Money & Finance

Recapitalising public sector banks by disinvesting in RBI: Right and wrong

  • Blog Post Date 09 May, 2016
  • Perspectives
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The Economic Survey 2015-16 put forth the argument that the Government of India could reduce its capital in the RBI from its current large level and use it to increase its capital in public sector banks, which face a capital shortage. RBI Governor Raghuram Rajan has stated that this argument is not valid. In this article, Prof. Gurbachan Singh contends that while the argument does not hold in general, it does so for all practical purposes under the present conditions.

Of late, public sector banks (PSBs) in India have faced major losses due to the need to write off large non-performing assets (NPAs). Accordingly, their equity capital has been reduced substantially. There is a need to recapitalise these banks, given the Basel capital adequacy norms1. Also, given the policy of the Government of India (GOI) to maintain the public-sector character of these banks, it is imperative that only the GOI recapitalises these banks. The GOI can finance this recapitalisation in three ways. First, it can increase its revenues. Second, it can increase its borrowing. Third, it can change its portfolio of existing assets; it can disinvest in some assets and increase its capital in PSBs. Given that the first two are not possible or not advisable, the Economic Survey of 2015-16 (Government of India, 2016a, p. 19-20, Box 1.6) has made the following observation and suggestion: The GOI owns the central bank viz., the Reserve Bank of India (RBI). It is interesting that the equity capital of the RBI (in different forms) is very large by international standards and also by other yardsticks. Given this situation, the GOI can reduce its equity capital in the RBI without affecting the credibility of the RBI (it can still remain an 'AAA-rated entity'). The GOI can use the resources to recapitalise the PSBs.

The RBI Governor has argued that the above argument of the Economic Survey is not valid. So who is right – the Economic Survey or Governor Rajan? In this article, I argue that the latter is right under some conditions (Scenario I) and that the Survey is right under other conditions (Scenario II). The more realistic scenario is Scenario II.

For analytical purposes here, the economy has the following entities: the GOI, the RBI, the PSBs, the firms and the households. I will consider some trades in assets among these entities. The term trade should be interpreted in a broad sense here to include any exchange of assets among the public bodies as well. The public bodies include the RBI, the GOI and the PSBs (though there is some private ownership as well in PSBs). Incidentally, in either scenario, there is no effect on the high-powered money issued by the RBI2as a result of the policy proposed here.

Scenario I

Consider the following trades. (We will see a little later the conditions under which the trades can materialise.) The RBI buys back some of its shares from GOI (say, for an amount of Rs. 2,000 billion). The RBI pays for these shares by giving up some of its holdings of GOI bonds. The GOI sells these bonds in the open market to the households and uses the proceeds to recapitalise PSBs. The latter make additional loans to firms. The latter, in turn, use the funds to buy some assets, say, buildings which were previously owned by the households. Finally, the households sell their assets (buildings in this case) and buy GOI bonds. Observe that we have come full circle. Recall that the GOI sells its bonds to the households.

The crucial assumption in the above analysis is that households are interested in buying GOI bonds on a large scale. This is not realistic (which is why public bodies like the RBI and PSBs are in one way or another expected to hold GOI bonds in the first place). In this context, the RBI Governor is right that the disinvestment of a large amount like Rs. 2,000 billion from the RBI cannot be used to invest in capital of the PSBs.

Scenario II

Now consider another scenario. As in the previous scenario, the RBI buys back its shares worth Rs. 2,000 billion from GOI and pays for these by giving up its holding of GOI bonds of the same amount. Hereafter, consider a slightly different story. The GOI sells bonds worth Rs. 250 billion in the open market. It uses this sum of Rs. 250 billion to recapitalise PSBs; this is the sum considered in the Union Budget of 2016-17 (Government of India, 2016b, p. 18). The rest of the story is the same as before, with the only change that the amount involved is Rs. 250 billion (and not Rs. 2,000 billion).

Of course, even with the sale of GOI bonds to the extent of Rs. 250 billion, there can be a rise in the yields on GOI bonds for these to be bought by the households (the latter term is used broadly in the context of both direct and indirect holdings of GOI bonds by households3). However, the rise should be manageable, given that the size of the usual borrowings by the GOI which are quite large (the Budget estimate for 2016-17 is Rs. 5,339 billion).

In this scenario, two objectives are achieved. First, the gross debt of the GOI is reduced by Rs. 1,750 billion. Now the measure considered by analysts internationally is typically government's gross debt (and not debt that is net of investments in the public sector). It does not matter very much for developed countries whether gross debt or net debt is considered, as investments in the public sector are usually not large in relation to the debt in such countries. But this is not the case in a country like India. However, this fact is often lost sight of. So the figure for gross debt exaggerates the fiscal difficulties in India. A reduction in gross debt through the proposed policy definitely helps in this context (even though the net debt of the GOI will be unchanged after the GOI disinvests in the RBI to the extent of Rs. 2,000 billion). Second, PSBs will be recapitalised to the extent of Rs. 250 billion. It is interesting that, at the present stage, the amount planned for the recapitalisation of PSBs is about this much. So the Economic Survey is right - given the present needs and circumstances, including the perception that public debt in India is large.


  1. The international norms for maintaining minimum capital in banks are referred to as Basel capital adequacy norms.
  2. High-powered money is the money issued by the RBI. It is the basis for the total money in circulation in the economy.
  3. Households may buy GOI bonds directly or indirectly through their holdings of mutual funds, pension funds, insurance funds, bank deposits, etc.
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