Credit where it’s due

Bank loans have lagged the economic recovery. Here’s why that’s about to change.

September 2, 2021, 10:09 PM IST / Neelkanth Mishra in TOI Edit Page (link)

Apr-June GDP estimates show that while real output in June 2021 was 9% lower than in June 2019, there is strong evidence of a sharp recovery in the economy after second-wave lockdowns, and July-September quarter GDP is likely to be meaningfully higher than pre-Covid levels.

But if broad-based indicators of real economy activity like mobility, energy demand and GST e-way bill generation are now substantially higher than pre-Covid levels, why is credit lagging behind, with growth near 60-year lows? Perhaps more importantly, will it continue to do so, and be a drag on the economy’s growth momentum? Funds business raise through loans, after all, are deployed for growth.

To answer tha, it helps to dig a little deeper to isolate the problem areas, slicing the pie of banking loans in three different ways: who is borrowing, for what duration, and in what size?

First, the weakness comes from corporate borrowers, as individuals continue to borrow and have accounted for more than half the incremental credit over the past year. This does not necessarily mean loans are only fuelling consumption: In the large informal part of India’s economy, businesses borrow on the proprietor’s name, so what appears as a personal loan is often for business purposes.

Among formal businesses, companies in major sectors like metals, telecom, cement and chemicals are repaying loans as cash flows from business have improved; only loans for road construction are growing. Further, new regulations like the Insolvency and Bankruptcy Code (IBC) made business-owners more careful about loan sustainability.

Second, if one splits loans by duration, it is shorter-term loans that have weakened. Growth in loans that need to be repaid in more than three years has been stable and in double-digits. But in loans that need to be repaid in less than one year, there is zero growth, and weakness in short-duration corporate loans is much worse. The recovery in loan growth is thus less dependent on revival in the investment cycle, and more on routine working capital loans.

Lastly, growth in larger ticket-size loans is soft, whereas the fastest growing segment in the last seven years has been of loans in the Rs 2 lakh to Rs 1 crore range: These loans now account for nearly half of banks’ loans outstanding from being less than a third in March 2014. By itself this is a welcome trend, as it suggests that use of technology is enabling much deeper credit penetration.

An important reason why India’s credit to GDP ratio is much lower than global averages is the inability of the financial system to profitably extend credit to smaller enterprises. As the cost of loan evaluation could not be reduced below a certain level if processes were manual (imagine an accountant manually going through physical statements to make a decision), for the loan to be profitable to the bank, the loan size had to be large.

That meant borrowers who only needed smaller loans could not be serviced. This has changed for the better, and with the “account aggregator” model now underway, which will allow users to share digital data about their financial and economic transactions with potential lenders, penetration should rise further.

For our investigation of the reasons for weak loan growth though, this suggests that large businesses have been reducing their short-term loans. This has two main reasons, in our view.

First, the fear of further restrictions due to a possible third wave meant every business is trying to keep its inventories low. After all, nearly all of short-term loans are for working capital: For a company this means inventory of raw materials and finished goods, and the credit extended to customers (called accounts receivable, that is, where the customer has not paid yet for goods already sold), minus the credit received by the firm from its own suppliers (called accounts payable).

For the economy as a whole, accounts receivable of one firm is accounts payable for another, and get cancelled out, leaving only inventory. In a few months, as vaccination continues, and businesses see reduced risk of a severe third wave, the fear of losing sales would start to overwhelm the fear of being stuck with unsold inventory in another lockdown.

Contrary to popular perceptions, short-term loans are more than a third of banking credit, and medium-term loans are another one-tenth. These loans usually grow in line with nominal GDP growth; if the latter hits the low-to-mid-teens, as we expect it to for two consecutive years, just normalization of inventory in the economy could take bank credit growth into double digits.

Second, just as in a drought in a jungle stronger animals corner most of the resources, in an economic contraction larger firms squeeze smaller suppliers and customers, reducing advances paid to suppliers and goods sold on credit customers.

While there may be a one-time shift in some businesses, this too should correct comfort on economic revival becomes more widespread, given that business managers learn at school the importance of treating suppliers and customers as long-term partners.

It is equally important to understand what the problem is not. Credit growth is not weak because of weak balance sheets of either borrowers or lenders. Corporate leverage levels are at decade-lows, and if this year’s profit forecast is accurate, they could fall to 15-year lows. Among lenders, banks as well as non-banking finance companies (NBFCs), leverage is at all-time lows.

If anything, even as policymakers have struggled with transmitting interest rate cuts to borrowers (partly due to dysfunction in the bond market), ebullient stock markets and even more active private equity funding have brought down the cost of equity capital, incrementally making it more attractive than debt. This has further improved debt-equity ratios in the economy.

While PSU banks may lack incentives in growing, most private sector financial firms, which account for 60% of overall credit, are almost like sprinters waiting for the starting gun. As evidence of a sustained pickup in the economy builds up over the next few months, both demand and supply of credit are likely to pick up.