Fitch Ratings said on Monday that operating environment remains difficult for India’s banks in line with its negative outlook for the sector despite some indications of an improvement in the macroeconomic outlook.

Senior Director Duncan Innes Ker said Fitch expects India’s economic growth to accelerate to 5.6 per cent in the financial year ending March 2021 (FY21) from 4.6 per cent in FY20.

“But asset quality at the banks is likely to remain under pressure for some time. This in part reflects exposure — both direct and indirect — to stresses among non-bank financial institutions (NBFIs),” he said.

“We believe that the NBFI sector has yet to turn a corner even though fund-raising by a number of NBFIs during the first two months of 2020 points to a slightly improved funding environment,” said Ker in a statement.

The authorities have sought to provide support through regulatory forbearance. The Reserve Bank of India announced on February 6 an extension of the one-time restructuring scheme for micro-enterprises and SMEs, and relaxation in asset classifications for certain real estate projects.

However, there is a risk that this approach could perpetuate moral hazard and weaken transparency over asset quality.

The government has allocated 10 billion dollars for capital injection into banks in FY20 but this will go mainly towards bridging regulatory capital gaps, providing for ageing impaired loans and absorbing the costs of merging 10 state banks into four by April.

“Indian banks may require significant additional equity beyond this by FY21 to support loan growth, cover non-performing loans and build buffers over Basel III minimum standards,” said Ker.

Raising this may be challenging, given banks’ limited ability to issue fresh capital which puts the onus on government to address shortfalls.

“Although we anticipate that macroeconomic conditions will improve in FY21, any setbacks for the economy could increase asset-quality strains among Indian banks, particularly if they cause pressures in the NBFI sector to escalate into a broader crisis,” said Ker.

India so far appears relatively insulated from the economic fallout from the ongoing novel coronavirus outbreak, but the virus has highlighted potential downside risks to our economic outlook, he said.