Effect of Demonetization

2nd Year PGDM Participants, IIM Shillong

The year 2008 witnessed the collapse of Lehman Brothers, which caused a domino effect of
financial crisis around the world. Amongst this period of turmoil, India stood distinct among
others, by anticipating a silver lining of growth, since it was able to insulate itself from the
subprime mortgage market. However, the foreign institutional investors were hugely
impacted as a result of this crisis. Within a few months of the advent of this crisis, they started
pulling out money from the Indian markets in an attempt to minimise their risk, by investing
in more secured bonds like gold. According to a report published by SEBI, FIIs withdrew almost
$1.8 billion dollars from the Indian market, which created a scarcity of capital. Thus, domestic
lending thrived in this situation, in an attempt to offset the effects of liquidity crunch in the
market. With high economic growth and infinite prospects, public sector banks (PSBs), with
huge rate of deposits, found high incentives to lend. Reiterating this phenomenon, the ex RBI
Governor, Dr. Raghuram Rajan commented, It is at times like that, across the world, banks
make mistakes.
Fig. 1: Declining repo rate and CRR

10 9
8
8
6 5.75
5.5
6 5

0
2008 2009 2010

Repo Rate CRR

Source: www.rbi.org.in

During this time, the PSBs started lending more, with the gross bank credit standing at 24.7%.
RBI aided them by drastically reducing the repo rate and CRR in an attempt to infuse more
liquidity into the market. But the graph in fig. 2 shows another side of the story.
 Fig. 2: Gross Bank Credit Percentage
30
24.7

Gross Bank Credit Percentage

25 23.2 23.8

20 16.4
13.9
15 12

10 7.8

5 1.4
0
Feb-08 Jul-09 Nov-10 Apr-12 Aug-13 Dec-14 May-16 Sep-17
Source: www.rbi.org.in

It is clear from fig. 2 that even with the declining monetary instrument rates, the credit growth
of the public sector banks started declining rapidly, and went down from 24.7% in 2008 to
1.6% in 2016. So, what caused this downslide? The answer is NPA (Non-performing Assets).
The loans given by banks during the booming period, started turning into doubtful assets
because of a variety of reasons. Numerous stalled projects along with global economic
slowdown, forced the investors to default on their payments. This started reflecting on the
bank balance sheets which created a lot of problems. Not only the banks were not getting
returns on their capital, but they were also supposed to keep aside a percentage of the loan
amount from their profits as provisions to absorb the shock, in case, they have to write off
the loan eventually. Thus, NPA acts as a cancer in the bank balance sheets, eating away both
the capital and profits. In an attempt to get these off their balance sheets, banks used to
upgrade these NPA accounts to standard accounts, only after a payment of interest on a small
portion of the debt, undermining the inherent weakness of the asset. To address this problem,
RBI made certain changes in their norms via circular No. DBOD.BP.BC.No.99/
21.04.132/2012-13, dated May 30, 2013, which stated that, a standard asset would be
classified as a substandard asset on restructuring, and the non-performing assets will
continue to have the same asset classification prior to restructuring for a specified period of
time. This implied increase of provisioning for the banks, since these accounts will stay in
their balance sheets for a longer period of time. As a result, public sector banks, already
reeling under the pressure of recovery, became more conservative in their approach of
lending. Except for personal and housing loans, these banks became apprehensive about
giving loans to the stressed sectors like industry, agriculture and MSMEs.

How did this affect the economy? The market share of the public sector banks is around 74%
and when a huge sector like this is struggling, the financial market also suffers. Lack of credit
and less liquidity in the economy stagnates the overall growth and development.
 Fig. 3: Inflation rate Fig. 4: NPA of PSBs

NPA of PSBs (in lakh crores rupees)

14.97
16 3 2.67
Inflation in percentage

14 2.5 2.16
11.17
12 9.7 9.47 9.13 2
10 1.56
8 6.49 5.86 6.32 1.5 1.12
6 0.71
1
4 0.4 0.44 0.57
2 0.5
0 0
2008 2009 2010 2011 2012 2013 2014 2015 2008 2009 2010 2011 2012 2013 2014 2015
Source: www.rbi.org.in Source: Department of Banking Supervision, RBI

As indicated in fig. 3, PSBs went on a credit spree around 2008, which created more liquidity
into the market and the inflation rate rose up. But, with the increasing number of defaulters,
non-performing assets started to creep into the balance sheets of these banks. In need of
some respite, the banks needed the RBI to reduce their interest rates. However, with the
rupee plummeting to a record low against the dollar in 2013, the then governor took the
decision of not obliging to such requests.

With a tightened monetary policy to curb the inflation and with rising NPA, capital inflow into

Fig 5: Change in GDP Growth Rate

12

10 11.4
GDP Growth Rate

6
6.64 6.64
4 5.62

0
2010 2011 2012 2013
Source: www.rbi.org.in

the market started drying up. Businessmen and investors were now stuck in no mans land,
since, obtaining a loan became more difficult. Due to high lending rates, set by the RBI, as well
as capital deficits, banks were unable to generate considerable profits. They started cutting
down on their deposit rates. This had an adverse effect on the consumers, particularly the
senior citizens and pensioners, who hugely relied on their income from interest, provided by
the banks. With consumers having less spending power, the economy and overall growth
experienced a setback. This is evident in fig. 5.
Think of a businessman who, after months of gruelling process, is able to acquire a loan at a
higher interest rate. Due to increase in the cost of products, he is forced to increase the selling
price, in order to maintain a thin profit margin. However, the customers are not getting
enough returns from the bank against their deposits. So, on one hand, the seller cannot
reduce their price, and on the other hand, the customer cannot increase their purchasing
power. The businessman incurs losses, due to reduced sales and this in turn increases the
chances of him defaulting on his loan. The loan account gradually converts into NPA in the
bank balance sheet, thus deteriorating the situation. It is clear that NPAs not only hurt the
banks; its presence indirectly affects the average consumer. So, in words of Dr.Raghuram
Rajan, deep surgery is needed instead of Band-Aid solution in order to insulate the banks
from it in the future. Now that we understood how NPA popped up suddenly post 2010 and
how it is effecting the banks and the overall economy, now it is time to understand how to
tackle the problem so that the government sector banks can get out of its clutches once and
for all.

Let us look at how the public sector banks have performed against the private sector banks in
the last ten years with respect to asset quality management.

The graph gives us a

visual representation
of how both the sectors
have performed with
the changing monetary
policy with respect to
the net non-
performing assets. The
sudden relaxation of
the monetary policy
immediately after the
global economic crisis
of 2008 didnt have any
effect on the asset quality of the banks at that time. But the negative effects came with a lag
and started showing its result post 2012. The amount of loan that was given by the public
sector banks at that time of relaxed monetary policy started turning into NPAs and with the
changed asset qualification norms by the newly appointed RBI Governor Dr.Raghuram Rajan,
these stressed assets also started showing up in the bank balance sheets. Here we can see
that although the public sector banks are reporting net NPAs over 5%, the private sector banks
are able to insulate themselves from the after effects of the public lending that followed after
2008 in a much better way. There are certain misconceptions about why the public sector
banks are being effected like this and these misconceptions should first be addressed before
heading forward.