Explained | Will the war in Ukraine rattle India’s banks?

The story so far: S&P Global earlier this week forecast that banks in India would face ‘headwinds’ as a fallout of the Russia-Ukraine conflict. The rating agency flagged rising inflation and borrower ‘stress’ that could affect companies’ ability to fully pay back loans.

How does a war in eastern Europe affect India?

The war has impacted the production and movement of a wide range of raw materials and commodities. Ukraine, for instance, is the main source of sunflower oil imported into India. Supplies have naturally been hit and are bound to further push up the retail prices of edible oils.

The conflict has also forced Ukraine to shut two neon factories that account for about 50% of the global supply needed in the manufacture of semiconductors. As semiconductors become scarcer, user industries bear the brunt. Already, the global chip shortage has led to the waiting period for the delivery of new premium cars in India being extended to several months. And with major carmakers having reported declines in sales for January and February, the profit outlook for these companies and their component suppliers looks significantly clouded. The domino effect on the automobile and other industries’ supply chains could impair the ability of businesses, especially medium and small enterprises, to fully service their loans.

What are the other factors that may undermine a company’s ability to repay loans?

Oil has been on the boil ever since Russia invaded Ukraine on February 24. After zooming to $139 a barrel — near historical highs — Brent crude prices were at the $106 a barrel level as of Friday. With India’s state-run oil marketing companies certain to raise the retail prices of petrol and diesel sooner than later, the higher cost of transportation is bound to feed into the prices of goods from agricultural produce to raw materials for factories and to finished products headed to store shelves, thus quickening inflation across the board.

Higher input costs for manufacturers and service providers would leave them in a tough spot as they would have to choose between passing on the price increases to consumers — thus risking the already tenuous demand — and hurting their profitability if they opt to absorb the impact. Here again smaller businesses, that are most dependent on bank credit, are bound to be hit the hardest. If the war in Europe is prolonged, Indian banks could end up facing delays in the repayment of loans or possibly even having to write them off as ‘bad’.

Separately, with the dollar benefitting from a global flight to less risky assets, as well as the start of the U.S. Federal Reserve’s calibrated monetary tightening to rein in inflation from a 40-year high in the world’s largest economy, the rupee is expected to weaken against the U.S. currency. With the exchange rate impacted, importers would have to shell out more rupees for the same dollar value of imports than before. Unless demand expands, allowing them to sell more volume, a weaker local currency eats into their profits, leaving them with lesser cash available to service loans.

Official data for February show that overall goods imports are growing faster than exports compared with a year earlier, widening the current account deficit (CAD). Widening CAD is likely to cause the rupee to weaken further to 77.5 to a dollar by March 2023, from 75, Crisil Ratings said on March 17.

Rising inflation, which is already just beyond the RBI’s 6% upper tolerance limit, may nudge the central bank into raising benchmark interest rates. This means more interest will have to be paid by companies that would likely face the prospect of lesser profit.

Earlier this month, India Ratings said that the increase in commodity prices could result in a stretched working capital cycle for small and medium enterprises (SMEs), weakening their debt servicing ability.

Why is the situation particularly worrying for Indian banks?

India’s lenders had already been struggling to cope with an overhang of non-performing assets or bad loans even before the pandemic severely hurt overall economic momentum.

In its Financial Stability report for December 2021, the RBI warned that from a Gross Non-Performing Asset Ratio of 6.9% in September 2021, commercial banks were likely to see the metric rise to 8.1% in a baseline scenario, and possibly soar to 9.5% under a ‘severe stress’ situation by September 2022.