The Effect of PSU Bank Recapitalization on The Economy of India

India’s banks have long been suffering from a massive pile up of non-performing assets on their balance sheets. This puts a strong drag on credit growth, which is exacerbated due to the recent sluggishness in the economy because of demonetization, aggregate liquidity, and demand shock. After a three-year record low of 5.7%, the Union Government decided to issue a massive credit infusion into the economy – a move that would help put India’s banks on the path to recovery.

How Do Non-Performing Assets Jeopardize India’s Credit System?

Indian banking non-performing assets have suffered from persistent new pension schemes as most of the existing banks have carried stress assets in double digits. India’s internal advisory committee (IAC) has found 12 accounts that have defaulted, totaling about 25% of the gross non-performing assets. Such huge defaulters put the entire credit system at jeopardy. Non-performing assets have been piling up because of the lack of proper bankruptcy codes and corruption in the system.  

Source: RBI Handbook Of Statistics On Indian Economy

How Can The Government Fuel Growth?

Bailout Schemes

The only plausible alternative for the government to induce a massive Keynesian push to the economy has been massive bailout schemes for the operationally weak PSU banks. It is to be noted, that strong regulatory requirements on liquidity and capital adequacy ratios contributes to an Indian banking system that is not structurally weak. The Indian economy has thus entered a phase of massive public spending and credit easing, and stock markets have seen a euphoric reaction this bailout, fuelling more growth to the already record levels of NIFTY and SENSEX.

Source: Bombay Stock Exchange Official Data

Source: Investing.com (The Black Line Represents Lower Inflation Trigger In The Indian Economy)

Issue Debt

The scheme is essentially of direct bond buying programs, which are sure to increase the off-balance sheet debt levels of the government. The government has not just issued debt but has also indirectly acquired parts of non-performing assets and stressed assets of such PSU banks. Due to this, rate structures would necessarily gravitate towards more spending. The Indian bond buy-back program has specifically been geared towards recap bonds. An earlier version of such a bailout was in mid ‘90s when recap bonds were issued to rescue banks from the pile up of NPAs. More than any significant inflow or fiscal deficit it has been proposed as a revenue neutral scheme. However, according to estimates from the Chief Economic Advisor, the program could possibly cost the exchequer 8,000-9,000 crore rupees. Most of it would consist of the arbitrage between the interest and the dividend payment (government banks are known to poorly pay dividends).

Equity Reinvestment

The funds collected from the banks would be reinvested into the equity shares of the banks, thus, forming a massive capital injection and a strong vote of confidence from the government. Most of the critique surrounding recap funds admonishes that they might simply be a book entry or may artificially de-leverage the government’s debt figures since the government is not only associated with the banks in sharing their risky assets but also has a responsibility to bail them out when required. The government might just offload these debts from its books by SPVs, however it does not reduce the government’s burden.

 Issuance of Recap Bonds

The refinancing risks of recap bonds, if staggered over a 10-15 year maturity period, would reduce significantly. Since, it is essentially a cash neutral transaction, the issuing of recap bonds would work in favor of banks’ balance sheets as they can be passed off as an investment and earn an interest on the same. On the other hand, banks can sell such bonds in the market when liquidity is required.

Rating agencies view such transactions as a positive credit on bank balance sheets as it increases the bank’s equity and in turn would increase the lending potential in the market. 

Source: Investing.com

The Impact?

In conclusion, the most important aspect to consider is that the massive bond issuing program has a spill-over onto stock markets and long-term interest rates since recap bonds do not contribute significantly to fiscal deficits or budgetary expenditures at least in the short run. This effect would be clearly visible by a simple concept of crowding out; issuing bonds to the fiscally weak sector may put a drain on the government to borrow from other sources. The structural details and nature of implementation of the bonds is yet to be disclosed. However, a probable response of the RBI to the expansionary plans of the government may be to increase interest rates to curtail higher inflation or possible future inflationary pleasure. The bond yield curves would likely become less lucrative under a high interest rate atmosphere or related expectations. Put simply, recap bonds would mend things for short term but the government needs to push in structural reforms to the banking sector.