Memo To Jaitley: Forget Recapitalisation Bonds And Invest Directly In Bank Equity To Make A Killing Later

The markets seem thrilled to bits by the government’s decision to recapitalise banks with a massive Rs 2.11 lakh crore – Rs 1.35 lakh crore through recapitalisation bonds, and the balance through budgetary allocations and raising money from the markets – over the next two years. Since Finance Minister Arun Jaitley, who made the announcement two days ago on 24 October, said the capitalisation would be front-loaded, it means the bulk of the capital will come in this fiscal year.

While the big numbers are warranted in the context of a bad loans portfolio hovering around Rs 10 lakh crore, what is less than clear is how this capitalisation will happen. Jaitley was reticent about it, and left the issue of the fiscal deficit hanging till December.

In the early nineties, the preferred technique was to float bonds which banks could subscribe, and this money was then reinvested back in bank equity, thus completing the recapitalisation process. In short, borrow from banks, call it government capital infused in banks, and then pay interest on it, and claim the fiscal deficit is not impacted.

This kind of financial engineering is not necessarily wrong, especially since the debt raised goes to strengthen banks and is not wasted in this freebie or that, one wonders why this kind of fiction is needed. Why not invest the equity directly by temporarily busting the fiscal deficit target, and then allowing banks to deploy the extra capital as they pleased? Some of it will, no doubt, be invested in government bonds, but some of the money may well be deployed in more profitable activities.

By directly investing in bank equity through preferential allotments, the government would not only have got a higher immediate stake in public sector banks cheaply, but also a chance to make a profit when these banks turn around and their share prices zoom. The government would thus have used the opportunity to profit from recapitalisation. The taxpayer would have cheered.

Instead, by announcing the huge recapitalisation programme, public sector bank shares have already hit the roof, and, by the time the recapitalisation funds are infused, the government may be buying these same shares at inflated prices. Is this a sign of smart engineering?

However, there is another side to this story. If the idea is to give bank shares a lift so that they can themselves raise money from the market on better terms, this move makes sense.

But one thing is clear: it is not necessary to maintain the fiction that investing in public sector bank equity has no impact on the fiscal deficit.

In the West, the fiscal deficit is not defined by how you categorise your expenses, but as the gap between revenues and expenditure that needs to be bridged by public borrowing. But fudging the two issues, by borrowing and reinvesting the same money in bank equity, the government shows this activity as a below-the-line expense, which is not necessary.

Honest fiscal management should define the fiscal deficit as the gap between revenues and expenses that needs to be bridged by public borrowing. You can, of course, choose to explain that this public sector borrowing requirement as a good kind of deficit to have, and not fiscally wasteful.

In any event, the deficit to really target is the revenue deficit, which should ideally be zero. The fiscal deficit, which can then be presumed to be an investment in improving the productive capacity of the economy, will then be more digestible.