The Indian government's announcement of large recapitalization plans for state banks is a significant change from the drip-feed approach pursued over the last few years and should help to address the capital shortages that are a major negative influence on the Viability Ratings of the banks, says Fitch Ratings.
State banks will now receive INR2.11 trillion (USD32 billion) in new capital over the next two years, with the government providing USD24 billion. The banks are expected to raise the rest through, for example, fresh equity issuance, with the government willing to accept a dilution of its ownership share to 52%.
The government had already budgeted USD3 billion for capital injections under a previous plan. The other USD21 billion will be raised by issuing bonds earmarked specifically for recapitalization. The government plans to begin issuing these recapitalization bonds within the fiscal year ending March 2018 (FY18) and has said it will front-load injections.
Details on the programme, such as which entities will issue the recapitalization bonds and who will subscribe to them, are still to be announced.
Fitch estimated last month that Indian banks would require around USD65 billion of additional capital to fully meet new Basel III capital standards that will be implemented by end-March 2019, and that the state banks, which account for 95% of the shortfall, would be dependent on the government to meet these requirements.
Viability Ratings under more pressure
Fitch also stated that the banks' Viability Ratings would come under more pressure if the problem was not addressed.
The latest planned injections will go a long way in plugging the total capital gap. They also exceed the USD6 billion-7 billion that Fitch estimated the government would need to pump in on a bare minimum basis (excluding buffers) to address weak provision cover and aid in effective NPL resolution.
Lending growth is still likely to remain weak, at least in the short term, as banks will prioritize asset resolution and provisioning over expansion.
The government's plan is to provide capital to all banks that need it, which carries some risk of encouraging moral hazard. However, the size of capital allocations is to be determined by performance, which suggests the largest share will go to stronger banks, while some banks - particularly smaller, struggling ones - could still be swept up into the government's consolidation agenda.
The government is also planning structural changes to governance and underwriting standards at state banks to guard against future systemic asset-quality problems - although this reform process is likely to be slow and vulnerable to implementation risks.
The finance minister has hinted that the recapitalization bonds could be sold directly to the banks, with the proceeds returned as equity. Effectively, this would mean converting banks' excess liquidity into equity. Banks' liquidity ratios are healthy, having been given a boost by a surge in deposits after demonetization.
The government is targeting a reduction in the central government fiscal deficit to 3.2% of GDP this year. The recapitalization plans could make this target more difficult to achieve if recapitalization bonds are to be issued by the central government, which might mean expenditure cuts elsewhere.
Recapitalization bonds would still imply contingent liabilities for the government if they are instead issued by quasi-government institutions. The USD21billion of planned issuance is equivalent to 0.9% of GDP.
From a sovereign rating perspective, the additional pressure on fiscal balances could be more than offset by the beneficial impact recapitalization may have in eventually helping to return the banking sector to health, which would support the longer-term economic outlook and reduce uncertainty.