Implications of recapitalisation bonds: Govt changes gear on fiscal consolidation

A few days after Diwali last year, India’s banks were tearing their hair out as they struggled to manage long queues of people and replace old currency notes of Rs 500 and Rs 1000 in the wake of demonetisation. 
 

This Diwali was different, particularly for the public-sector banks.
 

Less than a week after the festival, they heaved a sigh of relief, though for a different reason. On Tuesday, October 24, the government announced a grand plan: Public sector banks will be recapitalised to the tune of Rs 2.11 lakh crore over the next two years. 
 

This amount may be a little short of the estimated requirement of Rs 3 lakh crore of total recapitalisation, but it is a step that shows the government’s seriousness in tackling the financial mess in the state-owned banking sector.

Full details of the recapitalisation are not yet out. An estimated Rs 18,000 crore will come straight from the central exchequer by way of equity. Another Rs 58,000 crore is expected to come from banks raising capital from the market. The remaining Rs 1.35 lakh crore would be in the form of recapitalisation bonds, the details of which are yet to be made public.
 

But even as Finance Minister Arun Jaitley, RBI Governor Urjit Patel and Chief Economic Advisor Arvind Subramanian spoke separately on the implications of the recapitalisation plan, three messages are coming out loud and clear.
 

One, the Modi government is preparing for a slippage in its fiscal consolidation plan in order to provide the much-needed capital for public-sector banks. 

Contrary to suggestions made by some influential voices in the government, the fact is that the issuance of the recapitalisation bonds under the new package will result in an effective widening of the fiscal deficit.  And if higher revenues do not come to its rescue, this will be the first year of the Modi government when it would fail to meet its fiscal deficit target and indeed could change the trend of a declining fiscal deficit witnessed in each of the last five years.
 

True, as the RBI Governor pointed out, the issuance of bonds would be “liquidity-neutral” for the government, but they would certainly add to the government’s borrowing. Both the additional borrowing and the annual interest outgo of Rs 8,000-9,000 crore on these bonds should widen the government’s fiscal deficit. Indeed, Patel himself does not rule out a widening of the fiscal deficit when he says that by “deploying recapitalisation bonds, it will front-load capital injections while staggering the attendant fiscal implications over a period of time.”
 

The chief economic advisor has noted that international standards and even the accounting norms followed by the International Monetary Fund do not require these recapitalisation bonds for the financial sector to be captured while calculating the government’s total fiscal deficit. These numbers are mentioned “below the line”. But effectively it will imply a widening of the fiscal deficit. Even Subramanian has admitted in a public lecture that “under India’s convention, these bonds would add to deficit”.
 

It is possible that the government may choose to present the impact of the recapitalisation bonds separately “below the line”, as was done many years ago for the oil bonds to help oil companies absorb the impact of higher crude oil prices, without passing it on in the form of increased prices for consumers.
 

If that path is chosen, it is likely that analysts and rating agencies may start referring to two sets of fiscal deficit numbers - the actual fiscal deficit including the impact of the recapitalisation bonds and the official fiscal deficit that does not reflect such an impact. Analysing the Indian government’s fiscal deficit numbers will get a little more complex.
 

The final confirmation that the Modi government may be accepting a widening of its fiscal deficit in the wake of these bonds came from none other than the finance minister, though in an indirect way. In a tweet, Jaitley said: “Government is committed to maintaining a balance between fiscal prudence and capital spending to push growth.”
 

A balance between fiscal prudence and capital spending suggests that a middle path is likely to be followed wherein some relaxation in the fiscal deficit reduction target is possible to make way for higher capital expenditure to attain higher growth.
 

Two, the stock market has given its thumbs up for the government move.

A 435-point jump in Sensex on Wednesday has taken the Bombay Stock Exchange benchmark index to a record high, reflecting a Rs 1.2 lakh crore increase in the market capitalisation of 22 listed public-sector banks. The Nifty Bank index jumped by 30 per cent in a day – a record in itself. Clearly, the stock market believes that the combined impact of the Insolvency and Bankruptcy Code and recapitalisation of state-owned banks would help relieve the stress in the financial sector.
 

The positive market response is significant and augurs well for the government’s recapitalisation package. Remember that almost Rs 58,000 crore out of Rs 2.11 lakh crore will have to be mobilised through flotation of equity in the capital market. If the market sees an improvement in the listed state-owned banks’ ability to grow their business profitably after the infusion of recapitalisation bonds, it will help retail subscription of fresh shares of these banks. The RBI governor was hopeful that the package would help “involve the participation of private shareholders of public sector banks by requiring that parts of the capital needs be met by market funding.”
 

Three, the recapitalisation package will not in itself be capable of preventing further deterioration in the quality of assets of these public-sector banks.

Hence, expectations of what further reforms of these banks will follow have risen. The finance minister did talk about a package of reform measures that the government would announce to supplement its recapitalisation efforts. Details of such reforms will be eagerly awaited.
 

The RBI governor has already hinted at what those reform measures could be. Patel seemed hopeful that banks worthy of capital infusion would be prioritised. He said: “It will allow for a calibrated approach whereby banks that have better addressed their balance-sheet issues and are in a position to use fresh capital injection for immediate credit creation can be given priority while others shape up to be in a similar position.  This provides for a good way of bringing some market discipline into a public recapitalisation program compared to the past recapitalisation programs.”
 

Indeed, the battle against the twin balance sheet problems of the Indian economy (indebted India Inc and rising bad loans of banks) will not be conclusively won unless further reforms are implemented. Will the government go in for ownership change in the state-owned banks? Will the managements be revamped in a way that such bad loans problems do not recur?
 

In that sense, this package is incomplete even though it has elements of both the Sudarshan Chakra that Reserve Bank of India Deputy Governor Viral Acharya had asked for and of the Brahmastra, a term that Chief Economic Advisor Arvind Subramanian has used to describe the package.