Q2 may be worse than Q1 but economic growth is likely to recover from Q3 onwards despite the downside risks emerging in the banking sector
The fact that the world is witnessing an economic slowdown is not a surprise. Growth has slowed down across the world and it has even contracted in countries such as Germany. Leading Central bankers and Government officials have expressed concerns over the last couple of months with respect to addressing the global downturn.
Central bankers have further expressed the need to reduce trade- induced uncertainties and called for fiscal measures to address the current economic crisis. The very fact that we’re discussing a calibrated response to a global slowdown may ensure that the deceleration is short-lived, and we’re back to a decent growth level.
Back in India, we see high frequency economic data for the month of August which further reveals that the downtrend continued throughout the quarter. Be it the data on Goods and Services Tax (GST) collections, automobile sales or the Index of Industrial Production (IIP), the second quarter (Q2) of the financial year (FY) 2019-20 is unlikely to be better than the first quarter (Q1), if not worse.
The extent of the slowdown further points to the fact that we are likely to hit the bottom in Q2. This means that very likely we will see economic recovery from Q3 but there are fresh challenges that have emerged over the last couple of weeks. The slump in the real estate space has only created further concerns with respect to the Non-Performing Asset (NPA) crisis.
It is important to recognise that not all NPAs are cases of fraud or money laundering. Most of them were caused due to genuine business failures — they may have been because of flawed business plans or the severe economic downturn that India experienced from 2012 onwards. The instances of real business failures must definitely be penalised — and there have been honest efforts by bankers and investigative agencies on that front.
To solve instances of genuine business failures, the Government has already enacted the Insolvency and Bankruptcy Code (IBC), that has been instrumental in putting in place a resolution mechanism through which banks could recover their money. The process has also facilitated a change in management for many companies. There’s no doubt that the IBC reform is extremely instrumental in addressing the problem over the long run. However, unfortunately, it may not offer much help in addressing the current challenges faced by Non-Banking Financial Companies (NBFCs), particularly housing finance companies, builders and many homeowners.
Financial stability is built around trust and confidence in the system. It is this credence that allows firms to borrow and lend at cheaper rates of interests. Lack of trust pushes up the cost of capital and dries up the supply of credit as lenders are extremely risk-averse in nature. Something similar seems to have happened in India post the NBFC crisis, as domestic credit is choked but Indian firms raised record levels of high debt through external commercial borrowings. This shows that there’s definite demand for credit but our lenders are unable to service it.
This has severe implications for the real estate sector which is sitting on accumulated inventories worth trillions at a time when growth has slowed down. The real estate business has not witnessed a boom, except for the affordable housing segment, for a long time and this has further depleted the sector’s ability to absorb an economic shock. A part of this distress is already being felt by NBFCs and it is spreading over to the banking space.
Financial systems are fragile and, therefore, there’s an urgent need for intervention by the Reserve Bank of India (RBI) and the Government to address some of these concerns before they develop into a financial market crisis. India’s banking system is indeed robust and strong. However, at a time when growth is slow and credit is choked, it is imperative that we shed morality and intervene on the basis of economic rationality.
Growth will revive from Q3 onwards but we need to ensure that we systematically strengthen our financial system during the process. It is important to recognise that post the Lehman Bankruptcy in 2008, the US Government realised the extent of worthless assets that had accumulated in their banking system. They announced a Troubled Asset Relief Programme to address the problem which entailed infusion of fresh capital into their banks. The Indian Government has already done the same and the Finance Minister has already front-loaded the fresh plan for recapitalisation of Public Sector Undertakings (PSUs). There have been other measures to help some struggling NBFCs as well.
But the key difference is that in India, a lot of these stressed assets continue to be concentrated on the books of banks. There’s a genuine need to re-explore the possibility of taking them off their books, into a bad bank, which could then auction the same to asset reconstruction companies. We must forget the issue of moral hazard at the moment and approach the problem in a pragmatic manner. The Government did announce a policy to give finance to unfinished projects in the affordable real estate space on September 14. However, a bulk of the value is stuck in projects in the luxury housing space and so there’s a need to simultaneously extend the scheme to cover these projects.
The other important lesson from the 2008 experience is how the Federal Reserve System proactively merged investment banks with some commercial ones. This was done to strengthen and stabilise the financial system. We’ve seen a great consolidation of Public Sector Banks (PSBs) through mergers over the last couple of years but we’re yet to see further consolidation of NBFCs with some of the bigger banks. Doing so may make some of these merged entities bigger, but then, as of today also, they’re too big to fail.
Therefore, there’s no sound justification for not moving in that direction. The current troubles at Lakshmi Vilas Bank would have largely been resolved had the RBI facilitated its acquisition by Indiabulls. But of course, the RBI denied it and asked NBFCs to seek banking licence through the normal route. It is imperative that our regulators realise the importance of second and third order impact of their decisions. More so, in the financial space where their decisions have implications for systemic risks.
Over the next couple of months, we will have to take a decision with respect to the kind of financial system we want in India, specifically with respect to the degree of integration between banks, NBFCs and other depository institutions. It is important to keep in mind the objective of having a financial system that’s conducive for growth and can facilitate a $5-trillion economy.
While there may be downside risks to our growth but very likely the worst is over. There are some challenges that continue but we’ve seen the Finance Minister play a proactive role in addressing them. Most of the measures announced by the ministry are definitely in the right direction. However, we may need a few more steps to get there.
(The writer is a New Delhi-based policy researcher)