Study on the growing debt crisis in India and the primacy of the central

bank!

Abstract
This paper presents a comprehensive analysis of the debt crisis that has caused the recent
debate on the autonomy of India's central bank. It looks at the entire phase of the crisis in
cash liquidity which began with great care by public sector banks in lending to high risk
sectors in view of rising sinking loans or stranded loans (NPAs). Nevertheless, these banks
continued to provide loans to NBFCs (non-banking financial companies), who on the other
hand were already providing loans to high risk sectors (such as infrastructure and housing
sectors) from which banks were avoiding the negative consequences of this apparent
disagreement in providing loans will eventually emerge. In the meantime, the government
persuaded the Reserve Bank of India to relax lending or debt norms so that credit flow can
be resumed in a timely manner. In this paper, it has been cautioned against walking on such
a loan path, arguing that this cycle cannot be continued for long and it can lead to economic
crisis in the future.

Introduction
India's monetary policy makers must heed this advice of Ben Bernanke, former Governor of
the Federal Reserve Bank of the United States: 'Liquidity guidelines must take into account
those risks, among other purposes that would arise for the wider financial system due to
insufficient cash scheme of major financial companies and they should be ensured under the
same guidelines that these companies may be highly dependent on cash assistance received
from the central bank.’ Position to supply loans in India and cash is currently extremely
disappointing. Nonetheless, the recent debate on the autonomy of the Reserve Bank of India
(RBI) gave plenty of spice to widespread media coverage, but it also exposed the growing
tension within the government over the collapse of the country's credit supply system. This
confrontation, which led to Urjit Patel resigning from his post and then the appointment of
Shaktikanta Das as RBI governor, is actually more about the supply and cash of loans than
the autonomy of the central bank.

As per the prevailing practice, maintaining the autonomy of the central bank of any country
ensures effective operation of inflation targeting targets. However, in the case of India, if the
declining inflation rate is any indication, then it appears that the system of setting inflation
target in the country is not threatened by the lack of autonomy of its central bank. So what is
the reason behind the public confrontation between the Finance Ministry and the RBI? Is the
real reason for the conflict to be a gradual reduction in interest rates, which seems a reasonable
demand from the government? If the conflict has come about due to the reduction in the rate
of interest, could it not be resolved through discussions between the Finance Ministry and the
RBI? This is mainly due to ensuring uninterrupted lending which has resulted in the flow of
funds to various non-bank financial intermediaries in recent years. These funds greatly
increased the market valuation or sentiment of such non-bank entities, and this eventually led
to the continued good performance of the stock market indices.
In the first section of this paper, the events of the recent confrontation between the RBI and
the Finance Ministry are given. The second section lays out a theoretical background on the
autonomy and independence of the central bank, as well as related information or facts related
to India's experience. The third section analyzes the structure of bank loans, their flows and
risks. The last section deals with the nature of loans given by NBFCs and concludes at the
end of this paper.

RBI-Finance Ministry Confrontation: Events

Although this is not often mentioned, the current debate on the autonomy of the central bank
shows the shadow or impression of former RBI Governor Raghuram Rajan. Efforts by Rajan
to keep the issuance of drowning debt under control as well as to deliberately crack down on
defaulters resulted in the introduction of the Rapid Corrective Action regime for Scheduled
Commercial Banks (SCBs) under which recently 11 public sector banks were barred from
lending. As expected, after the new capital was added in December, the three PSU banks viz.
Bank of India, Bank of Maharashtra and Oriental Bank of Commerce have been exempted
from the purview of 'PCA' by RBI in February 2019.

