The decision of the government of India to turn to the World Bank for a loan to support its effort to recapitalise public sector banks has taken all by surprise. The financial position of public sector banks has been strengthened over the last decade and most of them have rather strong balance sheets. As compared with a mandated 9 per cent Capital to Risk-Weighted Assets Ratio (CRAR), the actual CRAR of public sector banks in 2008-09 varied between 11.37 and 14.35, with one bank (UCO Bank) recording an exceptional 18.41 per cent. Thus, even if the government’s decision that the capital adequacy ratio should be set at 12 per cent to make them capable of facing unusual financial stress is adhered to, there are only three PSBs that need immediate infusion of funds.

According to reports (Business Standard, 2 October 2009), the Finance Ministry has made an assessment that the public sector banking system would need as much as Rs.35,000 crore worth of Tier-1 capital by 2012, given projections of how much their business needs to expand. Past divestment of equity has significantly reduced the government’s shareholding in many public sector banks. Hence, it is argued, if 51 per cent government ownership has to be maintained to secure the public sector character of these banks, this recapitalisation has to be in the form of new government equity capital. Since the government is ostensibly strapped for funds for this purpose, it has decided to use this requirement as the basis for opting for a sector-specific $2 billion World Bank loan that will part finance the expenditure. Since reviving bank credit is being seen as part of the strategy to stimulate a recovery, the World Bank’s support for the banking sector through the government’s budget is seen as support for the “broad economic stimulus programme”.

It is not at all clear how the assessment of the additional capital needed by public sector banks (if true as reported) has been arrived at. If the idea is that these banks have to provide the credit to expand domestic demand and substantially finance the investment needed to meet that demand, it could imply an increase in credit exposure which may not be good for bank solvency in any case. If at all such an expansion in credit provision is being contemplated it should be spread over a much longer period.

But even if the estimated sums are indeed required, it only follows that the government, having divested its equity holding to generate revenues to finance budgetary expenditures in the past, has to now rectify that error by injecting budgetary resources into the banking system. There are three sources from which that money can come. First, with public sector banks having turned profitable, those profits can be ploughed back to help recapitalise them. In 2008-09 alone, which is by no means a high performance year, public sector banks earned profits totalling Rs.2,825 crore. Second, since this expenditure would strengthen the financial system and deliver profits to the government, it can consider diverting a part of its tax and non-tax revenues for this purpose. For example, there is no reason why a part of the windfall revenues of around Rs. 25,000 crore expected from the sale of 3G spectrum cannot be allocated for this purpose. Finally, the government can borrow domestically and can even think of modifying the FRBM Act to borrow from the Reserve Bank of India to finance this activity. There is no danger that domestic borrowing would weaken the fiscal position of the government, since returns from the banking system would definitely be higher than current interest rates on government debt. And the impact of the process via the expansion of credit-financed spending will be the same whether the money comes from the World Bank or the domestic market.

The principal objection against turning to the World Bank for a loan to part finance the recapitalisation of the public sector banks is that it can result in an erosion of the autonomy of the public banking system. Whatever the rhetoric accompanying the new loan, it is to be expected that the World Bank is unlikely to provide support without hidden (if not explicit) conditions. It has a track record of prescriptions on financial reform which include measures such as removal of restrictions on the markets and instruments that banks can be exposed to and moving from central bank supervision to self-regulation. These are part of the same policy framework that precipitated a financial crisis in Southeast Asia in 1997 and in the developed industrial countries in 2007-08. The World Bank therefore is unlikely to be interested in lending to the government so that it can strengthen the capacity of public sector banks to extend concessional credit to marginal farmers. It would be interested in the final analysis in supporting reforms that restructure the banking system to replicate the deregulated “Anglo-Saxon model”, considered till recently to be efficient and transparent.

It is clear from the recent global crisis that resistance to excessive liberalisation of India’s financial sector, including its banking system, has served the country well. As a result of restraint on “reform”, the exposure of Indian financial entities to the toxic assets that undermined the solvency of global banks was minimal and banks had been adequately capitalised to survive the downturn. Recommendations accompanying World Bank funding are likely to loosen these restraints and transform the public banking sector in ways that render it more financially fragile and vulnerable to failure.

Moreover, borrowing in foreign exchange for this purpose, whether from the World Bank or elsewhere, is most inappropriate. This will increase the currency mismatch in the system, since dividends earned by government will be in rupees, while the repayment will have to be in dollars. Moreover, with the country already experiencing a surge in capital inflows, this loan would only add to the difficulties faced by the RBI in managing these inflows and stabilising the exchange rate.

In sum, the decision of the government to turn to the World Bank is difficult to justify.

Keywords: Public SectorWorld BankSpectrum3G