Vivek Kaul
The ministry of finance has organised a two day retreat for public sector banks in Pune over January 2 and 3, 2015. The retreat is being attended by the RBI governor Raghuram Rajan and the deputy governors as well. It will end today with brief presentations being made to the prime minister Narendra Modi. After the presentations the the prime minister will interact and address the gathering.
A press release issued by the ministry of finance basically outlined four objectives for this retreat, which are as follows:
(i) To create a platform for formal and informal discussions around the issues which are important for banking sector reforms.
(ii) To achieve a broad consensus on what has gone wrong and what should be done both by banks as well as by the government to improve and consolidate the position of PSBs.
(iii) To get some out of box ideas from prominent experts in the field as also from the top level managers attending the retreat.
(iv) The final objective would be to prepare a blue print of reform action plan once adopted which could then be implemented by the banks as well as by the government.
On paper this sounds like a good idea. It shows that the government is serious about figuring out what is wrong with the banking sector in India and working on it, instead of just letting things drift. Nevertheless, the retreat shouldn’t boil down into an excercise of exerting pressure on the public sector banks (PSBs) to lend more. With officials of ministry of finance attending the retreat as well, there are chances of that happening.
The total amount of loans being given by banks have slowed down in the recent past. Data released by the RBI shows that in November 2014 loans to industry increaed by 7.3% in comparison to November 2013. The loans had increased by 13.7% in November 2013 in comparison to November 2012. “Deceleration in credit growth to industry was observed in all major sub-sectors, barring construction, beverages & tobacco and mining & quarrying,” a RBI press release pointed out. Loans to the services sector grew at 9.9 per cent in November 2014 as compared with an increase of 18.1 per cent in November 2013.
The finance minister Arun Jaitley has time and again blamed high interest rates for this slowdown in bank lending as well as economic growth. In a speech he made on December 29, 2014, Jaitley said: “The cost of capital…I think in recent months or years…is one singular factor which has contributed to slowdown of manufacturing growth itself.”
This and other statements that Jaitley has made over the last few months tend to look at credit (or banks loans) as a flow. But is that really the case? As James Galbraith writes in The End of Normal: “Credit is not a flow. It is not something that can be forced downstream by clearing a pie. Credit is a contract. It requires a borrower as well as a lender, a customer as well as a bank. And the borrower must meet two conditions. One is creditworthiness…The other requirement is a willingness to borrow, motivated by the “animal spirits” of business enthusiasm. In a slump, such optimism is scarce. Even if people have collateral they want security of cash.”
Further, as Jeff Madrick points out in Seven Bad Ideas—How Mainstream Economists Have Damaged America and the World: “Business investment is not just affected by the supply of national savings but by the state of optimism. If consumer demand for goods is not strong, a business will have little incentive to invest, no matter how great profits are or how low interest rates are on bank loans.” These are very important points that the mandarins who run the ministry of finance in this country need to understand.
So how good is the creditworthiness(or the ability to repay a loan) of Indian companies? The answer for this is provided in the recent Mid Year Economic Analysis released by the ministry of finance. As the report points out: “More than one-third firms have an interest coverage ratio of less than one (borrowing is used to cover interest payments). Over-indebtedness in the corporate sector with median debt-equity ratios at 70 percent is amongst the highest in the world.”
Interest coverage ratio is the earnings before income and taxes of a company divided by the interest it needs to pay on its debt. If the ratio is less than one what it means is that the company is not earning enough to repay even the interest on it debt. The interest then needs to be repaid by taking on more debt. This works just like a Ponzi scheme, which keeps running as long as money being brought in by new investors is greater than the money that needs to be paid to the old investors.
In this situation it is not surprising that the bad loans of banks, particularly public sector banks have gone up dramatically. As the latest financial stability report released by the RBI points out: “The gross non-performing advances (GNPAs) of scheduled commercial banks(SCBs) as a percentage of the total gross advances increased to 4.5 per cent in September 2014 from 4.1 per cent in March 2014.”
The stressed loans of banks also went up. “Stressed advances increased to 10.7 per cent of the total advances from 10.0 per cent between March and September 2014. PSBs continued to record the highest level of stressed advances at 12.9 per cent of their total advances in September 2014 followed by private sector banks at 4.4 per cent.”
The stressed asset ratio is the sum of gross non performing assets plus restructured loans divided by the total assets held by the Indian banking system. The borrower has either stopped to repay this loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan (which also entails some loss for the bank) by increasing the tenure of the loan or lowering the interest rate.
What this means in simple English is that for every Rs 100 given by Indian banks as a loan(a loan is an asset for a bank) nearly Rs 10.7 is in shaky territory. For public sector banks this number is even higher at Rs 12.9.
The question that crops up here is why is the stressed asset ratio of public sector banks three times that of private sector banks? The financial stability report has the answer for this as well. As the report points out: “Five sub-sectors: infrastructure, iron and steel, textiles, mining (including coal) and aviation, had significantly higher levels of stressed assets and thus these sub-sectors were identified as ‘stressed’ sectors in previous financial stability reports. These five sub-sectors had 52 per cent of total stressed advances of all SCBs as of June 2014, whereas in the case of PSBs it was at 54 per cent.”
As is well known that these sectors are full of crony capitalists who were close to the previous political dispensation. This forced the public sector banks to lend money to these companies and now these companies are either not in a position to repay or have simply fleeced the bank and not repaid.
The report further points out that the public sector banks have the highest exposure to the infrastructure sector: “Among bank groups, exposure of PSBs to infrastructure stood at 17.5 per cent of their gross advances as of September 2014. This was significantly higher than that of private sector banks (at 9.6 per cent) and foreign banks (at 12.1 per cent).”
Public sector banks haven’t been able to recover these loans from businessmen who have defaulted on them. Given this, if there is one assurance that Narendra Modi needs to give to public sector banks, it has to be this—he needs to assure them that there will be absolutely no pressure on them from his government to lend money to crony capitalists who are close to the current political dispensation.
This single measure, if followed, will go a long way in improving the situation of public sector banks in this country. It will be one solid move towards the promised acche din.
The article originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 3, 2015