As the financial crisis spreads around the world, many in India have expressed relief and pride that the domestic banking sector, with minimal sub-prime exposure, may dodge this bullet, just as it avoided major collapse during the Asian financial crisis. Some have attributed this resilience to the fact that the vast majority of Indian banks are government-owned, arguing that privatisation efforts are misguided.

Yet, just two weeks ago the Indian government announced that it was seeking a USD 3 billion loan from the World Bank to... recapitalise public sector banks. This expenditure is of course a drop in the bucket when compared to the 70,000 crore (approximately USD 14 billion) debt-waiver announced just in time to take effect before this year’s elections. While politically expedient, the proposal quickly won widespread support from politicians as quickly as it earned derision from economists.

From an economic standpoint, there was much to criticise: tremendously expensive, it does a terrible job targeting those who truly need relief, while rewarding wilful defaulters. Perhaps most importantly, it provides strong incentives for farmers to delay or default on loans in the future, in the hopes of receiving new debt relief. This in turn provides reduced incentives to banks to lend.

Political interference is often cited by academics as an important reason to oppose government ownership of banks. In India, one does not have to search long to find anecdotes of politicians promising either easier credit or debt relief prior to elections. Yet, it has been difficult to understand the depth and breadth of this problem.

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