(Bloomberg Gadfly) -- India's bleary-eyed bankers are raking it in. The outlawing of large-denomination bills led to angry lines at ATMs and long working hours for tellers, but it also triggered a stampede of deposits, lowering the banks' cost of funding.
There's another corner of finance, though, where New Delhi's gamble to ferret out undisclosed wealth by banning 500 and 1,000-rupee banknotes is causing distress -- the world of shadow banks that make small loans, sometimes against gold, but usually without requiring any collateral.
Before the surprise Nov. 8 move, finance companies' shares were outpacing those of deposit-taking banks. An 11 percent decline since demonetization has changed that.
The expectation is intact that over time Indian nonbanks' share of total credit, estimated at 13 percent by the Boston Consulting Group, will narrow the gap with 33 percent in China and 25 percent in Malaysia and Thailand. But it may now take longer.
There are at least six reasons for the reversal in fortunes. For one, shadow banks deal with individual borrowers who may earn in cash and repay in small installments. For Bharat Financial Inclusion Ltd., India's biggest micro-lender, each of its more than 7 million loans is worth just $158. Naturally, sucking out 86 percent of banknotes by value from the system has raised the odds of defaults.
Anticipating this, the central bank on Monday gave banks and finance companies an additional 60 days before they have to count a small loan that remains delinquent between now and December as substandard. This should prevent credit costs from blowing up, at least for now.
Two, the finance companies themselves borrow from banks, as well as selling debt securities backed by the income streams from their own loans to individuals. In the eyes of creditors, including banks and money-market funds, those income streams are a lot riskier now than they were just two weeks ago.
Third, those nonbanks that finance purchases of trucks or give advances against gold could be in trouble if demonetization ends up stalling the movement of goods and services (and demand for trucks), or triggers a collapse in the price of the yellow metal. Gold already is under intense scrutiny by tax authorities lest it become an even more attractive parking lot for the spoils of corruption.
The fourth problem is competition. Media reports suggest that rich businessmen wrong-footed by Prime Minister Narendra Modi's war on tax evasion are distributing their banned cash troves among a large group of poor people as informal short-term debt. To the extent these people can swap the notes for smaller denominations, they can access funds for which they otherwise would have tapped micro-lenders.
Fifth, rural households that supply labor for urban construction will lose jobs because the property market just had a seizure. Given pervasive corruption in real estate, it might take a long time -- and a big drop in land and apartment prices -- to bring buyers back. This would be another income shock for the rural economy, already reeling from a buyers' strike for farm produce usually sold for cash. Unless it's mitigated by a massive government-works program, that shock will weaken finance companies' credit portfolios.
Finally, the finance firms have risk-sharing arrangements among themselves. Reliance Capital Ltd., controlled by billionaire Anil Ambani, uses Satin Creditcare Network Ltd. to find borrowers who want to leverage their property assets; Satin does the credit checks and follows up on repayment to Reliance. But if a loan becomes nonperforming, it ends up on its books. In times of stress, risk sharing could amplify shocks to the system.
India's shadow banks will tell the story of the dislocation that lies ahead. Eventually, a new payments mechanism will supplant the one that just died. To the extent the new system is likely to rely on the exchange of purchasing power via mobile phones, however, the traditional strength of the finance companies -- their network of "human ATMs" in far-flung corners -- could gradually lose its advantage.
Banks, meanwhile, will be deploying their deposit bounty in the bond market to try to boost profitability in a slowing economy. (State Bank of India alone picked up $20 billion of deposits in eight days after the government move.) Their soured corporate loans made them a poorer cousin of nonbank financiers. Now demonetization has turned the tables.
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To contact the author of this story: Andy Mukherjee in Singapore at amukherjee@bloomberg.net.
To contact the editor responsible for this story: Paul Sillitoe at psillitoe@bloomberg.net.