The Indian banks' systemic gross non-performing loan (NPL) ratio, which stood at 2.3 per cent at end-2008, may not surpass 5 per cent in the next 12 months to early 2010 even after adjusting for bad loans that are restructured during this period, noted Fitch Ratings in its report Indian Banks - Annual Review and Outlook.

This is because, the banks are showing greater operational efficiencies, improved loan origination and monitoring systems, and better creditor rights leading to faster and increased recovery expectations, it said. NPL ratios of many banks are currently at historical lows. Overall, rising NPLs could affect the performance of Indian banks, although any sharp deterioration in their credit profile is not expected. Banks that have concentrations to vulnerable sectors, including commercial real estate, textiles and other export-led sectors, may come under pressure, particularly as external capital sources may remain limited for a while, the report added.

According to the report, the loan portfolio of Indian banks is fairly well diversified, with the single largest sectoral exposure to residential mortgages amounting to about 11 per cent of total loans. Corporate loans increased by 56 per cent between May 2007 and December 2008, the growth being more than double that for consumer loans during the same period.

Infrastructure projects account for the largest proportion of banks' corporate portfolio and have come up against cost and time overruns, to rising input prices and the drying up of domestic equity and offshore funding sources. The increased credit demand stems from extended working capital cycles, particularly for oil companies, as well as for ongoing funding needs of expansion projects that are currently unable to raise equity or overseas borrowings due to global economic downswing.

However, loan growth is expected to fall due to slowdown in industrial activity, reflecting the gloomy economic scenario. The infrastructure sector may affect Indian banks' asset quality in the long term, particularly in the event of a prolonged slowdown, although Fitch is not expecting an impact from this in the immediate future.

Growth in consumer loans slowed down in FY09as rising interest rates and lower affordability squeezed demand. Delinquencies in construction equipment and commercial vehicle financing have risen over the same period. There has been a rise in the number of non?performing residential mortgage loans, although the impact may be more visible if property prices were to correct even further, leading to lower or even negative equity for the borrower, the report said. About 90 per cent of loans in this sector are to owner?occupiers and may have a limited immediate impact on borrower delinquency unless job losses were to affect credit quality; mortgages taken for investment purposes are likely to suffer higher delinquencies.

Corporate delinquencies have held up so far, noted Fitch. The reported NPLs of government banks even reduced in 2008 aided by the central government's agriculture loan waiver scheme (see chart)

Pressures on corporate cash flows and their debt repayment capacities have, however, been rising due to falling domestic and international demand for debt?funded capacity expansions. Sectors such as textiles and real estate were among the first to be affected by the slowdown and there has already been some restructuring of repayment terms to banks. With the slowdown likely to deepen and become prolonged, NPLs in these sectors are likely to rise.

Corporate profitability has also been affected by volatile exchange rates, first due to an appreciating rupee in FY08 (11 per cent against the US dollar) affected mark-to-market positions on exotic derivative structures, and then again when the rupee depreciated 25 per cent against the US dollar in FY09, affecting the un-hedged parts of foreign currency borrowings by companies.

The asset quality of unsecured consumer loans has been under pressure since 2007, as reflected in rising incremental NPLs and lower recovery from NPL stocks by the 'new' private banks.

Specific loan loss provisions will rise, however, since at 53 per cent of gross NPLs at FYE08 may be inadequate to meet the requirements of the expected increase in NPLs. General provisions have provided a buffer during the past few years, but these have recently been relaxed by the market regulator thereby reducing the cushion that banks had been building up against the deterioration in the credit cycle, the report added.

Although there will be a deterioration in NPL ratio, it will be in an orderly manner. This, together with improved recovery expectations due to increased creditor rights, suggests that overall there would not be any significant breach in solvency in the near term for the Indian banking system, Fitch said.

Fitch Ratings is one of the three large global credit rating agencies.

(Also see: Economic slowdown to affect Indian banks' capital ratios: Fitch)