Commodity Price Shocks and Non-Performing Assets in the Indian Banking Sector

Executive Summary

The Indian banking system faced a significant challenge after 2011 with an increasing quantum of non-performing assets (NPAs). By the late 2000s, NPAs (as a percentage of gross advances) had decreased to less than 3.5 per cent. The downward trend in NPAs did not continue as NPAs began to rise in 2011 and peaked at 11.18 per cent in the fiscal year ended in 2018. As expected, the rise in NPAs occurred with the deterioration of the balance sheets of non-financial firms, and this twin balance sheet crisis contributed significantly to the deceleration of growth in the late 2010s.

The problem of NPAs has been argued as a problem of public sector banks due to the disproportionate share of non-performing assets with them. Poor management and governance issues in public sector banks have been cited as the major reasons for this. In fact, these governance issues have been the main argument in support of the privatization of these banks. But this poor governance does not explain the improvement in performance that public sector banks saw throughout the 2000s, a run that was followed by a sudden deterioration post-2010. It is improbable that governance suddenly improved and subsequently dwindled. Moreover, most of these NPAs arose due to defaults by private sector non-financial firms, making it more difficult to accept governance issues as a prominent reason for increasing NPAs. Since this narrative is simple and easier to communicate, it has stymied systematic scientific research in the area. This is a serious gap, as the economic factors, if any, influencing defaults by non-financial firms need to be understood to formulate effective policy at present, and to build a resilient financial system in the future.

A careful examination of the data reveals genuine economic reasons for the increase in NPAs. The rise in NPAs from 2011 onwards coincides with the fall in international commodity prices. This is not the first time we observe this co-movement of global commodity prices and NPAs. Even in 2008, a fall in commodity prices led to a rise in NPAs, and the decline in commodity prices in the late 1990s too strained the balance sheets of banks in India. As commodity prices recovered, NPAs also reduced in these episodes. These two previous downturns in the commodity market were not as prolonged and severe as the one between 2011 -16, thus, the latter was expected to strain the balance sheets of banks. This close link between commodity prices and non-performing assets has stood the test of time and is a causal relationship working via the worsening of profitability of non-financial firms which leads to defaults by them, and in turn, creates non-performing assets for banks.

A study of balance sheets of non-financial firms in India shows that the profitability of firms and international commodity prices are tightly linked. A decline in international commodity prices leads to a decline in raw material costs but it also leads to a more than a proportionate decline in sales revenue, and that combined with fixed labour costs crunches the margins of these firms. The persistent fall in commodity prices during the 2010s added pressure to these margins, rendering many firms unable to sustain their debt burdens. In other words, large adverse movements in prices, compared to the projected prices in 2010 and before on which business decisions were made, caused higher corporate default. Hence, we find that banks that were more exposed to sectors that experienced a large decline in prices had higher non-performing assets than other banks which were not exposed to such price changes.

However, banks lend to a large number of sectors with heterogenous price movements and that makes the estimation of the effect of movements in prices on non-performing assets difficult. To overcome this, we create a nominal price index for banks using novel data on banks’ sectoral exposure and commodity prices. We multiply the percentage of loans to a sector with sectoral price in the year and sum it over all the sectors for a bank to obtain the nominal price index. This captures the bank-wise heterogeneity in exposure to income shocks caused by a decline in commodity prices. Results suggest that a decline in exposure caused by an exogenous decline in prices leads to a significant increase in non-performing assets, and these models explain ~30% of the increase in non-performing assets. Since public sector banks in general had higher exposure to commodity-sensitive sectors, they experienced a relatively higher decline in the nominal price index and a bigger rise in non-performing assets after the price crash of the 2010s.

The ramifications of the aforementioned findings are critical. First, it helps us decipher the twin balance sheet crisis of the 2010s which affected growth adversely and has not been understood so far. Second, the NPAs argument has spawned a larger debate about privatising public sector banks as higher NPAs have been attributed to poor governance and management practices in public sector banks. However, to blame bad governance as the only reason for non-performing assets is too simplistic.

Downward movement in commodity prices played a significant role in causing non-performing assets to increase post -2011, as in the past. This is the reason that in the last two years, despite the worst kind of economic crisis due to COVID-19, we have hardly heard about any stress in the banking sector and this is partly because COVID-19 brought higher commodity prices with itself.

Keywords: Non-performing Assets; Commodity Prices; Sectoral Exposure; Sectoral Prices