Fear In The Financial System

The Indian corporate bond market is jittery. Debt mutual fund managers are also feeling the heat. And the commercial paper market has almost dried up. The general nervousness is because of a chain of events that started with the first Infrastructure Leasing & Financial Systems (IL&FS) debt default that took place in June last year. Nobody knows which is the next non-banking financial sector (NBFC) company or Housing Finance Company (HFC) that will find it difficult to repay its debt. And what kind of chain reaction that will set off.

Initially, it seemed that the swift action of the government in replacing the board of IL&FS would solve the crisis. IL&FS had over Rs  91,000 crore debt, but it was apparent that not all of it would be unpayable. After all, IL&FS also had a lot of assets and it could be liquidated in an orderly manner to repay a lot of the debt, if not all, as and when it came due.

The problem was that the IL&FS default spooked the commercial paper (CP) market, which had been the big source of funds for the whole NBFC sector. The NBFCs desperately needed the CP market to remain confident because they were perpetually rolling over old debt and taking new ones via the issuance of CPs. There was a huge asset liability mismatch in the books of most NBFCs. They borrowed short-term funds (via bonds and CPs) but lent out for the long term. The assets they lent out to included housing projects and road construction, apart from expansion projects of SMEs. They were the main source of funds for projects the banks thought too risky to lend to. (It is a different matter that the NBFCs also raised their money from banks and lent to the same people banks refused to lend to.)

As long as equilibrium was maintained, there was no real problem. But with the IL&FS default, the music stopped in the CP market. And that has triggered off a whole chain of events. The first issue that showed up was in the case of Dewan Housing, an otherwise sterling HFC. The company found it difficult to raise fresh money. Even while that was getting sorted out, the Zee Group announced that it had asked some lenders for time to repay while it tried to raise money through sales of its most profitable arms. A short while later, the news about Reliance Capital being in trouble came to the fore.

Why do we need to worry? Because it is a long chain. NBFCs (or shadow banks) lending keeps a large part of the economy going. If they get into trouble, the fund flow will get squeezed to companies in every sector. Equally, NBFCs have borrowed from banks and mutual funds. If the NBFCs are now unable to repay their debt in time, it could get these banks and MFs in trouble. All in all, a fairly scary prospect for the real economy.