EVERYONE LOVES A good conjuring trick. Unfortunately, when you work out how it is done, the magic quickly wears off. Last week, India’s Finance Minister Arun Jaitley announced a financial conjuring act which, if he can pull it off, will be a worthy rival to the fabled Great Indian Rope Trick.

Jaitley is hoping to revitalise India’s shaky state banks by injecting them with some 2 trillion rupees (HK$240.39 billion) of new capital, money he plans to raise by selling special bonds to the troubled banks themselves. Alas, successfully performing such a ticklish trick may well turn out to be beyond even his abilities as a magician.


Jaitley faces a daunting challenge. India must sustain an annual economic growth rate of about 8 per cent if it is to stand any chance of creating the 8 million new jobs it needs each year to employ its rapidly growing young workforce. Over the past 18 months, it has fallen woefully short of that target with the slowdown exacerbated by Prime Minister Narendra Modi’s demonetisation move, which last year withdrew large denomination bank notes from circulation.

As This Week In Asia warned at the time: “By throwing sand in the wheels of the informal economy, Modi’s initiative is set to cause a slowdown in growth next year.”

That slowdown has arrived. India’s growth rate in the second quarter of this year fell to just 5.7 per cent, down from 9.1 per cent as recently as the first quarter of 2016.

To revitalise growth on a sustainable basis, India needs to step up investment in roads, railways, power distribution and the like. Economic consultancy Gavekal Research estimates India’s infrastructure funding needs at about 12 trillion rupees a year over the coming years.

The government itself cannot pay for all those infrastructure projects. Collectively, India’s central and state governments are running a budget deficit equal to 6.5 per cent of gross domestic product. That means the funding will have to come from India’s 21 state-controlled banks, which together make up 70 per cent of the country’s banking system.

But the state banks are in no position to help. Although they are flush with deposits following last year’s demonetisation, their ability to lend is hampered by a shortage of capital and a 7 trillion rupee mountain of bad assets on their balance sheets, much of them the legacy of ill-advised earlier lending to stalled infrastructure projects.

Jaitley’s solution is to tap into their deposits by selling the banks special government-backed bonds. The proceeds can then be injected back into the banks as new capital, allowing them to write off their non-performing loans and resume lending, restarting India’s economic growth engine.

It is a neat idea, but unfortunately it suffers from a few potentially crippling flaws. First, the numbers do not add up. The state banks are currently sitting on bad assets with a face value of 7 trillion rupees (although some analysts believe the true amount is much higher), and they have set aside provisions to cover half that amount.

Assuming they could sell their non-performing assets on the open market at a value of 20 paise on the rupee, they would have to take a capital write-down on top of their existing provisions of an additional 2 trillion rupee.


That, of course, is the size of Jaitley’s proposed recapitalisation, so at first it looks as if the plan might work. But 2 trillion rupees would only restore India’s state banks to their present undercapitalised state. To cover likely losses on unacknowledged non-performing assets and to raise the state banks’ capital ratios to meet international standards, analysts estimate as much as an additional 1 trillion rupees will be needed on top of the government’s proposed bailout.

Second, recapitalisation bonds are no free lunch. If the government attempts to save money by paying only a low rate of interest on the bonds, then the earnings of the banks that hold them will suffer. That means they will struggle to generate enough capital internally to allow them to increase lending in the future.

Conversely, if the government pays a competitive rate of interest, it risks encouraging the banks to hold its bonds in preference to making potentially risky loans to the real economy. In short, the recapitalisation bonds may crowd out genuine borrowers.

Finally, injecting fresh capital will achieve little if the state banks do not change their ways. Unless they sever close ties to local politicians, sharpen their credit assessments and begin lending to commercially viable rather than politically expedient projects, they will simply accumulate further mountains of bad assets. Last week, the government promised to reform the sector, but did not specify what reforms it has in mind.

None of this is to say that Jaitley’s bank recapitalisation plan must inevitably fail. If the Indian economy takes off in the coming quarters, the resulting combination of greater fiscal leeway and higher bank profits from increased lending may be sufficient to plug the holes in his proposal. Of course it is a tricky circle, given that any pickup in growth will depend in part on a revival in bank lending.

Tricky, but not necessarily impossible. If the plan Jaitley announced last week can create a sufficiently convincing illusion of a successful bank recapitalisation to kick-start the process, he will have proved himself a master magician indeed.

Tom Holland is a former SCMP staffer who has been writing about Asian affairs for more than 20 years