Ratings agency bashing is a favourite pastime for many of us, which is why when Moody’s Investors Service last week downgraded the outlook for India’s banking system to negative from stable, citing concerns that global economic turmoil and a domestic slowdown may lead to loan defaults and curb profitability, there was a chorus of protests. A negative outlook is characterized by volatility and uncertain conditions. Senior bankers, economists and the government uniformly derided Moody’s action, dubbing it unwarranted and something that defied logic.

There was a collective sigh of relief when the next day another global rater, Standard and Poor’s, lifted the risk profile of the Indian banking industry by one notch, from 6 to 5, saying banking regulations in India are in line with international standards, and the banking regulator, the Reserve Bank of India (RBI), has a moderately successful track record. The agency’s country risk assessment is scored on a scale of 1 to 10, with 1 representing a lowest-risk banking system.

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Earlier, in May 2009, in the wake of the global credit crisis following the collapse of US investment bank Lehman Brothers, Moody’s had threatened to downgrade 13 Indian banks on concerns about the government’s ability to support the banking system through capital infusion when the fiscal deficit is high. It did not take action then, but last month it downgraded India’s largest lender, State Bank of India, for its rising bad assets and the lack of enough capital that can curb its ability to lend.

Crisis ahead?

There has been a dramatic deterioration on the macroeconomic front since the Indian central bank announced yet another rate hike in its October policy, its 13th hike since March 2010, to check persistently high inflation in the world’s second-fastest growing major economy after China.

There are telltale signs of a slowdown everywhere and many have started believing that the economy is heading for a crash landing.

India’s factory output expanded at 1.9% in September, the slowest in two years, against 6.1% in the year-ago period. In August, it had expanded at 3.6%, much lower than the consensus estimate and the 4.5% growth in August 2010, and worse than the upwardly revised 3.8% growth in July.

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The HSBC India Manufacturing Purchasing Managers’ Index (PMI) bounced back in October to 52 after dropping to 50.4 in September, its lowest since March 2009, but services PMI contracted for the second successive month at 49.1, after 49.8 in September, the first contraction since April 2009. A reading above 50 indicates expansion.

Among other slowdown signs, car sales fell for the fourth consecutive month in October, and the 23.77% decline is the sharpest monthly fall in almost 11 years. Indeed, disruptions in production schedules at the country’s largest car maker, Maruti Suzuki India Ltd, contributed to the fall in sales, but high interest rates and rising fuel prices also played a critical role. And if that’s not bad enough, slackening demand in developed markets widened the country’s trade deficit to a four-year high of $19.6 billion in October.

Growth in exports declined to 10.8%, continuing the trend that started in August, even as import growth remained steady at 21.7%.

The trade deficit in the first seven months of the current fiscal has been $93.7 billion, a level not seen in many years, and by the end of the year it may rise to as high as $150 billion, about 8% of India’s gross domestic product (GDP) on the budget estimate of growth. The current account deficit could be around 3% of GDP.

Adding to the gloom, indirect tax collections in October dropped 2.5% and gross direct tax collections slipped 0.61%. With demand slowing and corporate profitability being hurt, tax collections are likely to be affected further.

Around 2,150 listed firms that have announced their earnings so far have shown a close to 36% drop in net profit even though their sales have been up 22%. High interest cost is one of the contributing factors to the drop in net profit, and there will be no surprise if many of them fail to pay back bank loans. Gross bad debts of listed banks have crossed 1 trillion in September, 33% higher than a year ago, and will rise further as many of the restructured loans will turn bad.

Widening fiscal deficit?

Lower tax collection is not good news for the government as it will not be able to keep the fiscal deficit target at 4.6% outlined in the budget. The government has already raised its market borrowing programme in the second half by 52,872 crore, making this year’s borrowing a record high ( 4.7 trillion), but the reason behind the rise in market borrowing, we were told, was lower collections from small savings. If indeed the fiscal deficit overshoots the target, the government will have to borrow even more. This has a direct bearing on the investment cycle as it will push up interest rates and crowd out private investments.

The benchmark 10-year bond yield on Friday touched a 39-month high of 9%, and government bond auctions have been devolving on primary dealers as banks do not have enough appetite for sovereign papers when liquidity is tight. They borrowed 1.27 trillion from RBI on Friday and the daily average cash deficit in the banking system in the past week was in the range of 80,000-85,000 crore.

For RBI (and, of course, for the government), it’s time to worry about growth even though inflation continues to be high and may not drop to 7% by the year-end, as projected by RBI, with oil prices going up. One of the key assumptions of RBI behind pegging wholesale price inflation at 7% by March is a bearish outlook on oil prices. Besides, a falling rupee will also put pressure on inflation as the import of goods will become costlier in rupee terms. The Indian currency has breached the 50 mark against the dollar and is trading at a 30-month low. Inflation has remained persistently above 9% for 10 months in a row and at least 8% for the past 21 months.

RBI will not be in a hurry to reverse its monetary policy stance and start cutting rates soon, but it may have to find ways to infuse liquidity in the system, possibly through bond sales, as otherwise the government will find it difficult to raise money from the market and there will be no money for firms to borrow.

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We are close to a crisis and the best thing the government can do at this juncture is push for some reforms and stir foreign investors’ imagination. This can be done, for instance, by raising the foreign direct investment limit in insurance and opening up the retail sector. A cut in expenditure is ideal to contain fiscal deficit at the targeted level, but if that’s too difficult, the government can raise excise duty—which was sharply cut in 2009—even at the risk of adding to inflation. It can also bring down its stake in public sector banks, from 51% to say 33%, to help banks raise money from the market.

What’s the point in raising the fiscal deficit further to infuse capital in banks and maintain its status as the majority stakeholder when a 26% stake gives a shareholder powers to block any special resolutions and even a so-called golden share can help the government control the banks? Smart administrators see opportunities in a crisis.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as a deputy managing editor of Mint. Please email your comments to bankerstrust@livemint.com