Jaitley's strategy for the banking sector was flawed from the beginning

As Narendra Modi completes one year in office, the palpable mood in the financial markets is that of disappointment. The government’s ability to push forward the growth agenda is being viewed with some amount of skepticism by foreign investors in the backdrop of slow-paced reforms and faltering growth in core sectors.

The disappointment is logical. Expectations were sky-high when Modi took over and projected himself as an agent of quick change everywhere -- be it reviving a battered economy, improving governance or pushing the reform agenda to attract large investments.

But the danger in keeping expectations high is that if you fail to live up, the setback will be severe and even the good things done is overlooked.

Indian stock markets rallied like there was no tomorrow ever since Modi was named as the Prime Minister candidate of the BJP. Between September 2013 and 28 February 2015, when the union budget for 2015-16 was announced, India’s bellwether index, Sensex on the BSE, jumped 48.8 percent, while the Nifty jumped 52.2 percent. Everyone joined the party.

But the market euphoria somewhat ended post the budget when the government failed to give a convincing roadmap on how it intends to reboot the economy — especially on bank recapitalisation — something vital to the economic revival in the absence of the government’s willingness to spend. Since then, both the Sensex and Nifty lost around 7 percent. The bankex, the index of major bank stocks, plunged 7.3 percent (as of 15 May 2015).

The good things in Modi’s one year include passage of some of the reform bills (insurance, coal, mining and black money), easing the process of doing business by fast-tracking clearances and initiating a massive financial inclusion push using banking channels. That said, many high-priority items such as land acquisition reforms and bringing clarity on tax-front are still in the to-do list.

Modi has indeed managed to inject the much-needed positive momentum in the economy and, more importantly, has restored the faith of common man in the government, which was absent in most part of the UPA rule, marred by series of corruption cases and lack of political will. For him, Modi was an agent of change.

To be sure, the former Gujarat chief minister had lot of luck too on his side. For instance, Modi’s much hyped victory on inflation wasn’t really his battle but more due to a sharp decline in global crude prices and the timely use of monetary policy by Raghuram Rajan at the Mint road.

But despite all the positive economic factors the falling inflation and a marginal improvement in the growth compared with the UPA years (factory out improved to an average 2.8 percent in fiscal year 2015 as against a contraction of 0.1 percent in the year before partly due to the base effect) — foreign investors seem to be losing patience.

Foreigners have begun pulling out money from local bourses and no fresh investments are made beyond plain promises. The stock markets seem to have lost the steam and global agencies have begun raising eyebrows on the timing of the potential pick up of growth in the economy.

Clearly, the government couldn’t sell investors the brand new image of the economy depicted by the re-based GDP numbers that pushed India to the fastest growing economy in the world, matching China. Experts, both within and outside the country, questioned the lack of correlation between the GDP numbers and high frequency macro numbers that told a different tale.

The government’s statisticians were, and still are, struggling to offer an explanation to the sudden twist in the story.

What acted as a major turn off to investors, despite the slow-progress made by the Modi government, was the absence of strong growth drivers. By passing legislations and improving the operational environment to do business, Modi prepared a conducive environment for the growth to happen, but the question of who would fund the growth remained unanswered.

After a period of dormant economic activities, three factors can typically reboot the economy: 1) Higher government spending; 2) private sector funding; 3) Bank lending. Unfortunately, all three are absent in the current context. When the government didn’t put money on the table and private investors logically preferred to stay on the sidelines.

Perhaps, investors were more curious to know what precise plan the government had to revive economy using the third — the banking sector. The moment of distrust between the investor community and the government began when finance minister Arun Jaitley chose to mess up with the banking sector by cutting down bank recapitalisation in the February budget. This paralysed state-run banks from any further credit expansion and posed a question mark on revival.

Wrong strategy

The banking sector strategy of the government was flawed from the beginning. Jaitely announced a capital infusion of Rs 7,940 crore in the budget, much less than what state-run banks actually required and lower than what the government committed for fiscal year 2015.

Even for the previous year, the government has so far infused only about Rs 6,990 crore, out of the promised capital Rs 11,200 crore, that too based on performance. This further deepened the crisis in banks, which were already neck deep in bad loans.

Jaitley’s message was clear: Small government banks, especially which rank lower in terms of performance, will have to go to the market to raise funds or get merged with other banks. They needn’t expect any capital from the government from now on.

But Jaitley forgot that raising money from the market wouldn’t be an easy task for smaller banks, since there is very less investor appetite in these banks, burdened with high bad loans and poor growth. Except the large lenders, like State Bank of India, not many lenders have been successful in tapping private funds.

State-run banks, which control 70 percent of the banking sector, faced a deeper crisis with the government’s new approach. Instead, the government could have offered a phased approach for cutting down capital support from the government. But, Jaitely chose to give a shock treatment to banks, whose lending capacity was already constrained with high bad loans.

The impact was visible. Even with some revival on the ground, state-run banks, which control 70 percent of the banking industry, aren’t in a position to lend. Besides lack of capital, high bad loans too limited their ability, in turn, hurting revival in economy.

“On the one hand, they expect us to further the cause of growth, on the other, there is no capital support,” the chairman of a state-run bank told Firstpost on condition of anonymity.

With loan growth to industries remaining stagnant, mid-sized companies were caught in a crisis. Only a few top-rated large corporate managed to tap the corporate bond market. Others were constrained to shrink their business.

Had Jaitley handled the issue in a different way — by infusing a sizeable chunk of capital in state-run banks — it would have aided banks significantly to resume lending to good projects.

At this point, the business, investor confidence has surely taken a beating. Rebooting the economy would require two things:

One, put more money in the hands of state-run banks so that they can resume lending. This can be done by paring government holding in these banks.

Second, forget fiscal deficit and increase government spending on capital expenditure. There is no point in keeping the balance sheet of a corporation clean, when business is stagnant. Even if higher spending can push up fiscal deficit in the short term, this can eventually contribute to economic growth in medium-to-long-term.

The growth would remain a mirage unless funding channels are opened. This would continue to repel foreign investors, who are well past the Modi-wave. The signs of this happening are already visible.

(Data support from Kishor Kadam)