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Sajid Chinoy of JP Morgan | Asia Pacific Emerging Markets Research

In the wake of growing stress in the banking sector, and the need for banks to have greater visibility of capital as they undergo the resolution process through the new bankruptcy law, the government announced a bold package to recapitalize public sector banks to the tune of Rs2.11 trillion (equivalent to about 1.3% of 2017-18 GDP) over the next two years (fiscal years 2017-18 and 2018-19).

The package has three components: two old and one new.

First, under the previous Indradhanush recapitalization plan, the government had committed to infusing Rs700 billion from the budget over four years. Of that, authorities have already infused capital worth Rs520 billion over the last two years. Therefore, they remain committed to infusing the remaining Rs180 billion over the next two years. That was always part of the plan, and therefore not a surprise.

Second, also under Indradhanush, banks were expected to raise Rs1.1 trillion from the market. Thus far, they have managed to raise about Rs212 billion. However, the government still forecasts/expects banks to raise about Rs580 billion from the market. Therefore, the first part of the package is Rs760 billion (Rs180 billion from the budget and Rs580 billion that markets would raise from the market over the next two years). All this, however, is not new and can be thought of as the residual resource mobilization under Indradhanush.

What is new, however, is that the government also committed today to issuing Rs1.35 trillion as "recapitalization bonds" over the current and next fiscal year, and using these bonds to recapitalize public sector banks. While the details and mechanics have not been made public, we would surmise that the process could look something like this:

A Government of India issued bond (and it is not clear that it has to be – it could be issued by another government-owned entity or special purpose vehicle) will be issued, and transferred as capital to a public-sector bank.
On the bank-balance sheet, the bond would constitute equity on the liability side, and an investment on the asset side.
There is likely to be no cash involved; so these bonds will not necessarily increase the net supply of bonds in the market; instead they will be transferred directly to banks.
They will increase public debt, depending on the issuing authority.
If issued by the government, it will count as part of the fiscal deficit under typical Indian accounting norms.
However, under IMF-accounting norms – asset sales and recapitalization bonds are below the line – and therefore will not change the fiscal deficit, under the IMF definition.
Furthermore, even if the printed fiscal deficit is higher on account of this issuance, the fiscal impulse will not change, because aggregate demand will not be directly impacted through the recapitalization bond.
All that said, this is likely to push up bond yields because demand-supply dynamics in the bond market are likely to be adversely impacted because of a portfolio-balancing effect on bank balance sheets. Specifically, even though the direct market supply of bonds is not expected to increase, the incremental propensity of public sector banks to buy new bonds will decrease, since they will have a these bonds sitting on their balance sheet. Therefore, incremental demand for bonds from banks is expected to fall and yields rise.
It is also possible that banks could on-sell these bonds directly increasing supply, although there could be restrictions on when banks are allowed to sell these bonds. We expect the bonds will be non-SLR in nature.
In subsequent years, however, the interest on these bonds will directly impact the fiscal deficit, although this is impact is likely to be very second-order. If the bonds are issued under current market interest rates, the annual liability would be about Rs9000 crore, or less than 0.1% of GDP.
All told, however, this is a much-needed and bold announcement. The improvement in capital adequacy from a front-loaded and meaningful commitment from the government should: (i) boost the resolution process under the bankruptcy law by increasing the willingness of public sector banks to accept realistic (and therefore potentially large) haircuts during the resolution process; (ii) increase the propensity of banks to lend, and therefore boost credit and GDP growth prospects; and (iii) generally boost confidence in the beleaguered banking sector, and allow banks to raise capital from markets.

That said, the devil will be in the details about the mechanics of how these bonds are issued, and any riders that come along with it. For example, pressure to lend to any one sector, in the aftermath of this recapitalization, could interfere with allocative efficiency and lead to a further build-up of vulnerabilities down the line. All told, however, we believe this is a very bold and positive development that boosts medium-term growth prospects.

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