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Quantum View: Bank Recapitalization - Outside View by Arvind Chari

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Quantum View: Bank Recapitalization
Oct 25, 2017

The Government finally announced a seemingly large Bank Recapitalization programme. Over the next 18 months (2H FY18 and FY19), Public Sector Banks (PSBs) are expected to get INR 2.1 trillion of Equity infusion through various sources and means as detailed below. This is large in terms of size approx. (1.3% of GDP) and should ease concerns on PSBs capital standing.

  1. Indradhanush (Govt.): As part of the existing Indradhanush scheme, the government was to infuse INR 700 bln over 4 years. They have already added INR 520 bln in 3 years and hence will add INR 180 bln in this fiscal year. (this is already part and provided for in this year's budget)
  2. Indradhanush (Banks): Bank were to raise INR 1.1 trillion over 5 years. The government (as part of what was announced yesterday) expects them to raise INR 580 bln of that in the next 18 months. This was already planned and hence not new. The moot question is whether banks will be able to raise that much in a short span and also how much leeway they have as the government's stake cannot fall below 52%.
  3. Recapitalization Bonds (Govt): In an addition to the existing, the government announced a new 'front-loaded' issue of INR 1.35 trillion of Bank Recapitalization Bonds. Details are sketchy including on whether the government will issue the bonds or some other quasi-sovereign entity. We are assuming it will be GOI Bond issued to the banks in a cash-neutral transaction in lieu of Equity. This has been done before in the prior exercise of bank recapitalization bonds issued in the 1990's.
    1. Nature of Re-Cap Bond: The government will issue bonds worth INR 1.35 tn to PSBs against Equity Shares. This then becomes a Cash-Neutral transaction (instead of a direct Cash infusion). The Banks Equity Share capital increases, the government's holding goes up to that extent and banks get bonds as part of the investment portfolio as its assets.
      1. The government can also float a bank holding company, transfer all its shares in PSBs to this corporate entity, infuse some capital into this entity (INR 200 bln). This entity then borrows in the market (upto 10x leverage) against its equity as a AAA Quasi-Sovereign entity and uses the money to recapitalize the banks. This will require large legislative amendments and I don't think the government has so much time in hand.
    2. Fiscal Implication: Technically, since upfront it's a cash neutral transaction, the fiscal deficit will be impacted only by the interest cost on the bonds that the government pays every year. Assuming at 7% coupon, the annual interest cost will be around INR 9.5 bln. Government's overall Debt/ GDP ratio though will increase to the extent of the bond issued and so will its repayment obligations. We expect the bonds to be longer dated staggered over 10 /15 years maturity and hence refinancing risks would be lower.
      1. Rating Agencies should see this as credit positive for banks but credit negative for the government as the DEBT/ GDP rises which is already very high for India as against similar BBB- rated countries. Rating upgrade chances would be pushed back but there will be some positive aspect as the financial stability of the banking system gets better.
      2. Most analysts will show the 'reported' fiscal deficit and then add these bonds outstanding as fiscal deficit including re-cap bonds.
    3. What will banks do with the Recap bonds: As and when the banks require liquidity, they may be able to sell these bonds in the market, raise cash and use it for either lending or write-off purposes. In the current scenario of excess liquidity and low credit off-take, the banks would likely hold these bonds on their balance sheet as part of the investment portfolio and earn interest on the same.
    4. RBI's viewpoint: The Reserve Bank of India should be relieved on the plan as it increases bank equity capital to absorb the losses and to eventually increase lending. Also, the increase in fiscal deficit will not be inflationary, so it might support this plan of recapitalization. But it has to make few key decisions which will impact the marketability of these bonds and its actual usage
      1. SLR status: RBI will have to decide whether these bonds qualify as Banks Statutory Liquidity Ratio(SLR). If it does, it will have a significant impact on the demand for normal Government bonds and State Development loans which qualify as SLR that the government's issue to fund their fiscal deficit. Banks have to park 19.5% of their Net Deposits in SLR bonds (Government and State government bonds).
      2. Marketability: We assume that the Government will put some restriction on the marketability of these bonds. Banks won't be allowed sell all these bonds into the bond market at a point in time. The off-loading will be staggered. It that is the case, then the banks would need HTM dispensation for these bonds. Hold to Maturity (HTM) bonds do not need to be marked-to-market for valuation purposes. Bank can then hold these bonds in the books without worrying about market risks. RBI would though need to raise the HTM Limit, which actually they have been cutting in the last 4 years.
      3. Recognition: Whether the RBI nudges the banks to write down its bad assets against the increase in share capital in order to further clean up the balance sheet
    5. Bond Market Impact: It depends on the above points, the SLR Status, the marketability and the HTM issue. No SLR status, HTM limit dispensation and limited marketability is the most ideal situation for the bond market as it will reduce bond supply in the market while keeping the demand for SLR bonds intact. Also since it does not directly impact the fiscal situation (apart from the interest cost) and hence it is not all that bad for the bond markets. But given that potentially there would be extra bonds in the investment portfolio of banks which they can sell to fund its credit growth, it will remain a concern for the appetite for bonds. Bond yields will inch up a bit but the overall trend still remains hinged on the fiscal situation.

Governance, Consolidation and Privatization: The measures announced does not resolve the larger issue of governance at the PSBs and framework to ensure that we do not stare at a situation again in the future with banks running up 10%+ Gross NPAs. The current government has tried to instill discipline into the bank managements and have also delayed the capital infusion to first recognize the bad loan problem. But many of the PJ Nayak committee recommendations on bank governance have not been implemented. The government may restart the merger process post this round of capital infusion but is no where close to even talking about privatizing some of these public sector banks. In the short term though it is good for PSU bank Stocks and the market reaction shows that.

Government's commitment to Fiscal Deficit: The government appeared a bit cagey on meeting the 3.2% Fiscal Deficit target for Fy 18 and the 3.0% target for Fy 19. This remains the key risk for the bond markets. With the bank re-cap announced, bond markets will shift its focus on the fiscal slippages to determine whether 10 year government bond yields indeed rise to the 7% level as worried or remains in the range level of 6.4%- 6.75%. With the RBI sounding needlessly hawkish on inflation, the markets are not pricing in any further rate cuts.

We shift our focus to the fiscal trajectory for FY 19. Given the pressures of many state elections and the re-election in 2019, in the back drop of growth slowdown and government being questioned on its policies, we fear the government may use the 0.5% 'escape clause' available as a counter cyclical fiscal measure to boost growth and sentiment. If the government pegs next FY19 fiscal deficit at 3.5% instead of 3.0%, it would have serious repercussions for the bond and currency markets.

Arvind Chari is Head Fixed Income & Alternatives at Quantum Advisors Pvt Ltd and advises two India dedicated off-shore India fixed income funds. Arvind was previously the fund manager for the Quantum Liquid Fund and the Quantum Equity Fund of Funds at Quantum Asset Management Company Pvt Ltd.

Disclaimer:

The views expressed in the Article are the personal views of the author, Arvind Chari and not views of Quantum Advisors Private Limited (QAS). QAS may or may not have the same view and does not endorse this view. The views expressed here in this article are for general information and reading purpose only and do not constitute any guidelines and recommendations on any course of action to be followed by the reader. The views are not meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of any financial product or instrument. Information sourced from third parties cannot be guaranteed or was not independently verified. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and views given are fair and reasonable as on date.

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