Illustration by Binay Sinha
Under the announced scheme, PSBs will hold the R-bonds for a while, if not for the entire duration of the bonds (the details of R-bonds have not been spelt out yet). The R-bonds will be issued by the GOI or a government-sponsored special purpose vehicle. Now, the international ratings of GOI bonds are quite low; the rating by Moody’s was Baa3 positive as on October 19. So, GOI bonds are risky. This, as research by this author shows in a paper (‘Seemingly safe banks in an emerging economy’) presented at the ISI Delhi Centre’s sixth annual conference on growth and development in December 2010, can negate the strengthening of the banks’ balance sheets through recapitalisation of PSBs, thereby defeating the purpose of capital adequacy norms.
Such negation of Basel capital adequacy norms would not have happened if the GOI had decided to raise funds through normal bonds, and used the funds raised from the markets to recapitalise PSBs. In this alternative scenario, on the asset side of the PSBs’ balance sheets, there would primarily have been bank loans instead of (additional) risky GOI bonds.
Besides the low ratings, there are other facts that support the view that GOI bonds are risky. First, unlike the ratio of fiscal deficit to GDP, which is not alarming, the fiscal deficit is a whopping 26.52 per cent of the total receipts of the GOI (Reinhart and Rogoff have suggested this alternative metric in their well-known 2009 book, This Time is Different — Eight Centuries of Financial Folly, to gauge fiscal conditions). Second, though the nominal interest rate on 10-year GOI bonds is not very high at 6.808 per cent as on October 27, (considering the pre-announced four per cent inflation target), this number needs to be used carefully. This is because there is a captive market for GOI bonds, given that banks and key insurance firms are formally or informally required to buy and hold government bonds. This ensures that, notwithstanding the intrinsic risk, the yields on such bonds are lower than what they would have been in a truly free market for bonds.
It is interesting that though there is an intrinsic risk in GOI bonds, there may not be any fiscal crisis at all due to their captive market. Now we have an irony here. The very fact that banks hold such bonds can make these instruments safe in practice for banks! This, in turn, implies that there may not be, in practice, any issue of a banking crisis related to banks’ holdings of government bonds. This is fortuitous, but there is no free lunch.
If banks are required to hold GOI bonds, then bank credit is adversely affected. This affects the real economy. This is a real cost that the economy incurs for avoiding a banking crisis or fiscal crisis despite the use of intrinsically risky government bonds. We are familiar with this in economics literature as the (social) cost of financial repression, though this usually gets underestimated, if not overlooked; see, for example, the 2011 book, Growth With Financial Stability by Rakesh Mohan, former Deputy Governor of the Reserve Bank of India.
It is true that R-bonds have been used in the past in India and elsewhere, but that is not a good reason to use them again. It is also true that with normal GOI bonds (instead of R-bonds), the fiscal deficit as measured by the IMF would have gone up, but the substantive adverse effects on the economy at home would have been less.
If banks are recapitalised through R-bonds, then banks hold more of the risky GOI bonds than bank loans; this is considering not just the present but also the entire duration for which the R-bonds will need to be held, even when there is more demand for bank credit than at present. It may be argued that given India’s experience with non-performing assets (NPAs) and stressed assets of PSBs in the past, bank loans can be riskier than the risky GOI bonds! This is an important point. But then that raises a more basic question. Why recapitalise PSBs at all in the absence of other meaningful reforms that can keep some check on NPAs?
The author is Visiting Faculty, Indian Statistical Institute (Delhi Centre) and Ashoka University.
Published with permission from Ideas For India, an economics and policy portal