When Finance Minister Palaniappan Chidambaram stands up to present his government's annual Budget on February 28, the biggest quandary he will face is: "What can I say in the next two hours that will boost both the demand for credit and its supply?"
The right answer to that question has three parts: to recapitalise state-run lenders to the extent the government's meagre resources permit; to hand out new banking licences; and to remove the obstacles that prevent global banks from including India in the list of countries where they would like to deploy more of their shareholders' money.
Why should Mr Chidambaram be so desperate for more bank capital? The reasons are connected to both demand for credit and its supply. Right now in India, both sides of the equation are equally dire.
Demand for credit is low because an economy that had become accustomed to growing more than eight per cent a year before the global financial crisis is now expanding only five per cent annually. Companies that loaded up on debt when India was being hailed as the world's second-fastest-growing economy are now deleveraging to clean up their balance sheets.
While it's convenient to blame the Reserve Bank of India's aggressive monetary tightening for the slowdown in credit demand, a recent analysis by the International Monetary Fund (IMF) shows that higher real interest rates only account for about a quarter of the investment slowdown. Besides, the spurt in inflation that prompted the central bank to raise interest rates 13 times between March 2010 and October 2011 was occasioned by the government's pathological refusal to do anything about the expansion of its own spending, which is estimated to have more than doubled in six years.
The supply side of the credit equation is problematic because a bank-dominated financial system in which state-controlled lenders account for 74 per cent of total assets has all sorts of bad incentives to stretch out corporate deleveraging. Loans that have gone sour aren't written off but are "restructured" to give borrowers easier terms. And although the monetary authority wants banks to set aside more of their future income to offset potential losses, the current rate of provisioning is just 2.75 per cent of the value of the restructured loans.
In a typical business-cycle slowdown, the strategy works out. Most debtors see a recovery after a short blip and start servicing loans again. Demand for new credit picks up, and state-run banks are spared the trouble of making large capital calls on the Indian taxpayer, via their nominal owner, the government.
This time, it's different. The challenge in India is not the business cycle, but the credit cycle. In January, the cyclical component of commercial bank credit – after stripping out trend growth and seasonality – was at its weakest level in almost eight years, according to Reuters Breakingviews calculations.
Given the severity of the downturn, it's quite likely that banks' restructured loans will turn bad at a faster pace than before. In the past, the rule of thumb was that 15 per cent of restructured loans would eventually default, triggering large write-downs. A recent stress test scenario, conducted by the IMF, assumes that the default rate this time around will be higher. If it was three times the normal level, 90 per cent of India's state-controlled banks would see their Tier 1 capital ratio dip below the eight per cent minimum required by Basel bank rules - forcing a government bailout.
Even if these losses do not materialise, state banks will require more capital. According to central bank estimates, the government will need to inject as much as Rs 1.5 lakh crore – equivalent to 1.5 per cent of India's annual GDP – into the banks it controls in order to prepare them for new Basel III rules by 2018. That's 12 times the amount the government is expected to inject into banks in the financial year that ends on March 31.
The fiscal implications of recapitalisation are unwelcome, considering that Mr Chidambaram wants to reduce the federal government's annual budget deficit to three per cent of GDP by 2017 from an estimated 5.3 per cent in the current financial year. Nevertheless, restoring vitality to the banking system is something the finance minister should not shy away from. Putting Indian taxpayers on the hook will not be popular, but is necessary because no government has the political will to dilute its ownership of state-controlled financial institutions.
Yet recapitalising state-owned banks is only the first step. The second part of the solution is to hand out new banking licences so that domestic non-bank financial companies – and even non-financial companies – can start their own deposit-taking institutions. That will inject new capital and competition into the country's banking system. However, corporate conglomerates that might be tempted to channel loans to their own businesses should be kept at bay.
The third part of the puzzle is to adopt a more reasonable stance toward global banks. Since the 2008 financial crisis, big lenders have become pickier about where they deploy their precious capital. Persuading them to commit more funds to India, and to convert their local branch networks to subsidiaries – something the authorities are pushing them to do – will require carrots as well as sticks.
The biggest prize a foreign bank can win if it agrees to incorporate locally is that it will be considered on a par with domestic private lenders when applying to open new branches in large cities. At the moment, foreign banks are restricted to opening just a handful of branches every year. However, that benefit will be significantly diluted if the authorities simultaneously force the subsidiaries of foreign banks to build expensive rural networks.
While India has valid concerns about risks to financial stability that might emerge in future if foreign banks become too dominant, overseas lenders at present control just seven per cent of the commercial banking system's total assets. That gives the authorities considerable room to embrace a more pragmatic view than they have chosen to adopt so far.
Oiling the gears of the credit machine with fresh capital will revive the economy and generate the tax revenues that will make the planned fiscal consolidation possible. To hold off on this crucial task just to make the current deficit numbers look good will harm the economy.
The writer is the Asia economics columnist at Reuters Breakingviews in Singapore. These views are his own