Why Re-Energising India’s Financial System Is Critical To Economic Recovery

There are signs of a slow but steady economic recovery as we all anticipate growth to be back to a plus 5 per cent in the third quarter of the current financial year. The coming financial year will in all probability be better in terms of economic prospects too.

However, there are two important issues that are worth discussing.

First relates to how quickly we can get back to a 7 per cent or above rate of growth, while the second relates to addressing the financial vulnerabilities that have emerged over the last couple of quarters.

Both are intricately related as many of us believe the collapse of non-banking financial companies (NBFCs) to be the catalyst which resulted in the recent economic slowdown.

A characteristic feature of the Narendra Modi government is the possibility of economic reforms that can be announced even outside of the budget, and the Finance Minister has already indicated that steps, if required, would be taken.

It is in this spirit that I believe we must shift our focus to our financial system and address the systemic risks that have emerged in our banks, cooperative or commercial and NBFCs.

Though government has taken measures to address some of these issues, our financial system is not functioning as it would under normal circumstances.

Risk aversion continues to be the norm as banks avoid extending project finance, especially for manufacturing companies. At a time when we want to kickstart India’s manufacturing sector, lack of financing of fresh projects at affordable rates is a major bottleneck that must be addressed.

To be fair, the Prime Minister and the Finance Ministry have repeatedly tried to take steps and extend confidence to bankers, yet, they are reluctant to finance fresh projects. They are instead extending personal loans aggressively – which was earlier done by the NBFCs.

This risk aversion is a direct consequence of the rise in non-performing assets (NPAs) and push towards recognition and resolution of the same.

Most bankers end up stating how they do not want to end up with manufacturing projects which are difficult to resolve, and therefore, they are happy to process small ticket personal loans. This trend has not affected the big business houses who can always use the ECB (external commercial borrowings) route.

Credit is absolutely essential for creation of assets and the lack of it can have a significant impact on the economy. On one hand, we are focusing on restoration of corporate balance sheets, but on the other, we need to ensure that banks are willing to take some risks associated with creation of assets in the economy.

The best way to ensure this would be to reduce the risk-free rate aggressively which of course requires us to revisit the subject of sovereign bonds. The other important consideration could be a higher than normal rate of growth for money supply.

Two big challenges in front of us are related to Yes Bank, which is yet to raise funds and the other is to do with the sizeable exposure to the real estate sector. Both of them require urgent intervention from various stakeholders.

The exposure to real estate is concentrated in three or four major cities and the solution to this would be to take measures that will revive the demand for these assets.

A price correction in the real estate sector can have several unintended consequences due to the wealth effect. A good policy intervention could be with respect to stamp duties. However, this would have to come from state governments.

Over the last couple of months, the government has taken several measures to address each of these issues through several policy interventions. However, now would be the time to take a macro view of the situation and follow them up with further policy responses as and when required.

On a parting note, one must mention the impact of the adjusted gross revenue (AGR) fiasco on our financial system. Such moves are only likely to induce fresh uncertainty which will affect the stability of our financial system.

Perhaps, a macro view of the telecom sector, its impact on NPAs and our economy is warranted.

Modern financial systems are based on trust and an appetite for undertaking risks. The lack of both is unlikely to assist in our economic recovery. So the important task at hand should be of restoration of trust and bringing back the ability of our bankers to take reasonable risks.