The decline in non-performing loans recorded at many large state-owned Indian banks in the last quarter of the financial year ending-March 2014 does not mean the asset- quality stress in the banking system has subsided, Fitch Ratings says. This is because economic conditions continue to be rather weak, with recovery slow.

If the fall in reported NPLs was driven by an improvement in asset quality, we would expect a concurrent decline in the number of new NPLs as well as higher recovery rates in NPL workouts. The number of new loans becoming non-performing is still close to 3x the loans recovered and upgraded at the largest state banks at end-March 2014. There is some evidence of higher recovery rates, but the write-downs and portfolio sell offs to asset reconstruction companies are likely to play a larger role in reducing reported NPLs.

The efforts to deal with reported NPLs may mean the peak in stressed assets could be lower than our earlier forecast of 15% by FY15. The NPL ratios at many state-banks improved unexpectedly in the quarter ending in March 2014, and it is likely that stressed assets for the system will be lower than expected in FY14. However, regardless of the reported number, the asset quality pressures will remain until there is a fall in new NPLs.

The state-owned banks, especially the mid-tier banks, are in a particularly difficult position due to their high share of stressed assets and weak capital and earnings positions. State-owned banks' exposure to sensitive and structurally weak sectors is high, and we do not expect any dramatic recovery in the near-term, implying that we expect the asset quality challenges to remain in the foreseeable future.