As India's Economy Cools, the Spotlight Hits Its Shadow Banks

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Managing the shadow banking crisis will form one of the Reserve Bank of India's core challenges in the months ahead.

The central bank will balance its efforts at pumping cash into the economy with keeping a lid on inflation.

Avoiding a crisis in shadow banks will be key toward sustaining consumption amid an economic slowdown.

Editor's Note: This assessment is part of a series of analyses supporting Stratfor's upcoming 2019 Third-Quarter Forecast. These assessments are designed to provide more context and in-depth analysis of key developments over the next quarter. 

As growth in India's $2.6 trillion economy cools, the problems afflicting its shadow banking sector are increasingly coming to light. Shadow banks — also known as non-banking financial companies — are facing a cash crunch ever since a titan in the sector, Infrastructure Leasing & Financial Services, defaulted on its payments in September 2018. That event sparked fears of a contagion rippling through India's already sluggish corporate credit system. Traditional banks — saddled with a significant number of non-performing loans — are not as likely to extend credit to companies already swimming in red ink, the legacy of an infrastructure binge that accompanied roaring growth in the economy from a decade and a half ago.

This has left the banks and mutual funds, from which shadow banks source most of their capital, more reluctant to provide funding. For the Reserve Bank of India, managing the shadow banking crisis will be one of its core challenges in the months ahead. The central bank is taking measures to ensure that enough cash is circulating through the economy, including loosening reserve requirements for traditional banks and buying bonds through open market operations. But those moves risk stoking inflation above its target of 4 percent. The central bank's regulatory and monetary policy will play an outsized key role in boosting growth in India's consumption-driven economy through interest rate cuts that it hopes will translate into lower rates on bank loans, especially as the central government's fiscal stimulus options remain limited. In that context, the shadow banking issue will be an important one for it to solve.

Shadow Banks: Setting the Context

The more than 11,000 entities that constitute India's shadow banking industry occupy a semi-regulated gray zone between traditional banks and consumers. Unlike regular banks, they are unable to borrow from the central bank and don't insure customer deposits. Despite the limitations, they perform an important, if complementary, role in the banking sector, extending credit through financial instruments, including the types of long-term financing deals that infrastructure firms find attractive. For many rural Indians, who lack access to any kind of formal banking, shadow banks fill the gap. 

In recent years, a slowdown in lending by traditional banks has raised the profile of shadow banks as a source of credit. The origins of the lending slump began with India's growth spurt in the 2000s, which sparked an investment boom fueled by credit. Corporations funded infrastructure projects in the power generation, telecommunications and steel sectors, and investment climbed to 38 percent of gross domestic product. But projects began to run into complications, including problems with land acquisition and environmental clearances, causing their price tags to balloon. At the same time, inflation began to climb, and the central bank responded by increasing interest rates, making loans more expensive. These factors combined to limit the ability of indebted companies to repay their loans. Consequently, Indian banks — especially public-sector banks that comprise 70 percent of the banking system — watched their pile of non-performing loans grow. They now account for 9 percent of all loans as of March, although they have fallen slightly from earlier in the year.

Bigger Role, Bigger Impact

Resolving this conundrum — known as the "twin balance sheet problem" — will be key to India's investment revival, as even fixed investment — the main investment gauge measuring the purchase of physical assets such as land and machinery — has inched up to 29.5 percent of gross domestic product. With the lending ability of traditional banks still restricted, companies have turned to shadow banks to help fill the void: as a result, their share of the credit market climbed from 9 percent at the beginning of the decade to nearly 18 percent as of 2018. Thus, keeping shadow banks afloat is crucial to ensuring that credit keeps flowing in India. 

The default of Infrastructure Leasing and Financial Services has created a chill among investors that supply capital to shadow banks. Mutual funds, in particular, have cut back their holdings of short-term debt issued by shadow banks from 4.2 trillion rupees ($60.5 billion) in the quarter ending in December 2018 to 3.2 trillion rupees in the current quarter. And in May, the financial woes of another shadow bank, Dewan Housing Finance Corp., led to a credit-rating downgrade, sending its shares tumbling. The fundamental problem for shadow banks stems from an asset-liability mismatch: The shadow banks receive their capital from short-term financing that they then turn around to use as funding for long-term projects. This means that if those projects run into trouble, the shadow banks — like their mainstream counterparts — have trouble servicing their own loans to banks and bond payments to mutual funds.

Taking Steps to Mitigate

In announcing steps to address India's credit crunch, Reserve Bank of India Gov. Shaktikanta Das said the central bank would soon present a liquidity risk management framework to help buffer shadow banks against defaults. Additionally, the central bank's recent measures to pump more cash into the economy — including liquidity adjustment facilities, open market operations, and U.S. dollar buy/sell swaps — all helped India escape its liquidity deficit during March and April. But as the Dewan ratings downgrade demonstrates, more defaults may come to the surface under the greater scrutiny of the sector. The Reserve Bank's immediate focus will be to head off a crisis in the shadow banking sector to sustain a key source of credit in the strained financial system. A third consecutive rate cut in June brought India's key interest rate down to 5.75 percent. But over a key segment of India's credit market, the shadows loom large.