The atmosphere of the recent confrontation between the government and the RBI was
becoming increasingly frequent for some time. Actually, the government was constantly
criticizing the RBI for not ensuring loan flow. On the other hand, RBI, expressing its opinion,
had made it clear that it does not agree with the decision of merger of Bank of Baroda, Vijaya
Bank and Dena Bank. The differences between them widened further as differences emerged
on two more points. The second incident relates to the eviction of Nachiket Mor, an Indian
banker and National Director of Bill & Melinda Gates Foundation (BMGF) from the Central
Board of the Reserve Bank of India in September 2018. The Swadeshi Jagran Manch (SJM),
an organization associated with the Rashtriya Swayamsevak Sangh (RSS) wrote a letter to the
minister for the removal of Nachiket Mor, alleging a conflict of interest. The Reserve Bank
of India also closely monitors the flow of foreign funds to non-governmental organizations
such as BMGF.

Tensions between them reached a climax when the government expressed its desire to use
section 7 of the RBI Act, 1934, under which the central government can 'direct' the RBI in
the 'public interest'. Although this section has not been used till now after the independence
of the country, but by mentioning it only, a panic environment spread within the central bank
which resulted in Viral Acharya, deputy governor of the Reserve Bank of India, publicly
expressing his displeasure. Acharya clearly stated the central bank's independence as essential
to the operation of financial markets and along with this he highlighted issues like regulation
of public banks and transfer of reserves from RBI's balance sheet. He blamed the RBI for the
fact that the previous UPA government allowed banks to lend indiscriminately. Giving the
economy 'artificially' forward (between 2008 and 2014), resulting in NPAs of up to Rs 10
lakh crore (trillion) Accumulated. Just a day after this, with a view to calm the panicked
markets, the Central Government issued a press release saying: 'Both the Government and the
RBI have to do with the public interest and the needs of the Indian economy in its functioning.
At that time it seemed that both the Reserve Bank of India and the Ministry of Finance have
resolved the differences.
In an unprecedented move in early December 2018. RBI Governor Urjit Patel resigned from
his post citing 'personal reasons'. The government then appointed Shaktikanta Das as the 25th
Governor of the RBI. (Das supervised the demonetization exercise as Secretary in the
Department of Economic Affairs and is a trusted bureaucrat of the current government).

Monetary policy, inflation target setting and central bank

independence
The debate on accountability of the central bank is not new. Keynesian economics dominated
the formulation of economic policy in most countries until the sixties after World War II. The
role of monetary policy in a typical Keynesian structure and thus the role of the central bank
is limited because the economic system revolves around the various steps taken directly by
the government as well as its involvement in economic activities, especially investment and
capital formation. The main function of the central bank is to provide loans to priority sectors
specified by the government and to ensure the stability of the financial system, especially the
banking sector.
The first information about giving such limited role to monetary policy comes during the in-
depth 'Great Depression' in the thirties, when central banks were accused of bringing about
the recession and making it more frightening. In the fifties, when inflation began to raise its
head all over the world and economies were distanced from Keynesian theory, the
responsibility of making monetary policy was then given to central banks. Inflation started to
wreak havoc all over the world. In the early eighties, inflation was brought under control
through very stringent monetary policies of the United States, Britain and other countries. The
era of dominance of 'moneyism or monetaryism' as the main ideology in the formulation of
monetary policy began during the decade of the seventies and under the new norm the
inflation rate was reduced based on 'credible' monetary policies.
The result of continued special emphasis on controlling inflation is that the 'inflation target'
was designed under which the central bank sets as a 'monetary policy rule' a range of
appreciation for the next one year. Or sets a limit and then tries to keep the inflation rate
within that range. If inflation rises and exceeds the target range, the central bank reduces the
money supply by increasing the interest rates until the inflation rate returns to that range.
Other important features of setting inflation targets include vigorous efforts to communicate
with the public about the plans and objectives of the monetary authorities and in many cases
the arrangements that are associated with achieving these objectives.

Inflation and debt supply in India in recent years

Following graph shows how the inflation rate based on both the Wholesale Price Index and
the Consumer Price Index has come down in recent years. Although WPI-based inflation has
seen an upward trend since the year 2015-16, but it is still at a low level of 2.9 percent in the
year 2017-18. Even in the year 2018-19, it remained at a low level. WPI-based inflation fell
to an eight-month low of 3.8 percent in December 2018 due to the fall in prices of fuel and
some food items. CPI-based inflation also fell to an eight-month low of 2.19 percent in the
same month.

