India continues to stand out among emerging markets, with the International Monetary Fund having recently raised its growth forecast to above 7.5% for 2016-17 and 2017-18. Can this be sustained, give
n the weak external environment, and are domestic financial conditions sufficiently supportive to sustain growth?
The reality is that it is consumption that has been driving Indian growth, rather than investment. Private investment has not yet picked up, despite rising public infrastructure investment, structural reforms in key sectors such as power, the passage of a long-awaited insolvency and bankruptcy code, and the further easing of limits on foreign direct investment.
This trend in private investment will have to change if India’s growth is to be sustained, given the constraints on public investment from India’s still elevated public debt, and the government’s fiscal consolidation path. This will require, among other things, domestic financial conditions to become much more supportive of private investment. Like many emerging markets, India’s financial and corporate sector balance sheets have become strained in recent years because of credit-led corporate leverage now weighing on near-term credit growth.
The country’s corporate financing sources have narrowed in recent years, especially from domestic bank credit, and the corporate bond market remains relatively small. Bank credit growth to the corporate sector, especially to industry, has been declining significantly in recent years—it was barely positive over the past year—reflecting weakened capital, profitability and asset quality of many public-sector banks.
This is evident in banks’ stressed loans (non-performing assets and restructured assets) that now exceed 11% of total loans, with that of public sector banks reaching close to 15%—concentrated among large borrowers in industry and infrastructure. If not for the private-sector banks (one-quarter of Indian banking system assets), whose credit growth has remained significantly positive, domestic financial conditions for the corporate sector would have been much more stringent.
Demand side factors have been equally significant, evident in elevated corporate vulnerabilities that have depressed corporate investment. These mirror the weakened balance sheets of public-sector banks, given the high share of corporate finance in their portfolios. Corporate leverage in India is among the highest in emerging markets and, given their external borrowing, exposed to foreign currency and interest rate shocks. As a result, the investment plans of core industrial sectors remain thin, reflecting their still low capacity utilization and slow corporate deleveraging.
To deal effectively with the Achilles heel of the bank-corporate nexus, it is imperative to restore investment. This is the challenge that many emerging markets face and it is exacerbated by the commitment to quickly implement Basel III standards of capital and liquidity.
In recent years, India has introduced a series of far-reaching measures to deal with the bank-corporate nexus—especially, to better recognize the extent of the problem through the Asset Quality Review (AQR), increase banks’ loan loss provisions, improve corporate governance of public-sector banks, recapitalize them, and restructure stressed assets in a sustainable way through several asset-restructuring schemes (and move away from the unviable “extend and pretend” restructuring exercises that delayed the process).
With the framework to deal with bank-corporate issues now established, the challenge is to drive the process forward on both sides—implementing the new bankruptcy code, moving ahead with out-of-court debt-restructuring mechanisms, and actively recapitalizing public-sector banks rather than waiting for them to raise capital in the markets.
Delays in implementation risk a further rise in non-performing assets—which will diminish the banks’ capital-market appeal—and further delay the recovery of investment. The lessons from the European banking system point to the persistent, detrimental effects on growth because of delays in dealing with high levels of impaired assets, low profitability, and weak capital positions of banks that have curtailed the availability of bank credit.
In particular, in the coming budget, the government should unveil an accelerated approach to inject sizeable capital into public-sector banks and build on new recapitalization norms by raising the incentives for performance and debt resolution. This is consistent with the original AQR plan to achieve fully transparent and provisioned public-bank balance sheets by March. By doing so, the government will also be able to fast forward its plans for the potential restructuring of weak public banks and the divestment of non-core assets. Estimated recapitalization needs are still relatively modest and the accelerated government injection can be fitted into the medium-term fiscal consolidation plan without raising market concern.
Indeed, accelerating the implementation of declared plans for addressing the bank-corporate nexus in the next budget will shift market expectations virtuously, spur investment recovery, and broaden growth. It will also move policy attention to building both sides of India’s financial sector over the medium term—broadening debt markets and enhancing financing inclusion—which is critical for sustaining medium-term growth.
Anoop Singh is adjunct professor, Georgetown University, and former director, Asia-Pacific Department, International Monetary Fund.