A spike in retail loan defaults in India due to aggressive lending practices is echoing in the stock market, with analysts concerned about the potential spillover into the larger economy.

Concerns are growing as lenders such as Kotak Mahindra Bank Ltd and IndusInd Bank Ltd reported increased stress in unsecured loans during second-quarter earnings, causing shares to fall. The suffering is particularly intense in banks that focus on smaller-ticket loans, such as Ujjivan Small Finance Bank Ltd, whose shares has fallen more than 30% this year.

Personal-loan growth is slowing as the central bank pushed down on riskier lending practices last year following a post-pandemic credit boom. The impact is beginning to be felt in the market and on firm earnings, indicating that the world's fastest-growing major economy may face additional challenges.

"The issue will continue for at least the next two quarters, with slippages and credit costs remaining high. If the demand for these loans doesn't pick up in the festive season, the stress can last much longer. Choudhary is underweight in the space",  said Yuvraj Choudhary, Analyst at Anand Rathi Securities.

Last November, the Reserve Bank of India requested that banks set aside additional capital for unsecured consumer credit, particularly modest loans, as regulators became concerned about borrowers purchasing items they couldn't afford. The higher cost of loans, along with collection difficulties during the federal elections in April and June, triggered a spate of delinquencies.

Personal loan growth dropped to 14% in August, down from more than 30% the year before. Ujjivan Small Finance Bank Ltd and IIFL Finance Ltd warned in results calls last month that the hard situation will persist in the coming quarters.

Traders have already exited. Shares of microfinance lenders such as Fusion Finance Ltd and Spandana Sphoorty Financial Ltd. have fallen more than 60% this year, compared to a 15% increase in the BSE 500.

Private players have also seen an impact. Arohan Financial Services Pvt. Ltd., which predominantly lends to financially underprivileged women, is delaying its initial public offering.

This comes after the RBI ordered a group of shadow lenders last month to halt authorizing new loans due to the exorbitant interest rates they charge customers.

A slowdown in credit growth translates into less demand from consumers for large-ticket items such as automobiles. Earnings from numerous automakers were disappointing, ranking the sector among the worst performers in October. Shares of consumer powerhouse Hindustan Unilever and retail giant Avenue Supermarts fell on similar worries following the second-quarter results.

"Consumption has suffered from a clear policy tilt toward infra-led growth. The defaults are increasing as wage growth in metropolitan regions slows, but rural earnings have not increased significantly. Discretionary spending will definitely be affected", said Madhavi Arora, Chief Economist at Emkay Global Financial Services.