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The rot in the system

India’s banking scam has been ominous to the economy on account of its subprime lending and rampant corruption.

The rot in the system
A humongous problem that is being brushed under the carpet in India is the grave sickness of the banking industry, particularly prevalent in public sector banks. In fact, the banking scam is bigger and more widespread than the coal scam or the 2G spectrum scam. Diamond merchant Nirav Modi's banking fraud and Vijay Mallya's Kingfisher Airlines case are only the tips of the iceberg and the rot in the Indian public sector banks is far more unfathomable. Gajendra Haldea, a retired erstwhile Planning Commission official and former IAS officer, believes that corruption in Indian banking is huge and perhaps much worse than China's, when banks there had huge non-performing assets.
The Indian banking crisis is triggered by sub-prime lending to infrastructure, particularly to the power sector and highways. In a discussion paper as early as 2015 titled 'Sub-prime infrastructure: Crony capitalism in public sector banks', Haldea had warned that the principal cause of slowdown in infrastructure lies in the widespread sickness prevailing in a large number of infrastructure projects, which were imprudently financed by PSBs that control the bulk of the banking system in India. Just as irresponsible lending for sub-prime housing caused a slowdown of the US economy with global consequences, the reckless lending for sub-prime infrastructure projects has slowed down the Indian economy even though the scale of these two episodes was not comparable.
PSBs had lent Rs six lakh crore to the power sector and about Rs three lakh crore to highways. Gold plating of costs in these two sectors, apparently due to widespread corruption in the banking system, is the root cause of the mess that the public sector banks are in at the moment. The state electricity boards alone would have to shell out at least Rs three lakh crore to clear the dirt. The Central government's UDAY scheme is meant to restructure these cash-starved state electricity boards. The increased allocation of 42 per cent share to states from the central pool of taxes by the 14th Finance Commission to carry out developmental activities has come in handy. There are already unconfirmed reports to suggest that this money is being diverted by some state governments to clean up this mess, which is going to create further hindrances to state finances. Earlier, when the Planning Commission was sanctioning Central projects, there was some check on the states and tranches of money were released only when proof was shown for spending the previous tranche. Now, states have the autonomy to spend that money and are happily diverting, at times, to clean up their excesses and on wasteful expenditure, which will adversely impact developmental and social programmes.
Massive structural reforms are needed to clear the mess and the government has already announced a bailout package of over Rs two lakh crore over the next couple of years. The crisis is one of the reasons for bank deposit growth falling to 6.7 per cent, the lowest ever in the country since 1963. The bank NPAs have grown sharply to nearly Rs nine lakh crores.
Between April and December 2016 alone, over 3,500 cases of fraudulent transactions were reported, involving Rs 177.50 billion, which were allegedly facilitated by 450 employees in private and public sector banks. The public sector banks lost at least Rs 227.43 billion owing to fraudulent banking activities from 2012-16, according to an IIM-Bangalore study. RBI data showed 455 cases of fraud transactions of above Rs one lakh crore in ICICI; 429 in SBI, 244 in Standard Chartered and 237 in HDFC Bank were reported. In Nirav Modi's case, PNB suspended 20 employees in view of the Rs 11,400 crore bank fraud. Since 2011, several cases of fraud have been reported to investigative agencies and FIRs have been filed by the police involving several public sector banks.
China faced a similar situation when its banking system was in doldrums in the 1990s, when the economy was overheated, with inflation as high as 24 per cent and the country clocking 13-14 per cent GDP growth consistently. One of the reasons for the soft landing of its economy was the massive restructuring of banks and cleaning up of the bank balance sheets. Corruption was rampant and banks ran huge NPAs. At that time, China issued state bonds of RMB 270 billion to recapitalise state-owned commercial banks. In his recent lecture on 'Rise of China in the International Monetary System', senior IAS officer from Rajasthan cadre, V Srinivas, said Chinese authorities placed banking sector reform at the pivot of their overall policy agenda at that time. China also utilised its massive foreign exchange reserves to recapitalise banks: as much as $45 billion went into the recapitalisation of just three banks — Bank of China, the China Construction of Bank and the Industrial and Commercial Bank of China, according to Srinivas, who had earlier served in the IMF and the Finance Ministry.
This has sparked a debate on whether India too should use a portion of its over $420 billion foreign exchange reserves to recapitalise its ailing public sector banks. Of course, India's foreign exchange reserve is peanuts compared to China's, which is valued at over $3.5 trillion. Haldea is, however, of the view that this issue had cropped up in the past as well during the UPA government and after a prolonged debate by top economists and officials, the considered view was that it would not be prudent to use it as the reserves were not government money.
As former Prime Minister's Economic Advisory Council Chairman and former Reserve Bank Governor C Rangarajan cited Thailand's example during the East Asian currency crisis of the 1990s, high reserves cannot provide a shield if the fundamentals were wrong.
Also, China's huge reserves are built by huge current account surplus. China has a trade surplus of over $800 billion with the United States alone. India has hardly any current account surplus. India's current account deficit went up to 4 per cent of its GDP a few years ago. Now, it hovers around 2 per cent of the GDP. Besides, India is over-dependent on imports for its oil requirement. Nearly 80 per cent of oil is imported. Till India builds a current account surplus like China, it would not be prudent to use foreign exchange reserves for the recapitalisation of banks. Building current account surplus through merchandise and services exports is unlikely to happen in India in the immediate future. So, the government is left with no option but to use taxpayers' money at this juncture to bail out the public sector banks, which are in a mess because of corruption and sub-prime lending to infrastructure in the last seven-eight years. Warning signals were there from as early as 2015, but the government has been a little slow to respond.
(The views expressed are strictly personal)

K R Sudhaman

K R Sudhaman

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