Graph 2 indicates the insufficient growth in debt over the last three years, as can be seen in
the trends in the incremental debt-deposit ratio, points to the real reason behind the
government's real resentment from RBI.
 Source: Weekly Statistics Addendum, RBI at dbie.rbi.org.in.

The red lines in graph 2 show figures where both the numerator and denominator are negative
(ie both incremental debt and incremental deposits were negative). Despite the decline in both
incremental debt and incremental deposits, the ratios in these red areas are positive. This is
the reason that these ratios are excluded from the time series. Its low-level phase during the
period between December 2016 and September 2017 actually signaled the implementation of
demonetisation and GST, after which a truly dismal situation was seen on the incremental
loan front. Even more worrying thing is that recently the same trend has been seen again from
April 2018 till June 2018.
The stability trend in the credit growth of the banking system can be seen more clearly in
Graph 3. Looking at the credit growth trends in this one year, it shows that except for loans
and advances ranging from six to nine per cent and all other loans with interest rates ranging
from nine per cent to 20 per cent, except for advances this year. Stability is seen. Not only
this, the total amount of loans with some of these interest rates has also declined.

Graph 3: Interest rate range-wise classification of outstanding loans and advances of all
scheduled commercial banks (in million rupees)
 Source: Quarterly Basic Statistical Return (BSR-1): Outstanding Loans of Scheduled
Commercial Banks, RBI at dbie.rbi.org.in.

Comparing the interest rates recorded in the State Bank of India website [xxx] with the rates
of other public and private banks, it shows that loans with a range between six and nine
percent are mainly in the category of retail loan or retail loan category (Such as personal loans
and education loans). Business loans are charged at 11 percent and above. In such a situation,
one can conclude that during FY 2017, there was a stagnation in the business loan, which was
maintained even in FY 2018. In view of this, the Government's view (ie, RBI as a monetary
policy maker has probably failed to ensure the flow of credit in the economy) may get some
strength. However, the demand for loans may also have played a role in ensuring this
stagnation or stability.
The growth rate of capital formation or the growth rate of investment in real estate sector has
been falling continuously since that year. In view of this falling investment growth rate, it is
clear that loan demand for new investment will also decrease automatically. Therefore, the
responsibility of low or stable credit growth rate cannot be imposed only on the Reserve Bank
of India. If no investment is made in the economy, the debt demand for financing such
investment will also decrease. Therefore, even if the loan supply is increased further in some
ways, overall there will probably be no lifting of the loans.

Debt flow problem

An alarming decrease in debt growth made headlines shortly after the crisis-ridden
Infrastructure Leasing and Financial Services failed to meet its debt repayment commitments
in September 2018. It was acquired by the government after the company's unexpected
default. While this caused panic in the capital and money markets, the overall credit channel
of the economy was adversely affected, but the problem in the loan channel was already
becoming serious for some time (see Graph 2).

NBFCs, especially housing finance companies (HFCs) have been growing rapidly in the last
four years on the basis of some unusual factors. Most public banks adopt a no-risk approach
in the face of increased NPA pressure.

Meanwhile, domestic and corporate savings in the macro economy were forced to invest in
other financial assets as savings rates (including low savings rates) and long-term bond yields
were steadily reduced. Both domestic and corporate savings were invested in various financial
assets, mainly mutual funds (MFs). A large part of these MFs comes through a steady stream
of systematic investment plans (SIPs).

