Gridlocked in a crunch?

The Indian banking system is facing the worst crisis of the decade due to severe liquidity crunch, steep depreciation of Indian currency against US dollar, declining bank deposits, volatility in stock market, high non-performing assets and worsening credit-deposit ratio. A Bloomberg Economics Index revealed that cash deficit on January 23, 2025 was recorded at Rs 3.3 lakh crores (or USD 38.2 billion), which is the highest level since at least 2010. According to reports, the situation is so acute that the daily variable repo rate (VRR) auctions—a short-term liquidity adjustment tool employed by the RBI to supply funds to the banking system—has not been of much help to ease the situation.

Adverse impact on economy

Liquidity crunch is adversely impacting the economy for the last few months. As per the findings of the Trans-Union CIBIL Credit Market Indicator (CMI) report, India’s retail credit growth continued to moderate in the quarter ending September due to a general cooling in the rate of credit demand growth and a decrease in credit supply across most loan products. The CMI is a comprehensive measure of data elements that are summarised monthly to analyse changes in credit market health, categorised under four pillars: demand, supply, consumer behaviour, and performance. These factors are combined into a single, comprehensive indicator. The CMI for September 2024 was 100, lower than 103 in September 2023. While the indicator has remained consistently above 100 since September 2022, the cooling in credit demand along with the contraction in credit supply has led to continued moderation.

The CIBIL report also reveals that while credit demand and supply declined across most products, credit cards stood out with strong portfolio growth, highlighting their increasing role in consumer finance. Credit card portfolio balances grew 34 per cent year-over-year (YoY) in September 2024, up from 26 per cent growth in 2023. This surge came even as new credit card originations fell 24 per cent YoY. Analysts believe consumers are relying on their existing cards to finance expenses, as loan originations for personal and consumer durable loans slowed during the same period. While personal loans grew 11 per cent YoY in originations, a significant drop from 32 per cent in the previous year, other products, including home loans, auto loans, and consumer durable loans, recorded negative growth in new accounts. Credit card delinquencies (90+ days past due) increased by 31 basis points (bps) YoY, reaching 2 per cent in September 2024. Delinquencies in consumer durable loans also rose, highlighting growing stress in consumption-led borrowing, the report says.

A leading global credit rating agency has predicted that India’s banking sector is bracing for a significant challenge, with a 25 per cent increase in non-performing assets (NPAs) over the next two fiscal years, reports The Statesman. This alarming projection is attributed to rising stress in unsecured retail loans, particularly personal loans and credit card borrowings. Over the past three years, unsecured retail loans have grown at a staggering pace, with personal loans and credit card borrowings expanding annually by 22 per cent and 25 per cent, respectively.

RBI intervenes to inject funds

Anticipating liquidity stress in the banking system, the RBI reduced the cash reserve ratio (CRR) of all banks to 4.0 percent of their deposits in two equal tranches of 25 basis points (bps) each, effective from the fortnights beginning December 14, 2024, and December 28, 2024. This released primary liquidity of about Rs 1.16 lakh crore into the banking system.

The Reserve Bank of India (RBI) addressed the prevailing liquidity deficit by injecting Rs 1.45 lakh crore on January 16 via two overnight Variable Rate Repo (VRR) auctions. The first auction, amounting to Rs 1.25 lakh crore, attracted bids worth Rs 1.69 lakh crore, while the second auction of Rs 50,000 crore received bids totalling Rs 20,668 crore. The RBI’s objective is to align overnight rates (call rates) with the repo rate, the interest rate at which the RBI lends money to commercial banks, which currently stands at 6.51 per cent. As of January 17, the weighted average call money rate—the interest rate banks charge each other for short-term loans—was 6.59 per cent. To further ease the liquidity crunch, the RBI has scheduled another VRR auction worth Rs 2 lakh crore, along with a 14-day auction of Rs 1.75 lakh crore maturing on February 7. These initiatives follow a significant liquidity shortfall of Rs 2.87 lakh crore recorded on January 22, primarily attributed to monthly GST payments.

The RBI has also announced an open market operation (OMO) through purchase auctions of government bonds aggregating Rs 60,000 crore and a foreign exchange swap of USD 5 billion. “The Reserve Bank will be conducting a USD/INR Buy/Sell swap auction of USD 5 billion for a teure of six months” on January 31, the central bank said in a statement. Under this mechanism, a bank shall sell US dollars to the Reserve Bank and simultaneously agree to buy the same amount of US dollars at the end of the swap period. Following this announcement, the forward premium on the USD/INR one-month contract declined by 35 basis points (bps), while the one-year forward premium fell by 10 bps to 2.19 per cent.

