro enterprises (thereafter) has disincentivised MSMEs from scaling up. Those that increased scale faced greater challenges in access to credit. Outstanding bank advances to industry show the share of medium enterprises fell from 13.5% in 2007 to 4.3% in 2020. The 2020 change in MSME definition is a big move forward, but a more balanced approach in credit delivery for medium enterprises is also needed. Second, a small number of large accounts (above Rs 100 crore) dominate bank credit. In FY21, there were a total of only 11,790 accounts above Rs 100 crore compared to 29.8 crore accounts below. While the former category comprises only 0.004% of the latter, its credit limit and total amount outstanding is more than double. This reflects the “lazy banking” focus on big loans, leading to crowding out of MSMEs. Accelerating transition of large companies to corporate bonds can shift banks’ focus to MSME credit.

Sebi, via its November 2018 circular, implemented a new borrowing framework for large listed corporates (outstanding long-term borrowing of Rs 100 crore or above), mandating not less than 25% of incremental borrowing via issue of debt securities. This recognises the problem, but creates greater constraints and lower flexibility for scaling enterprises. Better-aligned solutions should be considered for accelerating MSME financing while also strengthening the corporate bond market. India’s corporate bond market penetration (total bonds outstanding/GDP), at 16% of GDP, remains well below South Korea (87%), Malaysia (57%), and China (36%).

India’s corporate bond market needs greater breadth with focus on all categories of investment grade bonds. AAA- & AA-bonds account for more than 90% of outstanding ones. A- & BBB-bonds constitute less than 10%, compared to more than 60% in the US, the EU, and Japan. Two interventions can help. First, a government scheme of first-loss guarantee for A- and BBB-rated issuers can accelerate investor interest and encourage issuers with lower borrowing costs. At current revenue buoyancy, this could be accretive to the Centre if designed right. Second, investment regulations of mutual funds, insurance, and pension companies need to encourage greater investment in A- & BBB-bonds up to reasonable limits. This could improve risk-adjusted returns of portfolios while accelerating the underlying economy’s growth. Steps towards an optimal financial architecture can help India sustain high economic growth with a lower share of government debt, driving private sector scaling and competitiveness. Financing needs of both MSMEs and large enterprises can be fulfilled faster along with rapid growth and balanced development of the financial sector.

Respectively, distinguished expert, and senior specialist, NITI Aayog Views are personal

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