Table 1: Inter-sector assets and liabilities - till March 2018 (in billion rupees)
Financial body Receivables Amounts due
PSU or public bank 6,841.1 3,236.2
private bank 3,036.6 8,512.3
Foreign bank 981.9 916.9
Scheduled Urban Cooperative Bank 126.2 31.6
(SUCB)
All india financial institution (aifi) 2,410.4 2,665.8
AMC-MF 8,851.8 560.4
insurance companies 5,022.1 207.4
NBFC 419.5 7,169.9
PF 583.6 1.3
HFC 312.4 5,283.8
* The analysis is based on a sample consisting of 80 SCBs, 20 SUCBs, 22 AMC-MFs
(which cover more than 90 percent of the assets under management in the mutual fund
sector), 32 NBFCs (both deposits and non-deposits Systemically important companies
raising), 21 insurance companies (which cover more than 90 percent of the insurance
sector assets), 15 HFCs, 7 PFs and 4 AIFIs (NABARD, EXIM, Nacbi and SIDBI).
* Inter-sector credit risk does not include transactions between entities in the same group.
Source: Financial Stability Report June 2018, RBI.

This is evident from Table 1. Asset management companies that manage mutual funds are the
major fund providers of this system. After this comes the number of insurance companies and
PSU banks. It is noteworthy that all the borrowers (who have net receivables relative to the
rest of the financial system), except SUCB (Scheduled Urban Cooperative Bank), registered
an increase in their net receivables in March 2018 as compared to March 2017. Thus,
sufficient cash flowed into the financial system and reached various financial bodies. These
funds mainly went to NBFCs and HFCs, as mentioned earlier. Private banks also got a large
share of this. By the way, since these are generally far more cautious lenders, their asset
quality indicators were found to be relatively more favorable. Due to this cash, the valuation
or value of these NBFCs increased significantly, which saw a considerable improvement in
the rating of their assets. Additionally, on the basis of attractive valuations, many of these
NBFCs managed to raise equity capital with great ease.

Stress test (stress test) is done by assuming a fixed percentage point increase in GNPA of a
particular sector and then assessing its impact on GNPA of the entire banking system. The
most disturbing aspect is that even a a shock of two percent on standard advances in any of
these sectors can significantly increase the GNPA of the entire banking system to well above
the 10 percent level. .Combine this fact with the NBFC's GNPA data in various sectors (see
Graph 4) and in doing so the credit situation in the country becomes even more worrisome.

Graph 4: GNP trends (in percentage) of NBFCs

Source: NBFC Report 2018, CRISIL.

Borrowing costs for NBFCs have decreased over the years. However, this cost is likely to
increase after the IL&FS episode. CRISIL's report on NBFCs has predicted that the cash
shortage will affect the growth of this sector and the growth will be reduced by six percent
during FY19 and borrowing costs will increase by 0.30-0.40 percent in FY 2019. And there
will be a further increase of 0.70 percent in FY 2020. This will greatly increase the operating
cost of NBFCs. Except for very large NBFCs, the profit margins of most other NBFCs are
bound to decrease significantly as a result.
This fear of loss of profit of NBFCs is causing panic among all the stakeholders in the
economy, especially within the government. Table 2 shows the trends in some of the key
financial ratios of NBFC-ND-SI (strategically significant non-deposit raising NBFCs), which
constitute 84.8 percent of the total assets of the NBFC sector. In the year 2016-17, both the
income and expenditure of NBFC-ND-SI were high at 11.2 per cent and 8.8 per cent of total
assets. The following year, income declined and at the same time, expenses also decreased,
resulting in an increased net profit margin of 1.6 percent of total assets.

Table 2: Trend of Financial Ratio of NBFC-ND-SI (as a percentage of total assets)

2016-17 2017-18
Income 11.2
Income from funds 10.9
Income from fees 0.4
Expenditure 8.8
Financial expenditure 5.6
Operating expenses 1.6
Tax provision 0.9
Net profit 1.5
Source: Report on banking trends and progress in India, 28 December 2018, RBI.

However, in the first half of the year 2018-19 ie the last half of the failure of IL&FS,
these ratios showed very worrying trends. In fact, both income and expenditure came
down to a very low level, giving a net profit of just 0.8 percent (of total assets). It is
needless to say that moving towards a zero level of net profit as a percentage of total
assets practically means that assets are not sufficient to cover expenditure.
Avoiding such a crisis situation is paramount for the NBFC sector and the economy.
However, pushing this crisis towards the banking system is certainly not a solution to
this problem. But the government is actually doing exactly the same by taking over the
command of the top bank in its hands as part of its efforts to maintain credit flow by
weakening the PCA system.

