Rising debts among India’s states
Unlike the central government, India’s states have not managed to improve their finances. Their overall deficit as a percentage of GDP doubled between FY2011/12 and FY2016/17, reaching 3.5%. That deterioration stopped last year, with the deficit falling to 3.0% of GDP in FY2017/18. However, the states’ debt has continued to grow and equalled an estimated 23.8% of GDP in FY2018/19.
The deterioration in the states’ finances is mainly due to higher spending, caused by:
- The decision taken by some of them to take on some debts owed by the poorest farmers[7] through the “loan waiver scheme”, costing an estimated 0.3% of GDP in FY2017/18;
- The decision to assume some debts owed by public electricity companies as part of their financial turnaround plan (“Uday scheme”) in FY2015/16 and FY2016/17, costing 0.7% of GDP per year;
- Higher spending on wages and rent allowances, which make up almost 25% of the states’ expenditure, applying the recommendations of the “7th Central Pay Commission”;
- An increase in interest expense to 1.7% of GDP in FY2017/18 versus 1.5% of GDP five years earlier.
Difficulties in strengthening the banking and financial sector
The gradual deterioration in the financial position of India’s public-sector banks between 2011 and 2018 has dragged down bank lending since 2016, and has also affected business investment. However, the Modi government and India’s monetary authorities have introduced some major reforms to shore up the banking sector and enable it to support growth. The Insolvency and Bankruptcy Code, the recognition of no-performing loans and moves to recapitalise the weakest banks have allowed an upturn in lending since August 2018. However, the banking and financial sector remains fragile. Public-sector banks have been unable to raise the funds needed to comply with new Basel III solvency rules that came into force on 31 March 2019. As a result, although government expenditure on recapitalising public-sector banks has been modest (1% of GDP), it has been much higher than the initial targets announced in October 2017. Although India’s public-sector banks are now more capable of meeting the economy’s financing needs than they were three years ago, the quality of their assets remains poor and their governance is a concern. In addition, the interrelatedness between public-sector banks and non-bank financial institutions – whose share of lending has sharply increased in the last five years – is a growing source of risk.
One of Narendra Modi’s ambitions was to tackle India’s shadow economy and clean up the banking sector. To fight the black market, in November 2016 he took the unexpected decision to withdraw all 500- and 1,000-rupee notes from circulation. Today, it appears that 86% of India’s money supply has been withdrawn as a result. However, the positive impact on the shadow economy seems highly debatable, because cash remains the main payment method.
Banking sector restructuring
In May 2016 India’s parliament adopted the Insolvency and Bankruptcy Code, which is now the sole regulatory framework for resolving payment defaults, since all other procedures are no longer valid. Banks have only 180 days from the time of default to restructure bad loans of more than INR 20 bn. To speed up the resolution of bad debts, in 2018 the central bank lowered the threshold for lenders to reach agreement[8]. The central bank can intervene directly in the loan restructuring process, providing advice to struggling banks. Finally, to force banks to set aside more provisions to cover bad loans, since February 2018 the monetary authorities have required restructured loans and “special mention loans” to be regarded as non-performing.
Public-sector banks: a more stable situation
The financial position of banks, particularly public-sector banks, deteriorated sharply between 2011 and mid-2018 but has recovered since the second quarter of 2018. The NPL rate across the whole banking sector fell from 11.5% in Q2-2018 to 10.8% in Q3-2018 (14.8% for public-sector banks), and the proportion of loans deemed “risky” also fell from 12.4% in Q1-2018 to 11.3% in Q3-2018 (15.4% for public-sector banks). At the same time, the provision coverage rate rose to 52.4%, although this is still far too low. The solvency ratio across the whole banking sector was 13.7% in September 2018, falling to 11.3% for public-sector banks alone. In December 2018 the central bank took the view that nine public-sector banks would not achieve a 9% solvency ratio on 31 March 2019. The government had to inject more capital into them in early 2019. The wave of recapitalisations that have taken place between 2017 and 2019 is estimated to have cost the government INR 1,960bn, equal to 1% of GDP.
Risks arising from the growth in shadow banking
The proportion of lending taking place through the shadow banking system has doubled in the last five years, due in particular to the problems experienced by public-sector banks. We define “shadow banking” as lending by non-bank institutions, which are mainly non banking financial companies (NBFCs) and housing finance companies[9] (HFCs). The proportion of commercial loans granted by NBFCs and HFCs was 18% and 8% respectively at end-September 2018, equal to 17% of GDP. In addition, 50% of lending to the real-estate sector was by NBFCs.
NBFCs are under the supervision of the monetary authorities and must comply with prudential rules regarding capital and bad loan provisions. However, they currently have no liquidity constraints.
Overall, their financial position has deteriorated since 2015, partly because their short-term debts have risen sharply, causing a major mismatch between their short-term assets and liabilities. In September 2018, this caused one of the largest NBFCs (Infrastructure Leasing & Financial Services) to default. However, for the sector as a whole and according to the latest report by India’s central bank, it appears that:
- Their assets are less risky than those of commercial banks, because the central bank estimated their bad loan ratio to be 6.1% in September 2018.
