India's $32 billion bank recap plan spurs share gains and questions

By Devidutta Tripathy and Manoj Kumar

MUMBAI/NEW DELHI (Reuters) - Indian banking shares soared on Wednesday, sending indexes to record highs after the cabinet approved a $32.4 billion plan to recapitalise its state banks over the next two years, although it was unclear how the injections will be structured.

The gains came after India's cabinet late on Tuesday cleared a plan to inject 2.11 trillion rupees ($32.4 billion) into state-run lenders over two years.

With the plan, Prime Minister Narendra Modi is bidding to tackle a major drag on the economy that has frustrated his attempts to boost growth.

Investors sent shares of State Bank of India, the biggest lender, up as much as 29 percent to its highest since January 2015. The benchmark NSE Nifty rose as much as 1.3 percent, touching a record high.

But details of how New Delhi will fund the injections were not available. Also, questions remain about whether these would add to India's fiscal deficit at a time markets are already doubtful it can meet its 3.2 percent target of gross domestic product for the year ending in March 2018.

The planned injections still fall short of some estimates, including from credit rating agencies, of what's required. Fitch Ratings estimates Indian banks need $65 billion of additional capital by March 2019 to meet Basel III global banking rules.

DRAGGING ITS FEET

For now, analysts said the long-awaited actions are positive, as India, worried about its finances, was widely seen as dragging its feet in resolving problems in a banking sector saddled with $145 billion in soured loans after years of almost indiscriminate lending.

Once the world's fastest-growing major economy, India has seen its growth rate plummet to the lowest in three years. A key factor has been the lack of private investment as state banks, which provide most of the credit, hold the largest amount of bad debt.

"At the end of the day, a good dose of the medicine that is required is being provided," said Jobin Jacob, associate director of financial institutions at Fitch Ratings.

"How the medicine is being sourced could have its own implications on the macro picture, but as far as the banking sector is concerned, it is helpful," he said.

Reserve Bank of India Governor Urjit Patel welcomed the injections - a step he has long advocated - calling the plan "a monumental step forward in safeguarding the country's economic future".

DEVIL IN DETAILS

Still, details will matter. The benchmark 10-year bond yield rose 3 basis points to 6.81 percent on worries about how the injections will be structured.

The government said on Tuesday that so-called recapitalisation bonds will account for 1.35 trillion rupees of the 2.11 trillion rupees injection, while about 580 billion rupees would come from share sales by banks. The government will also use 180 billion rupees left from its previously budgeted recapitalisation fund.

Analysts predict recapitalisation bonds would likely involve selling debt to lenders, with the government then injecting the capital back into state-owned banks, potentially in exchange for increased equity stakes in the sector.

India took a similar approach in the 1990s, and repeating such a step would avoid roiling debt markets by keeping it off markets, analysts said.

Srikanth Vadlamani, senior credit officer at Moody's Investors Service, warned that such an approach could have some negative implications for the banks depending on the structure, though he called recapitalisation a "significant credit positive" overall.

India's chief economic adviser Arvind Subramanian said in a tweet the total capital injected by the government could ultimately be limited to paying interest on the bonds as there would not be straight cash injections.

The government could also avoid adding to its fiscal deficit by funding the plan through state-owned bodies rather than directly, an accounting sleight-of-hand that could allow New Delhi not to count the expenditure as part of its budget under International Monetary Fund rules.

Importantly, investors warned that India also needed to announce accompanying reforms to the banking sector, to prevent moral hazard and impose more credit discipline on lenders.

Policymakers "should impose targets on these banks in terms of profitability, credit quality and efficiency. This has to be carefully managed," said David Marshall, Singapore-based analyst with CreditSights.

(Reporting by Devidutta Tripathy; Additional reporting by Abhirup Roy, Suvashree Dey Choudhury and Krishna Merchant in MUMBAI, Tanvi Mehta in BENGALURU, Neha Dasgupta in NEW DELHI and Umesh Desai in HONG KONG; Writing by Rafael Nam; Editing by Richard Borsuk)