I4I recently organised a panel discussion on ‘Financing Development in India’ with Prachi Mishra (Goldman Sachs), Andy Mukherjee (Bloomberg), and Ananth Narayan (SPJIMR). The discussion was moderated by Pronab Sen (IGC India). The panellists discussed the current economic slowdown in the Indian economy and crisis in the banking and NBFC sectors, and what might be done to address the problems.
Financing development in India: Introduction and context
[For a detailed discussion of the issues, please see: https://www.ideasforindia.in/topics/macroeconomics/i4i-event-panel-discussion-on-financing-development-in-india.html]
Shadow banking: Getting benefits while managing risks
Discussing the ongoing crisis in India’s NBFC (non-banking financial companies) or shadow banking sector, Minouche Shafik provided global context on shadow banking – what it encompasses, and associated issues. She explained that shadow banking is a catchall phrase for financial sector activity that occurs outside the regulatory perimeter; when regulation increased after the Global Financial Crisis (GFC) much financial activity migrated to the shadows. While it sounds ‘shady’ it also includes various good things such as microfinance institutions that cater to those otherwise unbanked, and specialised infrastructure finance companies.
There is concern around shadow banking because of how enormously and quickly it has grown – at about 8.5% a year since GFC, now representing 14% of global financial assets (Financial Stability Board).
NBFCs in India have been borrowing short term from banks and using commercial paper, and lending for long-term projects. The country had a near-Lehman moment in September 2018 when a leading infrastructure finance company IL&FS (Infrastructure Leasing & Financial Services) defaulted on payments to lenders, making people nervous.
Now, the question for the world, and particularly for India, is how we can get the benefits of shadow banking, while managing the risks. Shafik provided four broad lessons based on her experience at the Bank of England: First, there should be visibility of shadow banking activities so that central banks and regulators know what is going on and can assess when the risks may spill over to the rest of the financial system. Second, shadow banks should be kept away from depositors to avoid political pressure of bailout if they fail. Third, contagion to the rest of the financial system should be avoided by making sure that the links to deposit-taking institutions are minimal and managed carefully. Finally, it is important to have orderly failure regimes.
Current economic slowdown: Macroeconomic context
Based on a ‘current activity indicator’ of Goldman Sachs, Prachi Mishra contended that India’s current economic slowdown dates back to January 2018, pre-dating the NBFC crisis. Comparing with four previous episodes of slowdown since 2005-06, including GFC and demonetisation, the current episode looks different in that it is very protracted and it is not yet clear how and when recovery might take place. This slowdown is highly concentrated in consumption, whereas the earlier ones were driven more by capital expenditure (capex), with the exception of demonetisation. It is however shallower than the earlier episodes, and policy responses have been less aggressive.
Various factors are responsible for the current slowdown, and have compounded one another: global conditions, sharp decline in consumer confidence, and a negative central government fiscal impulse in this period.
Looking at the heydays of the Indian economy when it was growing at 8-9% and now, Mishra said that the main difference is investment. The investment slowdown is explained by global factors such as weaker exports but also domestic conditions including a sharp decline in corporate profitability, funding constraints, and issues around environmental clearances and land acquisition. Going forward, a tiny pick-up is seen, which is entirely driven by public capex whereas private capex continues to be very subdued.
As far as the growth outlook is concerned, Goldman Sachs has successively cut down forecasts and for the current financial year, it is about 6%. This assumes significant further easing of financial conditions and some pick-up in confidence over the course of the year based on government announcements.
Risks to the growth forecasts are clearly titled to the downside. Lending by NBFCs has slowed on account of reduced demand for credit, added regulatory constraints by the Reserve Bank of India (RBI), and a general lack of confidence and risk aversion in the market.
Pressing need for structural reforms
According to Ananth Narayan, there is a strong structural element to the current slowdown and the need of the hour is structural reform and not just stimulus. In fact, stimulus without reform may lead to more trouble.
The banking and non-banking system is clearly in a mess. While some good work has been done in terms of recognition of bank NPAs (non-performing assets), the resolution process is painfully slow and Rs. 2.4 trillion of more NPAs are expected to come up (Credit Suisse). In his view, the MUDRA (Micro Units Development & Refinance Agency) programme is only going to add to the NPA problem. We are still far from banking reforms; public sector bankers need to be given a lot more autonomy in the conduct of operations.
