When the bank recapitalisation package of ₹2.11 trillion, including recap bonds of ₹1.35 trillion, was announced, there was a strong rally in PSU bank equities (NSE PSU Index up over 30 per cent) and additional tier-I bonds (up to 150 bps). Surprisingly, the sovereign bond market did not see a sell-off initially, even though this meant a large potential supply.

Initial reactions were positive and it seemed almost like “magiconomics”. The impression was that it will be liquidity-neutral and essentially just involve accounting entries — only those banks which need the capital will subscribe to the recap bonds which, in turn, will be used by government to infuse equity into the banks. However, the details were scarce and remain so.

For banks with 8-10 per cent (or higher!) gross NPAs, a result of the spring cleaning process driven by the RBI, time (and capital) was running out. So, it was a very timely action to jump-start credit offtake by making the traditional credit drivers of the economy — the PSU banks (PSBs) — constrained by capital inadequacy, get back into lending mode.

The move has a number of positives: a) it strengthens banks, which can have multiplier effect on GDP growth b) the issue was addressed head-on through a bold and innovative idea, rather than providing a stop-gap solution, as the size of the infusion was considered large enough c) there are precedents globally (Mexico, Korea, Malaysia, Indonesia, etc.) and in India (in the 1990s).

Since the announcement over a month back, conjectures about the possible recap bond structure, along with fears of fiscal slippage, have led to the 10-year benchmark yield rising by 25-30bps to a peak of 7.09 per cent. Yields rallied post Moody’s upgrade recently, but promptly reversed to end the day almost unchanged.

The cancellation of OMO sales led to another bond rally which, again, was short-lived. Clearly, fiscal and inflation concerns have been keeping the market on edge. Clarity on the fiscal roadmap and the recap bond structure/mechanism will be important for the market to stabilise, given the size of issuance, which can be potentially disruptive.

Possible structures being considered include a special purpose vehicle (SPV), rather than the government, issuing the bonds. However, for the SPV to have an acceptable credit rating, it will either need to be backed by some form of sovereign recourse/guarantee or the government may need to transfer some assets (for example, part of its equity holding in PSBs) to the SPV to make it credit-worthy.

The former is essentially an addition to sovereign debt (though indirect), while the latter, though less disruptive from bond market perspective, will be extremely difficult to execute and hence quite unlikely. For the PSBs being listed and rated, any change in ownership structure may have implications for their stock prices and credit ratings.

Irrespective of who the issuer is, since the bonds are supposedly not adding to government’s fiscal deficit (except interest costs), government should ensure it does not hit the same market which it accesses to raise debt. So, the bonds should not be categorised as “SLR”.

Secondly, banks should be allowed to hold these in Hold to Maturity (Amortised Cost, under Ind-AS) book, not subject to mark-to-market (MTM). Restricted trading is not ideal, but at least it addresses the crowding out issue. At an opportune time, the RBI can make these bonds marketable.

Thirdly, rather than auctioning in open market, only banks which are beneficiaries should subscribe to the bonds. So, essentially cash-neutral, accounting entries, as the market has been expecting.

In case the banks proposed to be capitalised are not keen or able to subscribe to most-likely long duration, non-marketable bonds to the full extent of the capital being infused, as it may reduce their capacity to invest/lend to that extent, a part of the recap bonds can be issued through the following alternate routes, without disrupting or crowding-out the institutional markets:

Retail tax-free bonds

Systemic liquidity is still reasonably good (including MSS bonds of ₹1 trillion) – a lingering effect of demonetisation-driven bank deposits. Retail /HNI investors currently have limited avenues to invest. Bond yields are going higher, gold has lost its shine post demonetisation, real-estate market is weak as developers struggle with unsold inventory and compliances related to RERA, equity market seems overheated and IPOs are witnessing large over-subscriptions.

In such a scenario, a tax-free bond priced at, say, 6.5-7 per cent per annum range, limited to only retail/HNI investors, is likely to see strong demand. A quantum of ₹300-400 billion of issuance across 10, 15 and 20-year tenors can be easily absorbed.

The government will forgo the tax on the coupon, but this was anyway not part of the original revenue calculations. This can be a win-win structure as it gives retail investors a safe avenue to earn “annuity” type returns and also help mop up excess liquidity.

FPI limits

Currently the FPI limits on G-Sec as well as corporate bonds are almost fully utilised (around 97-98 per cent).

The government should use the window of opportunity by opening up a specific limit of, say, ₹300-400 billion for FPIs only for these bonds. As FPIs typically don’t prefer a long tenor, a five-year tranche can be offered.

There can be a lock-in (except trading between FPIs) of three years. Bonds can even be issued as zero-coupon, discounted instruments, thereby giving FPIs withholding tax benefit.

A revenue impact of around ₹200 billion due to recent GST rate reductions saw yields rising by 3-5 bps.

The likely market impact of large bond issuances of ₹1.35 trillion should, therefore, not be underestimated.

Any disruption can take yields much higher, increase government’s borrowing cost and result in potential MTM losses, including for the very banks which are proposed to be recapitalised.

The writer is Head Rates & Credit Trading, Indusind Bank

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