The way the Banks Board Bureau has been allowed to function so far does not create much hope for reforms.

Former Reserve Bank of India (RBI) governor Raghuram Rajan recently admitted that the cleanup of bank balance sheets by acknowledging bad debts which started from December 2015 should have started much earlier. The problem of loan losses were initially “easy to ignore” , hoping they would go away “somehow”. But the scourge “had a tendency to increase, get too big to ignore, too late to manage, and push the system into crisis," he had said.

Banks’ gross nonperforming assets (NPAs) rose in a single year from 8.42% of their assets in June 2016 to 10.21% in June 2017. Among the 20 banks with the highest gross NPAs, 18 are public sector banks. Rajan was prescient and now that the scourge is too big to ignore, the government has announced a massive recapitalisation of public sector banks by just over Rs 2 lakh crore or around $34 billion after their equity had been severely eroded.

This raises three questions. One, what happens to the fiscal deficit? Two, with the government pumping in so much money, what will it do to the rate of inflation? Three, will this booster dose of equity cure public sector banks of their ill health?

The first two questions are somewhat easy to answer. The fiscal deficit is a number which the entire financial sector, from multilateral agencies to private financial capital, lays great store by, somewhat akin to a physician’s constant watch over a patient’s blood pressure level. If there is a collective desire to look at this particular exercise as kosher, then the mere fact that the government’s own fiscal deficit target has been breached means nothing.

More important is our second question about whether the process will be inflationary or not. The whole exercise can be done through a set of book entries. The government puts fresh capital into banks which it owns. With this, banks acquire recapitalisation bonds issued by the government for the purpose, thus banks’ lend back to the government what they had received from it in the first place. This creates no additional purchasing power in the hands of anybody, not even the banks. They were in any case flush with funds – massively rising deposits post demonetisation. They were not lending for reasons other than shortage of funds.

With the fresh infusion of equity banks’ capital, adequacy will be restored and they will be able to lend again. As the debts of companies with large stalled infrastructure projects get resolved, they, likely under new owners, will get going again and the resultant spending will create demand and push up growth. It is only then that the issue of inflation may come up.

Additionally, when banks earn interest on their recapitalisation bonds, it can add to their spending capacity. But this potential source of liquidity can also be sanitised. Thus, higher investment spending down the road in itself is unlikely to be inflationary; or corrective action can be taken as and when inflationary pressure is seen to be building up.

This brings us to the last and most important question: what happens to the basic cause of banks’ ill health? The answer is, restored capital adequacy is an enabler, not a cure. For banks to get out of the practices that led them into the quagmire of huge non-performing assets, they will have to change the way they function.

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