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Despite all that the Indian government has done to revitalize the country's struggling banking sector, one crucial element remains missing from its effort: New Delhi isn't forking over enough cash.
The lack of liquid funds at a time when non-performing assets remain at high levels has incapacitated the banks' ability to lend and spur investments — the two major challenges confronting India, according to Finance Minister Arun Jaitley.
Growth in Asia's third-largest economy slowed to a three-year low of 5.7 percent in the April-to-June period, according to official data. Many analysts blamed the slowdown on the introduction of the new Goods and Services Tax and the recent ban on high-value notes. Propping up the banking sector, experts say, would get the economy going again.
This year, the government has consolidated operations of several state-owned banks to strengthen them and it enacted a new bankruptcy law to speed up insolvency cases, but there has been little indication that rescue will come in the form of capital.
Some analysts said the government's relative silence on that front was partly due to its challenging fiscal position. India exhausted 96 percent of its full-year deficit target in the first five months of its fiscal year, limiting its spending power to boost growth.
"Like most banking systems in Asia, India is also seen as possessing strong government support but this view has recently come under some uncertainty," CreditSights analysts wrote in a recent report. "We think the government will continue to support the public sector banks and its reluctance to recapitalize them to stronger levels in part reflects a desire to impose more discipline on the banks."
Analysts estimated that Indian banks need an additional $40 billion to $65 billion to clean up bad loans on their balance sheets and meet the stricter capital requirements set forth in an international regulatory framework called Basel lll.
State-owned lenders, accounting for more than two-thirds of India's total banking assets, would need a large majority of that estimated need — much more than the 700 billion rupees ($10.78 billion) that the government pledged for the four years to March 2019.
Bad loans accounted for 9.6 percent of banking assets at the end of March, the latest financial stability report by the Reserve Bank of India showed. Fitch Ratings estimated that the proportion of overdue debt at state-owned banks was at 11 percent, while that figure at private sector banks stood at 4.5 percent.
"Fitch believes the government will have to pump in significantly more even on a bare minimum basis (excluding buffers) if it is to address the system-related risks of a huge NPL (non-performing loan) stock, weak provision cover and poor loan growth," the agency said in a report.
Analysts said banks with stronger balance sheets such as State Bank of India, the country's largest lender, could tap the equity market for more funds, but options may be limited for the smaller entities. Shares of the state-owned banks have fallen out of favor among investors, with an index tracking them — the Nifty PSU Bank — hitting its lowest level in nine months on Oct. 11 even as the broader Indian stock market has surged by more than 20 percent this year.
"How are the banks going to meet the capital requirements? That's a question which we have no clear answer to," said Geeta Chugh, S&P's senior director for financial services ratings. "We think that it'll be a combination of raising money from government, government-related entities and AT1 (additional tier 1) instruments."
AT1 bonds are instruments that have no maturity date. The issuer has the option to cancel the bonds or repay the principal after a specific period of time. The bonds come with higher periodic payouts, which are attractive to investors, but risks are also higher since the issuer can sometimes choose to skip payments.
For some banks, Indian investors offer little respite and so they may be forced to raise capital overseas.
"One question we had for banks is if they will actually have to tap the offshore market for AT1," CreditSights analysts said. "The consistent answer was yes and this is because of a still thin domestic investor base."
Until further actions are taken by either the government or the banks, most analysts expect loan growth to stay weak and earnings to remain muted at the public sector banks.
Total bank loans in India grew around 5 percent in the fiscal year that ended in March — the slowest pace in more than six decades, Reuters reported. Recent central bank data showed loan growth accelerated above 6 percent in September, but that still pales in comparison to the double-digit increase commonly seen this decade.
"We think that we are close to the bottom of the credit cycle. We do see positive momentum in certain segments with revenue growth starting to increase, profitability increasing (so) at the margins, things are beginning to look better. But we think it's a very slow, gradual improvement," said Chugh.