Bad debts on the books of Indian banks are set to soar, as companies and individual borrowers hit hard by the Covid-19 pandemic continue to default on loans.
Signs of progress on reducing the worryingly-high levels of bad loans made before the pandemic hit Asia's third-largest economy are already eroding, pushing the country's financial sector into a precarious position.
“The non-performing assets situation is likely to deteriorate over the next year," says Ajit Mishra, vice president of research at Religare Broking in New Delhi. Lenders have limited funding capacity and "that could make the matter worse for banks which could lead to a credit squeeze”, he adds.
The Reserve Bank of India in its financial stability report on Monday said non-performing assets (NPAs) at Indian banks could almost double to 14.8 per cent by September this year under its "severe stress scenario", up from 7.5 per cent reported in September 2020. The report by the banking regulator projected that even in a "better case scenario", they could rise to 13.5 per cent this year.
If the situation prevailed until March next year, it would unfold the worst financial scenario since 1999 for Indian banking and financial services companies.
"The financial services industry plays a pivotal role in enabling growth of overall economy and all other sectors," says Dnyanesh Pandit, managing director of financial services at consulting firm Protiviti India.
“The NPA numbers will be [affected] with the impact of the Covid-19 lockdown as the ability of borrowers, in general, to ensure timely payments has undoubtedly been affected.”
The burden of bad debts has plagued Indian lenders for years. Before the pandemic, however, there were signs of improvement as authorities and lenders took steps to lower the ratio of non-performing loans and clean up banks' balance sheets.
“India's banking sector was already struggling with high NPAs and the non-banking financial sector was also going through its own credit crisis,” says Rajani Sinha, chief economist and national director at Knight Frank India. “In 2019, we saw things just about improving for India's financial sector, and then in 2020 we got hit by the Covid crisis.”
The RBI's bleak forecast comes despite indications that the country's economy is picking up amid easing of Covid-19 restrictions. The country entered into recession in 2020 as the coronavirus pandemic spread rapidly across India, making it the second worst-affected nation globally behind the US.
New Delhi has struggled to bring the virus under control, despite imposing one one of the world's strictest nationwide lockdowns that shuttered businesses and put millions out work. At the peak of the lockdown, in the April to June quarter, GDP growth plunged a record 23.9 per cent on an annual basis, official figures show.
Although the economy has bounced back from those lows and many economists expect the country to emerge from recession this year, banks are set to feel some of the lasting effects of the pandemic, experts warn.
“The pandemic threatens to result in balance sheet impairments and capital shortfalls, especially as regulatory reliefs are rolled back,” Shaktikanta Das, the RBI governor, wrote in the financial stability report. “In addition, banks will be called to meet the funding requirements of the economy as it traces a revival from the pandemic.”
Ms Sinha says that “one of the big challenges for India would be rising debt in the corporate sector, particularly in the small and medium[-sized] business segment” .
She explains that the impact of the pandemic on lenders is likely to worsen this year because temporary relief measures rolled out in 2020 by the banking regulator – including a loan moratorium and debt restructuring plan – were essentially just a case of “kicking the can down the road”.
Some banking experts say lenders' predicament could get even worse than what the RBI is forecasting.
“As these projections are merely indicative and the RBI being bullish about recovery of the Indian economy, it may not be surprising that we end up with an even worse situation for the banking sector from a bad loans perspective,” says Gaurav Dayal, a partner at Indian corporate law firm Lakshmikumaran & Sridharan.
Rising stress among Indian banks would also have a knock-on negative effect on the country's economy.
“We can see a contraction in the economy [again] due to the rise in bad loans,” Mr Dayal explains.
The rise in bad loans will significantly cut the lending power of the banks, which will have "a deep and long-lasting impact on the economy".
Fitch Ratings has also echoed these concerns in a report released on Thursday.
The ratings agency said following a sharp rebound of 11 per cent GDP growth in the coming financial year that begins in April, India will see its economy growing on average at 6.5 per cent in subsequent four financial years. It cited the lasting effects of the pandemic and the “weak state of the financial sector” among the reasons for slower economic growth.
“Constrained credit supply amid a fragile financial system is another headwind for investment,” Fitch says.
“The banking sector entered the crisis with generally weak asset quality and limited capital buffers. Appetite for lending will be subdued, particularly as credit-guarantee and forbearance measures rolled out in the crisis start to be unwound.”
Mr Dayal says the pandemic has pushed the banking sector to a tipping point. Lakshmi Vilas Bank, one of India's smaller lenders, which had struggled even before the Covid-19 crisis, collapsed in November as NPAs climbed.
“In the current scenario, even small [amounts of] bad loans could prove to be extremely difficult for the smaller banks,” says Mr Dayal. “If appropriate [support] measures are not taken to reduced the stress, one can expect similar scenes [unfolding] in the Indian banking sector this year [as well].”
Although the government and RBI have taken taken steps to shore up liquidity and the stability of the financial system, financial experts say they need to do more, given the extraordinary situation lenders in the country are facing in the wake of the pandemic.
This includes recapitalisation of banks.
“More steps and measures would be required especially for public sector banks from the government and RBI until the situation normalises,” says Mr Mishra. “This could be in terms of relaxing certain regulatory norms temporarily and infusion of capital to ensure stability and propel growth.”
The RBI has said it expects banks' overall capital ratio to weaken to 14 per cent in September compared to 15.6 per cent a year earlier.
In its severe stress scenario, the ratio may fall further to 12.5 per cent. Such a scenario would mean that as many as nine banks in India could fail to meet the minimum capital requirement of 9 per cent, according to the RBI.
The central bank did not specify which lenders are likely to breach its minimum capital requirements, but analysts say that India's public sector banks are most at risk. Private banks are more adequately funded, compared to smaller private and public sector lenders, according to Mr Mishra.
“It will be a challenge for public sector banks to raise capital from the equity markets in the near term, given their past growth and NPA challenges," says Suman Chowdhury, chief analytical officer at Acuité Ratings & Research. “We believe the larger private sector banks are in a better position to mobilise capital and that has been demonstrated in the past few years.”
He says the government will do everything possible to support state-run lenders and it has already set aside funds to provide adequate capital to stressed financial institutions.
"The government will support the public sector banks in maintaining their regulatory capital levels," says Mr Chowdhury. "They will also explore dilution of stake in some public sector banks to facilitate fresh capital mobilisation. There is also a proposal to set up a bank holding company in the public sector. However, the success of these measures remains to be seen."
He is also upbeat about prospects of Indian lenders and says a quick economic bounce back means banks may not be in as bad a position as many are forecasting.
“The bad loan trajectory over the medium term will be dependent on the extent of the economic revival in India over the next few quarters,” says Mr Chowdhury.