Fitch Ratings To Revise India FY17 GDP Growth Forecast Downward On Demonetisation

Ratings agency Fitch Ratings expects the government’s demonetisation drive to cause short-term disruptions in economic activity. This they say may warrant a downward revision in its GDP growth forecast for the current financial year.

“The impact on GDP growth will increase the longer the disruption continues, but we will already need to revise down our forecasts to reflect what will almost certainly be a weak Q4FY16 (October-December),” Fitch Ratings said in a media statement on Tuesday.

The ratings agency did refrain from putting out a new growth forecast though. Its earlier forecast stands at 7.9 percent.

The implications both for the economy and the banking system cannot be accurately quantified at this point, the ratings agency said. It pointed out that India’s sovereign credit profile would benefit from an improvement in government finances, but there are “considerable uncertainties over the potential positive effects”.

For one, there is a possibility that India’s informal sector, which according to the Fitch Ratings, accounts for 20 percent of the gross domestic product and 80 percent of employment, will bounce back once the effects of the demonetisation fade.

Fitch Ratings has retained India’s sovereign rating at “BBB-”.

“There are similar uncertainties over the impact on the banking sector,” the rating agency said.

Fitch expects that the sharp increase in current account and savings account deposits to improve transmission of the Reserve Bank of India’s policy rate cuts. The lower rates, the ratings agency said, could encourage stronger credit growth, and might also give a breather to companies with stressed loans.

“But it is more likely that banks will choose to protect margins, and may not pass on the entire benefit of the low cost of funding,” said Saswata Guha, director at Fitch Ratings.

A flip side to the benefits that banks could get from demonetisation is that it could affect the ability of borrowers in sectors that rely on cash transactions to service loans. A temporary relief was provided by the RBI in the form of 60-day grace period for small borrowers and firms that need to make repayments, but are short on cash.

Guha believes that the cash crunch is likely to extend beyond two months, and that banks could face asset quality issues on small-ticket loans.

Read: Three Charts That Tell Us How Demonetisation May Hit GDP Growth

Outlook On Banking Sector Stays Negative

The agency has reaffirmed its negative outlook on India's banking sector as capitalisation and resolution of non-performing loans continue to be areas of concern going into the new year.

The agency reiterated its estimate that Indian banks will need $90 billion, or over Rs 6 lakh crore in new capital by the financial year ending March 2019 as growth capital, for provisioning requirements, as well as to meet Basel-III norms.

"The bulk of the capital requirement is concentrated in FY18 and FY19. Core equity accounts for more than 50 percent, while the rest of the requirement is largely through AT-1 debt capital instruments," the agency said.

The government, through its Indradhanush programme has earmarked Rs 70,000 crore for capitalisation of public sector banks in the four years ending March 2019. Fitch Ratings, however believes that this amount may not be sufficient to meet requirements.

"Also, as far as the AT-1 issuances are concerned, banks have been able to raise funds recently, but there is a question on sustained momentum," he said.

This, according to the ratings agency is because banks will not be able to raise the requisite funds through additional tier-1 bonds only from the domestic market, and these instruments may not receive widespread support in overseas markets.

Bad Loan Resolution

Fitch Ratings expects the pace of creation of non-performing assets to reduce in the banking sector, but does not see much movement on resolution of existing bad loans.

For the sector as a whole, the agency expects the stressed asset ratio to rise to 12 percent in FY17 from 11.4 percent in the previous financial year.

"We are very cautiously optimistic that the resolution of bad loans will improve going forward," said Guha. "It is possible that the recent tweaks introduced by the RBI in the resolution mechanisms will create some traction, but the general feedback so far has been that it hasn't been effective."

The Reserve Bank of India recently made changes to its scheme for sustainable structuring of stressed assets, or S4A. Through the scheme, banks divide a bad loan into a sustainable and unsustainable portion. With the change, banks can now classify the portion that is sustainable as standard, reducing provisioning requirements.

"Large borrowers constitute about 86 percent of the NPL mix, which are generally complex exposures and mostly in sectors where high leverage, weak demand and structural challenges continue to persist," Fitch Ratings said.

The major concern for banks then, according to Guha, is the capital required for provisioning, which is expected to shoot up as bad loans age. Banks are required by the RBI to progressively increase provisioning on bad loans the longer it takes for them to be resolved.

As a result of the capital requirement, banks are unlikely to aggressively pursue credit growth.

"Fitch expects credit growth at 10 percent during FY17, given the overhang of stressed balance sheets, poor capitalisation and a high focus on recoveries," the agency said.