Indian banks' stressed assets are likely to have peaked this fiscal year, but the process of recovery is likely to be slow, says Fitch Ratings. A large stressed asset stock combined with structural challenges in key sectors will inhibit a quick resolution process despite a cyclical macroeconomic recovery.

Fitch expects Indian banks' stressed assets ratio or NPA ratio to improve after reaching a high of 11.1% in FY15 (to end-March 2016, but only marginally to around 10.9% in FY16. NPL formation should be held back by a pick-up in GDP growth, which we forecast to reach 7.8% and 8.0% in FY16 and FY17, respectively. The Reserve Bank of India's more accommodative monetary policy stance since January 2015 should also help to boost credit demand and aid the recovery in banks' asset quality.

Asset quality is likely to remain an issue for the sector for some time despite some evidence of 'green shoots'. First, state banks are in a weak position, as they account for 90% of stressed assets. State banks' ability to withstand even moderate amounts of stress is low, while most face some degree of core capital impairment in Fitch's updated stress test. Notably, around 60% of state bank NPLs have been overdue for over a year, and are increasingly resorting to write-offs and NPL sales to reduce their NPL stock. We expect this trend to continue.

Second, some sectors remain high risk, saddled with high corporate leverage and weak debt-servicing ability, despite the improving macroeconomic environment. The infrastructure and steel sectors could yet see greater asset-quality stress if structural and policy-related issues are not addressed more urgently. Infrastructure and steel together account for 20% of total system loans, and are reported to account for up to 40% of stressed assets.

Third, slow progress on stalled projects suggests risks remain to the recovery process, especially in the infrastructure and power sector where corporate leverage and weaker cash flows compound challenges for firms. Clearing stalled projects will be essential to reviving private-sector confidence and stimulating capital formation.

Fitch maintains that clearing stalled projects would have a significant positive effect for the infrastructure sector - and, in turn, on bank asset quality. To that end, the government's announcements last month on reforms aimed at electricity distribution companies are positive for the sector, though it remains to be seen to what extent long-standing structural issues will be addressed.

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