India Takes a Page Out of the TARP Playbook


October 26, 2017 [India, Government, recapitalization bonds, domestic loan growth]

In its most concerted effort to reverse slowing credit and economic growth to date, New Delhi devises a $32 billion public sector bank recapitalization.

Safdarjung's Tomb - New Delhi, India

In an unexpected move, the government of India has announced a $32 billion plan to recapitalize the country’s sour-loan laden public sector banks, its biggest step so far in addressing a lingering problem that has weighed on domestic loan growth and retarded a long-awaited investment cycle.

A resumption in credit growth and fixed investment would add some momentum to an economy that began slowing precipitously in early 2016, when it posted roughly 9% annual growth. In the quarter ended in June, India’s economic output expanded at an annual rate of 5.7%. While that may seem robust relative to other big countries, it’s on the light side for one that sees some 12 million people enter the workforce every year.

The government will inject the $32 billion into the PSU banks, as India’s public sector banks are known, over the next two years. The amount includes roughly $20 billion in recapitalization bonds, as well as $12 billion in “budgetary support.” Both the timing and scope of the recapitalization surprised the market, with a number of Indian bank stocks posting double-digit trading gains in the wake of the news.

PSU banks, along with some corporate-focused private sector banks, have been struggling to address legacy loan exposures to troubled conglomerates in the infrastructure, power, cement, mining and steel sectors. These legacy loans were mostly originated from 2011 to 2013, when the Indian economy was expected to grow at a rapid pace and commodity prices were higher. Most agree that under the current environment, a significant haircut is necessary for these projects to be viable again. However, due to insufficient capital, banks have been unwilling to write-off these loans, choosing instead to restructure them or sustain the exposures without their re-categorization as non-performing. Lack of problem loan recognition and the consequent anemic loan growth have been one of the reasons why India’s economic growth has disappointed over the last two years.

The Reserve Bank of India (RBI), the country’s central bank, has long recognized the problem and taken steps to clean-up the system. In 2016, banks were forced to publically disclose a “watchlist” of potential bad loans, helping market participants understand the scope of the problem. More recently, the RBI has forced banks to submit certain troubled credits to the National Company Law Tribunal (NCLT), a government body that works to expedite the resolution of bad loans. The NCLT has given lender syndicates six months to come up with a resolution, or else phase in liquidations, which would likely imply a larger loss, given defaults.

While the recent efforts have helped expedite bad loan recognition, the efficacy of the RBI’s approach had been called into question as PSU banks have not had the necessary capital to fill in the holes left behind by write-offs.

Specifics on exactly how the recapitalizations will work are still lacking. But it appears the government will issue recap bonds, while the PSU banks would use their deposits and other forms of liquidity to subscribe to the bonds. The government, in turn, would use the capital raised to inject equity back into the PSU banks, increasing its stakes in them. This capital would subsequently allow the banks to recognize bad loans, as they would have the necessary capital to withstand the losses generated by write-offs.

After the problem loans have been addressed, the PSU banks would then be in a position to lend again, restarting overall system loan growth that has dropped to 7%. That should eventually spur faster economic growth.

Many observers are calling this the Indian equivalent of the U.S. Treasury’s “Troubled Asset Relief Program,” more commonly known as TARP, which was created in response to the 2008 financial crisis to stabilize the U.S. financial system.

A better capitalized PSU banking sector will likely make additional market-share gains more challenging for the private sector banks that we like. But select private sector banks should still retain clear competitive advantages thanks to their high-quality management, superior customer service and technology. They should continue to grow their credit portfolios faster than overall system loan growth.

That means the double-digit compounding in book value of India’s premier private sector banks should continue, even as the PSU recapitalization proceeds, and, if things go according to plan, system loan growth revives and broad economic growth reaccelerates.

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