Explained: Is credit risk aversion constraining economic growth?

Or is it a case of expecting the tail to wag the dog?

The world has stepped into 2021 with hope for the future. For India, there has been intense speculation as to what letter of the alphabet the shape of the post-Covid economic recovery would take — a wide range has been predicted from U, V, W to even K! With vaccination now starting and segments of the economy showing resilience, there are good prospects of an economic recovery from 2021.

India’s GDP growth rate had fallen to 4.2 per cent in 2019 even before Covid had struck the country, and efforts were being made by the government, in tandem with the Reserve Bank of India (RBI), to revive growth. Many reasons have been ascribed for the sharp deceleration in growth. One of them has been the purported risk aversion of commercial banks to lend on account of their rising non-performing assets (NPAs) and stretched balance sheets. Experts in India and abroad have highlighted that the banking system, especially in the public sector, has turned risk-averse and this could impact economic recovery. A recent Nobel Laureate with roots in India has described the Indian banking sector as being in a ”zombie” state with banks half dead with bad debt. His fear is that if the books of the banks are carefully examined, they would be in the red.

The narrative that aversion to lending is the main cause of economic slowdown needs a closer look. An attempt would be made here to analyse how much the risk aversion of banks has impacted credit growth, partly through data and, to some extent, through the experiences of a banker who was on the ground. There was a sharp acceleration in credit growth in India, especially in the corporate and infrastructure books, after the global economic crisis of 2008, owing to easy liquidity and huge demand from companies for capex borrowing. This led to high GDP growth for a few years but the process started unravelling thereafter. Some of these investments did not yield the desired outcome and companies were saddled with over-capacity and high leverage, leading to stress on their balance sheets and defaults on their loans. The RBI rightly stepped in at this juncture with its Asset Quality Review (AQR) in 2015, which led to a sharp rise in NPAs from that year for all corporate lending banks, public or private. Two large private banks also declared losses in this period. The aim of the banks since then has been to clean up the balance sheet of the legacy accounts and make sure that fresh lending is done in a manner in which the shortcomings in credit underwriting are not repeated. The RBI supervisory focus on stressed assets has also been tightened significantly and with measures like the weekly reporting of loan accounts to the central bank under the CRILC system in place, apprehensions of hidden NPAs would now be misplaced.

In this backdrop, is it true that banks are now shying away from lending, which is leading to the GDP slowdown? Table A shows that it is difficult to establish a direct causal correlation between credit growth and GDP growth.

Loans to industry and infrastructure started slowing from 2013 onwards although GDP growth continued to be relatively high till 2017. A plausible explanation is that demand for credit from the industrial and infra sectors started coming down from 2013 because capacities had already been built earlier. The economy, however, continued to grow at a healthy pace for a few years since industry could utilise the capacity already built. Subsequently, companies have held back from investing and, therefore, the demand for credit has come down. The experience of State Bank of India (SBI) has been that the credit flow to companies with a healthy balance sheet, a good business model, and good ratings continued to be available but there was a contraction in demand for credit, both for term loans and working capital. In spite of the lower demand for credit, growth in the loan book has been reasonable. During the past few years, as part of the efforts to clean up their balance sheet, NPAs were significantly reduced either through recovery or resolution. Credit growth includes both standard accounts as well as NPAs, and thus reduction in NPAs brings down the growth figure. In the case of SBI, in the corporate book, the reduction in NPA outstanding in 2018-19 and 2019-20 was about five times more than the normal reduction seen in the previous years. Banks also saw large underutilisation of the limits sanctioned in 2018-19 and 2019-20 — this reflects the fact that banks did not hold back on lending but borrowers held back on borrowing due to adverse conditions in the market.

Funding for economic growth comes from various sources and each country has had its own path. An analysis of the data for “Domestic Credit to Private Sector by Banks” (% of GDP) for various countries and groups (World Bank 2019) shows that the figure is 50.2 per cent for India, in line with the consolidated figure for lower middle-income economies (44.4 per cent). The only major exception is Vietnam, where it was 138 per cent. Even for other groups like upper middle-income economies (120.8 per cent) and high-income economies (81.5 per cent), while the consolidated figure is higher, there is no set pattern as to which country avails of more credit from banks.

The Indian economy and the banking system have gone through a period of difficulty. Companies have cut down on leverage and realised the need to conserve more cash for difficult times. Banks have also done a lot to refine their underwriting and risk mitigation skills. As a result, even after a massive lockdown of the economy in the first two quarters of 2020-21, the number of companies that have come forward to avail of restructuring under the RBI Covid guidelines has been much lower than anticipated. This shows that the corporate sector and banks’ lending to them have indeed become more resilient. It is imperative that this healthy development is sustained. We will, of course, need banks to step in as the economy revives and companies make fresh investments. Banks now are in a position to do so and credit growth will pick up as demand revives. Our journey to a five-trillion-dollar economy will become smoother.

The writer is former Managing Director, State Bank of India