Bank reform: In India, here’s why recapitalisation can’t be put off

By: | Published: October 7, 2016 6:12 AM

Even in India, bank recapitalisation can’t be put off

The easy money policies of the Fed and other central banks have helped stave off what could have been the next Great Depression in 2008 but, as the IMF points out while adding its voice to the list of those opposed to these policies continuing, there are serious medium-term crises that are building up as a result—and fixing these will require a lot more action, including deep structural reforms. The IMF’s latest Fiscal Monitor points out, the global gross debt of the non-financial sector has more than doubled since the turn of the century, to 225% of GDP, and around two-thirds of this is that of the private sector. The lower global growth, it points out, hampers deleveraging and the debt exacerbates the slowdown—a vicious feedback loop by any standard. Every percentage point hike in the private-credit-to-GDP above the average, the IMF says, raises the probability of a financial crisis by 0.4%—it adds that GDP falls considerably more in financial than in normal recessions and that the pace of recovery is more protracted, especially in emerging market economies. The problem spreads to the banking sector since, with corporate leverage very high—in emerging markets, over a tenth of corporate debt is with firms whose earnings are below interest expenses—this can wipe out a lot of banking capital.

While China comes to mind immediately with its runaway loan build-up, the IMF points to the serious banking crisis in Europe—Euro area institutions are earning less than half their 2004-06 average profits —and points to the fact that a cyclical recovery is not going to be enough to be able to restore bank profitability; low interest rates globally have led to a situation where the average funding gap for US and UK pension funds is as high as 30%. Fixing this will require structural reforms—closing up to a third of European bank branches, for instance, is one solution talked of to boost return on capital. In the Euro area, IMF analysis suggests that the most recent sharp dive in bank equity prices could curb lending until early 2018—a 20% one-off fall in equity prices results in credit being 4% lower three years after the shock.

While India doesn’t have a China-like problem of a sharp growth in excess credit, there has been a rapid deterioration in corporate financials—a fifth of corporate debt, the IMF report points out, has an interest cover of less than 1—and relatively poor deleveraging. Since this has implications in terms of wiping out large amounts of banking capital—and that has larger implications in terms of how fast bank lending can take place—it is critical that the issue of bank recapitalisation be addressed by the government at the earliest. Right now with the government strapped for cash—the talk of an externally-funded bad bank hasn’t resulted in much so far and there is no resolution on using RBI equity either—the recapitalisation is woefully inadequate. But unless banks are able to lend, economic growth cannot possibly sustain, much less pick up pace. That means, perhaps as early as the next budget, the government will have to take a call on whether to spend its money on raising infrastructure investment in roads and railways or on recapitalising banks—the latter means sacrificing short-term growth but is critical for even medium-term growth.

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