Expand credit to boost growth

The low penetration of private credit as a percentage of India's gross domestic product suggests that all channels of credit have tremendous potential to grow

A significant portion of the Indian economy could grow a lot faster if its credit needs were better met. Estimates of unmet credit needs of creditworthy Indian companies and small entrepreneurs range from $500bn to $1tn compared to India’s current GDP of about $2.8tn and total outstanding credit of about $1.8tn from scheduled commercial banks (SCBs), corporate bonds, and HFCs/NBFCs. Closing this gap would clearly boost economic growth materially.

Private sector leverage in India (as measured by total private credit to GDP) is a fraction of that in other large economies, providing a long runway for growth in credit to support above-average economic growth. However, close attention has to be paid to managing the quality of credit growth and of the delivery channel.

The period FY14-18 has been one of significant deleveraging for SCBs, owing to the RBI’s much-needed tightening of norms for bad-loan recognition as well as imposition of PCA on about half the public sector banks. If SCBs were growing their advances in FY14-18 at the same pace as in FY09-14, all else being equal, it would have boosted GDP growth rates by about 400 bps in FY14-18.  

The vast majority of NPAs from the rapid FY09-14 credit growth was from very large projects with lengthy durations for return of capital. Too much of banks’ balance sheets were utilised for large long-term projects — a need generally best fulfilled by bond markets. During the FY14-18 banking deleverage, initially bond markets and HFCs/NBFCs filled some of the gap created and witnessed strong growth. In 2018, bond issuance slowed down, driven by rising yields, reducing issuer appetite.  Subsequently, accelerating growth in credit from NBFCs/HFCs encountered its own headwinds with September’s IL&FS debacle. The commercial paper market dried up and several HFCs and NBFCs had to sharply curtail disbursements.

The low penetration of private credit in India as a percentage of GDP suggests that all channels of credit in India have tremendous potential to grow. What is the optimal mix for the growth between banks, bonds, HFCs, and NBFCs? As a proportion of GDP, bank credit is roughly the same in India and the US — the world’s broadest and deepest capital market. However, total private credit is three times the proportion of GDP in the US relative to India. This suggests that the big gap between outstanding credit in the two countries is primarily in bonds and NBFCs, and while credit from banks should continue to grow modestly faster than nominal GDP in India, it is bonds and NBFCs that could grow significantly faster.  

A glance at the credit rating methodology of the credit rating agencies suggests that the vast majority of Indian companies would not be eligible for borrowing at investment grade rates, largely due to being of sub-critical mass in terms of size. As more Indian companies pass the threshold for accessing bond markets at friendly rates, they will serve to further develop the bond markets and gradually shift a significant portion of the credit markets, especially for larger and longer-term projects, to bonds.

However, the need is to enable credit growth to MSMEs (micro, small and medium enterprises), which provide employment to 40 per cent of the workforce and contribute about 37 per cent of GDP. It is in this underserved market that the gap between demand for and supply of credit is the greatest. It is also in this market that key enablers (credit scores, formalisation of the economy, and the emergence of HFCs and NBFCs as low-cost origination channels) have emerged to broaden credit access while reducing risk and bringing down credit costs.

On HFCs and NBFCs, the government and regulator need to take note of the changing landscape and while improving the collection and monitoring of data should enable more efficient growth in credit with fewer restrictions. Monthly data reporting on sources of capital and on end-market credit exposure by size of loan, industry and geography (state/UT) would help in mitigating potential build-up of unnecessary risk. Higher visibility into markets being lent to by industry and geography of NBFCs overall will help NBFCs themselves avoid overcapitalising industries and geographies, while vastly improving the management of their risk exposure.

Currently, HFC and NBFC data is available from the RBI with a very significant lag and is not granular enough to detect many inflection points and trends. The relative scale of NBFC and HFC segments and their contribution to overall credit has become sufficient to warrant more frequent data availability on at least a quarterly basis, if not monthly.

The dilemma for India currently appears to be on how to shift large project loans away from banks to corporate bonds and thereby reduce asset-liability mismatch at banks while getting banks to provide many more mid-size and smaller loans. Perhaps we have been overly conservative and not innovative enough to expand credit without the corresponding increase in risk of incremental credit, and have not kept up with changing times.  

A significant boost to the depth and breadth of bond markets could come from broadening the choice of bonds available to banks and insurance companies with ratings of up to a couple of notches below what is currently permissible. India’s corporate bond market appears on the cusp of attaining critical mass, with a whole class of corporates almost attaining investment grade status for even material issue sizes, a status that was originally limited to only the largest Indian corporations. Broadening the pool of potential buyers of bonds would likely advance the attaining of critical mass of the Indian corporate bond market by a couple of years, and accelerate GDP growth.  

What is also required is a more pragmatic approach from the government and regulator on NBFCs as an origination channel for credit. While both government and regulators have been overly focused on the risks posed by unsupervised growth of a sector that is not as regulated as banking, they have not optimised the use of a very low-cost channel for expanding credit in the market while also diversifying the risk across a greater equity base. In reality, the banking sector, even in its current structure of being dominated by the public sector, would be a lot safer if there was an additional cushion of equity providing riskier credit to the burgeoning demand for growth capital.  

The RBI’s threshold for classifying a company as an NBFC — financial assets comprising more than 50 per cent of total assets, income from financial assets constituting more than 50 per cent of gross income, and a minimum of Rs 2 crore of net own funds — appears low considering the well over 10,000 entities that qualify. However, the threshold is significantly higher for using MUDRA refinancing, with only those with an investment grade rating and over Rs 15 crore as net own funds qualifying.

Perhaps the authorities should revise the criteria for MUDRA to enable a broader selection of NBFCs to qualify for refinancing MUDRA loans, particularly those that can better understand the needs of smaller borrowers and also disburse loans with significantly lower execution cost. If banks lend to NBFCs that do not have investment grade ratings and have substantially lower net own funds than currently required thresholds, MUDRA refinancing could also be feasible and permitted to those NBFCs.    

The writers are Vice Chairperson and Officer on Special Duty at NITI Aayog. The views are those of the writers and don’t necessarily represent those of NITI Aayog