Warning from RBI – Tsunami of Bad Loans in 2021

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Equity market has been seeing a fantastic rally since March, 2020 and the rally has been continuing in 2021 as well. We all know that the primary reason for equity rally has been global liquidity which is due to huge stimulus from US and other countries.

We also know that there is a huge disconnect between stock market and the economy. Covid-19 and the consequent lockdown had a devastating effect on economy.  The GDP declined by 23.9% in Q2 of 2020. Thankfully, Indian economy has been seeing a good and better than expected recovery.

One unsolved puzzle has been that despite lockdown, negative growth in GDP and businesses being hit significantly, we have not seen loan defaults and banking crisis. The pertinent question before us is whether there is any impending risk in our financial system.

In 2020, two important developments happened for banking sector. They were as under:

  • RBI allowed restructuring of loans for everyone by offering moratorium (Postponement of payment)
  • Supreme Court on 3/9/20, directed the banks that loan accounts which hadn’t been declared as a bad loan shall not be declared as one, until further orders.

Due to above developments, recognition of bad loans by banks was postponed and the banking crisis was avoided. However, this was only postponed to future and someday it was supposed to come back to hound us.

The time of reckoning came sooner than expected when recently (January 11, 2021), RBI released Financial Stability Report (FSR). The FSR report is an important and exhaustive report on health of economy and financial sector.

The key takeaways from report are as under:

  • Gross bad loans on bank balance sheets could rise to 13.5% by 30th Sept, 2021 as compared to 7.5% in September 2019.
  • In the worst case scenario, the gross bad loans could rise to 14.8%—Almost double the size of the current bad loans.
  • In absolute numbers, total bad loans as of March, 2020 stood at ~Rs. 9 Lac Crores. It is expected that bad loans will double to ~Rs. 18 Lacs Crores by September, 2021.
  • At aggregate level, banking sector will be able to handle the stress. But at individual level, 5 Banks won’t be able to meet the regulatory minimum requirements and will come under stress.

RBI projection of bad loans:

Bad Loans and NPA RBI*Source : FT

The bad loans becoming double to ~Rs. 18 Lacs Crores and some of the banks coming under severe stress are big red flags and we need to be careful about them. Would also like to highlight that in the past, RBI has been conservative in predicting the bad loans. Actual number of bad loans have been higher in most of the times.

So what does this means to investor. According to us, following are the implications for investors:

1) GDP Growth – Because of huge bad loans, the banking losses will increase. Banks will have to do provisioning for these losses from their capital. This will lead to reduced equity capital and will hence reduce the credit off take (Giving of loan) by banks.

Due to weak balance sheet of banks, the banks will not be in a situation to give loans to corporates for new projects. This will slow down the investment in economy and will lead to slow down in GDP growth.

Similar situation has been playing out for India since 2014. Due to significant bad loans, banks have slowed down in giving out loans to corporates for investment and this has been one of the primary reason for slow GDP growth in last 7 years.

The solution to this problem is that either Government should capitalize the PSU banks or privatize the PSU banks. Both of them are not happening as Government doesn’t have enough money to capitalize the PSU banks and they don’t want to privatize the banks because they run various social loan programs through PSU banks and also because it’s a political issue to privatize the banks.       

Overall, bad loans will impact GDP growth in years to come for India. Investors should keep this in mind when setting up expectations of return from Equity.

2) Fixed Income/ Debt – Since bad loans are expected to go up, we may see defaults from corporates, NBFCs and even banks. So investors have to be very careful about their debt portfolio. Next few years, investors should not chase higher return on debt portfolio and should only focus on high quality. Investors should contend themselves with lower returns from fixed income investments.

At Alpha Capital, we believe that for debt portfolio, investors should not touch any fixed income product which is yielding 1% more than your bank FD return. Of course, there can be exceptions when risk return reward is in favour of the investor. Our experience, has been that ‘There is no free lunch’. If someone is offering even 0.1% extra return on debt then it comes with some additional risk. Its important for investors to understand and analyse the products carefully.

Accordingly, following is suggested for various fixed income products:

a) Debt Mutual Funds – Its suggested that we stay invested in only those debt mutual funds which have very high quality portfolio. We did a lot of restructuring for all clients between March and May of 2020 within debt portfolio to ensure that we exit all funds with risky papers. As of now, we are in very good situation and we have ensured that our debt portfolio is safe and very high in quality. Going forward, we are going to further closely monitor this space because sometimes even very high quality papers become junk (Example – IL&FS, DHFL, Yes Bank etc).

b) Bank Fixed Deposits & Bank Balances – These are mostly safe but Latin phrase ‘Caveat emptor’ which means ‘Let the buyer beware’ is more valid here. 10 years back, the perception was that anything which is backed by Government is safe and that Government will always protect investors. But now the narrative is changing. Government is now asking investors to read the documents carefully.

In the case of Yes Bank AT1 Perpetual Bonds, Rs. 8415 Crores of bonds became Zero for investors when Yes Bank went into restructuring. When this was challenged in Chennai High Court, then the RBI in its affidavit categorically stated that AT1 Bonds had the feature of its value becoming Zero in case of trouble in the Bank and the same was communicated to the investors. Hence, the bank was not liable to pay the investors for any kind of loss.

As per RBI, bank fixed deposits and bank balance is protected by insurance of upto Rs. 5 Lacs. Anything beyond this is at risk. Now this amount will only come at risk when the underlying bank comes under stress and defaults. Government in the past has communicated that it will protect bank depositors. But keeping ‘Caveat emptor’ in mind, it is suggested that investors should stay away from banks which are under stress or are expected to come under stress in future. These banks normally offer higher return on bank balance and fixed deposits. Its fine to earn low return for few years and stay invested in only high quality banks.

c) NCD, NLD, Perpetual Bonds – Because of low interest rates in deposits and other fixed income investment, instruments like Non Convertible Debentures (NCD), Nifty Linked Debentures (NLD), AT1 Perpetual bonds are becoming available with relatively better return.

Investors are required to review them with magnifying glasses and understand the default risk carefully. Issuer of underlying paper and terms of the product should be carefully examined to understand the risk. Stay away from them if something doesn’t feel right as there is no point in taking unwanted risk for extra return. It is better to take higher risk in equity where return payoff is proportional and higher.

3) Equity – As explained above, bad loans will have an impact on GDP Growth of India. This should fundamentally affect corporate earnings and equity returns. Will this lead to equity correction or fall? We don’t know. Its very difficult to predict the movement of equity in short term as equity market also gets influenced by liquidity and sentiment. If global liquidity continues for long,  market can also keep going up accordingly.

Always remember – ‘Markets can be irrational for a very long time’. Investors should definitely be careful and watch the investment closely. Book profit with upward movement of market and buy when markets are correcting. We feel volatility will be high in 2021 and will give good opportunity to investors to take advantage and generate better returns.

Are banking stocks going to be affected? Bank stocks have already been hit in the last 1 year, which can be seen as under:

Nifty vs Banking Index*Source : Ngen

As per the above chart, Nifty in the last 1 year has given a return of ~18.5% and during the same period, banking Index has given a return ~0%.

Its very difficult to say whether the worst is over for bank stocks. Could be possible that they fall further from here or even start recovering from here after the under-performance of last 1 year. Our suggestion will be that we should let the equity fund managers take this call based on their analysis and outlook.

2021 is definitely going to be an interesting year. Markets are expected to be volatile. We are excited and ready to handle any crisis. Crises and crashes always throw opportunity for big gains.

Wishing you a great and fantastic year ahead.

Best Regards

Dr. Mukesh Jindal CFA, CFP, CAIA, Ph.D.

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