Away from the immediate concerns on growth and currency management in the light of the recent demonetisation drive, a recently released report by the Reserve Bank of India points to some deeper concerns, particularly in India’s financial sector.

On the one hand, India’s macroeconomic conditions broadly remain stable and resilient with considerable moderation in consumer price inflation. And though the growth impetus has slackened recently, there is a positive undercurrent of growth moving to a higher trajectory. The current account deficit remains modest. A deceleration in worker remittances and software services has posed some concerns. In sum, against the fragile domestic imbalances witnessed in most of the emerging market economies, the outlook on growth and macroeconomic stability for India seems favourable.

However, developments in the financial sector tell a different story. The banking stability indicators as set out in the recently released Financial Stability Report of the RBI depict some serious concerns. The report highlights the elevated risks in the banking sector emanating from “continuous deterioration in asset quality, low profitability and liquidity”. That’s a triple whammy made worse by the upheaval caused by demonetisation, and adds new complexity to a situation that was already spiralling out of control.

Stress goes up

Consider some of the findings of the RBI report. The asset quality of the banks has deteriorated further with gross non-performing advances ratios (GNPAs) increasing to 9.1 per cent from 7.8 per cent between March and September 2016, pushing the overall stressed advances ratio to 12.3 per cent from 11.5 per cent during the same period.

The credit quality of large borrowers (with exposures of ₹50 million and more) has deteriorated considerably. The system level credit risk of the banking sector against macroeconomic stress revealed that the GNPA may increase to 9.8 per cent by March 2017 and further to 10.1 per cent by March 2018.

Further, capital to risk-weighted asset ratio (CRAR) for the public sector may continue to be lowest at above 11 per cent by March 2017 and less than 10 per cent by March 2018, an indication of just how much the public sector banks (PSBs) are undercapitalised.

The macro stress test also revealed that the provisioning and capital adequacy for the banks and particularly PSBs need to be further enhanced from the present level of 5.8 per cent for PSBs. While there is a persistence of subdued business growth, at the system level, public sector has lagged the private sector.

There has been a contraction of system level profit after tax (PAT) due to higher growth of risk provision but the PSBs recorded losses. The sectoral credit risk as evident from the macro test revealed that iron and steel sector is expected to record the highest GNPAs. The RBI report said banks in general may withstand liquidity shocks with their high quality liquidity assets (HQLA) and SLR investments.

Stability matters

The experience of 2008 financial and economic crisis suggests that deteriorating financial stability is a potential threat to growth and macroeconomic stability. Therefore, post-crisis, the world over, authorities have focused attention on financial stability through tightening regulatory reforms to address the structural issues associated with financial sector in general and banks in particular.

Indian authorities also contemporaneous with the global developments further strengthened the banking regulatory framework through a series of measures. However, on account of weakening of banking stability indicators and higher levels of impairment, the banking sector is expected to remain risk averse.

Also, due to the emphasis of the banking system on the cleaning up of the balance sheets, there is the likelihood that the capital position of the banks could be inadequate to support higher credit growth. This development could work as a cog in the wheel for effective transmission of monetary policy to the real sector via interest rate and credit channel.

The findings of the stability report when perused in conjunction with the Report on Trends and Progress of Banking released by the RBI divulge serious concerns for the banking sector in terms of indicators of profitability based on Return on Assets (RoA) and Return on Equity (RoE), particularly for PSBs with RoA of minus 0.20 per cent and RoE of minus 3.47 per cent during 2015-16. Another important aspect is the slow recovery of NPAs. The latest data released by the RBI on the outstanding credit of the banking system for September 2016 revealed that there has been a reduction in the bank credit to industry and credit to agriculture increased marginally. The weighted average lending rate (WALR) declined marginally to 11.26 per cent.

Currency recall impact

The banking system witnessed unprecedented stress and reputational risk post demonetisation. Thus, the business growth of the banking sector would have shown a significant slackening since September 2016, though data for this will follow with a lag.

One is not sure whether the stress test of the financial stability report captures any scenario like demonetisation on the banking business model, profitability and liquidity. Anecdotal evidence suggests that the banking business has come to a standstill in terms of credit growth. The management of excess liquidity due to the receipt of high value notes remains a severe challenge.

While writing the foreword for the financial stability report, the RBI Governor has mentioned that withdrawal of high-value notes will impart far-reaching changes going forward. He mentioned that this is expected to transform the domestic economy in due course in terms of greater intermediation, efficiency gains, accountability and transparency through increasing adoption of digital modes of payments.

This view from the inside stands in sharp contrast to the views of the highly respected former governor, YV Reddy, who has mentioned that he would not have accepted the recommendation of the Government on demonetisation because of institutional and reputational risks.

Pattnaik is Professor, SPJIMR. Rattanani is Editor, SPJIMR. The views are personal.

Through The Billion Press