As the Indian economy navigates through the consequences of the banking crisis, evident in the mounting pile of bad loans and severe governance issues in public sector banks (PSBs), one macroeconomic issue that needs increased attention is the risk arising out of the feedback loop between the country’s banks and the sovereign.

Simply put, a crisis in the banking system puts pressure on the sovereign in the form of higher fiscal costs resulting from bank bailouts. This fiscal pressure leads to rising interest rates, which cause significant losses to banks that hold a large amount of treasuries. High interest rates also make it harder for borrowers to repay their debt, resulting in increased bad loans. As the balance sheets of banks deteriorate and their losses mount as a consequence of higher provisioning, the sovereign is once again faced with the spectre of containing bank risk at the cost of higher fiscal slippage.

This vicious feedback loop between the sovereign and banks could potentially destabilize the economy and cripple any honest policy efforts made towards improving economic growth.

One factor that could exacerbate this feedback loop is weakening public finances and higher borrowing. Union finance minister Arun Jaitley had recently revised the fiscal deficit target for 2017-18 to 3.5% of gross domestic product (GDP) from the original 3.2%, owing to higher public expenditure. By February end, the fiscal deficit had already risen by 113.7% of the full-year target to touch Rs6.77 trillion.

India’s state budgets are also expected to weaken significantly owing to massive loan waivers, which, according to a Bank of America Merrill Lynch report, could rise to the tune of 2% of GDP before next year’s general election. This being a pre-election year, the possibility of the government rolling out populist measures too cannot be ruled out. The resulting fiscal slippages would have to be compensated through greater public borrowing, which would lead to higher interest rates.

In December last year, when the government announced an additional borrowing of Rs50,000 crore to fund its fiscal deficit owing to poor goods and services tax (GST) collection, the bond yields rose by 17.70 basis points in a single day as investors feared fiscal slippage. About 20 days later, when the government reduced this borrowing plan to Rs20,000 crore, the bond yields responded by falling 16.6 basis points. Yet, in recent quarters, the benchmark 10-year government bond yield has risen sharply, touching a high of 7.78% this month.

This has happened despite the Reserve Bank of India (RBI) maintaining a neutral policy stance in recent months. Since reducing the policy repo rate by 25 basis points in August, the monetary policy committee has kept it unchanged at 6%. The widening gap between the central bank’s policy rate and the benchmark bond yield is partly indicative of increased sovereign risk, reflected in fragile public finances. A 2015 working paper by Aitor Erce, the principal economist of the European Stability Mechanism, discussed the linkages between sovereign risk and bank risk in the euro area. It found that in countries where the public debt is large and where the banks have disproportionately large exposures to government debt, the sovereign risk tends to spill over to the banking system. This is because in the event that the sovereign defaults, the banks holding large proportions of government debt would significantly lose market value. On the other hand, in countries where banks face high non-performing assets, the feedback from the banking system to the sovereign is stronger because of the fiscal costs involved in bailing out banks.

In India’s case, there is a threat of the feedback loop working both ways.

Even though India’s combined government debt is far from being toxic to the economy—unlike many European nations during the peak of the sovereign debt crisis—the revision of the Central government deficit target, together with populist measures such as loan waivers by the states, are a cause for concern. It could limit the sovereign’s ability to contain bank risks in future.

On the other hand, high interest rates have resulted in massive treasury losses for PSBs. This is because these banks hold a significant portion of their fixed-income portfolio in government bonds. The Statutory Liquidity Ratio (SLR) mandates banks to invest 19.5% of their deposits in government securities, but many mid-sized banks have invested significantly more than this requirement as the overall demand for credit in the economy has remained bleak. The losses arising out of the treasury holdings of banks in a high-yield scenario could potentially offset the benefits of the current bank recapitalization plans of the government.

To be sure, the fiscal costs of the recapitalization plan are estimated to be around Rs8,000-9,000 crore in interest expenditure annually. Yet, if the treasury losses and bad debts of banks continue to mount, owing to poor bank governance and rising bond yields, the government’s future fiscal costs may come under pressure, leading to greater sovereign risk and the continuation of the sovereign-bank feedback loop.

To weaken the loop, therefore, it is imperative for the government to maintain sound public finance and implement reforms to improve bank governance at the earliest.

Harsh Vora is an entrepreneur, investor and trader.

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