Forex Reserves to the rescue

This was published in the DNA Opinion Page on 19th of June

The Public Sector Bank (PSB) recapitalisation debate continues unabated. Clearly, “simple” options — amalgamation, Bad Bank, Indradhanush — are “dead on arrival”. It is also quite clear that the government has limited appetite to infuse fresh capital, given fiscal constraints. Depressed valuations make raising capital from public markets a challenge, especially for weaker PSBs. So, is there a game left in town?

There could be, via direct Central Bank (CB) intervention. In recent times, both in the US and in Europe, CBs have bailed out banks, primarily through purchases of stressed assets (mortgage-backed securities in US, Greek bonds in Europe). The modus operandi is simple. Say, a bank needs to write off $100 of stressed assets, and it does not have the capital to do so. The CB prints $100 of fresh money uses it to buy out the stressed assets, enabling the bank to remain solvent. This, of course, means an increase in CB balance sheet and consequently money supply in the economy, which could fuel inflation. But in the low inflation scenarios in US/Europe for many years, it has been a politically acceptable risk to take.

Can RBI do this in India? Technically yes, practically difficult. India, unlike US/Europe, typically suffers from high inflation. While inflation has been tapering off recently, it is often vulnerable to systemic shocks like oil prices and bad monsoons. As recently as the last monetary policy, RBI flagged off upside risks on inflation. Ergo, RBI printing more money to buy back NPAs (non-performing assets) from banks has significant inflation risks, making it politically untenable (as well as running counter to RBI’s Inflation Targeting mandate).

There could, however, be another way, and that is to use RBI’s foreign exchange reserves to directly recapitalise banks. How does this work? Today, RBI holds $380 billion of Fx reserves as assets in its balance sheet. These are typically deployed in a variety of financial market instruments — predominantly hi-grade Treasuries (like US), Bonds and Gold. RBI could use a part of these reserves to buy capital instruments issued by PSBs. This would achieve a couple of objectives:

• It doesn’t expand RBI’s balance sheet/money supply — it simply swaps one type of securities (say, US Treasuries) for another (Indian Bank Capital, or IBC). There is no increase in money supply and downstream pressure on inflation.
• It keeps the funding off the government’s budget. Consequently, it does not deteriorate fiscal ratios. Let’s look at the broad math:

Total Banking NPA — estimated at $180 billion

Haircut required to make the loans viable (say) — 50 per cent

Capital required for write-offs — $90 billion

Now, RBI uses (say) $45 billion of its reserves to buy IBC, providing 50 per cent of the required capital. Such a large capital injection will lift underlying sentiments and stock prices, enabling PSBs to tap the capital markets for the balance $45 billion. Coupled with other reforms (Bankruptcy Code, RBI cover for bankers to settle NPAs etc), PSBs could start on a cleaner slate. In a few years, stock prices could rise sufficiently for RBI to sell off the IBC at a profit, similar to what happened with the TARP programme (to bail out banks in 2008) in the US.

There is no free lunch, and this approach isn’t without risks. The biggest is the fact that Fx reserves are not sovereign wealth. RBI has liabilities (primarily remittance claims from foreign investors/importers) against these reserves. These reserves are usually deployed in liquid, high-quality securities to enable RBI to have liquidity in times of stress. As IBCs would be illiquid, Private Equity-type investments, it would mean RBI has proportionately fewer reserves to call upon in an emergency.

That being said, $45 billion constitutes a fairly small part (12 per cent) of India’s reserves, and can be relatively quickly replenished given the strong capital flows that we are seeing today. A repaired banking system will add to the “India story” and further enhance those flows.

This isn’t an idea that’s new, but one whose time certainly has come (to at least being evaluated). India’s PSBs need capital, and to use a Sherlockian adage, once all wickers have been burnt, the one left standing is the most plausible one. Using Fx reserves is a plausible wicker left to recapitalise India’s PSBs.