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NPA ailment: Financial sector fragility persists

Renu Kohli
These counters could keep the lid on NPAs, preventing a full-blown reversal of the cycle.

Is the non-performing asset cycle beginning to reverse after a brief spell of improvement? Nascent signs have appeared, even though an enduring setback is not yet visible. The Reserve Bank of India reported, recently, that credit quality deteriorated in June 2019, with rise in stressed and NPA ratios in all sectors except industry (Monetary Policy Report, October). Although the central bank did not provide numbers, charted trend shows the gross NPA ratio closer to 10% from 9.3% in March, which represented a four-quarter successive decline. It was only a quarter ago that RBI stated NPAs seemed to have turned around (Financial Stability Report, June 2019). A Jefferies report in early October predicts a second wave of NPAs seeing significant divergence in ratings and financial health of some stressed corporates, adding that asset quality deterioration risk has risen, following a shift in lending to bottom-end customers from non-banks to the banks. Then, September quarter results indicate fresh stress, special mention accounts, NPAs, and provisions for several banks.

These are early signs, possibly mirroring weak demand conditions. It remains to be seen if the deterioration persists, leading to an enduring increase in gross NPAs. The aggregate NPA ratio may not necessarily reflect the increased underlying stress ahead: post-June 2019, the revised RBI framework for resolution of stressed assets expects lenders to initiate resolution even before a default, giving complete discretion for any decision including reorganisation, sale, and restructuring. One is not sure if financial intermediaries (non-banking financial companies or NBFCs, and small finance banks are now included) will engage in more restructuring to alleviate stress than recognise such assets as NPAs. Evolving developments indicate a tilt towards restructuring or disposal of stressed assets; lenders increasingly prefer to avoid the IBC path as unanticipated complications at the forum prolong resolution, and increase uncertainty. Moreover, the underlying stress in MSME loans will remain unrecognised from the one-time restructuring allowed for specific defaults classified as standard assets on January 1, 2019 up to end-March 2020.

These counters could keep the lid on NPAs, preventing a full-blown reversal of the cycle. Nonetheless, the emergent setback cannot be taken lightly in the context of intense strains in the financial system, which is visibly vulnerable to frequent defaults in fresh trouble spots, e.g., real-estate exposures of banks through NBFCs. Besides, increasing the extent of restructured or reorganised loans-with or without approved additional financing-is a sure sign of persisting financial fragility. It is significant that this transpires after substantial resolution efforts, and recapitalisation of public sector banks. If economic conditions continue to deteriorate, i.e., the expected recovery from October-December quarter does not materialise, a reversal in the NPA cycle could be a serious blow. This would add to the lingering presence of past NPAs, portending a perpetuation of a pattern that eventually ends in reduced lending.

Take the case of banks first. Charted trends show brisk credit growth (in real terms) in first round; this is followed by rising NPAs; real credit then slows down, or even comes to a standstill in some cases, as balance sheets are too weak for further lending. In 2006-11, real credit growth averaged 12% annually; NPAs followed with a lag, after which the pace of real credit slowed to an average 4.5% for four successive years (FY12-FY16)-banks retreated, short of capital to fund further growth with increased provisioning needs. As recapitalisation and resolution delays were addressed, the pace of real lending picked up to about 9% last year. But, in April-September 2019, real credit growth slowed again to 5.5%, down 1.6 times over a corresponding 9.1% one year ago; NPAs have started increasing. A sustained setback could result in a further lending slowdown, unless capital is quickly augmented.

NBFCs illustrate similar patterns (see graphic). Consolidated data for all NBFCs exists only from 2014-15, but it can be seen that an average 11.6% real growth in loans in FY14-FY16 shot up to 17.5% in 2017-18, followed by 15.2% last year, as NBFCs rapidly expanded lending, replacing banks. An almost five-point jump in real credit growth in this period is accompanied by a 1.5-2 percentage point jump in their gross NPA ratio, reversing the moderation in 2014-15. In 2017, RBI observed that their double-digit credit growth "has improved resilience and stability of the economy by filling up the financing gap opened up by the muted bank credit growth from 2014-15" (Report on Trends and Progress in Banking in India, December 2017), reaffirming last year that "the slowdown in SCBs' credit growth…provided a fillip to loan companies as substitution effects provided tailwinds. This was especially true of their lending to commercial real estate, consumer durables, and vehicle loans" (RTPBI, December 2018).

NBFC lending began to slow late last year, triggered by the IL&FS default that led to close scrutiny of funding sources, asset-liability mismatches, and exposures. For the current year, aggregate NBFC loan data is unavailable yet, but NBFC credit growth is reportedly declining 3-4 percentage points; new financing contracted `1.26 trillion in April-mid September against `412 billion correspondingly a year ago.

From the viewpoint of financial stability, matters are equally concerning. The June 2019 re-examination by RBI (Financial Stability Report) highlights extensive interconnectedness risks: inter alia, banks' exposure to NBFCs increased 9 percentage points in June 2017-March 2019; NBFC credit to four consumer credit sub-segments grew 20% CAGR in two years to December 2018, with retail assets as key drivers of portfolio size, growth, and delinquencies in asset finance and loan companies; NBFCs lead delinquency levels in almost all consumer credit sub-segments, applying the 90-day norm. Recently, RBI said "the events of 2018-19 showed there was irrational exuberance and considerable overleveraging, with asset-liability mismatches" (Annual Report, August 2019).

In a context of visible vulnerabilities within the financial system, a sustained increase of gross NPAs or the alternate build-up of restructured/reorganised stressed loans could have adverse consequences that could be more severe than they have been in recent past. Doubts could resurface about disclosed asset qualities, and return to past behaviour by lenders, like evergreening assets; equally, a loss of faith in IBC is not a good augur. If past patterns are a pointer, rising NPA stress could morph into a further lending slowdown by both banks, and nonbanks. Growth repercussions could be felt beyond credit supply. For instance, the credit channel that is still not fully operational may remain so, blocking full transmission and negating the positive impulse expected from monetary policy.

The chain effect loops back to the fiscal side if further recapitalisation is needed to unclog credit pipelines. The persistence of financial fragility could indeed be a long and severe drag.

The author is New Delhi based macroeconomist (Views are personal)