Mumbai: Asset quality at Indian banks is likely to get worse before it gets better, with the first signs of an improvement likely only by the end of the current fiscal year, the Reserve Bank of India (RBI) said on Thursday.

Bank assets are likely to remain under stress, more so at fragile state-controlled lenders, in the first half of the year, the central bank said in its biannual Financial Stability Report released on Thursday.

The report assesses the risk to India’s banking industry and is prepared by a sub-committee of the Financial Stability and Development Council at RBI.

Bad loans at state-owned banks, which account for about two-thirds of the Indian banking sector’s assets, have climbed as growth in Asia’s third-largest economy slowed in recent years and projects stalled by delayed project approvals and land acquisition problems, among other reasons, crimped corporate cash flows and made it difficult for borrowers to repay debt.

Although economic growth has picked up in recent quarters, under a new method of calculating gross domestic product (GDP), an improvement in bank asset quality will be visible only after government measures to boost the economy, including higher public spending and faster approvals for large infrastructure projects, kickstart the investment cycle and perk up demand.

The report suggests that stress at Indian banks is close to bottoming out, said Saugata Bhattacharya, chief economist at Axis Bank Ltd.

“Companies are refinancing their debts to lower costs, some projects have started and government spending, and consequently cash flows, have increased. In this environment, asset quality of banks should improve," Bhattacharya said.

Still, the recovery is contingent on how the Indian economy performs. If the macro-economic situation deteriorates, bad loans may increase, RBI warned.

Total stressed advances at scheduled commercial banks in India increased to 11.1% of total advances in March from 10.7% in September, the RBI report said. Stressed assets include gross non-performing assets (GNPAs) and loans that have been restructured by banks.

GNPAs of banks increased to 4.6% of total advances in March from 4.5% in September, the report said, adding that stress on bank books will persist in the first half of this year.

“The macro stress test of credit risk suggests that under the baseline scenario, the GNPA ratio may increase to 4.8% by September 2015 from 4.6% as of March 2015 which could subsequently improve to 4.7% by March 2016," the report said.

Data in the report suggests that a majority of the GNPAs (17.9%) came from industries, followed by 7.5% from the services sector.

Retail borrowers accounted for 2% of the stressed advances, the lowest.

The report flagged challenges to the economy from the possible reversal of foreign institutional investor (FII) inflows from the local equity and bond markets after the US Federal Reserve raises interest rates later this year.

“The search for yield inflows may be affected when the US Federal Reserve increases rates amid possible volatility in global financial markets and safe haven flows, though India seems to be better prepared to deal with volatility now than it was in the past," the financial stability report said.

FIIs pumped a record $42.41 billion into local debt and equity markets in 2014 as easy liquidity in developed markets and prospects of better economic growth and a stable currency in India attracted investors. They have invested $12.75 billion in the year to date.

The US Federal Reserve is likely to lift its benchmark interest rate from 0% later this year for the first time since December 2008, which is likely to lead to money flowing into that country as investors seek safety and shun emerging market assets perceived as risky.

In his foreword to the report, RBI governor Raghuram Rajan pointed out that two other central banks (Bank of Japan and European Central Bank) have eased liquidity which, along with policy tightening by the US Fed, is likely to pose a challenge to emerging markets.

“What we have seen might be only one of a series of such ‘tantrums’ that the global financial markets are likely to witness. Hence even as efforts continue on building a consensus around the need for greater degree of coordination among policy makers across the globe, there is a need to be vigilant about the spillovers," Rajan said.

The report pointed out that the divergence between public sector and private sector banks is widening. Public sector banks are considered safe, given the implicit government guarantee, but the same sense eludes the banks when it comes to their valuations, the report said. The new performance-based norms for capital infusion by the government into state-run banks will address this disconnect, it added.

The government initially said it will infuse about 8,000 crore of capital this fiscal year in banks that meet certain efficiency parameters.

That policy was changed later with finance secretary Rajiv Mehrishi saying earlier this weeks that the government will infuse 19,000 crore this fiscal, including in banks that were deemed not eligible for a capital injection in the first round.

“There may be a notion, albeit an incomplete one, that with the government deciding on performance based parameters for identifying banks which deserve fiscal support, those that are not up to the mark might find it even more difficult to raise capital," the RBI report said.

In an environment where the capital needs of public sector banks have to be predominantly met by the market, there is a need to clearly define the contours of an effective regulatory and oversight regime which reduces “informational asymmetry" and thereby promotes market access, the report said.

“In the absence of better information, markets are prone to take enabling provisions to be emblematic of across the board problems and tend to have a ‘PSB discount’ (public sector bank discount) attached to their market valuations," it said.

Investors are concerned that dealing with NPAs and the pace at which they are piling up will not be easy for the state-run banks to handle, said Gaurav Kapur, an economist at Royal Bank of Scotland in India.

“Hence, there’s a ‘PSB discount’. But government also cannot keep on recapitalizing the banks as resources are finite and the government has to decide how to use the scarce resource more efficiently," he said.

“By introducing the efficiency parameters in banks, the government is actually making PSBs more attractive to other non-government investors," he added.