After three years of hand-wringing, India has finally done the right thing by its struggling banks.
The 2.1 trillion rupees ($32 billion) capital infusion into state-run lenders announced by Finance Minister Arun Jaitley on Tuesday evening has been well received by rating companies, despite its unconventional structure.
As much as 1.35 trillion rupees will come from banks' own resources. The government will issue recapitalization bonds that will be bought by the lenders. Since about 1 trillion rupees out of the 5 trillion rupees of surplus cash that rushed into the banking system after last November's surprise currency ban is yet to leave, institutions should have little trouble paying.
Once the government has the subscriptions, it will plow back the funds into State Bank of India, Punjab National Bank and a score of other lenders as equity. Since this won't be enough to get the capital-starved banking system ready to meet Basel III requirements, not to mention the provisions they still need to make against a badly bruised portfolio of corporate loans, New Delhi will add a maximum 760 billion rupees over two years from its own budget.
That works out to less than $6 billion in annual fiscal slippage, plus the interest that the government will need to pay banks on the recap bonds. If that's all it takes to revive credit growth languishing at a 25-year low, then it's a bargain. Rating companies, which rank the sovereign one level above junk, are unlikely to punish New Delhi for this measured risk-taking, especially if the bond market shows few signs of stress. The yield on the 10-year government note has been climbing for the last three months, but at 6.8 percent it's way below the 9 percent-plus levels seen during the 2013 taper tantrums.
Foreigners have poured $22 billion into Indian fixed-income markets this year. The possibility of a bond-vigilante attack will only arise if U.S. interest rates or India's slumbering inflation suddenly spike. There's little immediate risk of either. Indeed, for a major economy to sleepwalk into a U.S. tightening cycle with a broken banking system and subpar investor and consumer sentiment would have been a bigger risk.
That begs the question: Were broken bank balance sheets in India really holding back supply of fresh credit, or is lackluster loan demand the real culprit? Now that the former is getting decisively fixed, the answer will become clear.
Just in case the problem is with demand rather than supply, Jaitley also announced a 7 trillion rupee road-building program. It's a five-year plan from a government that has less than two years left in power. So discount it accordingly.
However, pay attention to export data. The one handicap India faced in reviving new corporate investment was poor global demand. That constraint appears to be lifting. So if New Delhi now provides some simple fixes for the goods and services tax, things could turn around. The poorly implemented GST is burying small businesses in multiple rates, confusing paperwork and higher working capital requirements, and has even led Toyota to halt production of Camry hybrids.
Priming the banks to spur credit growth, now that the aftershocks of the harebrained cash ban are also likely to recede, could offer fresh legs to an equity market where lofty valuations are wobbling atop anemic earnings growth.
Markets are delighted that the dithering is finally over. Punjab National Bank shares jumped almost 42 percent on Wednesday, while State Bank of India surged by 27 percent. Investors would be even more thrilled if, after fitting banks up with fresh capital, the government also withdrew from running them, leaving fintech players and the many new private-sector lenders to take care of financial inclusion.
Hopefully, it won't take another $200 billion bad-loan shock for New Delhi to reach that obvious conclusion.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
(Adds data on government bond yields in the fifth paragraph, and stock moves in the second-last paragraph.)
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