Finance

Andy Mukherjee is a Bloomberg Gadfly columnist covering industrial companies and financial services. He previously was a columnist for Reuters Breakingviews. He has also worked for the Straits Times, ET NOW and Bloomberg News.

Three months ago, Gadfly advised India's state-run banks to stop lending because they didn't have the capital to keep up appearances. That was before the surprise Nov. 8 cash ban, which led to a deluge of low-cost deposits into the system. Add a government eager to dispel criticism that getting rid of 86 percent of the currency in circulation is bleeding the economy, and there's hope of credit soaring anew on the wings of fiscal sops.

Expect the flight of fantasy to be short-lived.

No Love for Lenders
Indian state-run banks' low valuation leaves them critically dependent on taxpayers' support
Source: Bloomberg
*weighted by market capitalization.

To see why, consider the changes since Nov. 8. Almost all the 15.44 trillion rupees ($227 billion) of currency outlawed by Prime Minister Narendra Modi has entered banks as deposits, with the biggest, State Bank of India, receiving $24 billion. This "unprecedented" surge in liquidity led SBI to cut lending rates by 90 basis points on Sunday. Other government-run banks followed suit.

But who's lining up to borrow? Not India Inc.

The average daily value of new investment proposals announced since the cash ban has slumped by three-fifths, according to the Centre for Monitoring Indian Economy.

To prop up credit demand, Modi's team decided to expand subsidies on interest payments by retail borrowers. On a $13,000 loan for a low-cost home, as much four percentage points -- half of SBI's benchmark lending rate -- will come from taxpayers, who also will have to bear higher credit risk on small-business loans. The government, which so far has underwritten collateral-free credit of roughly $150,000, is doubling its commitment, and extending the guarantee to loans originated by shadow banks.

A Crisis of Confidence
India's loan demand is grinding lower and has little resemblance to previous credit cycles
Source: Bloomberg; Reserve Bank of India

But the beneficiaries of this fiscal largess -- blue-collar workers and small businesses -- are precisely those whose earning power (and repayment ability) has been worst affected by the currency ban.

Supply chains greased by cash payments are broken. From diamond-polishing to shoemaking and construction, layoffs are increasing. As borrowers, both the average Indian worker and his employer are much more subprime today than they were just two months ago. Using this group to pull up credit growth, which has plunged to a 25-year low of 5.8 percent, is both impractical and risky. Doing it without first solving Indian banks' acute capital shortage means the strategy is doomed to fail.

Assume that India's top 11 state-run banks manage to lift the banking system's annual loan growth rate to 13 percent. To satisfy the minimum capital requirements under Basel III norms, these lenders would need about $18 billion in external equity by 2019, according to Moody's September estimates -- and that's assuming returns on assets of at least 0.5 percent to 0.7 percent.

But where's the profitability, and who'll provide the capital? As a group, these lenders are garnering returns of minus 0.4 percent on their assets and trading at a price-to-book-value average of 0.68. Recapitalization with taxpayers' money to finance a taxpayer-subsidized subprime lending boom doesn't sound like a smart idea. By contrast, luring middle-class homeowners away from mortgage-finance companies won't take much work, and is far less risky.

Almost two months into the note ban, depositors are still not allowed to withdraw money freely from their own accounts. Once they are, it will become clearer whether Indian banks' liquidity windfall is permanent or temporary.

Even if it lasts, expecting fresh deposits to set off a long chain of new lending is wishful thinking. Had liquidity been a serious constraint on loans, the flood of deposits would have made a real difference. But since April 2016, that wasn't the case: The shortfall was in the banks' capital and in Indian companies' collateral. Until those deficits are fixed, a durable revival in credit will be just a fantasy.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Andy Mukherjee in Singapore at amukherjee@bloomberg.net

To contact the editor responsible for this story:
Paul Sillitoe at psillitoe@bloomberg.net