The options we have to finance our economic revival

India has been able to withstand the impact of the covid pandemic far better than most countries. Recent high-frequency indicators show demand is holding up and the covid curve is flattening. India is looking at a strong rebound, with gross domestic product (GDP) likely to increase 10.5% in 2021-22. More importantly, some government initiatives, such as production-linked incentives (PLIs) and corporate tax reduction, have translated into a revival of India’s medium-term growth prospects.

Needless to say, more needs to be done. A growth revival is contingent on investment picking up—more importantly, private investment. Both household and corporate investment have been decelerating. On the other hand, government capital spending has been stable. Kick-starting the capital expenditure cycle will require the government to step up its investment rate to crowd in private investments.

But who will finance the government and then the private-sector capital expenditure cycle? India is one of the world’s high saving countries, with a savings rate of about 30% of GDP. This is lower than the savings rate of 39.6% for Asian export-oriented economies, but higher than the global average of 27%.

Still, India’s savings rate is not high enough to finance its consumption and investment. Thus, India runs a consistent current account deficit (1.3% of GDP over the last 5 years), except this year, which in turn is financed by foreign savings. These come in the form of capital flows. While foreign direct investment is relatively stable, foreign portfolio investment tracks the domestic growth outlook as well as global liquidity conditions.

Domestic savings are mostly generated by Indian households (18.2% of GDP). As much as 63% of these savings go into physical assets or real estate. This leaves net financial savings at 7% of GDP to be invested. Most of this finds its way into banks as deposits. The remaining amount is invested in pensions, insurance and kept as currency. While the corporate sector does save 10.4% of GDP, it also invests and borrows from banks. Thus, household savings are channelized to meet the needs of the corporate sector and government spending.

The intermediation is largely done through banks. For every ₹100 of deposits raised, banks have to invest ₹18 in government bonds. The remaining can be lent to corporates or consumers to meet their needs. This has not been the case this year. The credit-deposit ratio of Indian banks has fallen from 76.4% as of March 2020 to 72.8% as of December 2020. On the other hand, the share of government bonds has increased to 30.4% from 27.2%.

This is due to risk aversion as well as lack of investment opportunities. However, this has not always been the case. The credit- deposit ratio of Indian banks had peaked at 78.1% in 2011-12 from a low of 53.1% in 2000-01. This also coincided with an increase in India’s investment rate from 25.5% in 2000-01 to a peak of 37.6% in 2010-11. Since then, the country’s investment rate has been in decline.

Apart from finding few opportunities to lend, banks have also faced issues related to rising non-performing loans. A part of the assets created by banks from deposits could not service their principal and interest payments. Non-performing loans as a proportion of overall advances increased to 7.5% in September 2020 from 2.25% in 2010-11. This is lower than the peak of 11.2% in 2017-18. Most of these non-performing assets were with public sector banks (PSBs). Indian banks, in particular PSBs, have been able to clean up their books by increasing provisions to write off these loans. Their provision coverage ratio increased to 72.4% in September 2020 from less than 45% in 2014-15.

Non-performing loans are likely to increase on the back of covid. According to the Reserve Bank of India’s Financial Stability Report, non-performing loans are likely to increase to 13.5% of advances in a base-case scenario. Recent bank results suggest this ratio is likely to increase, but perhaps not to that level. Indian banks, in particular those with lower capital ratios, will have to raise additional capital. After raising capital, banks will be in a position to start lending.

For India’s economy to grow faster than 7% annually with inflation of 4% would imply nominal GDP growth of 11% plus. In the past decade, the banking system’s deposit growth has been 12.1%, which coincided with credit growth of 12.7%. This was possible as the government was able to rein in its fiscal deficit from a high of 6.5% of GDP in 2009-10.

What if we were to step up our nominal growth rate? During the 2000s, Indian banks managed a deposit growth of 18.1% and credit growth of 22.1%. This was possible as government borrowing was on the mend. While the fiscal deficit is likely to narrow going forward, Indian firms and banks can also look at foreign capital to finance domestic growth. Lower corporate taxes and higher exports under the PLI scheme imply higher profitability and a better ability to service debt. A similar model was followed by Asian exporters. Higher inflows that fund corporate credit will coincide with relatively benign global liquidity conditions.

But all of this will work if Indian banks start lending again, as was the case in the past. Lower government borrowings and surplus global liquidity will ensure that banks have enough and more to lend.