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Sep 12, 2023

Why India must mind the consumer credit trap

After more than a decade of turmoil, Indian banks seem finally set to turn a corner. As of March, the gross non-performing assets (NPAs) of banks, or bad loans, had shrunk to 3.9% of total loans in

After more than a decade of turmoil, Indian banks seem finally set to turn a corner. As of March, the gross non-performing assets (NPAs) of banks, or bad loans, had shrunk to 3.9% of total loans in 2022-23, the lowest level since 2014, according to the Financial Stability Report issued by the Reserve Bank of India (RBI) in June.

Indian banks never really recovered from the shock of the global financial crisis of 2008. As chart 1 shows, while their gross NPAs were low going into the crisis, they began a slow but steady upward climb over the next few years. While they survived the much harsher punishment that banks in other countries faced (closures, collapses and bankruptcies), it was clear by the middle years of the last decade that there was a serious problem—by 2017-18, gross NPAs had climbed into double digits.

This was partly a good thing, since it finally meant the system, as a whole, was being forced to recognize bad loans. But it also meant that a process of clean-up had to be put in place. On the downside, the ability of banks to actually recover money from borrowers that they had earlier written off (with the potential that this could go straight back to the bottom line), was abysmal. Just 18% of the amount written off could be recovered in the last three years.

But while banks were straightening out their balance sheets, a major shift was happening elsewhere. Banks were pulling back sharply on loans to industry, and were filling that gap with retail loans to individual consumers—home loans mainly, but also loans to buy vehicles and consumer durables, and on credit cards. This phenomenon was described as the ‘consumerization of credit’ by economists Rajeswari Sengupta and Harsh Vardhan, in an Indira Gandhi Institute of Development Research (IGIDR) working paper in 2022.

Between March 2014 and March this year, the share of non-agricultural bank loans to industry, services and trade declined by almost 20 percentage points to just under 50%. Over this period, the share of consumer loans rose from 18% to 32%, according to RBI data. A recent review of retail credit in the RBI’s monthly bulletin pointed out, “retail segment played a major role in the recovery of overall credit growth in the post-covid period."

What are the implications of such a shift for both consumers and the banking sector? For years, retail credit in India, especially home loans, was seen as a ‘safe’ bet by banks—for the vast majority of borrowers, a home loan was the biggest investment they would ever make. Even if economic conditions turned bad, and people lost their jobs, they would cut back personal spending sharply rather than default on their home loans. So far, the data has borne out the supposed ‘low-risk’ nature of such loans—gross NPAs for all consumer loans were 1.4% of total loans, as of March.

Over the next couple of years, however, this claim is likely to be tested—the 2008 global crisis was, after all, triggered by over-indebtedness of households in real estate. As the RBI review pointed out: “The better asset quality in the retail segment…appears to be contributing to banks’ increased focus on retail credit. However, this is not a risk-free segment and not a panacea for asset quality concerns in non-retail loans." On the plus side, the review argues that the boom in retail credit is cyclical, and is likely to reverse as corporate and industrial capital expenditure revives.

In absolute terms, retail credit outstanding of Indian banks amounted to about ₹41 trillion, as of March 2023—double that of the level just five years earlier. Over that time, the covid crisis hit, followed by the Ukraine war. Globally, monetary policy has undergone its most serious ‘tightening’ in decades. On 27 July, the US central bank hiked interest rates to levels not seen since the US housing crash in 2007, which precipitated the global crisis of 2008. RBI, too, followed suit, as have other central banks around the world.

Faced with such signals, banks also have been quick to increase interest rates across all categories of loans, including retail loans. Chart 2 breaks down the current outstanding amount of home loans given by banks by the interest rate charged on that amount to borrowers. As recently as two years ago, in March 2021, around 80% of home loans outstanding were charged at an interest rate of below 8%. By March this year, that component of home loans had fallen to just around 12%. At the opposite end, close to 70% of home loans outstanding are now charged at 9% or more.

To illustrate the impact on home loan EMIs (equated monthly instalments), consider a household that took a home loan of ₹50 lakh at 7% interest for 20 years. The EMI works out to ₹38,765. Increase the interest rates to 9%, and the EMI increases about 15% to ₹45,000. In many cases, borrowers can opt to increase the tenure of their loan, while keeping their EMI constant, but this increases the interest paid. Further, this is simply not feasible beyond a point, especially if the EMI is too small to even cover the increased interest on the loan. In such cases, banks will force borrowers to increase their monthly payments. Add inflation to the mix (even though it has come down in recent months), and this puts a further strain on household finances. What does this mean for the economy as a whole, in terms of long-term growth?

