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5 Things You Need to Know About India’s Banking Recapitalization Move

For investment advisers only

Background

The Indian public sector banks (PSBs) have been under stress as the total amount of non-performing assets had risen to US $150 billion[1]. These non-performing loans have severely restricted the ability of PSBs to extend further loans. Limited access to credit impacted the ability of businesses to make fresh investments and adversely impacted their growth. In summary, this overhanging issue has been a headwind to the growth of the economy.   

Corrective Measures Proposed

The government of India announced it would inject US $32 billion into the PSBs to provide them relief. US $2.5 billion will come from the budget, US $8 billion will be raised from markets by the banks over the next 2 years and the rest will come through the issuance of “recapitalization bonds” over the current and next fiscal year. [2]

Expected Outcomes

Investors see this move as a positive since it could help remove a significant overhang on credit availability, which with time might allow for higher loan growth to further encourage investment.

Competition between banks will likely reduce the cost of lending for businesses[3]. As credit becomes more readily available, a virtuous cycle of investment can be expected to kick start in the upcoming months.

The issue of Moral Hazard

One of the key issues with this decision is the question of moral hazard. It is true that banks are being bailed out even though they were at fault and were expected to exercise better judgment regarding loan lending practices. However, the government had to take this decision keeping in mind the greater interest of the economy. Speaking on the issue, Arvind Subramanian, India’s Chief Economic Advisor, states, “To some extent, moral hazard is unavoidable. In the real world, there are no costless actions, policy makers have to balance the perverse incentives created against the necessity of reviving the economy and creating growth and jobs.”

One of the ways by which the government is attempting to address the issue of moral hazard, is by adopting a differential approach towards allocation of recapitalization funds. Stronger banks with better track record are likely to get a preference in the allocation of funds.

Impact on Fiscal Deficits/Targets

Under the IMF accounting practices, the recapitalization move ought to be treated as “below the line” which means it should not be treated as part of the fiscal deficit since this move does not directly add to demand for goods and services.[4] However, under the Indian government accounting practice, the recapitalization shall be considered part of the deficit. Experts believe that the recapitalization move will have positive effects in multiple related sectors of the economy (multiplier effect) and may improve the overall investor sentiment.[5]  

The plan has been positively received by rating agencies such as Moody’s and Fitch. Commenting on the development, Srikanth Vadlamani, Moody's Senior Credit Officer said, “Even if only the recap bonds and the already announced budgetary support are factored in, the announced capital infusion should be able to comfortably address the bank’s capital requirements.”[6]   

 

[1] Arvind Subramanian, India’s Chief Economic Advisor, October 24, 2017, (Scroll.in)

[2] Government of India, Ministry of Finance, October 24, 2017

[3] Goldman Sachs Equity Research, October 25, 2017

[4] http://www.livemint.com/Industry/xje0dmj5lYHZkSZnqVRjwJ/Cabinet-approves-Rs21-trillion-PSU-bank-recapitalisation-pl.html

[5]http://www.thehindubusinessline.com/money-and-banking/recapitalisation-bankers-credit-rating-agencies-upbeat/article9921966.ece

[6]https://www.moodys.com/research/Moodys-Indias-capital-infusion-plan-is-a-significant-credit-positive--PR_374476

 

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Disclaimer

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.