By Invitation. Contraction in bank credit is worrisome

While demonetisation hogged the headlines from the RBI’s latest annual report, there are other noteworthy aspects as well in the report. The central bank’s views on economic growth, bank credit and markets, for instance, are interesting.

On economic growth, overall growth at 7.1 per cent was modest and continued to be driven by consumption (both personal and public), which has been the trend for some years now. Gross fixed capital formation, in spite of constituting a third of GDP, contributed a disappointing 0.7 per cent to growth.

In fact, but for the implementation of the 7th pay commission and defence pensions (both under public consumption), GDP growth would have been lower by 2 percentage points, a sobering thought.

The RBI seems to believe that consumption-driven growth may not necessarily be a good thing, since the growth multipliers were low and besides, the side-effects from higher level of indebtedness could retard future growth. It is the waning business confidence and investment intentions that was the main cause of worry, in part the effect of excess capacity created, falling aggregate demand and high leverage of companies.

The concern is from at least two counts — job creation and bank credit offtake. The infrastructure sector presented a mixed picture — while road and port projects grew impressively, the power sector was under stress.

Thermal power capacity utilisation declined for the seventh year in succession due to the precarious health of the discoms; oddly enough, while power reforms such as UDAY addressed the ‘supply side’ of the problem, it was the happenings on the demand side (plunging solar tariffs, lower demand for power) that were the current causes of stress, rendering the long-term power purchase agreements (PPAs) of discoms unviable and forcing them to look at lower-cost spot purchase of power. This also does not forebode well for new investments in mega thermal power projects.

Telecommunication was another sector where declining tariffs proved to be a double-edged sword — consumers benefited but telecom companies and their lenders struggled with falling revenues and profitability.

Overall, the growth of Gross Value Added (GVA) in industry decelerated during 2016-17 but this did not reflect in the new series of Index of Industrial Production (IIP) that was introduced in May 2017. In terms of the new IIP, industrial production actually accelerated in 2016-17 across sectors, with the difference between industrial GVA and IIP explained mainly by falling input costs.

Bank lending and the financing of corporate credit also reveal some interesting changes. Credit to industry contracted by 1.9 per cent during 2016-17 in contrast to a growth of 2.7 per cent in the previous year.

Credit to infrastructure (which accounts for about one-third of the outstanding bank credit to industry) contracted by 6.1 per cent in 2016- 17.

But what is remarkable is that non-bank sources have overtaken bank credit from as early as three years ago. Private placements of corporate bonds, commercial paper subscribed by non-bank entities are all significant domestic sources of corporate finance now, while FDI is beginning to contribute almost a fifth of total yearly funds.

The RBI quotes standard factors responsible for the contraction in bank credit — risk aversion, the overhang of bad debts and capital constraints, and an unusual one — the ‘pre-occupation of banks with exchange of notes under demonetisation’. It only grudgingly admits of the onset of disintermediation and terms the inconsistency between falling bank credit and rising GVA as a disconnect.

For a financial system that is predominantly bank-led and dominated by a risk-averse, capital-constrained public sector, this should be a concern because it brings to question the role of the banking system in general, and of the public sector model in particular.

Finally, the RBI’s thoughts on the stock markets should cheer investors. Benchmark Indian equity indices witnessed an increase of about 17 per cent during 2016-17 in an environment that experienced multiple shocks.

The RBI attributes this to the resilience of markets and, importantly, as an endorsement of economic reforms initiated.

While it acknowledges the easy liquidity and buoyancy in global markets that facilitated exuberance, the central bank does not think that markets are overvalued.

Another trend that is becoming increasingly significant is the activity of mutual funds — net funds mobilised by mutual funds during 2016-17 shot up by 150 per cent to over ₹3,400 billion in 2016-17, more than a third of total deposits raised by the banking system.

In fact domestic mutual funds have been a stabilising influence countering the volatile foreign portfolio investment flows. The retail asset class preferences are yet another indicator of the changes taking place in the financial system.

The writer is an independent consultant