Here's how Jaitley can fund India's struggling banks without busting the deficit

The Union Minister for Finance, Corporate Affairs and Defence, Shri Arun Jaitley addressing at the ceremony to launch the Goods & Service Tax (GST), in Central Hall of Parliament, in New Delhi on June 30, 2017.

Finance Minister Arun Jaitley Tuesday announced an unprecedented Rs 2.11 lakh crore recapitalisation programme for public sector banks intended to address the impact of growing bad loans on banks’ books.

Of the total, Rs 1.35 lakh crore is expected to come in the form of recapitalisation bonds – easily the biggest recapitalisation programme announced to date – while the rest will come as budgetary support from the government and government through stake sale.

When asked about whether or not the recapitalisation bonds will exert any pressure on fiscal deficit this time around, Jaitley remained non-committal and said that it would be a function of the nature of these bonds, something that the government will deliberate over.

The finance minister did say that globally, these bonds were typically treated to be under the line, i.e. not a part of the fiscal deficit, but added that in India, it was the other way around.

The government of India has, once before, tried issuing such bonds to address high bad loan levels in state-owned banks back in the 1990s. The stressed balance sheets were on account of unrestricted priority sector lending over the previous decade that had eaten into banks’ capital and profits.

This forced the government to come up with a way of shoring up banks’ equity capital without a exerting any additional pressure on its cash-strapped self. The answer – use banks’ own money, the money that they had for lending, to meet their equity capital requirements.

Towards that end, the government issued several tranches of special securities called recapitalisation bonds to nationalised banks, who subscribed to them by paying the government. The government then used the money raised through these bond issues to infuse fresh equity into each of the banks.

Initially non-marketable, these bonds were later converted into perpetual bonds, also known as additional tier-I bonds. Although the government was essentially just delaying its own repayment obligation, it did not have to bear any additional fiscal deficit burden given the returns it made in the market on bank shares.

In an interview with BloombergQuint a few months ago, former Reserve Bank of India deputy governor HR Khan said that he believed these bonds could really do the trick – recapitalise banks to the necessary levels without hurting the government’s fiscal position.

After Tuesday’s announcement, numerous market participants welcomed the government’s move to issue recapitalisation bonds but iterated that one would have to wait and see the nature of these bonds before determining how they were going to impact the government’s fiscal deficit.

“This milestone announcement on recapitalising banks in one-go is a bold and courageous move and was indeed the need of the hour. It will generate balance in overall demand and supply by bringing more investments in sectors like infrastructure. These funds will also help in efficiently managing risk and credit capital related requirements of the banks,” said State Bank of India Chairman Rajnish Kumar after the finance ministry announcement.