Reasons for the liquidity crunch

One of the reasons for this banking crisis is the mismatch between the supply and demand for money. India’s already fragile financial sector—burdened by non-performing assets (NPAs), debt, inflation, insolvency issues, and a mismatch between deposit and credit growth rates—has been further strained by the flight of offshore funds from the equity market and the steady depreciation of the Indian currency against the US dollar.

One must remember that the money in the economy is either injected by the Reserve Bank of India (RBI) or created by banks. When a bank lends, it creates an asset by debiting the borrower. Simultaneously, the borrower’s deposit account is credited with the disbursed amount. The very process of disbursing credit creates money in the system, some of which remains in the banking system as deposits, while some is withdrawn and circulates as cash in the hands of the public. This is effectively endogenous money creation.

However, not all money in an economy is endogenously created. A portion is exogenous, generated when the government directly distributes subsidies, spends in the economy, or when foreign savings are transferred into the economy. The RBI also influences liquidity through open market operations, buying and selling bonds. When it wants to inject money into the financial system, it buys bonds from banks and other financial institutions and provides rupees in return. Conversely, when it seeks to withdraw money, it sells bonds and receives rupees. The money injected by the RBI is referred to as base money or narrow money.

Demand for credit is significantly outpacing deposit growth in banks. Deposit growth is lagging behind the credit growth rate. For example, in June 2024, bank deposits grew at less than 11 per cent, while bank loans rose by around 14 per cent. On August 9, bank deposits showed a yearly growth of 11.7 per cent, whereas bank loans had grown by 18.4 per cent. Since January 2016, a decline in the growth rate of deposits in the Indian banking system has been observed. Some senior banking professionals claimed that this slowdown in growth has been one of the reasons limiting their ability to support high credit growth. While banks do not typically rely on deposits alone to provide loans, a strong deposit base nonetheless provides a cushion, particularly during times of financial uncertainty and economic volatility.

