There was a big announcement on October 25th about recapitalization of banks. Center announced a capital injection of Rs. 2.11 lakh crores. And with this news, I am motivated to write another blog on this describing why it is needed? Impacts of it, how it will work, etc..
So, let’s start with basic with a question,
What is capital injection?
Capital Injection is the supply of new money into the system (economy) or in a company or in an institution in the form of cash, equity or debt. This is generally done to make the financial condition of any sick company/companies better. Generally, capital injection is treated as the last option to make things better. It generally helps to unfreeze the credit instantly or fix the capital crunch problem. It may also have some bad impacts which are discussed later.
The last capital injection by a government into an economy, which I remember, is done by the US government in 2007-08 crises and they also treated this as very last option to unfreeze their credit system. Which now the US fed has started to unwind their balance sheet and reduce their debt.
Why Capital Injection in India? Are we in any crises?
The centre decided to do a bailout of Public Sector banks by injecting Rs. 2.11 lakh Crore or nearly 326 Billion USD, which is a huge amount, to treat the NPA problem of the Indian Banks.
Indian banks have nearly Rs. 8.29 lakh crores of NPAs and this is I think a severe threat to the Indian economy. Today, most banks are not able to lend further because of this huge NPA on their balance sheet. They are facing a problem of Capital Adequacy Ratio, which is defined as the percentage of bank’s capital to its risk-weighted assets like making a loan. According to Basel III, banks need to maintain the capital ratio of no less than 8%, but due to many defaults on the bank loans, the bank loses their capital and now the state came when banks are finding it difficult to maintain the minimum capital ratio and hence the credit seems to be frozen.
Let me tell you, in an economy, credit plays a very important role. Credit has an ability to create a modern economy and lack of credit can even destroy the economy. Credit helps shopkeepers to maintain their shelves, run their business and in many ways.
In India, we are facing a situation of lack of credit and the result of it can be seen in Indian GDP growth rate. From nearly 7-8% of growth we came down to 6-7% last year and then in the September quarter we grew by just 5.7%. Many say that demonetization and GST have pulled us down, but I think, it’s not only these two factors, we have a huge NPA problem as well which is pulling the growth down. And this needs to be dealt soon and in the best way possible. The government thinks Capital Injection is the best way to work.
I think, to handle a situation of dealing with a problem of NPAs, government and RBI should find some different way. As I first stated that capital injection should be the last option and this is mostly used at the time of crises. And I think we are not currently into a situation of “Crises”. So the answer to the question “Are we into Crises?” is “No, at least for now, we are not.”
How Government Plans to Do it?
To the best of my knowledge and understanding, the government has planned to buy Rs. 18000 Cr worth of shares through its budgetary allocation and then government issue bonds which might be called as ‘Banks Recapitalization Bonds’ for Rs 135000 Cr. which will further be used to buy more banks’ shares. So, in all government planned to inject 18000Cr. + 135000cr. that is 153000Cr. by itself.
The government bonds are yet not into a clear picture like how will they be issued, what will be the maturity? Or to whom they will be issued? Etc.. There is a belief that the bonds will be issued directly to the banks, so that banks can raise further capital from the market. Further capital is like 58000Cr Rs. which will sum up to total capital injection of 211000Cr Rs in the system.
What actually is done here?
This is actually a masterpiece idea of financial engineering. It is like, first, government give banks money and purchase their shares then Government Issue bonds which will certainly be bought by the banks. This means now banks give money to Government to buy more shares of banks. Banks will now have bonds of the government which can be used to issue new bonds in the market which has an underlying asset of government’s bonds.
Is it good to give Money to banks?
Well, we are giving money to someone whose sole job is to make money because it fails to make money. Perhaps, it doesn’t seem like a good idea but we are stuck in a jam. Indian banks seem frozen. So giving money to banks is like giving them a lifeline.
However, giving money to banks can only be fruitful if and only if, banks will book NPAs as their loss and clean out their balance sheet as soon as possible.
Banks have resisted themselves to clean their balance sheet till now because of the lack of capital they have. If they have booked losses earlier, they would have failed to maintain the minimum capital ratio requirement and therefore they have to call back their loans outstanding. Investors also would have lost trust in them and they would have also pulled their money out which further worsen their situation. But now as they are getting money from the government, they can book their losses and can clean up their balance sheet. It will not be any harm to the banks if they still resist or extend their loss booking as there is no such provision of it. However, the government can now force banks harder to book losses. So ultimately, it all depends on banks if the plan for government go successfully or not.
What Can Go Wrong?
I think, if banks do not book their loses and acted upon the capital injection which they were supposed to do, everything might go wrong. 2.11 lakh is not a small amount. It is a big capital injection and if this not used properly, it will result in hyperinflation problem.
I think, in India, there is always a huge demand for credit and if everyone starts getting it easily then it may cause a hyperinflation. We may say the greed of the bank may also increase and they go an extra mile to lend more. When the banks’ pockets are again full of money, they will lend it more and even to sub-prime customers and this may cause more default and increase in NPA.
What about the Bonds?
With the new capital injection of bonds, I seriously think that the yield of the fixed income securities will go up. With the capital injection, the short-term securities will be the first to react upon it and the yield on those will first increase. The long-term securities also will not remain unaffected. Even 10-year T-Bill of India will have its yield increased.
We will definitely be going to see some increase in inflation after the capital injection and which will increase the yield of every fixed income securities. We may soon find the RBI also increasing the rates to control the inflation. And now this could also lead to an end of low-interest rate cycle. There is also a potential threat to Indian fixed income securities as the yield of US T-Bill is also increasing. It reached near to 3%. This will further increase the yield of the Indian bonds.
What Problem the recapitalization bonds may cause?
The government bonds are issued to take a share into the banks. The government will have a certain percentage of ownership into the banks. When the government issues the bonds, it will certainly be bought by the banks and then the government will use that money to purchase shares of the banks. And with the help of the government bonds, banks will able to raise the further capital and issue more shares into the market.
Increase in the number of shares in the market will lead to lead to dilution in the EPS of the share. This means if you today have a share of a bank of EPS say 10Rs then after government’s purchase of the new shares it may come down to say 5Rs. So, the current holdings into the banks may get diluted with the increase in the share of government in the banks. The government is going to be an owner in the banks.
How Government describes this?
The government has a say in this as it will not be creating any problem and this is well planned financial structure. And hopefully, it should be well planned.
Previously, looking at the government’s figure about the disinvestments and all, the fiscal deficit target of 3.2% seems to be achievable. But with this new plan of government, I think this year, the fiscal deficit will going to increase. The government says it’s just shares in exchange for cash. The whole scene doesn’t look this. There are a lot of moving parts which have a lot of risks involved. The government has taken a huge risk by giving money to the banks. We may end up into hyperinflation, if not monitored properly. I think in near future the inflation is going to increase and fiscal deficit is going to widen up. This is an additional debt on the balance sheet of the government.
Well, I think that is pretty much about something which we can call “A mega-bailout”. I just recommend stay away from the long-term fixed income securities and expect inflation. Rates will be increased, yields will go up. So plan your investments accordingly as it may affect you as well.
Stay safe and keep learning.