Though the State Bank of India (SBI) is a trusted institution in India, it has had a rating of only C- from Moody?s for some time. This was further reduced to D+ in early October this year. Subsequently, the Government of India (GOI) announced that it would recapitalise SBI. This was welcome news, given the policy of not diluting the government?s stake. However, on October 14 , there was another piece of news. Though the government wanted to sell bonds to the tune of R13,000 crore, there were no takers for R4,037 crore of bonds! This is actually not surprising considering that the S&P rating of GOI itself is only BBB-. So, not only is there a weakness in SBI (and other banks), there is also a weakness in the rescue team i.e. GOI. There is an element of fragility here.

In recent years, SBI has expanded rapidly. However, its capital base has not kept pace. So, the institution?s leverage is high. Let us remember that one problem that many financial institutions in the US faced in the recent financial crisis was precisely this. They had high leverage and actually got into difficulties. So there is an important concern that needs to be

addressed here. There is a need to increase the capital. Moreover, there are signs of rising non-performing assets (NPAs). This adds to the difficulty and the need for more capital.

Consider next the fiscal condition of the GOI. It is true that if we use measures such as the debt-to-GDP ratio, then the situation is not particularly bad in India as compared to that in several other countries. However, if we use other measures, like the debt-to-taxes ratio, as authors like Reinhart and Rogoff have in their well-known book (This Time is Different?Eight Centuries of Financial Folly, 2009), then the situation in India is not comfortable. The ratio of debt to taxes in India is high and is comparable to that in European countries in difficulty. There are good reasons to use the alternative measure i.e. debt to tax ratio. Briefly, in the context of the capacity of the government to repay or service its debt, what is important is the amount of income that the government has, rather than the income that the nation as a whole has. So, it is important to consider the ratio of debt to taxes instead of the more popular ratio of debt to GDP. The debt-to-tax ratio was more than 3 for both India and Greece last year! We know how Greece has got into serious difficulties. So, there is a need to take care in India too.

It is true that the growth story in India makes our situation quite different from that in Greece. However, there are also macroeconomic vulnerabilities and rising needs for

social expenditures in emerging economies. It always helps to supplement growth with an improvement in the tax-to-GDP ratio. This is, in any case, required given our objective of growth with a human face.

It may be argued that the real yield on GOI bonds is still very low (actually negative), given the nominal yield at 8.79% (October 14, 2011) and inflation rate of about 9%. This seems to put India on very different grounds as compared to PIGS (Portugal, Italy, Greece and Spain) where the real yields on government bonds are much higher than those in India. However, the yield on GOI bonds is not truly market determined. The GOI has imposed a statutory liquidity ratio (SLR) of 24% on banks. So there is a captive market for GOI bonds. Also note that there are de-jure and de-facto restrictions on banks in India from holding bonds issued by AAA countries like Germany, Canada, and so on. So, again there is a captive market for bonds issued by the GOI.

It is true that at present the banks? holding of approved securities is much more than 24% (it is estimated by some at about 29%). So there, it seems, is nothing to worry about since the banks are voluntarily holding excess government bonds. However, there is an interesting tale here, too. Due to the reluctance to lend on the part of the banks and also the reluctance to borrow by the business sector in the recent past for various reasons, we have, at present, a temporary phase of excess ?voluntary? holding of GOI bonds by banks. However, as and when investment picks up further, the holding of excess government bonds could fall in no time. We have an illusion of safety here.

The SLR regulation is supposed to help banks with liquidity management. However, the main role is different in India. It enables the government to finance deficits. (We may ask how banks in other countries manage liquidity without an SLR regulation.)

The low rating of GOI bonds has an interesting implication for the balance sheet of SBI and other banks.

A quarter (or more) of the banks? deposits are invested in bonds of low rating, given the SLR requirement. This implies that the banks hold a risky portfolio of assets, given the possibility of default by the government (why else would the rating of GOI bonds be low?). This further adds to the need for more capital with banks.

It is true that the government and RBI can always print more money to repay the public debt and avoid a default on government bonds. Accordingly, we, it may be argued, need not fear a financial crisis. However, printing of excess money can be inflationary. There is little tolerance for very high inflation in India. So it is not clear that this route will definitely be available if it is required (Anna Hazare may go on a fast again!). It is also not obvious whether largely unanticipated (high or double digit) inflation crisis is superior to financial crisis.

Public sector banks? balance sheets are interesting. On the one side, they have capital infusion by the government. On the other, they hold government bonds. There is government on both sides of the balance sheet. In a sense, the government invests in bank capital by borrowing from these very banks (after all, they are themselves running deficits). This is different from the bank capital raised in the market. In this case, there is an actual inflow of funds into the banks from outside. This capital can be more meaningful capital than that financed by borrowing from banks themselves.

We have an interesting situation here. People have confidence in banks because they have faith that these are government-backed in one way or another (public ownership and management, considerable regulation, and government deposit insurance). So we have government-backed banks, which may be all right but the government itself is backed by the banks! It relies on banks to finance its own deficits.

It has helped so far that there is considerable (misplaced) confidence. However, if something shakes up this confidence, then there can be difficulty. Can all this actually happen? This is a difficult question to answer. Misplaced confidence can last a long time. On the other hand, anything small can trigger a panic even when fundamentals are in good shape. So, it is better to straighten things out. How? The banks? capital needs to be meaningfully increased and the SLR needs to be brought down to improve credit for business. For this, the government needs to reduce its debt relative to its taxes, and move towards financing whatever deficits it has in the open market. There are no easy solutions.

The author is visiting faculty,

Indian Statistical Institute, Delhi