India slowing down but still growing
Shrinking demand, tightening credit and a simmering shadow banking crisis slow India’s drive for a US$5 trillion economy in 2025
High growth aspirations matched with bold government measures have been unable to stem recent sharply shrinking forecasts for an economy beset with numerous challenges, including a slowing business cycle and a profitability-and capital-constrained banking sector crowded with cash-strapped NBFCs
WITH limited room on the fiscal side, the US-China trade war slowing global growth and exports, and a credit crunch dampening consumption and job creation, the newly re-elected Modi government has focused on bold measures to restore confidence, reverse a string of five quarters of declining growth, and get back on the road to its much-touted goal of a US$5 trillion economy in 2025.
The slowdown has also affected the banking sector burdened with non-performing loans and assets, declining investment, and shadow banks rocked by last year’s default of Infrastructure Leasing & Financial Services (IL&FS), one of the country’s top non-bank financial institutions (NBFCs), which play a crucial role in the economy.
India’s GDP growth rate slipped to a six-year low of 5% in the second-quarter of 2019. To reach the US$5 trillion goal, India needs a steady string of 8% GDP annual growth on the back of 10%-plus investment and 3% productivity growth, which was only achieved during the 2000-10 decade, points out Samiran Chakraborty, Citigroup’s managing director and chief economist, during a panel discussion organized by The Asset in association with Fitch Ratings.
The Reserve Bank of India (RBI) forecasts growth of 6.1% for the fiscal year 2019-20, a sharp drop from the 6.9% it forecast in its August review. Fitch rates it even lower. “We have 4.6% for this year, 5.6% for next year, and 6.5% the year after,” Thomas Rookmaaker, Fitch Ratings’ director of sovereign ratings, notes, explaining the drop on the credit crunch’s impact on demand. “Once confidence drops, people no longer want to invest.”
The decline in the growth rate over the last 12 months has been swift. “Nobody predicted 5% GDP growth for this April-June quarter six months ago,” Citigroup’s Chakraborty adds. “[The credit crunch] started even before the IL&FS default. Demonetization in 2016 led to a lot of inflow into the financial system. Then the RBI started to take that excess cash out of the system. And once that tightness was a fact, that triggered the next round of [tightening] moves.” Fitch’s Rookmaaker believes the slowdown is a reflection of the business cycle and structural problems inherent in the financial system. Chakraborty notes that “even with those structural problems, we could have grown at 7% or 8% if the [business] cycle tailwind was with us. Now, since it’s gone, the slowdown is more exacerbated.” At this end of the cycle, he explains, Indian corporates are generally over leveraged, and the markets and investors have become risk adverse, tightening lending and shrinking consumption. “Salary growth over the last few years has not been good,” Chakraborty adds. “The bulging of the middle class has not happened, and that means that consumption growth was funded by household savings and borrowings. But with this credit crunch, those channels got blocked.” It’s not all doom and gloom however, V. Srinivasa Rangan, executive director at India’s Housing Development Finance Corporation (HDFC), is more optimistic. He sees the housing sector continuing to deliver the growth it has been posting over the last few years. The lending support has been there, he points out, and the sector is intact with a reasonable amount of asset growth – 12% to 15%. And this has happened, he notes, amid a lot of structural change and the introduction of numerous government measures – demonetization, the introduction of GST, the creation of the Real Estate Regulation Authority, the passing of the Insolvency and Bankruptcy Code and RBI rate cuts. Chakraborty finds onshore investors more pessimistic than offshore ones, noting that the government’s economic measures seem to have reassured offshore investors that the downside is manageable. As an investor, he points out, if you see the slowdown as cyclical, this may be the time to invest; while if you consider it as structural, you’ll wait. Rookmaaker questions the extent of the impact the government’s measures will have over the next few years, suggesting investors want to see more structural reforms, especially in areas of labour and land acquisition. “The government tried to pass the Land Acquisition Act a few years ago, but it didn’t work,” he says. “Maybe over time, it will gain a majority in the Rajya Sabha, India’s Senate, and it will become easier to implement this kind of reform.” In addition to structural reforms, Chakraborty thinks “a bit of fiscal stimulus is probably required just to get the economy out of the rut”, warning that in this risk-adverse atmosphere transmitting the RBI’s rate cuts into actual growth could be limited. “In ideal circumstances, with the monetary policy working, you probably wouldn’t need the fiscal.” Rookmaaker agrees that fiscal policy is needed as “monetary policy can’t do all the work”.
The health of the banking system is not great. “We’ve had pretty ambitious growth among the private banks, but the public banks continue to be constrained in terms of profitability and capital,” Jonathan Cornish, Fitch Ratings’ head of APAC financial institutions, shares. He adds that the RBI took too long to recognize the issue of non-performing loans, and new capital coming in is fortifying the banks’ balance sheets, leaving no capacity for lending. This creates an even more negative, risk-averse environment. And “we see the potential for a build-up of more problem loans before they have addressed the existing stock”.
The capital constraints of state banks are a systemic issue, Saswata Guha, Fitch Ratings’ director of India bank ratings, warns, adding that the government has been providing them with capital support, one of the reasons for the continuing high level of risk aversion. The current consolidation of state banks is a good thing as there are many similar banks, he says, but it doesn’t solve their capital and asset quality problems.
Fitch’s Cornish adds that the government clearly wants to see the state banks in a better position to lend, but worries this could prompt them to make more bad loans and prolong this weak environment in which state banks are saddled with problem loans and weak capitalization.
“All of our long-term ratings are predicated on expectations of government support,” Cornish says. “And I think in the latest round of bank mergers, we are going to see 10 banks folded into four.” India’s finance minister has announced the merger of 10 public sector banks (PSBs) into four as part of a wider two-year merger plan, begun in 2017, that will see the number of PSBs reduced from 27 to 12.
“Collectively, their balance sheets are going to grow by over 40%, and they will become systemically more important,” Cornish notes. “But with fewer, more important banks, perhaps there will be more potential for earlier intervention.”
At the heart of the credit crisis are the NBFCs, which are facing a tough challenge with US$10 billion in developer loans coming due in the first half of next year. “There is a contagion risk,” Guha admits. But he points out the market distinguishes between stressed and less-stressed NBFCs, and continues to fund them. Fitch estimates actions by regulatory authorities over the recent months have provided the sector with six months of liquidity.
“But that doesn’t address the long-term concerns of investors,” Cornish says. “In early 2019, we revised our operating environment score from triple-B minus to double-B plus. Many investors felt we were slow in moving, but we think it was a pre-emptive move.”
Going forward, concerns about the health of the Indian banking system, over-leveraged corporates and structural reforms will have to be addressed. Investment, productivity and consumption will have to pick up. Despite the negatives, the economy, ranked seventh in the world in 2018, is still growing well ahead of its triple-B peers and in contrast to 90% of other economies. However, reaching the US$5 trillion goal may take a little longer than the promised 2025.