If banking is in a mess, NBFCs are in an even bigger mess and we have not even started with the recognition of that. The Financial Stability Report of the RBI says that there are 6.1% of gross NPAs in NBFCs (the corresponding figure for banks is 9.3%) as of March 2019. This is hard to believe because NBFCs lend to sectors that are more risky than banks.
Several other sectors such as power, airlines, shipping, real estate, and telecommunications are in dire need of structural reforms. Speaking of manufacturing, with supply chains moving out of China, India should be in a good spot. However, constraints such as inflexible labour laws, poor port infrastructure and connectivity deter factories from being set up in India.
The problem with all these huge reforms is exactly that – it is too huge. Instead of thinking of ‘boiling the ocean’, we try for short-term fixes to crises. If we can get the hard reforms right, none of these problems are unsolvable and in fact, can easily be converted into opportunities.
It may be argued that reforms will take a long time and we do need fiscal and/or monetary stimulus at the moment to get us out of this morass. However, the problem is that the quality and extent of our fiscal deficit is already far worse than is acknowledged.
3Cs challenge: Collateral, counterparties, and cash flows
Andy Mukherjee framed the issue of financing development in India as a three-pronged challenge of collateral, counterparties, and cash flows. The first problem with collateral is that so much of it is trapped: there are known to be US$ 200 billion of NPLs (non-performing loans) in the banking system alone, and even more hiding in the NBFC sector.
Behind these bad loans are real assets such as power plants, steel mills, residential real estate, and so on. The Insolvency and Bankruptcy Code (IBC), 2016 has been in place for three years now and the recovery rate is 42%. While this is an improvement, we should not lose sight of the fact that the global steel cycle turning for the better may have artificially inflating recoveries. Rs. 2.4 trillion of debt held by 16 companies is currently being decided outside of IBC for out-of-court restructuring. Almost half of this has been extended from banks to NBFCs that have very little real assets and hence, the recovery rate is likely to be low.
Further, collateral is pledged to weak hands. Around 2015-16 when banks started retreating from lending, NBFCs rushed in and became big shadow banks. Another important shadow bank that does not get mentioned very often is households. In the top seven Indian cities, the housing stock that has been sold but is stalled is already worth US$15 billion – 50% more than the magnitude of the IL&FS crisis. In Mukherjee’s view, this wealth shock may have something to do with the consumption slowdown.
Collateral chains have started collapsing. For instance, if a big media tycoon pledges the shares of his valuable media company to raise money and invests that money as equity in an infrastructure company; the infrastructure company then takes debt and its projects get stuck. The original collateral – the media company shares – also comes under pressure.
Those without any collateral have been left entirely to microfinance and those with insufficient collateral need to over-collateralise to meet working capital needs of a small business. Are these the only options, and what are the risks to the system?
Pronab Sen remarked that the sharp decline in consumption could reflect a wealth effect (credit demand) and/or access to credit for consumers (credit supply), and the two have different implications for how the financial sector deals with it. Mishra put forth her view that it is the credit demand effect that is binding at the moment. Credit supply effects are important but less so now than they were about a year ago. The economy has gone through two big structural shocks over the last couple of years – GST (goods and services tax) and demonetisation. These adversely affected smaller companies leading to lower wage and income growth and, in turn, lower demand for goods and services.
Discussing the collateral chain problem of high exposure of banks to NBFCs, highlighted by Mukherjee, Sen contended that given the relative strengths of banks as deposit-taking institutions and NBFCs as lenders, it seems like a marriage made in heaven. Mukherjee said that the marriage will now be solemnised: something that can begin quickly – and the market will drive it – is a co-origination model of lending wherein 80% of the loan value will come from the bank and 20% from NBFC and the NBFCs will manage everything on the lending side.
Sen drew attention to the fact that earlier nearly 80% of Indian bank loans were essentially for working capital and this figure has now dropped to 36%; 48% of bank loans are for fixed capital. Current production is essentially driven by working capital. Narayan argued that banks should lend short-term as their liabilities are short term and pension funds and insurance companies should invest in infrastructure and other long-term assets. On working capital, the requirements have gone up due to the way GST works and so it is unfortunate that banks have become reluctant about lending and working capital loans have taken a knock.
Mishra added that the decline in growth between the Indian economy’s heydays and now is almost entirely explained by the sharp collapse in investment and if consumption also slows down we really need to think about the growth prospects going forward. This is especially important in the context of the US-China trade war and whether India can occupy some of that space. If that happens, investment will pick up and the demand for working capital loans should pick up as well – demand is the binding constraint.