Indian banks warned of prolonged credit pressures due to sharp currency slide

But there are 2 potential silver linings.

The sharp depreciation of the Indian rupee will add to credit pressures on Indian banks, says Fitch Ratings. The current economic slowdown is also likely to be deeper and longer than our baseline expectations, adding to the pressures already faced by the local banking sector.

Here's more from Fitch:

The 21% depreciation of the rupee since 1 April is likely to pressurize the financial performance of the Indian corporations with unhedged foreign-currency borrowing. As a result, Indian banks' asset quality could remain under prolonged pressure.

Moreover, the sharp weakening of the rupee, if not swiftly reversed, will delay any chances of recovery in domestic demand.

Recent monetary measures to support the currency have raised the likelihood of a further slowdown within the fiscal year ending March 2014 (FY14).

These policy measures, which have sharply raised short-term rates, follow a sub-5% year-on-year GDP growth rate over the past few quarters. These developments belie our earlier expectation of a modest pick-up in India's economic growth. They will also subdue any improvement in the growth rate of loan books.

One likely result is that banks' earnings profiles will encounter more pressure than previously anticipated. This is because of weaker margins resulting from higher funding costs, and a lower ability to pass on costs to the customer due to soft demand and slowing loan growth.

Most recent RBI data on stressed assets (NPLs and restructured) for the system was 10% of total loans. But this was before the onset of the most recent fall in the rupee.

Fitch's original estimates of stressed assets in the system peaking in FY14 would need to be revised, and is now likely to peak only in FY15. A more prolonged deterioration in asset quality will also raise provisioning requirements and weigh on banks' earnings profiles.

No bank is likely to be unscathed by recent events. But public sector banks remain under relatively greater pressure.

This is because their (standalone) stress-absorption capacity is comparatively lower than their private-sector peers, adding further downward pressure on their Viability Ratings.

However, as most public-sector banks' IDRs factor in support from the sovereign, the outlook at that level remains stable - in line with that of the sovereign.

Overall, heightened credit pressures would add to concerns about capital adequacy for certain parts of the system. That said, recent statements by the authorities which recognize the need to maintain the capital positions of public sector banks should prove supportive.

There are two potential silver linings, however, amid the rising credit pressure. First, the normal monsoons this year could put a floor beneath slowing domestic demand, especially in the agricultural sector.

Second, greater recourse to bank borrowing by Indian corporates which face sharply heightened pressure in the local bond market, could also limit the risk of a slowdown in loan demand greater than what might have been feared.