In order to address the problem of bad loans in PSU banks, the government today announced the bold measure of recapitalizing PSU banks to the tune of INR 2.11 trn (over current fiscal and next fiscal).
The structure of bank recapitalization
The capital infusion of INR 2.11 trn involves issuances of PSU bank recapitalization bonds worth INR 1.35 trn, budgetary support of INR 180 bn and market based capital raising of INR 560 bn. Of the INR 180 bn, INR 100 bn has already been provided for in the Budget FY18, hence, additional INR 80 bn would be provided for either this year or next fiscal year.
What are bank recap bonds?
Recap bonds are bonds that are issued in lieu of capital and banks can subscribe to these via investment book. Capital infusion through this route is cash neutral and is merely an accounting entry. On the liability side, bank’s capital gets boosted and on the asset side their investment book shows an increase. As such, these are cash flow neutral and liquidity neutral both for the banks as well as the government.
These bonds can be issued either by the government or by a government backed entity. The most common category of bank recap bonds include those issued by the government and placed directly with the banks.
A 2003 IMF study shows that more than 30 issuing countries such as Malaysia, Korea, Croatia, Mexico, Thailand, Indonesia, Tanzania among others found such instruments to be most effective when they are tradable and pay high enough coupons such that banks can still fund loan growth.
The 90’s bank recap episode
In order to address the problem of capital erosion if banks, the government issued several tranches of non-marketable securities called ‘Recapitalization bonds’ to nationalized banks between 1985 and 1995. However, later these bonds were converted into marketable securities or into perpetual bonds through mutual agreement between banks and the government. Estimates suggest about INR 200 bn worth bank recap bonds were issued ( 9.45% of the FY 95 credit outstanding). The size of current issuance is 1.7% of the credit outstanding.
Impact on growth
We expect the growth potential of the economy to get a boost from the recovery in credit growth. Our analysis suggests that the nominal growth sensitivity to credit growth for India is at an average of 10 bps for different time periods pre and post liberalization. As such, a 300-400 bps improvement in credit growth could provide a growth support of additional 30 bps to 40 bps to our current expectation of 7.3% for FY19.
Impact on fiscal deficit & government liabilities
Under IMF accounting norms, asset sales and recapitalization bonds are below line items and hence do not alter the fiscal deficit. However, its issuances are counted as liabilities on government books and hence the public debt to GDP is expected to rise. Basis FY17 public debt quantum, the public debt to GDP ratio is expected to move up by 100 bps purely due to issuance of bank recapitalization bonds.
Additinally, assuming these bonds are issued at a coupon of 7.0%, (10 yr Gsec closed 6.78% as of 24th Oct, 2017) it would entail debt servicing burden of INR 95 bn annually.
Impact on bond market
Since there is not cash flow impact and no additional supply of bonds is entailed, the impact on debt market is expected to be not very aggressive. However, since debt liability of the government is expected to increase, the bond market could open with a modest gap down.
The true impact on the bond yields expected to play out when there demand for credit picks up and banks propensity to invest in Gsecs reduces incrementally with bank recapitalization bonds already sitting on its balance sheet.
Currently, banking system is flush with surplus liquidity of INR 1trn (as on 23rdOct). The system also has outstanding MSS bonds of INR 940bn and OMOs of INR 700 bn. As such, so long asliquidity in the system remains sufficiently supported, bond market is unlikely to see a very strong adverse reaction to the recap bond issuances.
More reforms needed
While we may certainly hail government’s decision to issue recap bonds as bold and audacious, it is important to note that permanent solution to PSU banking crisis calls for sustained improvement in governance, better credit appraisal standards and autonomy in decision making is called for, in absence of which it could create a moral hazard problem in times to come.
*Source : Sundaram AMC