Is the IL&FS debt default truly a Lehman moment for Indian markets? What investors must know

There is panic in equity investor circles with regards to what’s cooking in the opaque and mysterious debt markets.

In part, the panic is justified because a crash in financials stocks is seen as a leading indicator of an imminent and broader stock market crash.

Debt investors are known to be more conservative than equity market participants and a debt market freeze is often indicative of a shock across stock markets and the economy.

Stocks of Indian public banks and NBFCs have corrected sharply, partly due to fear and in part also from changing fundamentals from rising cost of borrowings. Bond yields have gone up and are expected to keep going up given the end of central bank quantitative easing, and the uptick in costs of funding globally. Money is getting expensive.

Fears of an Economic Crisis

Closer home, there is a much larger and looming fear than a stock market crash. A fear that the stress which was previously on the asset side of the balance sheet (non-performing loans) of financials has now spread to the liability side of the balance sheet (funding and liquidity for NBFCs).

Crippling of NBFCs will be akin to choking off the oxygen supply of the wider economy.

Regulatory actions and restructuring of the bad loans from profligate and irresponsible lending have turned public banks into lenders of last resort.

This critical credit vacuum has been filled by private banks and NBFCs. Small businesses must get affordable cost of capital to generate earnings and for effective job creation. Without availability and affordability of funding, infrastructure projects will also be IRR negative. Simply put, without money as raw material, the GDP cannot chug along at 8% growth.

If credit growth is the oxygen of the economy, then debt borrowings are the legs that NBFCs stand on in lieu of CASA funding available to banks.

NBFCs therefore are critical to not just credit growth but to the growing Indian economy as a whole.

IL&FS as a systemically important NBFC

Infrastructure Leasing & Financial Services (IL&FS) is a complicated holding company structure controlled partly by the Government of India. As the name suggests – it was created to fund the booming infrastructure sector. Not so long ago, IL&FS AA rated bonds were hot property for debt and mutual funds that are amongst the biggest and strongest cartel of bond buyers in the illiquid Indian debt markets.

Infrastructure projects have long payback periods and often are financially unviable. As a result IL&FS began to default on its bond payments.

Investors choose debt funds precisely because they are perceived as lower risk when compared to equity based funds but a default on IL&FS interest payments would lead to massive redemptions and NAV losses. Debt and mutual funds would have proactively sold the bonds and there would be a freeze on buying further bonds in the illiquid Indian debt market.

Not being able to meet their funding needs, NBFCs would collapse. MSMEs would not get money, home lending would stop. Credit growth would fail.

The government has therefore bailed out IL&FS as a systemically important financial institution. It has changed the composition of the IL&FS board and offered funding through the Life Insurance Corporation.

Has the Risk Contagion been stopped?

Now coming to the key question for investors – has the timely government intervention stemmed the possibility of a wider risk contagion through the markets?

The 2008 risk contagion started in the debt markets, spreading through securitization structures (such as Collateralized Debt Obligations) and leading eventually to huge trading book losses for banks.

This crisis is different or was. It is a crisis of trust and not a crisis of complexity and interconnectedness. I illustrate this below –

US Markets in 2008:

Risk path = Sub-prime Debt -> Securitization -> Debt Instruments in Trading Book

Indian Markets in 2018:

Risk path = Doubtful Infrastructure Debt -> Debt fund buyers -> Funding and liabilities for NBFCs

As you can see, fortunately, complex securitization structures are absent from the Indian debt markets. Additionally, Indian banks do not have large volumes of trading book exposures to debt products.

In other words, the 2018 Indian risk map is linear. A risk contagion event would start with credit defaults and would play out as shown below –

Credit risk -> Counterparty risk -> Market risk -> Liquidity risk

For the most part, debt markets in India serve simple functions of providing liability funding to the issuer and low-risk interest payments to the borrower. For banks it serves treasury functions rather than trading functions.

By funding IL&FS the government mitigates credit risk and by backing IL&FS through its timely intervention, the government infuses key element of TRUST to stabilize counterparty risk

Market Risk is mostly caused by noise rather than fundamentals and will stabilize as soon as a steadiness in expected cash flows are perceived.

Conclusion

If I had to put my money on the probability of a localized financial crisis – I would wager a grand total of 100 rupees, just to be a good sport, because I do not believe anything akin to 2008 Lehman Crisis in scale or spread will occur in the foreseeable future.

The optimist in me believes that the Indian debt markets will recover soon and it will be business as usual for NBFCs. In a few years, it is possible that 2018 would be seen as a great buying opportunity for NBFCs, similar to what was seen during December 2016 after the demonetization of currency notes.

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