Indian Finance Minister Arun Jaitley at the Vibrant Gujarat investor summit in Gandhinagar on January 11, 2017. Photo: Reuters / Amit Dave

The recently announced 2.1 trillion rupee (US$32.5 billion) strategy to recapitalize India’s state-controlled banks over the next two years has received a thumbs-up from equity investors. Details are lacking but investors have responded enthusiastically to the prospect of resolution of a lingering bad-loans problem.

India’s banking system has about 9.5 trillion rupees worth of bad loans, amounting to more than 6% of gross domestic product. More than 90% of those non-performing assets are on the balance sheets of 21 state-owned banks, which account for about 71% of bank credit. The state-owned banks have been forced to throttle back commercial lending as the bad debts have piled up.

The recapitalization is part of a multi-pronged strategy. A new bankruptcy law has enough teeth for lenders to take over defaulting businesses. However, distress sales of assets could mean big haircuts.

Fitch Ratings reckons about 4.25 trillion rupees may eventually be required to provision losses adequately and shore up the net worth of the affected banks to meet global Basel III standards, which become effective in March 2019. So even this recap, massive as it is, may not be enough.

Many unconventional methods have been adopted to deal with financial crises. After the subprime crisis exploded in 2008, the US and the European Central Bank (ECB) chose alternative methods of refinancing.

The US Treasury Department instituted the Troubled Assets Relief Program. Between 2008 and 2012, TARP bought $426 billion of dodgy mortgages and other bad loans, at heavy discounts, from distressed lenders. TARP ended in 2014, with the recovery of $441 billion from reselling those assets.

Simultaneously, the US Federal Reserve instituted its quantitative easing program, which went through several stages before tapering to an end in October 2016. The Fed bought bonds from banks to release liquidity.

The ECB also mounted a QE, which is ongoing and scheduled to continue until September 2018, at least.

The Indian government will deploy only about 180 billion rupees of its own money in this recap, allocated out of the 2017-18 federal budget. Another 580 billion rupees will be raised by selling equity in these institutions. The buyers may include government-controlled institutions such as the Life Insurance Corporation (LIC). It’s not clear if the banks will issue fresh equity or the government will sell some existing stakes.

A significant proportion of the current bad loans were offered to politically influential promoters and badly run state electricity companies. The government is also moving into election mode

The rest of the funding – about 1.35 trillion rupees – will be raised in convoluted fashion. The government will issue “Recapitalization Bonds,” to be bought by the banks. The money received from the bond sales will be used to subscribe to the equity of those same banks. There would have been an outcry if the promoter of a private bank had borrowed money from that very bank to buy shares in the self-same institution. But by definition, the recap bonds carry a sovereign guarantee, even if that is implicit.

There are no details available about the proposed structure of the bonds, in terms of tenure, interest rates, fungibility for secondary sales, etc. Although the bonds will clearly increase the government’s debt obligation, it is possible that this will not be formally counted toward the fiscal deficit, thanks to some accounting legerdemain. The 2017-18 budget estimated that the federal fiscal deficit would be held to 3.2% of GDP. About 91% of that deficit has already been spent.

The government’s stake in the recapitalized banks would also rise, both directly and also indirectly, if LIC and other government-owned institutions are instructed to buy bank equity. This reverses the trend of disinvesting government stakes in businesses.

There are disturbing implications. A significant proportion of the current bad loans were offered to politically influential promoters and badly run state electricity companies. The government is also moving into election mode, with a general election due in 2019 and multiple state assembly elections before that. That may mean more handouts  such as farm-loan waivers and free power, bankrolled by state-run banks.

On the positive side, recapitalized state-run banks would be able to step up credit disbursal. That may provide a large stimulus that helps reverse a trend of six successive quarters of lower growth. However, in the absence of reforms to give the state-run banks the autonomy to run on commercial lines, this may just lead to an even bigger bad-loans problem some years later.

Devangshu Datta

Devangshu Datta is a journalist and columnist. He writes about investment, economics, science and technology and the intersections between them.