When the Modi government came into power in May 2014, it found itself inheriting a host of legacy issues resulting from the after-effects of global recession and UPA II’s financial misadventures. There was a deep macroeconomic instability brought about by the high fiscal and current account deficits, raging inflation, tapering of GDP growth rates and the unravelling of the infrastructure sector. The state electricity discoms were in financial turmoil and power companies were not able to access the abundant coal reserves due to insufficient coal linkages. The banking sector was also battling a systemic problem of highly stressed assets.
Now, as 2016 begins, the macroeconomic indicators have seen a turn for the better. Inflation, the current account deficit and fiscal deficit have been brought under control. The fiscal deficit which stood at 5.8% in FY12 was brought down to a more manageable 4% in FY15. GDP is also growing steadily on the back of higher infrastructure spending by the government and improving urban consumption.
While there has been a significant improvement in macroeconomic stability, the economy is still not out of the woods completely.
The legacy issues are still festering and need to be removed surgically for the economy to be on a stronger footing. The non-performing assets (NPA) crisis is only getting worse for banks as time is progressing. According to the Financial Stability Report issued by RBI in December, the stressed assets of Public Sector Banks (PSBs) stood at 14.1% for September 2015. This number is extremely worrying and needs to be looked into immediately. The government estimates that around Rs. 1,80,000 crore is required over the course of the next three years to clean up the public banking system. Out of this, the government has set aside Rs. 70,000 crore as recapitalisation amount through its Indradhanush program and expects the PSBs to mop up the remaining amount from domestic and foreign investors by tapping the equity markets.
The recapitalisation of banks is a welcome step but the amount that has been aside is not enough to root out the problem completely.
Expecting investors to perform the heavy lifting required to bail out the banks is leaving too much to chance. The government will have to step up its efforts and allocate more resources to recapitalisation as it is extremely crucial for reinvigorating the economy. This allocation has to be frontloaded as soon as possible to avoid further festering of the NPA crisis. For instance, an extra Rs. 40,000 crore over and above the Indradhanush allocation can be provided in the upcoming budget for FY 17 itself. In this case, outside investors will be more than happy to pitch in with the rest of amount as this move would significantly improve the viability of PSBs. As long as the banks are in distress, it would be difficult for investors to lend support to banks other than marquee ones like State Bank of India and Bank of Baroda.
It can be argued that increasing allocation towards recapitalisation will create further pressure on fiscal deficit targets. But unless the banking sector is unshackled from the burden of its bad loans, it will not be able to contribute as much to growth in GDP. The mid-year economic review states that private investments and exports are lagging behind in driving the economic growth engine. Not much can be done about exports as it is a function of global demand but private investments can be kickstarted if banks have an increased capacity to lend to the corporate sector. An increase in private investments will be able to more than offset the pressures created on the fiscal side as it will provide a boost to GDP growth.
Piecemeal approach won’t help
A slow and steady approach towards cleaning up the banking mess will prove to be counter-productive in the long run even on the fiscal front. If private investments are stalled, the lion’s share of the responsibility of infrastructure building will fall on the shoulders of the government. This will entail further borrowing, which will not help the cause of fiscal consolidation. On the other hand, if growth in credit off-take restarts, then private investments will share the burden of investing in infrastructure sectors like power, roads, ports and non-renewable energy sources. Right now, since the hands of the domestic corporate sector are tied, the government is relying heavily on FDI to fill the gaps in infrastructure funding. But a more holistic and sustainable approach would be to involve private investments to also contribute towards financially viable infrastructure projects.
The funding tap for these projects has been left dry for too long. Hence it becomes all the more essential for banks to start with a clean slate. Bailouts are never a pleasant outcome. But once it becomes necessary, it needs to be undertaken quickly and unflinchingly. If the problem is left untreated for too long it spreads rapidly across the system, like an untreated cancer.
The high NPAs are a grave cause for concern and there is good reason to believe that even the current level of high NPAs may be understated. The kitchen sink cleaning efforts by Bank of Baroda in the previous quarter is a case in point. In such a scenario, banks will be in no mood to lend extensively due to the scarcity of capital. Only a comprehensive bailout package will enable the banks to rekindle the lending spirit.
The electorate provided a decisive mandate to the Modi government in May 2014. The prime minister can ill afford to fritter away this mandate on dealing with legacy issues throughout his five year term. It is time to do away with band aid efforts which may linger for years and instead clinically remove the infestation that is plaguing the banking sector. This is especially important given that the ‘Make in India’ initiative and infrastructure development holds such a prominent place in the NDA’s economic policy.
Limited access to capital will definitely stifle these initiatives. Structural reforms should also be reinforced in the banking sector to ensure that such bailout efforts do not take place in the future. But for now, it is imperative that there be a comprehensive cleanup of stressed banking assets at the earliest.
Smiran Bhandari is the Co-Founder and Managing Partner of Moneyville Financials, a boutique investment banking firm. He tweets at @smiranb