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Bailouts for India's troubled banks 'a morality play', says government adviser

India's chief economic adviser, Arvind Subramanian, said the government's reluctance to inject more capital into the country's troubled public sector banks was more a moral issue than a financial one.

Indian banks had accumulated bad debt amounting to 9.22 trillion Indian rupees as of June 2016, up 14% from December 2015, Reuters reported in October 2016, citing data from the Reserve Bank of India. State-run, or public sector banks, accounted for nearly 90% of the bad loans, the report added. Public sector banks also need US$27 billion in fresh equity capital to meet Basel III requirements by 2019.

"The ability of the system to write off these loans is very tricky. There is no democratic political system in the world that finds it easy to forgive debt to the private sector," said Subramanian, speaking at a conference organized by Credit Suisse in Hong Kong on March 29, noting that in India, most of the problematic debt was held by large corporations.

Subramanian was responding to a question on why the Indian government has not been aggressive in reforming public sector banks and recognizing nonperforming loans. Rating agencies have been vocal about asking the government to inject more capital to aid troubled banks.

"Money is the least of the worry. Coming up with money to recapitalize bank[s] is in some sense not a big deal. My estimate is if we recover 40% of a very generous estimate of bad loans, fiscal cost is 2% to 3% of GDP and India’s GDP is 6% to 7%," Subramanian, a former IMF economist, said. "It gets complicated as there is a kind of morality play here," he added.

Subramanian said the government is also considering establishing a bad loans bank. Such an entity would buy troublesome loans from the books of the affected banks at market price.

But the argument against a bad bank is that it would let public sector banks off the hook and the problem could recur several years down the road, he said.

Any short-term solution the government implements should be coupled with measures that would have a long-term impact, “including a fundamental reassessment of the banking system in India, whether it is consolidation, shrinking some banks, or privatization,” Subramanian said.

As of March 28, US$1 was equivalent to 65.04 Indian rupees.