The Reserve Bank of India (RBI) implemented liquidity tightening measures last month in order to support the rupee. This has resulted in a lending squeeze as the risk of a relapse in non-performing loans (NPLs) across India’s banking sector increases.
On July 15, India’s central bank surprised the market with measures aimed at pushing up short-term rates to support the currency, which had fallen to a historic low. Then just over a week later, the RBI further tightened liquidity.
Initially, the measures were only expected to remain in place for a short period of time, with the forward market pricing in a reversal in policy after four months. But the rupee has continued to weaken (it is at a record low of 61.80 to the US dollar at the time of going to press) and many are now forecasting a longer period of tight liquidity.
This has led many banks to hold back on issuing loans – according to anecdotal evidence - due to uncertainty over the RBI’s policy direction an unwillingness to pass on the higher cost of funding to clients for fear of becoming uncompetitive, and the relative attractiveness of alternative investments.
“These measures taken by the RBI have led to short-term rates rising by around 200 to 250 basis points (bp). So with short-term rates that much higher than long-term rates it is very natural for banks not to lend more when they can make money in the short term by investing in CDs [certificates of deposit] at 10.5%,” said Punit Srivastava, deputy head of research at Daiwa in Mumbai.
“This is particularly true as the lending rates have not gone up so much – some banks have raised their base rate by 20bp to 25bp to try to compensate for the loss in margins they may face in raising short-term money at high rates, but not all have even done this.”
Lenders are slowly beginning to adjust to the changes. In the past week, Yes Bank increased its base lending rate from 10.5% to 10.75% and HDFC Bank became the first major bank to raise its base rate – from 9.6% to 9.8% - effective August 3.
In the short term, this is likely to have limited impact on either banks’ profitability or on corporate access to funding.
“Loans given for working capital are unlikely to be stopped, it’s just that there will be less inclination to lend at this point of time because of the higher rate. The [benchmark 10-year] government bond is giving a risk free return of 8.21%, so in that scenario it’s really natural that one would see some kind of slowdown in loans,” said Srivastava.
Long-term problem
However, if these measures continue for six months or more, this could result in the higher rates being passed onto corporates, with a negative impact on GDP growth, loan growth and asset quality. In the worst case scenario, this could result in a jump in total impaired loans (non-performing loans plus restructured loans) for banks to as high as 15.5%, according to Anil Argawal, analyst at Morgan Stanley.
“Previously, our expectation was that Indian banks’ fundamentals would remain weak, but asset quality would bottom out in the coming quarters as GDP starts to recover, and rates and inflation begin to ease. However, there is now rising risk of a relapse in asset quality if the RBI’s quantitative tightening measures are prolonged and macroeconomic conditions weaken,” he said.
He has raised his forecast for the overall banking system’s impaired loans from 9.2% in 2013 to 12% in 2015 in his base case and 15.5% in his bear case. This is a similar level as in the late 1990s and early 2000s, when NPL ratios were in the double-digit range.
Indian banks, particularly the SOE banks, have been struggling with NPLs for the past two years. With the weakest loss-absorption cushions among the Asian banks (less than 2% of risk-weighted assets), Indian banks are not in a good position to take on another wave of fresh NPLs,” he said.
“In particular, SOE banks may require additional capital injections from the government, which would add further pressure to the government’s already constrained fiscal position.”
Whether or not this happens depends in large part on the RBI’s policy stance. If the central bank continues to defend the rupee through enforcing tight liquidity, the banking sector could come into severe stress.
“The relief so far is that they have not done anything new. We are hearing they are trying to sell dollars in the market to try to protect the rupee so there seems to be some shift in their stance for now,” said Srivastava.