- Although their solvency ratio has fallen by more than 5 points compared with 2015, it was still 21% in September 2018, higher than the regulatory minimum of 15%.
- NBFCs’ profitability remains weak, with a RoA of 1.8% and a RoE of 4.4% at end-September 2018.
Shadow banking’s growing market share is problematic because of its growing interrelatedness with the banking sector.
Bank loans are one of the main sources of funding for NBFCs and HFCs, accounting for 47.2% and 41% of their funding respectively. However, the related systemic risk remains low because lending to NBFCs as a proportion of Indian banks’ total loans outstanding rose was only 7% in December 2018. Indeed, the Indian authorities have encouraged banks to increase lending to non-financial companies. The aim is to help them access long-term funding in order to reduce the maturity mismatch between their assets and liabilities.
External vulnerability: lower than in 2013, but India is not attracting enough FDI
India is now less vulnerable to external shocks than it was in 2013. However, the country is not attracting enough FDI to speed up its development and make it less vulnerable to volatility in the international financial markets. In 2018, India’s FDI stock equalled only 14.3% of GDP, versus 22.5% in Indonesia and 21.7% in China. India remains vulnerable to rises in oil prices (23% of its imports) and tensions in international capital markets. Lower FDI inflows in 2017 and 2018 compared with 2015-2016, has made India much more dependent on volatile capital flows to cover its current-account deficit, although India is less exposed to capital outflows than Indonesia or Malaysia. India has sufficient foreign exchange reserves to cover its short-term external financing needs.
Short-lived improvement between 2014 and 2016
Between 2014 and 2016, India’s current-account deficit fell significantly, averaging 1.1% of GDP per year, having averaged 3.6% of GDP between 2010 and 2013. The improvement stemmed from a sharp fall in the trade deficit. India is an oil importer, and benefited from the fall in international oil prices.
FDI also increased sharply in 2015 and 2016, coinciding with the Modi government’s move to lift investment constraints, averaging 2% of GDP per year as opposed to 1.6% of GDP per year between 2010 and 2013. For two consecutive years, therefore, net direct investment fully covered the current-account deficit, leading to a sharp rise in foreign exchange reserves, which equalled 1.7 times India’s short-term external finncing needs in 2016.
Weaker external accounts since 2017
In 2018, India’s external accounts worsened again as oil prices rose and as foreign investors became more risk-averse against a background of US monetary tightening.
India’s FDI fell in 2017 and 2018 compared with 2015-16, and amounted to only 1.8% of GDP in 2018. It no longer covers India’s current-account deficit, which as a proportion of GDP has risen 1.7 points since 2016 to 2.4% because of higher oil prices. This makes India vulnerable to a potential shock in the international capital markets. In 2018, India, along with Indonesia, was one of the Asian countries worst affected by the loss of investor confidence in emerging markets. Capital has flowed out of India – with net portfolio investments falling by 1.4% of GDP in 2018 – and combined with the increase in the current-account deficit this caused a 9% fall in the rupee against the dollar and a USD 20bn fall in foreign exchange reserves. Nevertheless, foreign exchange reserves totalled more than USD 400 bn at end-March 2019 and remained comfortably enough to cover India’s short-term external financing needs (1.3 times).
To make India less vulnerable to external shocks and support its growth, the next government will have to attract more foreign direct investment. The fall in foreign investment in the last two years (compared with 2015-16) is hard to explain. According to UNCTAD’s latest report dating from mid-2018, FDI inflows into emerging Asian countries were broadly stable in 2017, and flows into Indonesia and Vietnam did not decline in 2017 and 2018[10].
Structure of external debt: moderate risk
India’s external debt is fairly low and its structure shows moderate risk. At end-December 2018, it amounted to USD 521.2 bn, equal to only 19.2% of GDP, and more than 36% of it was denominated in rupees in Q3-2018. More than 37% of external debt consisted of securities issued by Indian companies (“external commercial borrowings”) and deposits by non-residents (24% of debt). Government debt accounted for 20% of external debt.
Refinancing risks are moderate for India’s external debt. At end-December 2018, the amount of debt due for repayment by December 2019[11] was USD 226.6 bn (43.5% of debt), representing 55.7% of currency reserves in March 2019. However, non-resident deposits are included in the amount “due” in less than one year. As a result, debts due to be repaid in less than one year, excluding non-resident deposits, amounted to a mere USD 136.5 bn, equal to only 33.5% of foreign exchange reserves.
In the last five years, Narendra Modi’s government has pushed through some important measures – the Insolvency and Bankruptcy Code, the Goods and Services Tax and greater openness to foreign investment – taking advantage of its majority in the lower house of parliament. However, to achieve a significant increase in GDP per capita and reduce India’s vulnerability to external shocks, the new government due to be elected on 23 May 2019 will have to go even further with its reforms to create an environment that is more conducive to domestic and foreign investment.
The government’s room for manoeuvre in the next five years will depend on the result of general election.