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India's government on Tuesday announced a massive bank recapitalization plan worth tens of billions of dollars — a possible "game changer" for the country's bad loans problem.
The plan could not only provide cheer for investors worried about Indian banks' worsening balance sheets, but it may also have far-reaching implications for the country's economic prospects.
The announcement has been awaited for a long time. India's growing mountain of bad loans has created weak bank balance sheets, crippling the lending ability of financial institutions and hindering the country's growth. That, in turn, makes debtors less able to pay off loans — creating a vicious cycle.
Earlier, analysts had estimated that India's banks need an additional $40 billion to $65 billion to clean up their balance sheets and to meet stricter capital requirements set by an international regulatory framework called Basel lll.
A significant capital injection from the government, however, could be a "game-changer" in breaking the cycle, Goldman Sachs said.
Many have called for New Delhi to provide more of a bailout to India's banking sector, but the government finally appears poised to address the situation.
Over the next two years, New Delhi plans to pump in 2.11 trillion rupees (about $32 billion) into public sector banks in a bid to increase money flow, loosen credit conditions, and boost investment and growth.
The government plans to finance 1.35 trillion rupees ($20.7 billion) by issuing bonds. Another 760 billion rupees ($11.7 billion) is set to come from the budget or the institutions' own fund-raising efforts.
For perspective, the total funds for the initiative equal roughly 1.3 percent of the country's gross domestic product — and the sizable sum could significantly spur economic activity. That is, within one year of implementation, the drag on bank credit growth is expected to decrease by up to 10 percentage points, while GDP growth could rise by up to 5 percentage points, Goldman Sachs said.
The Indian rupee is expected to gain in strength over the next year as a result of recapitalization, analysts at both Goldman Sachs and ING bank said.
Despite the anticipated benefits to investors and to the economy at large, the move does not come without risks.
For one, interest payment on the bond will come at a budgetary cost, which could push up government expenditure and the fiscal deficit, according to Radhika Rao, economist at DBS bank.
Already, India faces a challenging fiscal position, having spent 96 percent of its full-year deficit target in the first five months of its fiscal year. The squeeze limits the government's ability spend and boost growth.
Economic expansion had slowed to a three-year low of 5.7 percent in the April-to-June period, which many said was caused by the introduction of the new Goods and Services Tax and a recent ban on high-value notes.
The country's central bank, the Reserve Bank of India, is also more likely to hike rates sooner than markets currently expect, according to Goldman Sachs. That would prove bearish for short-term interest rates, although the impact on rates in the longer term remains uncertain, the Goldman note added.
Furthermore, the move could "sustain the risk of more public sector bank loans turning sour, swelling the country's [bad loan] ratio," according to a note by ING bank.
—CNBC's Lee Yen Nee contributed to this report.