With the much-awaited Union budget out of the way, the focus will now shift to implementation and other impending policy challenges in the economy. The International Monetary Fund (IMF), in its report on India released on Wednesday, noted that although the balance of risk has improved, it still remains tilted towards the downside. There are risks on both domestic and external fronts that can affect India’s growth prospects. On the external side, these could emanate from financial market volatility due to the slowdown and large capital outflows from China, or an unexpected change in US monetary policy, which is on the course of normalization. On the domestic side, excessively leveraged corporate balance sheets and their impact on banks in terms of rising non-performing assets (NPAs) can pose a risk to economic growth.
In dealing with external risks, the best that Indian policymakers can do is work towards a stable macroeconomic environment internally; steps are being taken in the right direction here. The government’s decision to move forward on the predetermined fiscal consolidation path in the budget will help improve India’s credibility and will reduce external vulnerability. Further, paving the way for constitution of the Monetary Policy Committee in the budget will help boost investor confidence. However, these steps can only minimize external risks; they cannot eliminate them completely. Policymakers, therefore, will have to remain vigilant to be able to respond in time in case of disruptions in global financial markets.
But the problem on the domestic front is more pressing for them at this stage, both in the central bank and the government: the weak corporate balance sheets and rising NPAs in the banking sector. The issue was also highlighted in the Economic Survey as the twin balance sheet problem. Indian corporate entities, as noted by the IMF, are some of the most leveraged in emerging markets.
A number of factors contributed to the indebtedness of Indian companies. Excess investments were made in various sectors including infrastructure in the boom period of the past decade and were largely financed through bank credit. The flow of credit continued even in the aftermath of the financial crisis and contributed to the rise in corporate leverage. Indian companies have also borrowed heavily from the international market, which has made them vulnerable to external shocks such as a sharp depreciation in currency and rise in hedging costs. The change in macroeconomic conditions due to the global financial crisis and a number of domestic regulatory issues such as land acquisition and other clearances contributed to delays in project implementation, which affected the debt-servicing capability of a number of companies.
The concentration of debt in sectors such as infrastructure and commodities has significantly damaged the asset quality of banks, particularly those in the public sector. To be sure, the government is working to address the regulatory side of the problem so that some of these projects can be put back on track. It has also prepared a road map to revive public sector banks. However, it might have to revisit and revise the plan on this account because of a rapid deterioration in the asset quality of state-run banks and limited fiscal space. The allocation of Rs.25,000 crore in the budget for recapitalization of these banks is being widely recognized as insufficient.
In the absence of support from the global economy, the Indian economy will have to depend on domestic drivers of growth. For this to happen, it is important that banks are well capitalized and are in a position to facilitate growth as the corporate sector in India is mostly dependent on them for its credit needs. Further, the emphasis on capital expenditure by the government will also have a limited impact in terms of “crowding-in” private investments if the problem of stress in both corporate and bank balance sheets is not adequately addressed—and thus, will affect growth prospects in the medium to long run. The drivers of economic growth will also depend on policy support and movement on economic reforms, which has suffered some legislative setback in recent times.
Do weak corporate and bank balance sheets pose a risk to economic growth?
