Should the Indian Economy bust?

Should the Indian Economy bust, what will be the Impact on banking sector?

Dated: 06-July-2008
The current turmoil in the Indian stock market could be caused because of a host of reasons: oil price hike, inflation, too high demand chasing stocks. The demand for stocks was fuelled by Life insurance industry’s ULIP plans, mutual funds, increased stock market activity by retail investors, FIIs. The swing in the stock prices of most respectable stocks indicates that the price is driven by market demand, rather than by fundamentals. The 52Wk Range of SBI is Rs.1,078 – 2574.

Now whether this situation coupled with the political environment is signaling an unsustainable economy that would lead to a bust in near future can only be answered by time.

The present economic situation turned me towards an academic activity performed (by me and Rama V V) in 2007. We attempted to compute the loss (worst case) suffered by Indian banks if there is high delinquency on private sector lending triggered by an economy bust – this is a kind of Extreme Value Theory application to compute the loss and might not occur in practice. Before we look at the conclusions of this activity, let us explore reasons why there will be high delinquency.

Firstly consumer demand will be affected which will in turn the profitability of the businesses. The straight forward argument is that higher inflation would make people lower or postpone consumption. With prevailing high interest rates and with the earlier investments yielding negative return because of high inflation, people would tend to save more and reduce consumption. The psychological factor of wealth erosion in stock market as the stock market cools down following overheating because of high demand for stocks would also affect consumer demand. This would create a small spiral that the reduction in consumption demand will erode further the stock market returns. The reduction in profitability or viability of companies will make them default on loans.

Taking the stock market value erosion to the next dimension of how it impacts profitability of businesses. Many companies are managing the working capital by temporarily locking their funds in mutual funds. Now with a huge fall in stock market value, companies would have to borrow at higher rates to manage their liquidity. The usually stable position of current asset - Cash and Bank balance which was transformed into Cash, Bank and MF because of stock market high in the past has also become unstable and would impact businesses.

Borrowing funds from Banks at a lower interest rate and investing in equity was also done by investors. With the rising interest rate scenario triggered by inflation, the retail segment might also default on bank loans.

The FII investment in realty sector and easy availability of loans has caused the realty prices to soar in India. Since the asset prices were higher, banks have also lent high amounts of home loans. With the increasing interest rate, the consumer will be left with less money for consumption after paying off their monthly loan burden. These factors can potentially lead to delinquency of loans.

Going back to academic activity, if there is high delinquency, then the banking sector would lose Rs.229,153 crores (12.19% value erosion) on its claim on private sector as at 2006. Now apportioning the sector’s loss to two individual banks based on their 2006 loan book, (applying the same percentage ignoring the quality of loan book and lending practices).
ICICI Loss Provision: Rs.23,866.93crores
SBI Loss Provision: Rs.41,105.66 crores.

This activity was performed based on bank data available in gmid database for period 1978-2006. Read on, if you are keen to know how the above results were obtained.
Methodology:

We tried to correlate the bank claim on private sector[1] to GDP growth%, interest rate, exchange rate, and inflation.

As a first step to determine if both interest rate and inflation are decision variables, we tried to establish correlation between interest rate and inflation (for period 1978-2006) and observed that lending rate = .49*inflation + 10.93. The t-value was 13, 5 for intercept and coefficient respectively and so the correlation is significant. So we decided to skip inflation as a decision variable in the subsequent regression analysis.

Used multivariable regression analysis and arrived at a correlation between bank claims on private sector to GDP growth%, interest rate and exchange rate.

The output of the regression analysis is as below.
Intercept 15391868.97
Xch Rate 71796.96521
GDP growth 56345387.36
Lending Rate -112096654.3

Then ran a Monte Carlo simulation with bank claim on private sector as the risk output with the following assumptions: GDP growth being normal distribution with mean as 8% and standard deviation as 2%, Xch rate being normal distribution with mean as Rs.42 and standard deviation as Rs.4, Interest rate being normal distribution with mean as 12% and standard deviation as 4%, and obtained the 95th percentile value.

There is a 5% probability that the claims on private sector can go below Rs. 1,651,407 crores.



Then computed the loss suffered by banking sector as (current value – 95% percentile) and value obtained was Rs.229,153 crores (12.19%)


© Copyright 2008 Annapoorani S and Rama V V

Note: @RISK trial version was used for academic purpose only.
[1] The private sector comprises private corporations, households and non-profit institutions serving households (NPISHs)