After the world’s most severe lockdown and the sharpest decline in economic growth among emerging markets, India’s financial fragility is expected to increase. The share of non-productive assets (NPAs) in its banking system could reach 18% of outstanding debt, double the level experienced by countries affected by the 2008 financial crisis. NPAs were high and widespread even before the covid shock does not increase the vulnerability of financial institutions. If India had a “twin balance” problem earlier, it might have a “quadruple balance sheet” problem today.
What to do to avoid a banking crisis? Much will depend on how the issues are resolved and when. Cyclical interventions and restructuring loans are unlikely to work. The insolvency system could take decades to tackle bad debts and the ability to recast them seems stifled. An extension of the Indian moratorium on loan repayments would also not be effective.
Cyclical interventions are insufficient because there is only limited space to use fiscal and monetary policies against a banking crisis. Current savings will not be able to absorb the scale of bond issues necessary for a fiscal response. Some deficit monetization could be achieved, given India’s balance of payments surplus, but it will be a one-time fix. The action of monetary policy is hampered by a faulty transmission mechanism.
The root cause of India’s banking vulnerability is structural, not cyclical. Three key structural interventions are needed:
First, shift the focus of the banking sector more towards promoting entrepreneurship and wealth creation. Help efficient businesses, especially new ones, to access bank loans. This can be done by eliminating the factor market distortions that allow large, less efficient firms to obtain a disproportionate share of loan disbursements.
Second, modernize credit risk supervision in financial institutions to improve credit allocation and identify who is “naked,” as the expression goes.
Third, increase investment in physical infrastructure and human capital.
Businesses need land, labor and capital to produce. Land markets are extremely distorted compared to other factor markets. As banks rely on land as collateral, their loans are also distorted by land grabbing by less efficient companies. Over time, these distortions have worsened, with a growing gap between access to finance and its optimal use. This problem is worse in the manufacturing sector than in the service sector. Empirical evidence has shown that there are huge growth gains by reducing land misallocation and, with it, improving capital markets (see G. Duranton, E. Ghani, A. Grover, & W . Kerr, ‘A detailed anatomy of factor misallocation in India’, Policy Research Working Paper Series 7547, World Bank).
Indian banks also need operational changes. They should be configured for sector analysis, borrower resilience and high frequency analysis, so that they can deepen their understanding of what is happening in the financial lives of debtors. Digital advances allow banks to deploy new techniques to promote entrepreneurship and monitor which borrowers are not meeting their payment obligations.
There is growing concern that the Achilles heel of the Indian financial system is the government’s “fiscal domination”, which has compromised the functioning of financial institutions. balance between the roles played by government and the private sector in wealth creation. However, the evidence is weak that “fiscal domination”, particularly involving investments in infrastructure and human capital, is the main cause of banking fragility. The experience of India’s investment projects such as the Golden Quadrilateral Highway contradicts this perception. Improved transport infrastructure has enabled bank branches to expand more widely from urban to rural areas, and from mega-cities to mid-sized cities, allowing many more entrepreneurs to access bank loans. An effective and well-targeted fiscal policy has an important role to play in promoting investments in infrastructure that will encourage entrepreneurship, and for banks to extend more credit to new businesses. The two objectives are complementary.
India also needs to improve capital markets to reduce financial vulnerability. Businesses continued to rely excessively on bank loans, and less on capital markets, for funds. Developing capital and corporate bond markets require investors to obtain timely information on default and credit quality. Modernizing financial institutions will reduce excessive bank borrowing by large companies and create space for new and young entrepreneurs.
Solving the banking crisis in India, relaunching economic growth and stimulating job creation will depend on timely interventions on all fronts: improving the bankruptcy system and restructuring corporate loans; efficient use of the limited space available for fiscal and monetary measures; modernize the banking system; and the development of capital markets, in particular for bonds. Now is the right time to tackle the root cause of India’s banking vulnerability.
A reorientation of the policy of cyclical interventions towards structural interventions could help to avoid a banking crisis. Failure to address the vulnerability of the sector today could stifle the access of millions of new and young entrepreneurs to credit. This will create a high level of uncertainty, hinder wealth creation and threaten the sustainability of inclusive capitalism.
Ejaz Ghani worked at the World Bank and taught economics at the universities of Delhi and Oxford
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