In response to this article by Joe.
Some scattered thoughts could be found here.
With demonetization, banks got a surplus liquidity to the tune of Rs. 4 trillion which was largely responsible for call rates becoming tepid. However, there was no commensurate demand for credit as most corporates with a good credit rating managed to raise funds in the bond market at much lower yields. The result was that banks ended up investing most of this liquidity in government securities resulting in the Statutory Liquidity Ratio (SLR) bond holdings of banks exceeding the minimum requirement by up to 700 basis points. This combination of a surfeit of liquidity and weak credit demand can be used to design a recapitalization bond to address the capital problem. Since the banks are anyways sitting on surplus liquidity and investing in G-Secs, recapitalization bonds can be used to convert the bank liquidity to actually recapitalize the banks. Firstly, the government of India, through the RBI, will issue Recapitalization Bonds. Banks, who are sitting on surplus liquidity, will use their resources to invest in these recapitalization bonds. With the funds raised by the government through the issue of recapitalization bonds, the government will infuse capital into the stressed banks. This way, the surplus liquidity of the banks will be used more effectively and in the process the banks will also be better capitalized and now become capable of expanding their asset books as well as negotiating with stressed clients for haircuts. Recapitalization bonds are nothing new and have been used by the RBI in the past. In fact, the former RBI governor, Dr. Y V Reddy, continues to be one of the major proponents of recapitalization bonds in the current juncture. More so, considering that the capital adequacy ratio of Indian banks could dip as low as 11% by March 2018 if the macroeconomic conditions worsen, the motivation for going in for recap bonds has no logical counters. As I have often said this in many a fora, when banks talk numbers, transparency and accountability the way it is perceived isn’t how it is perceived by them, and moreover this argument gets diluted a bit in the wake of demonetization, which has still been haunted by lack of credit demand. As far as the NPAs are concerned, these were lying dormant and thanks to RBI’s AQR, these would not even have surfaced if let be made decisions about by the banks’ free hands. So, RBI’s intervention was a must to recognize NPAs rather than the political will of merely considering them as stressed assets. The real problem with recap bonds lie in the fact that the earlier such exercise in the 90s has still resulted in bonds maturing, and unless, these bonds are made tradable, these would be confined to further immaturities.
If we are still thinking of Demonetization and GST as speed breakers to economy, which entirely isn’t false, the what could one say of Bank Recapitalization? Is this a master stroke of sorts to salvaging sensibility before the present ruling dispensation of BJP is red-faced before 2019 GE? Or, is Bank Recapitalization is all about safeguarding the dismal dip in the growth and especially so when the world economy is on an ascent, despite warnings of a Minsky Moment? What are the challenges to Bank Recapitalization and how would these face up to the challenges of the NPAs and PSB consolidation? These are pressing questions that simply cannot be answered by a political will getting catalyzed, but requires a deeper economic drift and traction.
So, if Bank Recapitalization to the tune of Rs. 2.1 lakh crore infusion into the public sector banks were to come through, and which it would, the budgetary allocations are a mere chunk, while raising money from the market too isn’t that major a factor. The roost is to be ruled by recapitalization bonds, or recap bonds, in short. What then are the challenges of this methodology?
Technically, in the current context, there is really not much of a risk in issuing recapitalization bonds. The outside risk of recapitalization bonds is that this move may tighten liquidity in the system if all the surplus liquidity in the banking system goes into its capital. However, since recapitalization bonds are callable in nature, this risk should not be too great. Also, the debt markets are now sufficiently deep and broad and can support the funding needs of the India corporates and hence that is unlikely to be a major issue. The only concern is that rating agencies globally will look at recapitalization as a form of off-balance sheet financing, which does not give them too much comfort. Many rating agencies look at such bonds as a means of raising debt that is not visible in the fiscal deficit. This lack of visibility is what might be the hurdles race for the government. But, then is there a way out?
Alternatively, what if the government were not to recapitalize? Then, it can look to postponing its adherence to Basel III from 2019. But that will be seen by global markets as an admission by the Government of India that it does not have the liquidity to capitalize its banks. That may not go down well with foreign investors. Under these circumstances, infusing capital into the banks through the issue of recapitalization bonds may be the best option available!
What are the main economic ramifications as a result of these? The government’s plan at recapitalization would have little impact on its target to shrink the shortfall to 3.2 percent of the GDP because the IMF rules classify such debt as “below the line” financing. Only interest expenses would be added to the fiscal deficit, and this is estimated at about Rs. 90 billion or 0.4 percent of the total budgeted spending. Technically, however, India’s accounting rules require the bonds to be included in the budget deficit, so the government would reclassify them later as off-balance sheet items. The government is yet to disclose the details on the structure and pricing of the bonds, as well as how it would raise the rest of the cash. These will determine if there is a liquidity squeeze. If the measures do revive credit growth, inflation may accelerate as well, limiting scope to lower the policy rate. When it comes to the question of who would buy these bonds, the answer is probably banks themselves, who are flush with deposits following the note ban. Banks can then cleverly invest these funds in the recap bonds which will then be ultimately routed back as equity in the system. This would ensure that the bond market would not be impacted by such a large issuance for the private sector issuers.
Now, these are serious questions questioning some of the advocacy groups have to come to terms with. For one thing, in my opinion, mergers and acquisitions to consolidate PSBs are to be put back on the back foot, for recapitalization has at least punctuated to for the time being. Second is credit growth, or more precisely credit demand, which would be induced with an energy following this exercise. Third, and most importantly, the lending might gain velocity, but only after April 2018, since banks would require a correctional facility on their balance sheets. This lending would somehow be channeled towards infrastructure giants like Sagarmala and Bharatmala with a key difference being that the Government might prioritize Engineering, Procurement and Construction (EPC) over Hybrid Annuity Model like the PPP for the obvious risks associated with the latter subsequently feeding into the NPAs and/or stressed assets.