Moody’s upgrades India outlook but warns Modi: Time running out to reform banks

Global rating agency, Moody’s Investors Service on Thursday upgraded India’s growth outlook to positive from stable and retained the sovereign rating at Baa3, observing that the actions of policymakers would strengthen the country’s economic growth. But the outlook upgrade by Moody’s appears half-hearted and a bit distant from translating into a rating upgrade since the potential risks that could act as credit constraints — a weak banking sector and stress on the fiscal front — are serious in nature. [caption id=“attachment_2190479” align=“alignleft” width=“380”] The villain in an otherwise promising India story is the banking sector:[/caption] The villain in an otherwise promising India story, as Moody’s has highlighted, is the country’s bad loan-ridden, capital-starved banking sector. “This poses sovereign credit risks because of the banking sector’s role in financing growth as well the government’s deficit through its purchase of government securities and the contingent liabilities due to government’s ownership of a major portion of banking sector,” the agency said. Translated, what Moody’s is telling the NDA government is this: India has all the ingredients to become an economic superpower and the world is willing to change its perception on India as a weak economy. There is a stable government at the Centre, willingness to kick start reforms in critical sectors but repairing the damaged banking sector — something that can derail the juggernaut — is essential. In the absence of any improvement in the banking system metrics over coming months, India’s sovereign credit profile will remain constrained, the agency warns. Apart from the obvious legacy issues that broke the back of Indian banks mostly during the UPA’s ten-year rule, the Narendra Modi government’s policies are also dealing a blow to the sector now. Until this point, Jaitley has arguably poorly handled the banking sector issues so far, with faulty strategies and weak assumptions. As Firstpost has noted before , wrong handling of the banking sector reforms can potentially derail an unfolding India growth story since Indian firms are still heavily dependent upon bank funding with the corporate bond market still nascent. Most of the problems pertaining to the banking sector begins and ends with state-run banks since majority of the private sector banks are largely self sufficient and are focused on low-risk assets, while much of the nation building is still a responsibility of public sector banks. At a glance, here is where things stand. State-run bans are on the brink of a crisis. Over 90 percent of the bad loans and a good chunk of the restructured loans are on the balance sheets of these entities. The Tier-I capital ratios of at least 12 banks are not seen healthy under the Basel-III norms. Stressed assets now constitute about 12 percent of the total bank loans given by Indian banks. The higher the sticky assets, the more the chunk of money banks need to set aside in the form of provisions. This, in turn, impacts the profitability and turns them more risk averse. Beginning April, the provisioning burden for banks became even higher with any fresh loan restructuring now demands 15 percent provisioning as against 5 percent before, equal to that of a bad loan. Most of the NPAs on state-run banks happened in the last 10 years on account of three reasons. 1) Careless lending by state-run banks for years to meet the credit growth targets. Most times, senior bankers manage to reach the corner office at the fag end of their career. During the few years of their stint, the focus mostly is to show maximum growth than focus on quality of assets and get into the good book of the government. 2) Lack of autonomy played its part. Frequent micromanagement by the government in the operations of state-run bank, missives from the north block on the credit decisions and multiple forms of directed lending also significantly contributed to the bad loans in the subsequent years. Loan waivers destroyed the credit culture. The infamous banker-middlemen-corporate nexus worked in full swing during the UPA regime and lost some prominence only after the 2010 corporate loan scam. Political interference dominated the scene. 3) Prolonged economic slowdown, bureaucratic hurdles and absence of fresh investments added to the woes. Project delays for various reasons resulted in cost overruns for companies and put banks’ money at risk. This resulted in massive loan restructuring, especially in the infrastructure sector, many of which subsequently turned non-performing assets (NPAs). The capital woes of state-run banks turned worse when the government backtracked from the promise of infusing Rs 11,200 crore in these banks in fiscal year 2015 and chose to infuse only a part of it in select banks based on performance and efficiency in operations. Many mid-sized, ‘non-performing’ state-run banks were taken aback by this decision. The second shock came in the Budget 2015, when Jaitley announced a capital infusion of Rs 8,000 crore, half of the amount which banks actually require. Small banks are only left with two options. Either merge with other banks or go to the market to fend for themselves. Given that there is no significant investor appetite in these banks, merger appears to be the only way out, for these banks. On the other hand, merging a weak, NPA-ridden bank with a strong one or another weak one, has been termed as a bad idea by Indian central bank, since the resultant entity will have to bear the burden. Jaitely, instead, could have offered the capital assistance to the struggling banks and revamp their operations and let the bigger ones raise money from market. To be sure, the proposed bank boards bureau and investment holding company to facilitate capital raising for state-run banks is an idea that can work in the long term, but won’t be a solution in the short-run. State-run banks will require at least Rs 2.4 lakh crore to meet Basel-III norms and significantly larger amount to address the asset quality issues. This is something far beyond the capacity of the state-exchequer. The solution, as the P J Nayak committee suggested, lies in lowering government stake in these banks below 51 percent and let these entities operate as independent entities and not extended arms of government. Moody’s is right in highlighting the banking sector constraints as a major risk for the economic growth since only a strong banking sector can fund the India’s growth story. Until banks remain fence-sitters, growth is a myth.