India crisis threatens big hit on banks

The arrival of Raghuram Rajan at the Reserve Bank of India has been eagerly awaited by investors anticipating what monetary steps he will take to rescue the rupee, restore economic growth and curb inflation.

On his first day as central bank governor, however, Mr Rajan postponed comment on monetary policy until September 20, just after the US Federal Reserve policy meeting, and spoke almost entirely about his plans for liberalising the banking sector, which he regards as essential for poverty alleviation and long-term growth in one of the world’s most underbanked economies.

Mr Rajan, formerly chief economist of the International Monetary Fund, is credited with having warned of the financial fragilities that led to the global financial crisis of 2008, and economists and analysts say he is right to focus in his new job on the weaknesses of Indian banks.

Fears are rising for the health of India’s banking system as slowing economic growth and rapid currency depreciation threaten to worsen asset quality and reduce demand for bank credit from large industrial companies.

Non-performing and restructured loan levels in Asia’s third-largest economy have risen steadily over the past year to stand at about 9 per cent of assets and could reach 15.5 per cent over the next two years, according to Morgan Stanley.

A combination of weaker growth, waning business confidence and RBI measures to support the rupee will further dent asset quality, analysts say, in particular as some of the larger industrial companies struggle to repay loans.

Recent research from Credit Suisse showed that gross debt at 10 of the most indebted groups – including Vedanta and Essar as well as infrastructure companies such as GVK, GMR and Lanco – exceeded a combined $100bn for the first time over the last financial year.

The series of measures described by Mr Rajan on Wednesday as “a big initial package” are aimed at liberalising a financial sector dominated by state banks and making it more competitive, but also at protecting banks from interference by government and by the big “promoters” who are typically their largest creditors.

“Promoters do not have a divine right to stay in charge regardless of how badly they mismanage an enterprise, nor do they have the right to use the banking system to recapitalise their failed ventures,” Mr Rajan said.

He announced plans to improve debt recovery procedures and to have the RBI collect data – which it would share with commercial banks – on financial institutions’ exposure to large debts.

Banks, he said, would be encouraged to clean up their balance sheets and raise new capital when necessary. “The bad loan problem is not alarming yet, but it will only fester and grow if left unaddressed.”

That view is shared by analysts. In a report this week, Bank of America Merrill Lynch described India as Asia’s most “financially vulnerable” large economy, blaming problems stemming from bad loans following excessive credit expansion during periods of strong growth.

“While the lending boom of 2002-07 is over, the consequences in terms of bad loans are only now showing up,” wrote equity strategist Ajay Singh Kapur. “There is a wide breadth of trouble in India.”

The sector’s outlook is further darkened by the sliding rupee, according to rating agency Fitch. The currency has fallen by about 18 per cent against the US dollar since the end of May, hitting record lows along the way, amid rising investor speculation that the US Fed could start to taper its asset purchases as soon as this month.

Indian companies hold about $225bn of US dollar-denominated debt – as much as half of that estimated to be unhedged – while some larger Indian banks including State Bank of India and ICICI have raised money via dollar-denominated bonds in recent years.

Some of these funds have in turn been lent to the corporate sector, whose ability to repay could now be affected as the rupee’s sharp fall compounds the broader economic slowdown.

“Does all this together necessarily turn into a major banking crisis? No, it doesn’t,” says Rajeev Malik, senior Asia-Pacific economist at investment group CLSA, “although worryingly there are now scenarios where something like that might begin to happen.”