Conclusion
The economy is currently on a volatile debt path. Banks supply funds to NBFCs;
NBFCs put those funds in some sectors that banks initially tried to avoid; Some parts
of the economy become highly dependent on NBFCs if banks do not increase credit
flow; Hidden financial irregularities come out of some major NBFCs; Irregularities in
the financial sector pose a risk of derailing economic stability, but the government
through the RBI directs banks to continue to provide funds in exactly the same
direction. In fact, this kind of debt path is like walking on a 'knife edge' (this phrase is
by 20th century development economist Roy F. Herod). Wandering through this route
can cause stagnation and slowdown in the real economy, but by continuing on this path,
banking and financial crisis can be a possibility.
Accumulation of NPAs in PSU banks is a stylistic fact in the current Indian economy,
which cannot be avoided even if desired. Interruption in the loan channel is a real
problem due to reluctance of PSU banks. However, once the NBFCs continue to
pressurize these PSU banks to continue credit flow to risky areas such as power,
telecommunications and housing, this is a solution that cannot be sustained for long.
At a time when it is difficult to get loans and the economy is stagnating, instead of
considering RBI and PSU banks as 'protectors', there is a need to adopt new thinking
in policy formulation. In such a situation, the Keynesian path or measure of fiscal
stimulus cannot be a bad idea altogether. However, adopting new thinking to solve
some serious economic problems in the election year may not be the first thing or
priority on the government's agenda.

References
1.
Abhijit Mukhopadhyay, “New GDP Series: More questions than answers”, ORF Online, 12
September 2018.
2.
Central Statistics Office (CSO), “Press Note on First Advance Estimates of National Income
2018-19”, 7 January 2019.
3.
RBI, “Chapter II, Financial Stability Report”, June 2018
5.
The Indian Express, “RBI takes three banks out of the PCA framework”, 1 February 2019.
6.
The Economic Times, “After Rs 12,600 crore bank fraud, should Reserve Bank stop
policing the banks?”, 12 March 2018.
7.
The Indian Express, “RBI wanted to pull out nominees from public sector bank boards,
Govt says no”, 17 October 2018.
8.
The Economic Times, “Nachiket Mor’s 2nd tenure on RBI board cut short”, 1 October 2018.
9.
Financial Express, “RSS-affiliate SJM welcomes Nachiket Mor’s sacking from RBI board”,
1 October 2018.
10.
Bloomberg Quint, “S Gurumurthy and Satish Marathe appointed to RBI Board”, 7 August
2018.
11.
The Economic Times, “Govt may invoke Section 7 of RBI Act for Governor to follow
board’s majority view”, 1 November 2018.
12
The Reserve Bank of India Act, 1934.
13.
Business Line, “Viral Acharya: Govts that don’t respect central bank independence, invite
wrath of markets”, 27 October 2018.
14. Ibid
15.
Livemint, “The gloves are off in the RBI-Government fight”, 31 October 2018.
16.
Ibid
17.
Ministry of Finance, PIB Release, “Autonomy of RBI”, 14 December 2018.
18.
The Economic Times, “Urjit Patel resigns as RBI Governor”, 11 December 2018.
19.
The Hindu, “Shaktikanta Das appointed as RBI Governor”, 11 December 2018.
20.
Samuelson (1985).
21.
Chapter VI, “Report on Trend and Progress of Banking in India”, op. cit.
22.
Bombay Stock Exchange, “Top 100 Companies by Market Capitalisation”, As on 1 April
2019.
23.
Livemint, “Sensex retreats nearly 400 points as NBFC meltdown resumes”, 18 October
2018.
24.
Bombay Stock Exchange, “Historical Stock Prices”, 1 April 2019.