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Photo: AP
Photo: AP

Structural interventions could avert a banking crisis

Fix anomalies and market distortions so that credit can be allocated in ways that are best for India

After the world’s severest lockdown and biggest decline in economic growth among emerging markets, India’s financial fragility is expected to spike. The share of non-performing assets (NPAs) in its banking system could rise to 18% of outstanding assets, double of what countries hit by the 2008 financial crisis experienced. NPAs were high and widespread even before the covid shock upped the vulnerability of financial institutions. If India had a “twin balance sheet" problem earlier, it may have a “four-fold balance sheet" problem today.

What can be done to prevent a banking crisis? A lot will depend on how problems are addressed and the timing. Cyclical interventions and restructuring loans are unlikely to work. The insolvency system could take decades to tackle bad debts and the capacity to recast them seems choked. An extension of India’s loan-repayment moratorium would not be effective either.

Cyclical interventions are insufficient as there is only limited space to use fiscal and monetary policies against a banking crisis. Current savings will not be able to absorb the scale of bond issuance needed for a fiscal response. Some deficit monetization could be done, given India’s balance of payments surplus, but this will be a one-time remedy. Monetary policy action is hampered by a broken transmission mechanism.

The root cause of India’s banking vulnerability is structural and not cyclical. Three key structural interventions are needed:

First, shift the banking sector’s focus more towards promoting entrepreneurship and wealth creation. Help efficient firms, especially new ones, gain access to bank loans. For this, eliminate factor market distortions that let large and less efficient firms get a disproportionate share of credit disbursals.

Second, modernize the supervision of credit risk in financial institutions to improve credit allocation and identify who is “swimming naked", as the phrase goes.

Third, increase investments in physical infrastructure and human capital.

Enterprises need land, labour and capital for production. Land markets are hugely distorted compared to other factor markets. As banks rely on land as collateral, their loans are also distorted by land grabbed by less efficient firms. Over time, these distortions have worsened, with an ever widening gap between access to finance and optimal use of it. This problem is worse in manufacturing than in the services sector. Empirical evidence has shown that there are huge gains in growth from reducing land misallocation, and, with it, improving capital markets (see G. Duranton, E. Ghani, A. Grover, & W. Kerr, ‘A detailed anatomy of factor misallocation in India’, Policy Research Working Paper Series 7547, The World Bank).

Indian banks also need operational changes. They need to be configured for sector analysis, borrower resilience and high-frequency analytics, so that they can dig deeper to understand what’s happening in the financial life of debtors. Digital advances allow banks to deploy new techniques to promote entrepreneurship and monitor which borrowers are not meeting their payment obligations.

There is rising concern that the Achilles’ heel of India’s financial system is the government’s “fiscal dominance", which is said to have compromised the functioning of financial institutions. There is plenty of room to strengthen the country’s institutional framework so as to strike a good balance between the roles played by the government and private sector in wealth creation. However, the evidence is weak that “fiscal dominance", especially involving investments in infrastructure and human capital, is the main cause of banking fragility. The experience with India’s investments projects such as the Golden Quadrilateral highway contradicts that perception. Improved transport infrastructure has enabled bank branches to spread more widely from urban to rural areas, and from mega cities to medium size cities, thus granting many more entrepreneurs access to bank loans. There is a strong role for an efficient and well-targeted fiscal policy to promote infrastructure investments that will encourage entrepreneurship, and for banks to provide more credit to new enterprises. The two goals are complementary.

India must also improve capital markets to reduce financial vulnerability. Corporations have continued to rely excessively on bank loans, and less on capital markets, for funds. The development of capital and corporate bond markets require that investors get timely information on default and credit quality. A modernization of financial institutions will reduce excessive bank borrowings by large corporations and create space for new and young entrepreneurs.

Solving India’s banking crisis, reviving economic growth and spurring job creation will depend on timely interventions on all fronts: improving the bankruptcy and corporate loan restructuring system; efficient use of the limited space available for fiscal and monetary measures; modernizing the banking system; and developing capital markets, especially for bonds. This is the right time to address the root cause of India’s banking vulnerability.

A shift in policy focus from cyclical to structural interventions could help avert a banking crisis. Not addressing the sector’s vulnerability now could choke the access of millions of new and young entrepreneurs to credit. This will create a high levels of uncertainty, dampen wealth creation and threaten the sustainability of inclusive capitalism.

Ejaz Ghani worked at The World Bank, and has taught economics at Delhi and Oxford universities

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