India’s Public Sector Banking Crisis on Foreign Investment

Posted by Reading Time: 4 minutes

By: Tracie Frost

A recent study by Moody’s titled “Indian Public Sector Banks: Weak Financial Performance Highlights the Banks’ High External Capital Needs” outlines a potential solvency and liquidity crisis in India’s public sector banks (PSB). PSBs account for roughly 73 percent of India’s domestic banking sector assets. The report indicates that capital requirements for India’s public sector banks are far higher than the 450 billion rupees (US$6 billion) in the government’s budget for capital distribution. Moody’s suggests the actual amount may be close to 1.2 trillion rupees (US$17 billion)– more than double the amount set aside by the government to prop up state banks. The report gives little reason for optimism that capital requirements will lessen for PSBs over the next several years as bank shares are trading below book value, which constrains their ability to use public offerings to raise capital.

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The public sector banking system has long been in need of reform. Stressed assets at PSBs have risen sharply over the last decade fueled by delays in projects at industrial conglomerates and failed or stalled projects primarily in the energy and metals sectors and textiles and agriculture sectors.  Loans for projects that have not been completed or have significant cost over-runs have resulted in an increase in impaired debt levels at PSBs from six percent in 2011 to more than 14 percent in 2016. 

But the Reserve Bank of India (RBI) in December 2015 argued that PSBs’ disclosed stressed asset levels were in fact far below the actual non-performing loan rate. The December asset quality review audit forced banks to recognize visibly nonperforming debt as bad and charged PSBs to clean up their balance sheets by March 2017. The result so far has exceeded forecasts. Analysts who at first predicted bad loans would peak in the first quarter of 2016 have begun to talk about March 2017 before the cycle turns. According to Credit-Suisse, non-performing assets (NPAs) at PSBs are currently 30 to 75 percent of their capital, and loans which could become NPAs are even higher at 65 to 200 percent. The new flood of bad debt (and higher provisions to cover for them) resulted in PSBs reporting combined losses of 153 billion rupees (US$2.3 billion) for the March 2016 quarter.

The high degree of bad debt combined with the weak capital position of India’s PBSs threatens the overall credit profile of India’s banking system. In order to clean up their balance sheets and continue productive lending, banks must have adequate capital. However, because of crushing amounts of stressed assets, credit costs for banks have increased further dampening profit potential, investor interest, and deposit growth. 

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PSBs’ critical position has not only affected bank stock prices and profitability, but it has also weakened the government’s planned overhaul of India’s infrastructure. And this is where foreign investors will primarily feel the impact of India’s underperforming public sector banks. The impact may be two-fold. Foreign investors struggle to meet the demands imposed on their bottom line by the lack of infrastructure in India. Costs to move goods and services can deter market entrants and force others out of business. However, because Indian businesses receive the majority of their finance through the banking system instead of through capital markets, a credit crunch at public sector banks could also open a window of opportunity for foreign direct investment, especially as the government has simultaneously increased foreign direct investment limits across the board.

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