Narendra Modi’s second term will be spent confronting some of the unintended consequences of his first.

The Indian Prime Minister’s corruption crackdown went a long way to helping his Bharatiya Janata Party (BJP) secure another five years in power. It also chastened tycoons and hurt private investment. A crisis of confidence now hovers over the $3 trillion economy.

Many executives cheered Modi’s efforts to clean up corporate India. These have included an effort to extradite beer baron Vijay Mallya from London to face fraud charges at home while preventing founders of other failing companies including Naresh Goyal at Jet Airways from going overseas.

The trouble is that breaking up the cosy nexus between bankers, politicians, and tycoons is causing harm too.

Multiple worries

Growth in India slowed to 5.8 per cent in the most recent quarter, its weakest pace in five years. And the reality may be worse: Arvind Subramanian, Modi’s Chief Economic Adviser until last year, published research in early June saying the country’s GDP was likely overestimated by 2.5 percentage points in two recent fiscal years, one before Modi took office. The government defended its methodology, but after a similar controversy over unemployment figures, there is a growing perception that data is being politically managed.

 

Big business is holding back. New proposals for investment are at their lowest in 14 years, amounting to just $138 billion in the latest annual account, according to the Centre for Monitoring the Indian Economy. Another proxy for private investment remains subdued too: gross bank credit extended to industry grew just 6.4 per cent in May from a year earlier, nearly half the rate as when Modi first came to power.

Consumers are also jittery. Passenger vehicle sales plummeted 17 per cent in April, to below 250,000, their worst monthly fall in more than seven years, according to an industry trade group. Higher insurance costs under new rules is one reason, reckons Capital Economics. Tighter credit is probably another.

Three pillars under threat

The fears stem from cracks in all three pillars of India’s financial system: the state banks, the private ones and the shadow lenders . Each has been compromised in different ways over the past five years, ultimately hobbling the flow of money to both corporate and individual borrowers.

The state banks, which account for more than two-thirds of assets, were exposed first. Regulators in 2015 forced them to recognise bad debt they were carrying. The decision caught out many of India’s wealthy moguls, who had been masking delinquencies by calling in favours to borrow more. This reset led to a surge in non-performing loans, to 9.3 per cent as of March, according to the Reserve Bank of India (RBI). Although the number is declining, it is still too high.

Next up were the shadow banks, which rely on short-term funding from money markets and such, instead of deposits. They were permitted to expand rapidly as conventional lenders sputtered, in a move seen as a way to stealthily privatise the industry.

The downfall of Infrastructure Leasing and Financial Services (ILFS) in September, however, has been in large part blamed for closing off the taps from these liquidity sources. The highly-leveraged group defaulted on a portion of its debt, now at $14 billion, as banks and mutual funds became more discerning about refinancing loans.

Uday Kotak, Asia’s richest banker, was appointed by the government to sort out the mess. However, there have been too few signs of progress in securing buyers for IL&FS road and power assets. In the meantime, the ripple effects are being felt. Another alternative lender, Dewan Housing Finance Corp, is also now struggling to make repayments.

All is not well with private financial institutions either. Heads have rolled at Axis Bank, ICICI Bank, and Yes Bank following improper reporting of bad debt or allegations of improper lending.

New management is only part of the solution. Yes Bank, for example, is exposed to weak shadow lenders and suddenly looks short of capital. Its shares have tumbled almost 40 per cent since the start of the year and board members have resigned.

Taking bold steps

Kotak says India needs to take bold steps to reform the financial sector. There is no shortage of ideas circulating in private, from buying toxic loans from banks to help inject fresh capital into them to giving tycoons a freer hand to own large lenders. A new bankruptcy regime has helped, but more is needed.

The best way to boost confidence, however, would be to comprehensively tackle problems at the state-controlled banks given their dominance. They will be allocated fresh funds in Friday’s annual budget, according to media reports, but further recapitalisation is unlikely to change sentiment. They were given a $30 billion lifeline in 2017.

New Delhi is also pushing to combine banks to create fewer stronger ones. State Bank of India has mopped up various subsidiaries, and Bank of Baroda merged with smaller rivals Dena Bank and Vijaya Bank. However logical the combinations, they have not altered attitudes much either, mainly because the risks of repeating past lending mistakes remain.

That is why improving governance would have a bigger impact. State banks will perform better if they are able to appoint their own chief executives, offer competitive incentives and salaries for senior management, and are freed from the long arm of India’s investigative agencies.

Cutting ties with the government is the best way to achieve these outcomes.

Former RBI Governor Raghuram Rajan says that although some private lenders got into trouble, New Delhi should privatise one or two state banks and see what difference it makes. A committee assembled earlier by the RBI suggested the government could transfer some, or all, of its shareholdings into a holding company like Singapore’s Temasek and let lenders be treated the same as private-sector ones. Either is worth a try.

As part of an effort to root out corruption, Modi forced bureaucrats and bankers to uncover fraud and bad lending practices. Now it is time for him to show India Inc that he will take equally bold steps to put the financial system back on the right track.

(The author, Una Galani, is a Reuters Breakingviews columnist. The opinions expressed are her own.)