'Flexibility', fragility and risk

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Each of these developments has increased the fragility of instability in India’s financial structure. Developments in the commercial banking segment support the view that transforming the development finance institutions into commercial banks was a blunder. With the continued absence of a market for corporate bonds, an important structural break occurred in banking policy and performance in the period after 2003 till 2013, when compared to the years from 1991 to 2003. While the effort to attract foreign direct and portfolio investment, particularly the latter, had begun in the early 1990s with some effect, the real change occurred in the years after 2003. While initially liberalisation did increase inflows into the country, large capital flows, which were substantially in the form of portfolio capital, were a later development. Till 1993—1994 total net inflows amounted to less than a billion dollars. Subsequently, foreign investment flows rose sharply to S4.2 billion in 1993-1994 and averaged about $6 billion during the second half of the 1990s.

However, there were more significant changes subsequently. During the first decade of this century these inflows rose to $15.7 billion in 2003—2004, and then rose to $70.1 billion in 2009-2010, despite the fall in crisis year 2008-2009. Subsequently, after averaging an average of around $64 billion during 2000—2013, the figure fell because of the ‘taper tantrum’ in 2013—2014.4 But flows bounced back to $73.6 billion in 2014-2015, before falling to $35 billion the next year. In sum, despite volatility the trend has been one of a sharp increase after 2003. This increase would not have been possible without the relaxation of sectoral ceilings on foreign shareholding and the substantial liberalisation of rules governing investments and repatriation of profits and capital from India. But liberalisation began rather early in the 1990s, whereas the boom in foreign investment flows occurred much later.

These direct and portfolio flows of foreign capital affect domestic money and asset markets. One counterpart of the capital inflow surge was an increase in the overhang of liquidity in the domestic economy. Reflective of that overhang was a dramatic expansion of the deposit base of banks from Rs. 1.93 trillion in 1990-1991 to Rs. 9.6 trillion in 2000-2001, Rs. 52.1 trillion in 2010-2011 and Rs. 107.6 trillion in 2016—2017.

Because banks do not have the option of sitting on deposits that they must accept and pay interest on, the surge in the deposit base would have forced banks to seek out new avenues for investment and lending. While the ‘flexibility’ offered by financial liberalisation helped in this context, the fact that fiscal reform had after 2003 shrunk the space for parking funds in safe government securities was a source of pressure.

The result was an explosion in credit growth. While the ratio of scheduled bank credit to GDP stood at around 20% through much of the 1980s and 1990s, it rose by two-and-a-half times between 2000-2001 and 2011-2012, to touch 51.4%. This increase, it must be noted, occurred in a period that includes the high growth years between 2003-2004 and 2008-2009, which makes the rise in the ratio of credit to GDP even more significant. The high expansion in the universe of borrowers and the level of exposure per borrower this implies does increase risk. But associated with that is higher returns. So long as the boom lasts, this points to a huge expansion in profit-making opportunities in the banking area.

Moreover, post-liberalisation changes have made banking extremely important from the point of view of the financing of economic activity. Prior to liberalisation the understanding was that banks could provide long-term funding to industry and the housing market only to a limited extent. Being dependent on relatively small depositors who would like to hold their savings in highly liquid deposits, lending to long-term, illiquid projects would result in maturity and liquidity mismatches. So the resulting shortfall in the financing of long-term investment had to be met by creating specialised financial institutions with access to more long-term capital directly from the government or the central bank, or through pre-emption of a part of the resources of commercial banks.

Liberalisation involved ending that dichotomy, with banks now being encouraged to foray into term lending of different kinds. As banks sought to expand their volume of lending, and their universe of borrowers, there were two sets of sectors that gained in share. The first comprised of retail advances, covering housing loans, loans for automobile and consumer durable purchases, educational loans, and the like. The share of personal loans increased from slightly more than 9% of total outstanding commercial bank credit at the end of March 1996 to close to a quarter of the total by the mid-2000s. This was a ‘natural’ diversification, because they were either loans of short-term maturities that could also be easily pooled and securitised, or they were loans that were backed by implicit collateral, which was the asset financed. In fact, housing loans accounted for a very large share of the total.

What was less natural was a second direction of change. This was that despite the huge increase in credit provision, the share of credit going to industry stood at around 40% of total bank credit, not too far below pre-reform levels of about 50%. What is more long-term loans to corporates, including for infrastructure accounted for a significant share of this lending. The share of infrastructural lending in the total advances of scheduled commercial banks to the industrial sector rose sharply, from less than 2% at the end of March 1998 to 16.4% at the end of March 2004 and as much as 35% at the end of March 2015. That is, even as the volume (though not share) of lending to industry in the total advances of the banking system has risen, the importance of lending to infrastructure within industry has increased hugely. Sectors like steel, power, roads and ports, and telecommunications have been the most important beneficiaries. For commercial banks, which are known to prefer lending for short-term purposes, this turn to lending to infrastructure was a high-risk strategy.

Three factors could explain the latter tendency. The first, is demand pressure from the large corporate sector, now deprived of financing from the development finance institutions. After the Indian government chose to dismantle its development banking infrastructure, investors in capital intensive projects had to turn to the remaining main source of financing, the banks, for long-term funding.

