India’s banking sector: a liability for monetary policy effectiveness?

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Author: Rajeswari Sengupta, IGIDR

The effectiveness of monetary policy depends largely on the stability and soundness of a country’s financial system. In India, banks are the largest financial intermediaries. The banking sector plays a crucial role in transmitting changes in the policy interest rate to the real economy. Lingering problems in the banking sector hamper the smooth transmission of monetary policy, potentially rendering an important macroeconomic stabilisation policy tool impotent. The problem is exacerbated during periods of worsening macroeconomic outlook such as the slowdown triggered by the pandemic.

A worker walks past the logo of Reserve Bank of India (RBI) inside its office in New Delhi, India, 8 July 2019 (Photo: Reuters/Anushree Fadnavis).

A worker walks past the logo of Reserve Bank of India (RBI) inside its office in New Delhi, India, 8 July 2019 (Photo: Reuters/Anushree Fadnavis).

Even prior to the pandemic, the link between monetary policy changes and bank credit growth had become tenuous. Since 2015, amid falling economic growth and deteriorating private corporate investment, India’s banks have been struggling to deal with stressed assets on their balance sheets. Their percentage of gross non-performing assets (gross NPAs) is among the highest in the world. Before the pandemic, the ratio of gross NPAs to total assets was 8.3 per cent for the overall banking system and close to 10 per cent for government-owned public sector banks.

The stress in the banking sector was exacerbated by structural weaknesses such as government ownership of 70 per cent of banks and regulations that allow banks to hide and delay problems, among other governance issues.

Years of balance sheet issues made the banks highly risk averse. Combined with the low demand for credit due to the investment slowdown in the private sector, this resulted in dismal credit growth. By the time the pandemic hit India in March 2020, bank credit growth had fallen to 6.14 per cent — the lowest in about six decades.

While the stress in the banking sector has been increasing, India’s GDP growth rate has been declining since 2015–16. The annual growth rate fell from 6.1 per cent in 2018–19 to 4.2 per cent in 2019–20, the lowest since 2008–09.

To stop the growth decline, policymakers implemented standard macroeconomic stabilisation policies. Between February 2019 and February 2020, the Reserve Bank of India (RBI) lowered the short-term monetary policy rate (repo rate) by 135 basis points to 5.15 per cent — the lowest rate in nearly a decade. But bank credit growth continued to decline. The effectiveness of monetary policy was hindered because banks did not pass on rate cuts to borrowers even on loans that were made during this period.

The pandemic compounded the structural problems in the Indian banking sector. To deal with the spread of the coronavirus, the Indian government imposed one of the most stringent lockdowns in the world on 24 March 2020. In the following months, the economy witnessed massive disruptions to supply chains as well as a severe collapse in aggregate demand. In the April–June quarter, India’s GDP contracted by almost 24 per cent, making it the worst performing major economy in the world.

The RBI further lowered the repo rate from 5.15 per cent to 4 per cent in a bid to boost growth. To provide temporary relief to cash-strapped firms, the RBI also imposed a loan moratorium for six months and recused borrowers from making repayments to the banks on outstanding loans as of 1 March 2020. With the end of the moratorium on 31 August, corporate delinquencies will inevitably increase. The balance sheet problem this time is likely to be far more severe than before. The prolonged lockdown has damaged the balance sheets of many firms, large and small. According to the RBI’s latest Financial Stability Report, in a severe stress scenario, the gross NPA ratio of commercial banks is likely to increase to 14.7 per cent by March 2021.

To address the situation, the RBI has initiated a restructuring program, where firms that get restructured will not be declared NPAs. This kind of a forbearance strategy will temporarily avert the severity of the NPA problem by postponing it to the future. The underlying balance sheet stress will not be resolved.

The widespread uncertainty associated with the pandemic combined with the devastating consequences for the economy will heighten the risk aversion of an already fragile banking sector, further impeding the transmission of the persistent rate cuts. It is no surprise that bank credit growth remains stifled.

So far there does not seem to be any coherent strategy for sorting out the banks’ balance sheet problems. The Insolvency and Bankruptcy Code was enacted in 2016 to resolve the NPA crisis but over the past few years the law has been diluted significantly. Operational challenges have also hampered its effective implementation. During the pandemic, the ambit of the law has been curtailed, which may significantly worsen the problem of stressed asset resolution going forward.

The experience of the past few years and the ongoing economic slowdown in India have brought to the fore the limited role that monetary policy can play in reviving growth when there are structural problems in the financial sector. For monetary policy to be effective in addressing growth challenges, first and foremost the banking sector needs to be fixed.

Rajeswari Sengupta is Assistant Professor of Economics at the Indira Gandhi Institute of Development Research (IGIDR), Mumbai.

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