An institutional loan must meet three requirements: It should come cheap; it should meet a genuine requirement; and its conditionalities, if any, should be acceptable. On September 22, the World Bank signed a $4.3-billion loan for capitalisation of India’s public sector banks, capitalisation of the India Infrastructure Company Ltd and debt support for the Power Grid Corporation of India. It is necessary to assess the loan from these three standpoints.

The $2-billion capital support loan for public sector banks is meant to support the stimulus package. The Finance Ministry has not revealed the terms of the loan. The loan has a 30-year tenor, with a five-year grace period. The Bank’s loan support does not come cheap. Its rates are not very different from commercial capital accessed by public sector banks from the global financial markets.

The IBRD Flexible Loan is 1.05 per cent over the London Interbank offered Rate (Libor) for tenors over 14 years. Some banks have already obtained better terms from the global financial markets. In December 2004, the State Bank of India raised a $400-million medium term note to international investors at 0.74 percentage points over Libor. In 2006, Canara Bank had raised 15-year medium term notes at 1.20 percentage points over Libor. This was the pricing when the US Federal Reserve Board was hiking fund rates.

Unlike investors in the public sector medium term note programme, who have only the comfort of an implicit sovereign guarantee, the World Bank loan is fully covered. It has an explicit sovereign guarantee — the Government will service the loan. In that event, the World Bank loan should have been much cheaper.

Domestic banks have also raised funds through Innovative Perpetual Debt instruments in the domestic markets. Coupons on the issues ranged between 8.5 and 9.5 per cent. The costs are as competitive as the World Bank’s if swap and hedging costs are factored in. The guarantee also translates into a fiscal cost. In the past, when the Government extended capital support to the public sector banks it was done through two steps. Equity was infused into the banks. An equivalent amount was invested in Government of India recapitalisation bonds — 7-8 per cent perpetual and 10 per cent close-ended bonds.

However, in making these investments there were no fiscal costs involved. Instead, the Government actually made money between 2003 and 2004 when bank equity was divested. It allowed public sector banks to buy back equities ahead of an initial public offering.

The equity buybacks from the Government were made at the then prevailing market value. The bonds were also redeemed at market value, implying a premium to face value. This was because interest rates at that point of time were low. The 10-year yield to maturity (YTM) on Government securities had dropped below 6 per cent.

However, the World Bank capital support is not fiscally neutral. Instead, it actually contributes to an increase in the fiscal deficit, through an increase in Government external liabilities. This is happening at a time when the Government is talking of fiscal consolidation.

But do the public sector banks actually need the World Bank’s capital support, especially at none-too-attractive rates? At the current juncture, there is little evidence to prove that the capital is required. Banks are already compliant with Basel I capital requirements. Under this regime, the minimum Tier one capital prescribed is 6 per cent and tier two capital is 3 per cent. But in 2007, even before the sub-prime crisis unfolded in the rest of the world, the Reserve Bank of India had pushed domestic banks for a Capital to Risk-weighted Assets Ratio (CRAR) of 12 per cent. As a result all the public sector banks currently have a capital to risk weighted ratio of close to 13 per cent.

In addition this year, banks have also been feverishly raising capital, mostly tier one, taking advantage of the liquidity overflow. This is because banks are permitted to raise up to 15 per cent of their net worth through perpetual bonds/preference shares that form part of tier one debt. Further, 50 per cent of tier one is allowed to be raised through subordinated bonds. After such capital raising efforts, it is possible that the domestic banks would become overcapitalised.

This is especially after migration to the Basel II regime from this financial year. The Basel II regime prescribes lower risk weights on retail loans. As a result, banks will actually see some risk capital being released. This is likely to push up their capital closer to 14 per cent. A classic instance is that of the State Bank of India that has a Basel I CRAR of 13 per cent and Basel II CRAR of 14.25 per cent.

The possibility of overcapitalisation, given the sluggish growth in credit, is no virtue, as it opens up the possibility of misuse of funds.Credit-deposit ratio this year is down to 68 per cent, the lowest level since the 1990s. The credit to GDP ratio is barely 50 per cent. In the US it is an astounding 375 per cent. So who is undercapitalised?

The 2008 annual report of the International Bank for Reconstruction and Development (IBRD) says that its activities “preclude lending to members who may have access to international credit markets”. Then, why is it interested in lending to India? Are there other policy objectives that are being pursued?

It would appear that the World Bank is not in a position to impose direct lending terms on borrowers — disbursements of the bank between 2007 and 2008 were down $565 million.

But ruling out conditionalities altogether would be a simplistic assumption. As the IBRD annual report says, “Decisions to make loans are based upon among other things, studies by IBRD of a member country’s economic structure...”

To be sure, it will no longer be easy to flog the rhetoric of “financial sector reforms”, at a time when the global consensus has shifted considerably in favour of regulation, with India’s public-sector-dominated banking sector being an exemplar.

In this scenario, an equity dilution of Government stake in public sector banks to 33 per cent cannot be regarded as an immediate consequence of the loan. However, the opening up of the financial sector could take a more subtle form, in the garb of reciprocity.

So, does India need the World Bank loan?