The RBI's latest Financial Stability Report (FSR) has given the banking system a reasonably clean bill of health. It's a significant achievement, considering the stress of the previous decade, the shock of the pandemic and the associated slowdown of the economy. However, the improvement in banks' financials presents a glass half-full picture. It is still unclear whether the banking system is healthy enough to provide the sustained credit growth needed for a strong economic recovery.
Two key indicators demonstrate the banking system’s progress. Successive waves of recapitalization have given banks enough resources to write off most of their bad loans. As a result, they have been able to bring down their gross NPAs from 11 percent of total advances in 2017-18 to 5.9 percent in 2021-22. NPAs for industrial credit have been reduced even more dramatically, from 23 percent to 8.4 percent. Even after these large write-offs, most banks retain comfortable levels of capital.
This financial turnaround has given banks the space to resume their business of extending credit. During the decade when banks were under stress, non-food bank credit growth had been declining, reaching just 6 percent in 2020, its lowest point in six decades. Since then, credit growth has nearly doubled.
These are the visible signs of a healthier banking system. However, the broad aggregates conceal a worrisome picture, raising questions about the role bank credit will play in supporting GDP growth. The problem is that very little of this credit is going to large-scale industry or for financing investment.
Consider first the sectoral distribution of credit. Over the last decade, banks have increasingly shifted away from providing credit to industry, favouring instead lending to consumers. Consequently, the share of industry in total banking credit has declined from 43 percent in 2010 to 30 percent in 2020, while that of consumer loans has increased from 19 percent to 29 percent. This trend is continuing: in the year ending March 2022, consumer loans grew at 13 percent, whereas loans to industry grew at just 8 percent.
Bulk of the industry loans has been extended to the smaller firms (MSMEs), which benefitted from the credit guarantee scheme offered by the government in the wake of the pandemic. Loan growth for MSMEs went up from 3 percent in 2020 to 31 percent in 2022. In contrast, lending to large industries has been stagnant in nominal terms during the last two years, implying that it has declined sharply in real terms.
A related problem is that there has been little lending for private sector investment. Over the last one year, bank lending to infrastructure has grown by 9 percent, up from 3 percent in 2020, but this was fuelled mainly by public sector capital expenditure. Meanwhile, much of the lending to private industry has been in the form of working capital loans, necessitated by the increase in commodity prices, which has led to a sharp rise in the cost of holding inventories.
Why is there so little lending for investment by large firms? Both demand and supply side factors seem to be at work. On the demand side, private sector investment has been sluggish for nearly a decade. The boom-and-bust of the mid-2000s had saddled firms with excess capacity, giving them little reason to expand their production facilities. In addition, the Global Financial Crisis had shown the dangers of ambitious expansion supported by excessive borrowing, leading firms to conclude that it would be prudent to scale back their plans and instead focus on reducing their debts.
On the supply side, banks have learned similar lessons. During the period 2004-2009, rapid GDP growth in the Indian economy was fuelled by an unprecedented lending boom. Credit doubled within the span of a few years, primarily on the back of lending to large infrastructure projects. Subsequently, many of those loans turned bad, leading to high levels of NPAs on bank balance sheets. As a result of these financial problems, banks for a decade were unable to extend much in the way of credit. Even when their health improved, they remained wary of lending to large-scale industrial projects, preferring instead to shift to smaller-scale and less risky consumer lending. This situation of risk aversion on the part of firms and banks has not changed perceptibly during the post pandemic recovery.
On the positive side, firms seem to have finally used up much of their spare capacity. But on the negative side, the fundamental problems that led to the difficulties of the past decade still have not been resolved. There is still no framework that will reduce the risk of private sector investment in infrastructure, certainly not in the critical and highly troubled power sector. Nor is there any reassurance for the banks that if problems do develop, they can be resolved expeditiously, since the Insolvency and Bankruptcy Code (IBC) has been plagued by delays and other problems. Now, heightened global macroeconomic uncertainty, growing geopolitical tensions and uncertain recovery prospects of the domestic economy are likely to make matters worse.
In other words, a healthy balance sheet of the banking sector is a necessary but not a sufficient condition for economic growth. The important question is whether banks and firms will once again be willing to take on the risk of investment in industry and infrastructure. And this seems unlikely unless there are deep structural reforms – to the infrastructure framework, the resolution process, and indeed in the risk management processes at the banks themselves. In the event that these reforms do not materialise, there may continue to be shortfalls in credit, investment, and ultimately in economic recovery and growth.
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