Recap bonds: The grand design-a solution, at last

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Published: October 24, 2017 6:46:27 PM

The idea of issuance of recapitalization bonds is alluring as it handles the problem of bank capital quite well with no risk attached.

bonds, bond recapping, bond recapitalisation, recapitalisation of bondsTypically in such a situation the government would issue bonds to the extent of Rs 1.35 lakh crore which will be subscribed to by banks with their surplus funds.

The idea of issuance of recapitalization bonds is alluring as it handles the problem of bank capital quite well with no risk attached. Typically in such a situation the government would issue bonds to the extent of Rs 1.35 lakh crore which will be subscribed to by banks with their surplus funds. Presently, they are investing in excess SLR securities to earn money on the excess deposits that have been kept with them post demonetization. Hence, it looks like a win-win situation.

It is a good solution that was used earlier too to recapitalize banks in the nineties when there was a pressing need to make them commercially viable in terms of enhancing their lending power when capital was scarce. Presently with high NPAs and provisioning, it is hard for them to raise funds on their own as the market would not give a good price given their situation. Also as the government is on it toes when it comes to direct budget allocation beyond what has been provided for, this route is a better option.

How does this work? The government raises these bonds which are then used to capitalize banks where the funds actually come from their own kitty. The bonds issued will add to the debt of the government which has to be serviced. And if the rates are determined by the market forces in a transparent manner, then automatically the cost will be about equal to that on GSecs of similar duration and hence banks would receive the same amount as before on SLR securities.

Will it add to the fiscal deficit? Yes, it has to add to the deficit because at the end of the day when bonds are issued it has to be borrowing on someone’s books. Therefore, the overall debt of the government would go up ti the extent of these issuances. To draw an analogy with the UDAY scheme where state governments took on the debt of DISCOMs, the 3% rule was allowed to be skipped for 2 years, which can be done here too. This is globally acceptable as it is not really fresh debt being issued which adds to the demand spiral which is normally the concern of very high fiscal deficits.

Also as this capital is coming from the government through these bonds, there is zero risk as the Government of India is always solvent. Hence, there is no catch in terms of accounting. But an interest cost has to be paid on these bonds which mean that at say 7% rate, an additional interest cost of around Rs 9500 cr will be added to the revenue expenditure and hence becomes a running cost until such time these bonds are extinguished or converted into equity at a later date, which is also an option for the government.

This approach appears to be fairly pragmatic for the government given that banks require money to be in position to lend in future and the PSBs, which account for around 70-75% of credit, in particular are constrained due to pressure on capital going ahead. Presently as demand for funds is low, there is no apparent problem as banks clean up their balance sheets by accelerated recognition of NPAs and making provisions thereof. However, once demand picks up when the economy actually moves into the high 8% GDP growth orbit, which is expected din the coming years, then there would be a capital cliff for PSBs which has to be addressed now. The conventional modes of finance are not feasible today. Why?

If the government has to infuse directly, then it will mean flouting the 3.2% mark fiscal deficit mark which is being held sacrosanct today (which it will also do through these backdoor recap bonds which are being floated). This will not be acceptable, but the route of recap bonds is palatable as it comes in a different form.

Alternatively selling stake is an option, but while it has been included to be a part of the balance Rs 0.76 lkh crore to be raised by these banks, valuation is always a challenge. With high levels of losses, the market cap of these banks is presently low and will be so until they turnaround thus making it circular in nature. Hence selling at this stage may not yield the best results and can ignite controversy at a later date. Therefore, thinking obliquely is required today and the recap bonds could be the answer.

What are the next steps? The government will have to decide the exact mode of issuance and how this will be spread over the years. This cannot be a onetime exercise and has to be spread over 1-2 years depending on how the PSBs shape up. Also it has to cherry pick the banks that should be capitalized through this route; and ideally it has to be those which are the weakest and are not in a position to command a good market value. Also such funding should be conditional for banks just like the UDAY Scheme with safeguards built in to ensure that the banks keep their side of the deal or else the scheme can go awry. It looks certain that the clinical way in which the government has approached the issue of bank capitalization that these tenets will not just be drawn up but also followed rigorously to get value from the process.

(The author is Chief Economist at CARE Ratings. Views are personal)

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