Behest lending can give rise to a NPA problem

Relevance: A lesson from the 2008 global financial crisis that can help India tackle post-pandemic situation better

Synopsis: Aggressive lending to MSME sector can result in a NPA problem in the future.

Background

Response to 2008 financial crisis
Central banks and governments across the developed world adopted extraordinary policy measures to avoid panic and to boost growth.

• Central bank policy rates were slashed to historic lows. Markets were flooded with liquidity (money supply). The US Fed Funds rate was cut from 5% to 0%. Japan and Switzerland took policy rates below 0%.
• In addition, governments stepped up their spending, resulting in high fiscal deficits all around the world.

Policy response of India
India’s policy response was similar to the world governments.

• The Reserve Bank of India slashed policy interest rates from 7% to an effective low of 3.25%.
• Moreover, the central government expanded the fiscal deficit from 2.5% of GDP in FY08 to 6% in FY09, and 6.5% in FY10.

All these steps resulted in recovery too, but things went sour after 2011. Fiscal spending alongside low-interest rates led to inflation and increased imports. After dipping sharply in 2008, India’s WPI and CPI entered into double-digits beyond 2010. Twin deficits (Current Account Deficit & Fiscal Deficit) and inflation caused India’s growth rate to return to the pre-crisis level in FY12 through FY14 (FY = Financial Year).

Present situation – impending problems

Two problems that can have long-term consequences need to be looked at carefully. One is linked directly to the actions of the central bank (RBI followed these steps post-2008 crisis too) and the other is linked to the action of the government and PSBs.

Inflation: To initiate a speedy recovery of the Indian economy post-COVID, RBI has slashed interest rates this time too. So, are we going to see a repeat of the post-2008 financial crisis scenario? Signs are visible.

• At 6.3%, inflation in May 2021 has already crossed the upper end of RBI’s tolerance band of 6%.

Behest-lending: This problem has not received appropriate attention so far. This is the phenomenon of behest-lending by public sector banks (PSBs) at the order of the government, and its side effect, a rise in non-performing assets (NPAs).

• The post-2008 period saw banks increase lending to the infrastructure sector, we now also see PSBs being exhorted to lend to the MSME sector (micro, small and medium enterprises) by the finance minister.
• Aggressive lending to the infrastructure sector post-2008 crisis ultimately led to the problem of NPAs, as banks lent without any sound sense of judgment. Hence, this time, authorities should exercise some restraint and leave lending decisions to the commercial judgment of banks.

Impact of lending to MSMEs

Once again, the government is pushing banks to lend, this time to MSMEs rather than infrastructure projects. Banks have been urged to restructure loans under various schemes. Already, the impact of aggressive lending is visible.

• Dramatic rise in net credit inflow to MSMEs: Boosted by schemes like the Emergency Credit Line Guarantee Scheme (ECLGS), net credit flow to stressed MSMEs during March 2020-February 2021, has risen dramatically.
• Findings of RBI’s financial stability report: RBI’s Financial Stability Report of July 2021 released last week warns: “Despite re-structuring (to the tune of ₹56,866 crore), stress in the MSME portfolio of PSBs remains high. Banks face prospects of a possible rise in non-performing loans, particularly in their small and medium enterprises (SME) and retail portfolios, especially as regulatory support starts getting reduced.” Also, banks’ exposures to better-rated large borrowers are declining.

All this could lead to increased NPA problems in the future.

Shortcomings of credit schemes

On paper, schemes like ECLGS might seem just like what should be done in a pandemic. But the danger is two-fold.

• One, with pressure from the government, PSBs could end up lending to unviable borrowers/ventures in the MSME sector.
• Second, on paper, the ECLGS guarantee is 100%, but there is nothing automatic about it. The National Credit Guarantee and Trustee Company (NCGTC) is committed to giving only 75% of an ‘eligible’ claim preferred by the bank within 30 days. The balance 25% is paid at the conclusion of recovery proceedings or when the decree gets time-barred, whichever is earlier. (Read about ECLGS scheme to better understand this point)

As with the earlier Credit Guarantee Corporation (the NCGTC’s predecessor, prior to 2014), claims could be turned down on various grounds. In which case, it will be back to the vicious cycle of high NPAs, leading to high provisioning, capital impairment, and finally capital infusion in PSBs at taxpayer expense.