Did Narendra Modi govt err over public capex?

By: | Published: September 29, 2016 6:26 AM

RBI’s recent efforts to stimulate the corporate bond market by pushing large, risky borrowers out of the banking system are steps for the future only; they cannot help banks in the immediate present.

Private investment in India has been mostly bank-financed, where public banks added nearly 70% to outstanding loans. (Reuters)Private investment in India has been mostly bank-financed, where public banks added nearly 70% to outstanding loans. (Reuters)

Amidst a fast-paced economic recovery, there is one matter bothering all: weak private investment. After assuming office in May 2014, the NDA government seemed to have accepted several important suggestions highlighted by RBI, different multilateral institutions and vocal market experts. It quickly got its act together to remove policy paralysis and cleared many stuck projects, the UPA government’s albatross; willingly adopted a new monetary policy framework; pretty much stuck to fiscal consolidation for low, stable inflationary conditions; implemented several structural reform measures, including opening many sectors to FDI; and above all, allocated an important share of budgetary resources gained from the oil bonanza, a generous RBI dividend and spectrum auction revenues to scale up public capex for crowding-in private investment. Yet, after nearly 28 months in office, there are no visible signs of private investment taking-off!

Where does the problem lie? There is an undertone from the banking sector, in particular the public sector banks (PSBs). Private investment in India has been mostly bank-financed, where public banks added nearly 70% to outstanding loans. The continuously weak credit growth for the past several quarters was sending unambiguous signals that this bank-group was in deep trouble and needed urgent support. Strangely though, both RBI and government remained in partial denial, until matters turned from bad to worse.

RBI, as the supervisor of the banking system, had the responsibility of timely recognition of NPAs and their effective resolution. However, its responses have swung from one extreme—large-hearted forbearance in letting banks restructure troubled assets for longer time periods—to another, viz. forcing the PSBs to recognise all bad assets within a short span of time but without adequate wherewithal to resolve these. This equally reflects how badly RBI misread the underlying economic conditions. Its evolving NPA resolution frameworks, from CDR to SDR to S4A, have but had marginal impact for PSBs especially remain stuck with the larger mass of troubled assets without knowing how to move forward.

The responses of the government, owner of these banks, have not been any different either. Its initial views were that PSBs were not capital starved, while the credit growth slowdown was purely due to poor loan demand. Citing budgetary constraints, the finance minister announced infusion of Rs. 700 billion ($10.5 billion) as fresh capital over four years. Banks were also asked to raise further capital from the market as credit demand revived, tempting some analysts to interpret this as a signal for privatising a few capital-starved PSBs ahead. Subsequent public positions of the prime minister and the finance minister—that the political environment is not yet ready for privatisation of public sector banks—has poured cold water on any such optimism however. And efforts to improve operational efficiency through reforms under Indradhanush have remained mere promises so far.

Where does this lead to? RBI itself now attributes the insipidity of credit growth to the NPA stress, but its own strategy of fast-paced recognition that was presented as a planned, step-by-step approach, now seems to have had no next stage. Its recent efforts to stimulate the corporate bond market by pushing large, risky borrowers out of the banking system are steps for the future only; they cannot help banks in the immediate present. The finance minister’s recent statement that NPA recoveries and hence, resolutions, are not progressing as expected and the government is not in a position to strengthen the banks’ financial health aptly reflect the current impasse. It appears as if both institutions are waiting in exasperation for a fast-paced economic recovery to assuage the situation!

What are the ways out? Once privatisation is ruled out, the government is left with few choices. Press reports in recent past indicated the government was examining the option of creating a bad bank to shift most bad assets there and enable PSBs to restart with clean balance sheets. But the idea is apparently dropped, although reasons for this are not known.

This leaves only one feasible option in support of aggressive capital infusion. This begs the question as to why the government has been reluctant to recapitalise PSBs so far. This admittedly, as mentioned above, is the “budget constraint”, given the premium it placed upon fiscal consolidation. The government’s thinking of using cash from RBI’s balance sheet to recapitalise PSBs has remained a non-starter so far.

Could the government have created more room for capital infusion? It certainly had policy choice while allocating budgetary resources from the fiscal space created by huge tax revenue gains from the oil-price bonanza, RBI’s generous dividend, nontax revenue from successful spectrum auctions and more importantly, a 50bps fiscal pause. But it chose to focus on capital expenditure; rightly so, for the consensus was that a higher multiplier could potentially crowd-in private investment. Planned capital spending therefore increased 35.4% in FY16, while non-plan capital expenditure (excluding defence) rose 45%, a year in which gross NPAs rose to 7.6% from 4.6% the year before. This suggests a weaker link between public capex and private investment.

Why has the fiscal multiplier failed to kick-in so far? Was its impact overestimated, i.e. that public capex multiplier is significantly larger than that of revenue expenditure in a fiscal consolidation framework? It is possible that benefits could flow in with a lag, but what is worrying is that even this window is narrowing as the pressure upon revenue expenditure mounts from the pay commission award and DBT-linked savings are not visible at a significant scale as yet.

The PSBs meanwhile, remain checkmated, hoping a consumption-led economic recovery will revive private activity, just as the government and RBI have been betting at. RBI’s recent options to let banks raise capital from international markets seems an attractive avenue. But it’s hard to be sure of investors’ responses considering the large stock of bad assets and uncertainties around their resolutions, which naturally pushes up risk premiums. The resulting, higher cost of funds could hinder monetary policy transmission in that case.

In hind sight, it is compelling to look back at an alternative policy scenario—one where the government had chosen to recapitalise banks aggressively, going slow on public capex at the same time. The worry is if the slow pace of public sector bank recapitalisation may block private investment and growth, potentially turning into this government’s albatross. Only time will tell!

The author is a New Delhi based macroeconomist

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