When economists talk about increasing investment in the country, they almost always mean corporate and infrastructure investment—money put towards building more factories or bigger factories, or bridges or roads. But as Nikhil Gupta and Tanisha Ladha of Motilal Oswal pointed out in a recent research report, households account for two-fifths of all investments in India, primarily in housing. This is higher than in China, the US, France or Germany. Yet, the authors argue, housing debt, at 10% of GDP (gross domestic product), is much lower than in most countries they studied.

Yet, in a way, this number is misleading. As the latest RBI Financial Stability Report points out (in a reference to overall indebtedness of households across all categories of loans), the ratio of household debt to GDP “does not factor in household wealth across income groups and provides no information on distribution of debt." More simply, the bulk of that debt is concentrated among a small sliver of households which are eligible for loans.

The RBI report, for instance, estimated that as of March, 40% of all home loans were owed by households earning more than ₹1.4 lakh per month, or ₹16.8 lakh per annum. The data was based on a sample rather than the entire universe of home loans, but it is worth noting that as of 2018-19, a total of 2.5 million individuals filed income tax returns with a reported income of above ₹15 lakh per annum.

In an exercise, the central bank report attempted to estimate the proportion of borrowers who did not earn enough take-home income to pay their EMIs, and have money for basic necessities, in the current environment, when inflation has risen (making necessities more expensive) and interest rates are up (forcing households to pay more toward EMIs). It found that the share of home loan borrowers who ended up with such a negative ‘financial margin’ was 31.6%. In another ominous finding, the same study also noted that the RBI-imposed capital requirements for two banks with large housing loan portfolios fell below the threshold level in such a scenario.

Thus, the risks for banks have not really gone away, even as they have provisioned for their NPAs from earlier years, and pulled back on corporate loans. Instead, the new bets on consumer credit mean that those risks have reappeared, though from a different source. There is unlikely to be any significant danger to the financial system, or even individual banks, in the short term. But the ‘consumerization of credit’ has bigger implications for the economy as a whole. In the longer term, banks can’t avoid being affected.

A slowdown in overall household consumption, possibly induced by families cutting back to save their loans from going under, will have economy-wide effects too. Households that have a high enough income to qualify for a home loan, as a group, are precisely those households which also tend to be the biggest spenders, in an economy defined by high inequality and a very uneven distribution of discretionary income (after allowing for spending on necessities and for paying debts).

In the last few years, though, personal income growth has been anaemic at best. The Motilal Oswal report points out that the growth of consumption expenditure in the last decade has outpaced that of household incomes, with the only exception being in 2020-21, due to covid, as lockdowns suppressed consumption. “Because of this combination of weak income and higher consumption growth, not only has household savings collapsed, but its leverage has also increased almost continuously," the report points out.

In 2009-10 and 2010-11, household debt was only slightly higher than household savings, implying that one year worth of savings was enough to pay off all household debts. “In 2021-22, as much as 1.8x-year worth of savings are required to do the same job, implying a deterioration of three-fourths in just about a decade," the report’s authors say.

The report’s authors, in the context of assessing the health of the real estate sector, point out that, “unless there is significant improvement in household income growth, we find it difficult to believe that the momentum in the realty sector could be maintained in India." As an aside, construction investment as a share of GDP in India is over 15%, outpacing many other developed economies such as the US and the UK. Thus, a slowdown in this sector will have economy-wide effects.

High interest rates, volatile prices of essentials and even increased bank lending to consumers are likely cyclical in nature to an extent. As the economic cycle progresses, and prices adjust downwards, RBI is likely to move to an easier monetary policy as well and cut interest rates. Over time, corporate and government capital expenditure will likely see a bump as well.

In such a scenario, household incomes could reach a comfortable enough level that more households will be able to cover home loan expenses and fewer households will end up with a negative financial margin. But India has a seen close to a decade of underwhelming growth in personal incomes. Even if we move to a higher growth trajectory in the next few years, we are likely to still be playing catch up with other high-income economies.