India finds itself in an unenviable position. Choosing an option has become ever more difficult. The financial sector crisis continues and the country has been suffering from negative shocks to credit growth which pushes up the macro vulnerability and increases downside risks to the growth in GDP. However, as the economy recovers from the pandemic, it needs a strong GDP growth at a much higher level and will need to be sustained over the near and medium-term to achieve many of its development goals. But higher GDP cannot be achieved without higher credit growth, and the whole situation becomes cyclical and vicious one.
India’s financial sector has faced many challenges in recent decades, including a rapid increase in non-performing assets (NPAs), referred to in this paper as NPLs, after the global financial crisis (GFC) and the 2018-2019 run on non-banking financial companies (NBFCs). Credit growth has been weak for some time, with a large, negative, and persistent credit to GDP gap since 2012. Just as the balance sheets of the financial sector started to gradually improve, the Covid-19 shock hit the economy, raising concerns about a new wave of NPLs and corporate defaults. At the same time, real GDP growth averaged 6.7 percent from 2011 to 2018, before moderating to 3.7 percent in 2019 (NBFC crisis) before the Covid-19 crisis. The credit-to-GDP ratio peaked at around 106 percent in 2012 and declined to around 90 percent in 2021, while the bank-credit-to-GDP ratio currently stands at around 55 percent. Following a period of double-digit credit growth, the credit-to-GDP gap turned negative in 2012. The decline in credit since 2012 was mostly driven by the deleveraging process of the corporate sector. Corporate credit growth slowed from a peak of close to 30 percent in 2008 to zero at its trough, with a sharper decline in corporate credit growth compared with the household segment. At the same time, the broad credit growth also experienced a sharper slowdown than bank credit growth, suggesting that the deleveraging process not only took place in the banking sector but also in broader debt financing. The NPL ratio peaked at around 11 percent in 2017 but has since come down to around 8 percent.
It was therefore an opportune time to examine the nexus between the financial sector in India and economic growth. An analysis of the potential impact of financial sector weakness on India’s economic growth has therefore been carried out in the latest IMF working paper titled “Financial Sector and Economic Growth in India.” Since the financial sector could affect economic growth through multiple channels, with both cyclical and long-term effects, the paper focuses on these two channels. The long-term analysis result confirmed that in India, at least for private banks, the level of capitalisation is strongly correlated with credit growth. The relationship between public banks appears to be much weaker. Additionally, it is when those banks which are better capitalised extend more credit that India observes higher real GDP growth, but only on the condition that these banks do not have excessive NPLs. Given the difference between the private and public banks, efforts to better understand the drivers of this difference should be carried out and addressed, which could help promote economic growth.
