Capital rush shows plumbing problems TESSELLATUM

Growth in bank loans is at a 50-year low when financial savings are rising: As a percentage of gross domestic product (GDP), they have been rising for the last two years, as seen in healthy deposit growth, strong inflows into small savings schemes and mutual funds, and the weakness in gold imports. Demonetisation only added to that. Combine this with the Union government’s absolute fiscal deficit being where it was six years ago and there is a lot more now left to lend to businesses and individuals.

There is of course a demand problem: In a slowing economy with overcapacity in most sectors that are open to private sector investment, there is less need for corporate credit. However, this defines demand too narrowly, as, unlike most major economies, India is under-leveraged. The ratio of bank loans to GDP, a measure of banking penetration, is among the lowest in the world, and overindebtedness is limited to a handful of groups with stretched balance sheets (as Credit Suisse’s “House of Debt” series of reports have tracked over the years).

Poor credit availability for the micro enterprises that employ nearly all Indian workers is a problem begging for a solution, and one that was not a high priority for the financial system while capital was in short supply. Similarly, for personal credit, notwithstanding the cultural bias against it in India, the threshold above which its marginal utility can be questioned is much above the current levels in the country.

These suggest a severe plumbing problem that always existed but that has only surfaced now due to a situation that the economy likely never faced before: A surfeit of domestic capital.

The Indian financial system, which is dominated by banks, and where more than two-thirds of outstanding loans are still issued by government-owned banks, had little incentive or space to innovate on this front. Busy as they were issuing loans to larger corporations (it is relatively easier to cut one large cheque), the system never learned to issue large numbers of small loans. To compound this problem, Indian financial regulators were uncomfortable allowing lightly regulated private nonbanking finance companies (NBFCs) to grow beyond a certain size. Periodically, a regulatory push to get credit to small and medium enterprises (in the form of lending quotas or “priority-sector” lending) only led to waves of non-performing loans, as lending standards were jettisoned to meet targets.

However, it is only when an industry faces challenges like it does now, of surplus savings but low loan demand, that real innovation is triggered. Private firms, now a sizeable part of the financial system, are indeed innovating. Banks, if anything, have been followers of NBFCs in lending to borrowers like auto-rickshaw drivers in Lucknow and small artisans in Odisha. But such change is slow, particularly as most public sector banks, the bulk of the system, are slow to adapt to this change. System credit growth is therefore unlikely to pick up meaningfully anytime soon.

That means capital oversupply should persist and prices must fall. The banking system’s equivalent of pricing is the net interest margin, that is the difference between the cost at which they get deposits and the price at which they issue loans. It has been falling steadily for the past five years, and the recent oversupply is likely to accelerate that decline as suppliers (banks and NBFCs) jostling for market share. This means banks may cut interest rates irrespective of Reserve Bank of India action.

Stock prices being pushed higher by strong mutual funds inflows are also signs of declining cost of capital. The Union government recognising its limitations – in the recent Budget, it kept its expenditure-to-GDP ratio to the lowest in four decades – has accelerated the process. At the same time, it is now critical for the private sector to step in to revive growth. For that to happen, capital costs must decline meaningfully. It may be a slow grind, but a steadier and healthier one.

One must be watchful of the not insignificant risk of capital misallocation as prices fall, like in mutual funds making risky loans to companies, or stock market bubbles. However, so long as these do not hurt systemic stability, they may not require intervention.

The risk that may require intervention this year is the stress that falling interest margins would create for public sector banks. The government’s apparent “privatisation by market share loss” approach for the banking system (like what happened in airlines and telecom), is convenient, as it obviates any active decision-making. However, given the sharply slowing credit growth (nearly all the incremental credit in the past year came from private banks), rising fixed costs, a persistent bad loans problem, and now plummeting interest margins, benign neglect may no longer be sufficient. The recent clamour for bad loans resolution needs to be looked at through a broader prism of reform of public sector banks.