India slowdown sparks debate over threat from shadow financing

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Concerns are mounting about the risks to India’s financial health posed by a growing shadow banking sector that has helped fund a decade-long investment-fuelled consumption and investment boom.

While the initial economic boom was fuelled by capital inflows, the massive credit expansion to companies and households it produced has created asset bubbles in real estate and construction. And with credit expanding at 15% annually, loan growth is outstripping internal capital generation.

Now the economy is slowing, the rupee weaker and infrastructure projects for which banks have made large loans are stalled, bad debts are beginning to build up.

While the country’s NPL ratio grew to around 4.2% in the year to March, restructured assets are rising faster. According to Fitch, combined bad and restructured debts will account for 12% of loans by the end of 2013-14 as banks use restructuring to avoid classifying loans that have gone bad as non-performing.

Much like China, shadow banking in India has developed to fill a gap left by an uncompetitive and restrictive formal banking system. Shadow financing is utilized by business and individuals that formal banks are either unwilling to service or cannot compete for due to banking regulations.

The bank-lending market is distorted by priority sector rules that require 40% and 32% of the respective net credit domestic and foreign banks extend that must go to agriculture, small enterprises, education and housing – meaning less money is available to be lent to sectors where it is needed.

India’s negative real interest rates also create fertile ground for shadow banking, which can offer much better returns for depositors.

With little official data, quantifying the shadow financing sector is difficult but analysts believe it contains a substantial black market element but is neither as large or risky as that of neighbouring China.

India has around 12,000 non-banking financial companies (NBFCs), ranging from deposit-taking and non-deposit-taking institutions that extend credit to investment companies that invest in securities, and are subject to Reserve Bank of India (RBI) regulation, including capital-to-risk-asset-ratio standards.

The more heavily regulated deposit-taking NBFCs have been on the decline since a regulatory crackdown after a rash of scandals in the early 2000s and there are now less than 300. However, a new type of super-NBFC that the RBI has identified as systemically important has emerged since 2006 and now number more than 300.

Systemic risk is injected into the equation not only because shadow financing has gone into risky real estate and speculative investments but that it is closely bound up with formal banks.

Loans make up a substantial and rising proportion of NBFCs’ liabilities, exposing banks and other formal financial institutions to risk of losses in the event of failure in the economy, and the risk of a credit squeeze.

The assets of systemically important NBFCs now exceed Re7 trillion ($107.3 billion) or 10% of total bank assets with financing companies, which are much more reliant on bank loans than investment companies, lending as much as 75% of assets.

“The biggest problem in terms of India’s shadow banking system are the connections to the banking system. NBFCs possess a relatively small deposit base – overall about Re58 billion ($889 million) in 2012 – so when there is a liquidity crunch as there was in 2008, they experience a real crisis in obtaining steady bank loans to finance their capital base,” says Sara Hsu, assistant economics professor at State University of New York.

“Liquidity dried up and even when the Indian government opened a window through banks to extend funding, banks refused to lend to NBFCs because of the extent of uncertainty in markets.”

Data from the World Bank shows domestic credit provided to India’s private sector reached 51.5% of GDP in 2012, up from 31.8% in 2002.

However, that is just known lending. Alongside the banks and finance companies exists a vast informal shadow financing sector serving SMEs, entrepreneurs, small investors and India’s vast numbers of urban and rural poor with no access to banking services.

The informal sector consists of a range of networks, some legal and some illegal, from badla financiers – a type of market maker – commodity trade financiers, and gold saving and loan companies to pawn brokers, chit funds and money lenders.

As much as 40% of lending in rural areas comes from the informal sector, according to estimates.

Hsu says the linkages run right through financial system, with NBFCs the common thread.

“There are various links from the NBFCs to the informal sector,” she says. “One example has to do with microfinance institutions (MFIs). MFIs are one type of NBFC that lend to poorer individuals, but unlike microcredit institutions set up by NGOs, they are interested in making a profit.

“These institutions charge high rates of interest and impose various penalties to gain a profit. Individuals borrow from the informal financial market to repay these types of debts.”

Informal financing has also helped inflate India’s property bubble through lending on off-plan developments, where developers sell apartments and houses at the current market price to fund future construction. Off-plan properties are often bought as investments that are quickly sold, sometimes even before completion.

The sector has attracted some less-reputable elements as the race to cash in on spiralling prices has grown into a scramble, and exposed banks have been ordered to reclassify these type of home loans as construction finance with stricter rules and higher rates.

To avoid tax, some developers want a certain proportion of deposits from outside banking channels and thus demand buyers come up with cash deposits which the purchaser has to obtain from the informal sector.

However, the boom is under threat from higher interest rates and inflation, and from moves by foreign private equity investors to reduce their exposure to Indian real estate.

Mumbai Property Exchange says it has seen a substantial number of people buying properties – through recommendations from friends and relatives – not getting their money back or the apartment.

“There’s a lack of regulation which is fuelling this type of bubble,” says Nida Ali, India Economist at Oxford Economics. “Without the banks, investors take on this added risk alone.

“This is rampant in real estate with builders going directly to prospective buyers and getting funding from them with massive returns to be made for all – provided the properties get built.

She concludes: “If we now see more developers getting into financial difficulties due to the economic slowdown, or going bankrupt, buyers lose their money and cannot repay lenders. This does fuel risk in this environment when India is in a very vulnerable economic state.”