• CMEI data, as mentioned in Mint by Vivek Kaul, shows that narrow money growth has slowed down over the years after 2020-21. At the end of 2017-18, narrow money had grown by 21.8 per cent, primarily because the RBI was replacing money it had demonetised in November 2016. In 2020-21, narrow money grew by 16.2 per cent as the RBI created and injected money into the financial system to drive down interest rates in the aftermath of the pandemic. After that, narrow money growth declined to 7.3 per cent in 2023-24 as the RBI had to restrict the money supply due to high inflation. Hence, there was a slowdown in money supply in the economy. Only in December 2024, when the inflation rate declined, did the RBI decide to cut the CRR to 4 per cent to infuse more money into the banking system.
• It appears that the Indian banking system is not interested in retaining its non-prime depositors (subprime depositors). Reports indicate that more than one in every five accounts under the Pradhan Mantri Jan Dhan Yojana (PMJDY) had turned inoperative by December 2024. This translates to approximately 110 million inoperative accounts. A bank account is classified as “inoperative” if there are no “customer-induced transactions” for a continuous period of 24 months. Inoperative Jan Dhan accounts rose from 19 per cent of total accounts in March 2024 to 21 per cent in December that year.
• The Indian rupee has been on a depreciation path in the last few months due to various factors such as a widening trade deficit, rising crude oil prices, a surge in the dollar index after the US Federal Reserve hinted at fewer rate cuts in 2025, India’s sluggish growth in Q2FY25, and foreign investor outflows from equities. According to RBI data, India’s foreign exchange reserves fell to $623.983 billion as of January 17, 2024, compared to $701.176 billion as of October 4, 2024. During this period, the Indian rupee depreciated to 86.3550 against the US dollar on January 27, from 83.8213 against the greenback on October 1, 2024. In the last three months, the Indian rupee has depreciated by around 2.97 per cent against the US dollar. The Reserve Bank of India (RBI) has spent $77 billion from its foreign exchange reserves through intervention in the spot market to defend the Indian rupee from falling sharply, reports Moneycontrol.
• In December, Minister of State for Finance Pankaj Chaudhary said in the Rajya Sabha that, as per provisional data from the Reserve Bank of India (RBI), gross NPAs of public sector banks (PSBs) and private sector banks as of September 30, 2024, were Rs 3,16,331 crore and Rs 1,34,339 crore, respectively. Further, gross NPAs as a percentage of outstanding loans were 3.09 per cent in public sector banks and 1.86 per cent in private sector banks. Chaudhary further stated that as of March 31, 2024, 580 unique borrowers (excluding individuals and overseas borrowers), each having a loan outstanding of more than Rs 50 crore, were classified as wilful defaulters by Scheduled Commercial Banks. However, the rating agency Fitch predicted that the gross non-performing assets (NPAs) of Indian banks may decline by 40 basis points to 2.4 per cent by March 2025 and a further 20 basis points in the next financial year. NPAs and bad debt erode the assets of banks and make them vulnerable in the long run.
• Banks have had to take a haircut of over two-thirds in corporate insolvency cases resolved through bankruptcy courts, a report by ICRA stated in November 2024. “Lenders continue to face steep haircuts or reductions in loan amounts of nearly 72 percent in Q2 FY2024-25 as the overall resolution process continues to face material delays due to litigation from either promoters or dissenting creditors,” it said. Seventy-one percent of ongoing Corporate Insolvency Resolution Processes (CIRPs) had exceeded 270 days post-admission by the National Company Law Tribunal (NCLT), a quasi-judicial body in India that adjudicates corporate disputes. The Insolvency and Bankruptcy Code, introduced in 2016, suggests that a case be resolved within 270 days. One of its primary objectives was to maximise value for lenders by resolving assets rather than liquidating them. According to ICRA, the overall realised value from CIRPs yielding a resolution plan declined to 31 percent as of September 2024, attributed to a marginal drop in recoveries from large accounts. Reserve Bank of India (RBI) data indicates that the number of cases admitted under the IBC in 2023-24 dropped to a six-year low, excluding the two Covid-affected years. Recovery rates for banks through the IBC channel plummeted to 28 percent in 2023-24, down from 40 percent in 2022-23, reflecting growing concerns over the value erosion of non-performing assets (NPAs) due to prolonged delays. In the first half of this fiscal year, the number of cases admitted to the NCLT stood at about 417, compared to 501 cases in the same period last fiscal, reports The Hindu Business Line.
• Indian equities have been sliding since September, as foreign investors, spooked by a slowdown in the country’s economy, exit their holdings. Analysts view this as a “healthy correction.” India’s benchmark stock indexes, the Nifty 50 and Sensex, are hovering at more than seven-month lows. The data in Table 1 shows that in January 2025, Domestic Institutional Investors (DIIs) invested more than the Foreign Institutional Investor (FII) sales. Who are these DIIs? The Life Insurance Corporation of India (LIC) is the largest DII in India. As of December 2023, the President of India held stakes in 78 companies, with LIC being one of the top holdings, worth Rs 38,42,672 crore. The top holdings by value include LIC (Rs 5.69 lakh crore), SBI (Rs 3.18 lakh crore), IRFC (Rs 1.88 lakh crore), Oil and Natural Gas Corporation Ltd. (Rs 1.84 lakh crore), and Coal India (Rs 1.56 lakh crore). Other major DIIs include the SBI Group, Birla Group, HDFC Group, Kotak Mahindra Group, and Reliance Group. As these DIIs mobilise funds from the Indian financial market, liquidity in the banking system tightens.

• Post-demonetisation, there has been a clear shift toward stock market investment over bank deposits. Retail participation has been a key driver of positive stock market trends. The number of demat accounts surged from just 4 crore in 2020 to 14 crore in 2024, with over 10 crore new investors joining the capital market during this period. Reports reveal that mutual funds in India are gaining popularity as investors seek to diversify their portfolios and benefit from professional fund managers’ expertise. Moreover, investors looking to lower their tax liability may find certain mutual fund schemes, such as Equity Linked Savings Schemes (ELSS), attractive since they provide tax deductions under Section 80C of the Income Tax Act.

Observations

It appears that credit, despite high demand, is not being used to invest in productivity-enhancing activities, but rather to finance borrowings or existing debt (from households to firms to government). This will likely create additional troubles for India’s macroeconomic position in the long run, argues Professor Deepangsu Mohan.

Non-prime depositors have been excluded from the banking system of India and RBI is more concerned with stabilising deprecating INR and boosting the stock market by infusing the much needed fund, through DII, to compensate flight of FIIs. Sharp increase in unsecured loans and jobless growth will put the fragile banking system under further stress.

Views expressed are personal