Banking scam: A drag on the economy

KR Sudhaman
Veteran Economic Journalist

AHUMONGOUS problem that is being brushed under the carpet in India is the grave sickness in the banking industry, particularly the public sector banks (PSBs). In fact, the banking scam is far bigger and widespread than coal scam or 2G spectrum scams. The Diamond merchant Nirav Modi banking woes and the Vijay Mallya Kingfisher airlines cases are only the tip of the iceberg . The rot that has set in public sector banks is far greater and unfathomable. 

Gajendra Haldea, who retired from the erstwhile Planning Commission and former IAS officer, is of the view that corruption in the banking sector is perhaps worse than China when banks there had huge non-performing assets (NPAs) in the 1990s, similar to the situation in India at the moment. The Indian banking crisis is triggered by sub-prime lending to infrastructure, particularly to the power sector and highways. 

In a discussion paper in 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 projects which were imprudently financed by PSBs. 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, though the scale of these two episodes is not comparable. 

PSBs had lent Rs 6 lakh crore to the power sector and about Rs 3 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 PSBs are in. The state electricity boards alone would have to shell out at least Rs 3 lakh crore to clear the mess. The Central government's UDAY scheme is meant to restructure these cash-starved boards. The increased allocation of 42 per cent share to states, from the central pool of taxes by the 14th Finance Commission for developmental activities have come in handy. There are unconfirmed reports to suggest this money is being diverted by some state governments to clean up this mess and that is going to create a problem to state finances in future. 

Earlier, when the Planning Commission was sanctioning central projects, there was some check on states. The next tranche of money was 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 the mess and on wasteful revenue expenditure, which will hit developmental and social programmes of the state, thereby messing up state finances in subsequent years.

Massive structural reforms are needed to clear the mess in PSBs and the government has announced a bailout package of more than Rs 2 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 since 1963. Bank NPAs have grown sharply to nearly Rs 9 lakh crore.

In April-December 2016 alone, over 3,500 cases of fraudulent transactions were reported involving Rs 177.50 billion, which were alleged to have been facilitated by 450 employees in private and public sector banks. PSBs lost at least Rs 227.43 billion owing to fraudulent activities from 2012-16, according to a study by the IIM, Bangalore. RBI data showed 455 cases of fraud transactions of above Rs 1 crore in ICICI, 429 in SBI, 244 in Standard Chartered and 237 in HDFC Bank. In Nirav Modi's case, PNB has suspended 20 employees in view of the Rs 11,400-crore fraud. Since 2011, several cases of fraud have been reported and FIRs filed involving PSBs.

China faced a similar situation when its banking system was in the doldrums in the 1990s when the economy got overheated, with inflation being as high as 24 per cent as its economy clocked 13-14 per cent GDP growth consistently. One of the reasons for the soft-landing of its economy was massive restructuring of banks and cleaning up of bank balance sheets. Corruption was rampant and banks ran huge NPAs. China issued state bonds of RMB 270 billion to recapitalise state-owned commercial banks. 

In his recent lecture on the 'Rise of China in the International Monetary System',  IAS officer, V Srinivas, said China placed banking sector reform at the centre of its overall policy agenda at that time. China also utilised its massive foreign exchange reserves to recapitalise banks. Srinivas, who has served in the IMF and the Indian finance ministry, said as much as $45 billion was pumped into the recapitalisation of just three banks-the Bank of China, the China Construction of Bank and the Industrial and Commercial Bank of China. 

Srinivas' assertion sparked a debate on whether India too should use a portion of its over $420 billion foreign exchange reserves to recapitalise ailing PSBs. Of course, India's foreign exchange reserves are peanuts compared to China's, which is over $3.5 trillion. Haldea said this issue had cropped up in during the UPA government as well and after a debate by top economists and officials, the considered view was that it would not be prudent to use it as the reserves are not government money.

Former Chairman of the Prime Minister's Economic Advisory Council and former Reserve Bank Governor C Rangarajan, at a recent lecture, cited Thailand's example during the East Asian currency crisis of the 1990s, indicating that 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 had current account surplus. At one point, India's current account deficit went beyond 4 per cent of the 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 current account surplus like China, it would not be prudent to use foreign exchange reserves to recapitalise banks. Building current account surplus through boosting merchandise and service exports is unlikely to happen 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 hit by corruption and sub-prime lending to infrastructure in the last around eight years. Warning signals were there as early as 2015, but the government has been a little slow to respond. At least now it should respond quickly before it becomes too late.