Context:

Rapid credit growth often promises prosperity but can lead to financial crises. India faces the delusion highlighted by Carmen Reinhart and Kenneth Rogoff, where governments and markets dismiss past crises by claiming "this time is different," hyping the country's performance.

India's Financial Fragility

●     Overhyped Expectations: India is caught in a cycle of overhyped expectations, driven by policymakers promoting the country's performance. The "this-time-is-different" narrative touts India's digital infrastructure for financial innovation and inclusion, promising growth and equality. However, this has led to an underregulated financial sector and increased borrowing.

●     Decades of Economic Policies: While recent government terms have contributed to this situation, three decades of economic policies are also to blame. Unable to generate job-rich manufacturing growth, policymakers have relied on the financial sector to boost GDP growth rates, with it contributing over a quarter of GDP growth in the last decade.

Praise for the Lending Surge

●     IMF's Praise: Both international and domestic analysts have praised the lending surge. In December 2023, the IMF praised India's financial sector, noting strong bank lending growth and low non-performing assets.

●     Domestic Analysts' Support: Similarly, the March 2024 review by the National Council of Applied Economic Research celebrated a 20% increase in bank lending. They saw the rise in personal loans, amid stagnant industrial lending, as a sign of bright prospects.

India's Looming Financial Crisis

●     Overlooking Underlying Deficits: The credit growth overlooks the underlying job and human capital deficits, leading to dangerous territory. While lending expands, the financial sector seems healthy as new loans repay old ones. However, when lending slows and options for more loans vanish, the situation collapses.

●     Household Debt Boom: Financial intermediaries promote loans, driving lower- and middle-income households to spend on housing, gadgets, cars, education, and lifestyle. However, this household debt boom is fundamentally risky. Instead of boosting productivity, it raises domestic prices, reducing competitiveness.

●     Warnings from Economists: Economists Atif Mian and Amir Sufi warn that higher household debt burdens lead to more severe crashes. Heavily indebted households and businesses cut spending sharply to repay debt, causing an economic crunch. This scenario is likely to repeat in India, given the rapid expansion of household lending at 25% to 30% annually.

●     Stock Market and Exchange Rate Issues: Adding to the bad credit boom is a stock market rising unmoored from weak corporate investment and anaemic consumer spending, an overvalued exchange rate, and a tendency for Indian authorities to inflate dodgy data.

The Risks of India's Chaotic Financial Sector

●     Chaotic Financial Services Industry: India's liberalization has led to a chaotic financial services industry, with large banks and NBFCs alongside numerous smaller players. However, lending opportunities have narrowed, pushing institutions to seek profits aggressively.

●     Shift to Household Lending: Amid COVID-19, lending shifted towards households, with fintech offering high-interest loans. Many borrowers became dependent on such loans, leading to a significant portion of unsecured household debt.

●     Credit Card Ownership Surge: Credit card ownership surged in India, but aggressive marketing to low-creditworthy individuals raised concerns. Many people, lured by rewards and offers, ended up in debt traps, posing a macroeconomic risk.

●     Sluggish Household Consumption: Despite credit growth, household consumption remains sluggish. A high household debt-service ratio, akin to pre-crisis levels in other countries, indicates trouble ahead. The crisis could unfold rapidly, with defaults triggering economic contraction and financial distress.

Addressing the Crisis

●     Downsizing the Financial Sector: To prevent India's hype, the financial sector needs to be downsized to match lending capacity and productive borrowing needs. Weakening the rupee to boost exports and cushion the downturn is also crucial.

●     Policy Change Challenges: However, policy change seems unlikely. Indian policymakers believe finance will drive growth, despite the risks. They also prioritize a strong exchange rate. Meanwhile, the looming crisis coincides with a severe job shortage, pushing many back to agriculture.

●     Reassessing Risk Models: Banks and NBFCs may need to reassess their risk models and lending practices for unsecured loans. They should prioritize creditworthiness assessments and explore alternative strategies to manage risk while maintaining lending activities.

●     Diversifying Loan Portfolios; Financial institutions might diversify their loan portfolios by shifting focus to more secured lending or targeting other creditworthy segments to balance the impact of increased risk-weighting on unsecured loans.

●     Learning from the 2008 Global Recession: India needs to learn the lessons from the 2008 Global Recession, highlighting the need for robust financial regulation, rigorous risk assessment, and enhanced transparency. The crisis also underscored the interconnectedness of global financial systems and the necessity of international cooperation, emphasizing the crucial role of central banks in managing economic stability through effective monetary policy.

Conclusion

India's heavy reliance on credit is like a car speeding toward a cliff without brakes. Unfortunately, the nation's elite seems oblivious to the risks, leaving the vulnerable to bear the burden of the crisis and exacerbating inequalities. Thus, the need of the hour is to turn the over-hyped expectations into reality and make digital financial inclusion work for growth and equality, propelling India towards becoming a $5 trillion economy.

Source- The Hindu