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Why India's Banks Are Especially Vulnerable to a Downgrade

As the odds of a credit downgrade for India rise, the country’s banks could prove to be especially vulnerable, due to their significant exposure to government debt.

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Ratings agency Fitch on Wednesday downgraded its credit outlook for eight Indian banks from “stable” to “negative,” affirming a BBB- rating – the lowest investment grade. The move affected two private lenders ICICI Bank and Axis Bank, the country’s largest lender State Bank of India, and public sector lenders Punjab National Bank and Bank of Baroda.

The move comes two days after the firm slashed its outlook for India’s sovereign debt to negative on risks that the country’s growth outlook could deteriorate if policymaking and governance fail to improve.

“The immediate trigger is the change in the outlook on the sovereign foreign and local currency IDR (Issuer Default Rating). We won’t rate any financial institution higher than the sovereign - this means that the outlook has changed on the (financial) entities as well,” Ananda Bhoumik, senior director at Fitch Ratings told CNBC on Wednesday.

Commercial lenders in India are heavily exposed to sovereign debt as they are required by the central bank to invest 24 percent of their core deposits in government bonds. A downgrade of India’s credit rating to below investment grade would therefore have a knock-on effect for local banks.

“There are two ways a (sovereign) downgrade would impact the banking sector. As (government bond) prices go down, this impacts the capital base of banks. Secondly, the banks’ cost of funding goes up,” said Anita Yadav, managing director at the corporate bond brokerage and asset management firm SJ Seymour Group.

To an extent, Indian banks are protected from rising costs of funding because 70 to 80 percent of their funds come from domestic deposits. But a change in funding costs would still affect the profitability of banks as foreign investors account for 10 percent of their liabilities, according to Fitch.

“On the external funding side, pricing would increase but it’s not significant because external funding is under 10 percent of total liabilities,” Bhoumik said.

While Yadav agrees that a downgrade would not threaten the financial position of the lenders, she points out that a downgrade would limit banks’ ability to tap overseas investors for funds.

“Many international fund managers and asset managers can’t hold speculative paper – if they do hold it, they may be forced to sell. Their (the banks’) access to foreign funding will get limited,” she said.

Asset Quality a Concern

On top of the threat of a sovereign credit downgrade, Bhoumik warns that if India’s growth continues to deteriorate it could pose challenges for the asset quality of banks.

“The sovereign rating change is a reflection of turbulence on the macro side - lower growth and higher fiscal challenges - this could reflect in challenges for banks’ asset quality given concentrations that have built up,” he said.

He says banks with significant exposure to the infrastructure sector, as well as cyclical sectors such as commodities and automobiles would be at risk of rising bad loans.

The non-performing loan (NPL) ratio for commercial banks stood at 3.2 percent for the fiscal year-ending March 2012. Bhoumik says a continued slowdown in economic growth could force NPLs to rise to 3.75 percent by March 2013.

By CNBC's Ansuya Harjani

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