The demand for financing of private capital intensive projects was strengthened by the widening infrastructural gap that resulted from the self-imposed restrictions on public investment stemming from fiscal conservatism. The government declared that given its fiscal ‘constraints’, crucial infrastructural investments had to be undertaken either through the private sector or through public—private partnerships. This placed the onus of finding the finance for such projects partly on the government, which in this instance owned the banks. So, it was natural that the banks would be under pressure to lend to projects varying from roads and ports to power and steel.

Finally, this situation suited the banks as well, which were under pressure to lend, given the expansion in their deposit base that resulted from the foreign capital inflow-generated overhang of liquidity in the system. They needed to keep credit flowing to match the expansion of deposits and needed to find new borrowers. Since the government was interested in facilitating capital intensive private investment, especially in the infrastructural area, it could be presumed that the financing of such projects would be backed by the government in case of liquidity problems or even default. There appeared to be an implicit sovereign guarantee.

The net effect of these multiple factors was a sharp increase in lending to capital intensive projects, including those in infrastructure, where maturity and liquidity mismatches were significant. But once this tendency of lending large sums to a single project or business group began, it did not stop with such projects, but was extended to other areas of corporate lending as well. In practice, the failure of these projects to generate the revenues needed to bear the debt service costs associated with their high debt to equity ratios, led to defaults, even in cases where much effort at restructuring was made. The result was a sharp increase in non-performing assets on the balance sheets of the public banks, place now in excess of 12% of total advances. As the Economic Survey 2016—2017 recognised, if the banks had not been publicly owned, this would have threatened at least some of the banks concerned with insolvency, perhaps triggered a bank run, forced bank closure and even precipitated a systemic crisis.

A second source of potential instability is the large increase in foreign capital flows into India. As noted above, underlying the credit boom that India experienced was the liquidity infusion resulting from the large inflow of foreign capital into the country. A substantial proportion of such inflows was in the form of portfolio investments in India’s debt and equity markets. Foreign investors were exploiting their access to cheap money in global markets to engage in a form of carry trade — borrowing cheap in dollars and investing in rupee securities that yielded much higher returns, so long as the rupee did not depreciate sharply in the interim. This form of flow was volatile because any expectation of an interest rate rise in countries that were the source of capital or any fear of currency depreciation in the host country can trigger an exodus of capital, and precipitate a crisis.

Even in the case of borrowing by domestic corporates aiming to exploit the availability of low-cost capital abroad to mobilise cheap resources to finance long-term investment at home, inadequate hedging makes them prone to stress when interest rates abroad rise or when the currency depreciates at home. Such borrowing has increased for a number of reasons. Foreign investors have overcome their reticence to invest in Indian bond issues, even if they still show a preference for the private placement route. The government has substantially relaxed ceilings on external commercial borrowing by the corporate sector, resulting in significant increases in borrowing abroad by corporations. And, above all the Indian government has decided to exploit to the full the country’s access to borrowing from the World Bank and Asian Development Bank, on the one hand, and the new sources of‘multilateral’ lending on commercial terms such as the Asian Infrastructure Investment Bank and the New Development Bank. For example, despite China’s dominance in these institutions and India’s strained relations with China, India is one of the largest borrowers from the AIIB. As of June 2018, while AIIB’s total loan portfolio stood at around S4 billion, lending by it to India was a significant S1.3 billion. Given the terms of such borrowing, this is another source of fragility.

To these sources must be added the fragility implicit in relying on new forms of long-term financing from the NBFCs created as alternatives to the old DFIs. As noted earlier these entities tend to rely on relatively short-term deposits for their capital. Using that to finance capital intensive investments or long gestation projects would involve liquidity and maturity mismatches that can lead to fragility. This is precisely what happened, as the government cajoled publicly owned banks to lend for large corporate investments, resulting in mega-sized debt defaults. Bank exposure is not just directly to corporates, as the yet unfolding IL-&FS sags reveals. It is now clear that banks also invest in bonds issued by the non-bank financial companies, which in turn use that capital to lend to business of various kinds. Given the structure of this activity, NBFCs need to constantly roll-over debt to sustain their operations and meet their own payments commitments. The fragility this gives rise to was illustrated by the experience of two different NBFCs, Industrial Leasing &Financial Services and Dewan Housing Finance Limited, both of which have defaulted on payments due to issuers of short-term paper, leading to a liquidity crunch for other NBFCs that the government is attempting to address. When a large player like IL&FS defaults on debt, the flow of credit to the rest of the non-bank financial sector tightens, resulting in ‘liquidity’ problems that can precipitate collateral default and increase the risk of more systemic effects.

In sum, India’s decision to give up on old style development financing, in a situation where the government is committed to a form of austerity and the bond market is inadequately developed, has generated NPAs that ‘reform’ was supposed to prevent, led to large scale default and rendered the system prone to instability and crises.


  • 1 In 1975 the IFCI set up a Risk Capital Foundation in the form of the IFCI Venture Capital Fund to provide soft loans to first generation and technocrat entrepreneurs. IVCF later managed funds of the Venture Capital Unit Scheme of the Unit Trust of India.
  • 2 Public Law 480 enacted in 1954 in the US allowed for the use of surplus agricultural produce (especially wheat) from the US as food aid to developing countries through sale at concessional terms including payment in local currency, with the local currency funds being used for US diplomatic and development expenditures in the country concerned.
  • 3 Besides meeting conventional cash reserve requirements banks in India are required to meet a specified ratio of liquid assets (consisting of cash, gold and specified RBI-approved securities) relative to their net time and demand and time liabilities.
  • 4 All figures from the Reserve Bank of India’s database at www.rbi.org.in.


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