India’s bad bank plan would be a $60 billion mistake

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New Delhi: With most of its state-run lending businesses resembling one giant bad bank, it’s puzzling why India keeps toying with the idea of setting up a new one.

The government’s annual assessment of the economy, released ahead of Wednesday’s budget, even invokes Sherlock Holmes to make a fresh case for an asset reconstruction company within the public sector:

Other schemes have not worked, years have flown by, and meanwhile the costs are continuing to mount. To paraphrase the learned economist Holmes, “Once you have eliminated the impossible, whatever remains, no matter how difficult, must be the solution.”

As for finding the money, the Economic Survey suggests, among other things, dipping into the coffers of the central bank. It even has a figure in mind: four trillion rupees, or roughly $60 billion.

It’s a realistic assessment. Fitch Ratings puts India’s recapitalization burden at $90 billion by 2019. Of this, the government has committed $10 billion in fiscal resources. If the central bank pitches in with $60 billion, private-sector investors could foot the remaining $20 billion to shore up listed banks’ capital plus fund the proposed Public Sector Asset Rehabilitation Agency (PARA).

India’s recapitalization burden: $90 billion

But how would the Reserve Bank of India find $60 billion without printing new notes or drawing them out of existing stock? Arvind Subramanian, the government’s chief economic adviser, has thought of everything. The RBI would shrink its inventory of government bonds—and simultaneously reduce its capital and reserves—by handing a part of those holdings back to New Delhi as a dividend.

That would allow room to issue new sovereign paper without piling on additional debt. Commercial lenders could sell their troubled assets to PARA and use the proceeds to purchase government bonds. The government could then use some of that money to capitalize the bad bank, and inject the rest into commercial lenders as equity, making them whole after the haircuts they’d take selling loans to PARA.

It’s a clever plan, though maybe too much so. A free pass for state banks isn’t just a signal to them to resume reckless lending. More dangerously, it removes all pressure on New Delhi to restrict itself to owning perhaps just State Bank of India, the largest lender by assets, and privatizing the rest.

And while shrinking the RBI’s size may not have any immediate negative impact, it could still damage the institution’s credibility. Following the government’s ill-conceived and poorly executed demonetisation move, there are serious questions around RBI’s independence. Whittling it down would n’t sit well with investors.

The bulk of India’s stressed debt problem is restricted to 57 corporate accounts, which require haircuts of 75% or more. It’s hard to see how a government that managed to repudiate 86% of sovereign money in one fell swoop can’t find the courage to tackle a much smaller problem.

Aligning the incentives between banks (which don’t want to book losses) and privately owned asset reconstruction companies (which won’t buy the loans otherwise) is still the best course of action. Issuing a special government bond to plug the capital hole is the most honest way of financing a resolution.

Creating a bad bank is unnecessary, and raiding the RBI’s treasure chest to do it could turn out to be a $60 billion mistake