In 2003, the Vajpayee government’s claim that the Indian economy’s growth rate would exceed 8% for the first time in history was met with guffaws. Today, when the union government asserts that India can breach the 10% real gross domestic product (GDP) growth mark, there is similar disbelief and derision.

Given India’s demographic profile and latent demand drivers, the economy can and should grow sustainably at a 10%-plus rate. As heretical as that seems, it requires specific policy reforms that will unleash more effective capital allocation in the economy and accelerate the build-up of infrastructure.

Over the last few years, the principal bottleneck holding back firms from investing has been a freeze on bank lending. About 66% of the $1.3 trillion in domestic credit originates from India’s public sector banks (PSBs). After a small round of consolidation recently, India has 21 PSBs. Tellingly, China’s banking system is dominated by four large state-owned banks while Brazil’s government controls three major banks.

India’s banking system is still mired in crisis as companies, primarily in steel, power and infrastructure, have been unable to repay loans taken during the Congress-led United Progressive Alliance (UPA) government. As a result, non-performing loans (NPLs) as a percentage of gross loans for PSBs is about 11.7%, with the net figure including all impaired loan types standing at 16.9%. For perspective, the average Core Tier I ratio for India’s 21 PSBs is about 8%, implying that most of these banks are technically insolvent or at the very least, in urgent need of a capital injection.

Given that PSBs control two-thirds of credit extension, lending has virtually ground to a halt. Today, nearly all lending and incremental deposits are being hoovered up by private sector banks that are well-capitalized and growing robustly. But for how long can 33% of the banking system be responsible for all incremental credit and deposit taking? Something has to change.

So how big is the ticking time bomb sitting within the banking system? To quantify the problem, let’s haircut our previously discussed 17% NPL number down to 15% of the $1.3 trillion stock of domestic credit, or $190 billion approximately. While India’s private sector banks have provided 60-70% coverage for NPLs, average coverage for PSBs is just 35%. Assuming 35% of NPLs are cured in recovery, this implies a further coverage need of approximately 25% for PSBs, or $45 billion (Rs 2.9 trillion).

The Modi government has been in a Catch-22 situation—it would be wrong to simply bail out the banks and give a free pass to company promoters once again, but not addressing the crisis carries its own costs in terms of stymied growth and job creation. An economy that seeks to grow 10% in real terms with 5% inflation needs credit growth to be at least 1.0-1.2 times the targeted real gross domestic product (GDP). This would imply 15-20% credit extension system-wide, compared to the 5%-7% we have today.

Rather than recapitalize the banks and break fiscal discipline, the government chose to bring a modern bankruptcy law. Now, possibly for the first time in India’s history, the country’s elite business owners are facing the consequences of taking on excessive debt and mismanaging their companies. They are not getting away by socializing their losses.

But erosion of capital caused by bad lending practices isn’t a new thing for Indian banks.The structural issue with the banks is a classic manifestation of what economists call the agency problem.

While private sector banks have an average NPA level of 5%, the figure for PSBs is 17%. Private banks have been more responsible lenders because they are less subject to political interference, and cannot avail of bailouts that have been euphemistically labelled “recapitalization" in our lexicon.

Though the Reserve Bank of India (RBI) requires private bank promoters to limit their shareholding, no such rule applies to government-owned banks, where the government continues to be a majority shareholder owning over 51%. Now is a good time to end this discriminatory arrangement.

As for the $45 billion NPL coverage hole mentioned earlier, the authors believe that this can be plugged without undue burden on India’s fiscal position.

First, the government should move to achieve structural reforms in the sector by reducing its stranglehold over banking, and require that banks divest non-core assets such as valuable urban land holdings. PSBs are large landowners across India. Real estate assets controlled by the State Bank of India (SBI) alone are valued in excess of 20,000 crore, SBI chair Arundhati Bhattacharya had said last year. The 10 largest PSB’s land holdings are valued at approximately 70,000 crore.

Second, the government could once and for all divest Specified Undertaking of Unit Trust of India holdings, releasing another 57,000 crore. This would leave a gap of about 1.6 trillion ($25 billion).

Finally, as Kotak Mahindra Asset Management’s Nilesh Shah has pointed out, recent amendments to the Enemy Property Act 1968 clear the path for the government to monetize assets worth over Rs1 trillion held by the Custodian of Enemy Property.

Thus, even partial realizations from divestment of real estate, SUUTI, and enemy property holdings together can substantially address the balance sheet problem, with no immediate impact on the country’s fiscal position.

The remainder can be raised through a direct government infusion supplemented by an equity market capital raise that should cut government ownership below 51% in all but the most critical PSBs. The bankruptcy resolution process will address the crisis to some degree, but it is not preventive in nature. Reduction in government shareholding, and an overall consolidation in the sector to reduce the number of PSBs to less than 10 would be a comprehensive and elegant solution so that banks re-focus on their core business with accountability.

Bringing these structural changes to Indian banking will unclog credit flow and enable faster growth. The politicization of banks is a legacy of Nehruvian socialism and of former Prime Minister Indira Gandhi, who nationalized 20 banks between 1969 and 1980. Prime Minister Narendra Modi has taken some bold steps of late to extricate India from that philosophy—by initiating the possible privatization of Air India, an airline that Jawaharlal Nehru infamously seized from the Tatas, and forging a strategic relationship with Israel, in a sharp repudiation of Nehru’s policy of non-alignment.

The justification for nationalizing banks was the classic central planner’s fallacy of intelligently directing credit to priority sectors to ensure growth—a paradigm that is anachronistic in the present landscape where market economics is taking hold across industries. The old paradigm is also inconsistent with the Modi government’s own welfare philosophy of targeted benefit delivery to the individual.

This is the first article in a two-part series on how to put India on the path to double digit economic growth. Click here to read the second article.

Navroz D. Udwadia is co-founder of the New York-based investment firm Falcon Edge Capital. Rajeev Mantri is executive director of venture capital firm Navam Capital.

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