Why it is hard to lend to the right borrowers
The decline in relative importance of industry in the country's GDP has caused problems for banks that we probably have not acknowledged
Is avoiding borrowing a secret of corporate success? Not in classical corporate finance theory, but going by the stellar, consistent success of information technology, consumer goods and pharmaceutical industries over the last 15 years, it would seem so. They have stood their ground during the recent downturn; the few black sheep within these industries who did leverage or participated in the misadventure called foreign currency convertible bonds met their brutal comeuppance. Actually, miners and exploration companies too could have joined this elite club of non-borrower successes, but for the government deciding to convert them to toxic waste.
Whereas the economic importance of all these sectors put together is uncertain, the fact that several sectors by nature sit out of the credit growth arena is by itself concerning. Add to these a number of large companies who do borrow but cheaply from non-bank sources, and banks are forced to target the rump, lending credence to the adage that banks lend to only those borrowers who do not want any money. However, the unfortunate challenge is that bank credit is necessary for oiling the wheels of the economy. So we have a system that is from the beginning set for adverse selection.
Unnecessary scaremongering? Perhaps another explanation will illustrate. When we say India’s credit to GDP ratio is only 55% and hence we are underleveraged with plenty of room to expand, we conveniently forget two things: credit to government comprises another 20%, and then there are sizeable parts of GDP that are effectively out of this, taking the real percentage to anything between 85% and 100%. Add unaccounted subsidies and bank capital shortfalls, and we are probably at 125%. So while we were not watching, India seems to have become an advanced country.
Another illustration. In the late 1990s it was fashionable to suggest that the Indian software industry can grow at 40-50% a year for several years to come as its global market share was only 2%. The problem with this analysis was that the effective market share was actually more like 15%. There were several product and service areas that Indian companies were simply not present in, and the difference in billing rates onsite and offshore meant that the share in effort terms was much higher. And 15% was actually very high for an industry with low market concentration in cross-country terms.
This issue gains particular significance when the decision to lend is so fraught with uncertainties, like it has been for the last 3-4 years. But like the reasons for many other ills, we are happy to ascribe this too to a weak economy. It is not just a weak economy but a mixed problem.
An apparently low loan-to-GDP ratio of 55% is certainly not a sign of financial stability in an economy where the least credit-intensive segment—services—is not just the largest contributor to GDP but has been growing the fastest. For 2012-13, agriculture, industry and services loans to their respective GDP (not the entire GDP) were 36%, 134% and 35%, respectively. But services comprise 65% of total GDP (at current prices). There could be some classification issues with the basic data used, but if industry—18% of the economy—soaks up even 100% of its GDP as credit instead of the 134% noted above, banks have a serious saturation problem here. Also, let us remind ourselves that the compounded growth in real GDP for agriculture, industry and services over the last five years have been 2.8%, 5.3% and 8.8%, respectively.
Moreover, whereas credit to industry has largely been the domain of banks, big chunks of agriculture and services have stuck to shadow banks for years, a nexus that has proved notoriously difficult for banks to break. In addition, it is much easier to lend to industry than to agriculture (operationally challenging) or services (fragmented market), and now it is clear that banks have done too much of this easy thing for years.
Since 75-80% of the banking system (state-owned banks and a few private banks) are overly dependent on credit to industry, the steady decline—not just a cyclical one—of the relative importance of industry in GDP has pulled down overall credit growth, which could have regressed to single digits had it not been for close to double-digit inflation. Banks will have to continue to work hard on catering to the services and agriculture sectors not just because of financial inclusion mandates but because the low-hanging fruit—industry—has become both low-yielding and high-calorie.
So when you observe that the sectoral pie of loans looks pretty much the same as the sectoral pie of stressed loans, do not blame it just on crony capitalism. Bankers structurally have limited options. We are characteristically prone to pushing credit to less appropriate borrowers because the more apt ones do not want it or at least need less of it.
The author has been a research analyst on financial services as well as other sectors at various investment banks, and is now an independent consultant focusing on banks and financial services.
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Business NewsOpinionWhy it is hard to lend to the right borrowers
First Published:27 Mar 2014, 02:10 PM IST
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