A man walks past the Reserve Bank of India head office in Mumbai. Photo: Reuters/Danish Siddiqui

India’s shadow banking crisis remains a political charade that may damage the country’s political economy beyond repair. The source of this problem is the Rajya Sabha, the dysfunctional upper chamber of the Parliament. More specifically, at the core of this impending fiscal disaster is the cynical relationship between India’s plutocratic political class and the government. Only through arduous self-reform efforts can Prime Minister Narendra Modi’s team fix an inept institution; mollifying the Rajya Sabha leadership through the unethical application of monetarist principles at India’s central bank will fail.

The world’s second-most populist country is flirting with a self-induced Lehman moment.  No amount of Hindu monetary chicanery will suffice, for it isn’t a liquidity problem. Failed loans amounting to $100 billion cannot be excused; team Modi needs to recapture the ethics of leadership that animated his initial turn at prime minister beginning in 2014.  Throughout the previous decade, India ran double-digit levels of GDP with sizable domestic capital inflows. Now, New Delhi’s state-run banking system is registering hundreds of billions of failed loans. The contagion is growing, but India’s dominant political class has calculated to pressure the central bank into conjuring money to paper over the debacle.

Its magnitude exceeds the global crash of 2008.

Just two months ago, India’s Infrastructure-Leasing & Financial-Services firm (ILFS) defaulted on $13 billion of debt. Contagion struck India’s shadow banking network, which relies on nearly $300 billion a year of borrowing to remain solvent. Having its market value collapse by nearly 40% initiated political talks between the Modi government and the Reserve Bank of India (RBI). But no one wants to look at the political nature of the relationship between India’s governing plutocrats in the upper chamber and BRI loans.

India’s domestic financing-banking system possesses both American and Chinese characteristics; a self-induced fiscal suicide at government-run lenders compounded by liquidity runs at banks throughout the country.  Politically, the state wants compliant banks, but the RBI understands the absolute necessity of ethics regarding how monetary policy is applied.

Current troubles have their roots in the years between 2005 and 2012 when state banks decided to lower lending standards and began extending non-deposit-led credit to plutocrats throughout the upper chamber for infrastructure. Because the government will not recapitalize state-run zombie banks, they began finance themselves by issuing unsecured debt.

India’s domestic banking system straddles the 19th and 21st centuries; some are highly regulated while others resemble digital rickshaws untethered to any governing body

However, from 2012 to 2017 India witnessed enormous sums of foreign capital flows that pushed down interest rates. State-managed banks replaced cash with issued debt mutual funds. Being flush with cash permitted them to fund illicit shadow banking units that remain unregulated. In summary, India’s domestic banking system straddles the 19th and 21st centuries; some are highly regulated while others resemble digital rickshaws untethered to any governing body.

Borrowing short to lend long works when one can trust the self-reported capital ratios that underwrite official and nonofficial banks. For months now, Indian citizens have suffered liquidity crunches while the RBI and other regulatory agencies report solid capital ratios. The impact of a failed demonetization regime and illiquid banks will damage Modi’s government beyond repair.

As it stands now, team Modi faces an election next year and wants the RBI to lend freely to flailing shadow banks. India’s central bank leadership has acknowledged the crisis with partial help by indirectly arranging to inject liquidity by making asset purchases or by managing debt auctions by underwriting discretely identified state-run banks, effectively guaranteeing bond purchases.

The RBI’s leadership is correct to identify the political and ethical nature of this crisis. It wants the Indian government to directly recapitalize struggling state banks by openly reforming them toward privatization, extracting entire political classes from state-run finance.

How will one know if and when India’s dominant political class is open to reform? When they end regulatory arbitrage that permits shadow banks to raise monies from retail investors and deposit-taking institutions.

Just like the global US-led crisis in 2008; it was never a liquidity crisis but an ethical, political crisis of bank capitalization.

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William Holland

William Holland is North American recruiter for Wikistrat global consultancy monitoring Pakistan's nuclear program.