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The economic recovery part 2 — what the Indian economy needs is a reverse Indira Gandhi policy

Guest post by Akshay Alladi

To catalyse the investment cycle, the government needs to privatise banks, rather than use public funds to recapitalise them with no change in management and ownership

The principal problem holding back  Indian economic growth now is the “twin balance sheet” problem described in the Economic Survey, whereby the investment cycle has been stymied since public sector banks are unable to lend due to high NPAs, and large conglomerates are unable to borrow due to high debt on their books.

To solve this policy interventions are required on two fronts- with large conglomerates, and with the public sector banks.

In Part 1- What the Indian economy needs is to help more companies fail!, I described the potential solutions with large conglomerates. We turn our attention now to the policy interventions required with public sector banks.

The NPAs and stressed assets in public sector banks is at over 12% of total assets. With high NPAs, and stressed assets, the banks are constrained from lending; and without such lending large companies will be unable to borrow to invest- leading to lower GDP growth. In fact the public sector banks are in such bad shape that the market cap of 20 public sector banks put together is nearly matched by HDFC Bank alone- despite those banks having 70% of the assets of the entire banking industry!

The simplistic solution would be for the Government to bailout the banks- essentially by infusing equity into them. Then the banks will not be capital constrained any more and can lend. Variations of this include hiving off the stressed assets into a “bad bank” that is passed on to an asset reconstruction company, so that the PSBs do not have them on their books any more and can then start lending.

Two challenges with this approach are i) The stress it would place on the Government’s own finances- and the opportunity cost of the use of such funds and ii) The moral hazard it creates which would exacerbate the problem in the future.

Firstly on the Government’s own finances: By the FRBM Act,  the Government needs to reduce the fiscal deficit to 3.5% of GDP by 2017. It would be unwise to deviate from this path as that would reduce credibility, leading to increasing costs in the bond markets. Also, it is highly unlikely to work anyway- what India suffers from now is not lack of domestic demand (in fact consumer demand has been quite healthy), but inability of the supply side to work due to balance sheet problems; a credible argument for Government spending to drive fiscal stimulus could have been made if the issue is low consumer spending due to stressed consumer balance sheets (like it was in the USA after the financial crisis), but that is not the situation that obtains in India today.

In fact an increase in Government spending or in the use of funds for recapitalisation leading to stress on Government finances at this stage could not just be ineffective, but actually counterproductive. With an aggressive inflation targeting central bank like the RBI under Raghuram Rajan, any deviation from the fiscal path that would increase inflation risks would be counteracted by the RBI by a tighter monetary policy with high interest rates. High interest rates would exacerbate the balance sheet problems of the corporations (since firms would have a higher interest burden and even less money to invest) and hence would further slow down the economic recovery. As the economist Ila Patnaik argues, India needs a “tight fiscal, loose monetary” regime. Deviating from the fiscal deficit target to fund the banks is a move towards the exact opposite policy- “loose fiscal, and tight monetary”

The scale of the requirement for recapitalisation is also huge- the government has already committed Rs. 70,000 crore for recapitalisation, but several agencies, such as Moody’s, believe that the amount required would be much higher- upto Rs. 1.45 lakh crores (and could be even higher given that the total impaired assets are closer to Rs. 7 lakh crores). While some of this can be raised by the RBI itself helping bank recapitalisation, there will still be a huge gap to fill.

While evaluating whether recapitalisation led by the government reasonable we should look also at opportunity costs. Money spent on large scale bank recapitalisation is money that is diverted away from other core functions of the government. In fact the Economic Survey itself points out that the highest Return on Investment (RoI) that the government can get from any spending is on maternal and early life health and nutrition. Even at its current stage of economic development, India underperforms on key indicators of maternal and early child health. Hence from a both moral and practical standpoint it would make sense to over-index on government spending in these areas, rather than on bank recapitalisation.

The moral hazard issue is the other to consider. This bank recapitalisation is yet another in a series undertaken periodically- a virtual bailout now will probably lead to the same behavior repeating, and a need for further recapitalisation in a  few years. Merely recapitalising banks is a Band-Aid solution, that doesn’t address the underlying issue- which is that the political economy of public sector banks is fundamentally flawed. Over 90% of the loans written off over the last 5 years have been of large corporates– and this is no coincidence. Public sector banks are prone to interference from political forces, which in turn could also lead to capture by large, well connected corporations. While the “Indradhanush” reforms, and Bank Board Bureau are welcome reforms, they are still far from addressing the root and branch reform of the way PSBs are governed and managed.

The only way out is a large scale privatisation of banks- essentially a full reversal of the nationalisation undertaken by Indira Gandhi. That would not only infuse equity capital into the banks and help them cleanup their balance sheets without the government ploughing in more money, but it would also address the root cause- and cause a change in the management and governance of PSBs which would help their long term health. Japanese banks, in particular, may be attractive candidates to court as they are awash with funds and large balance sheets with low yield ,and search for high growth opportunities which the Indian market offers.

The Chinese character for “crisis” is composed of two parts- danger and opportunity. The boldness of the Government in reversing the course set by Indira Gandhi will determine which of those two paths the current crisis leads us to.


Akshay Alladi is a participant of the 13th cohort of GCPP, the flagship course in public policy of Takshashila Institution.

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