A default at some units of IL&FS exposed structural weaknesses in the debt market.
It was a tale too good to last. For years, non-banking finance companies (NBFCs) grew at a scorching pace. Their loan growth was double the rate of bank credit as bad loan-hobbled public sector lenders eased up on advances. Now, the growth story threatens to unwind.
A default at some units of IL&FS exposed structural weaknesses in the debt market, with poor secondary market liquidity, and NBFCs' own business model. They had been borrowing on a short-term basis to fund long-term assets.
Now, a default by real estate company Supertech means questions will now be asked of their assets as well, not just liabilities.
The near-term risks are high. According to a Credit Suisse estimate, NBFC debt securities worth around Rs 2.5 lakh crore held by mutual funds are expected to mature between October and March. In October and November alone, around Rs 1.6 lakh crore of debt is up for redemption or rollover.
Rolling over this debt is not going to be easy. Mutual funds are pretty close to maximum exposure to NBFC debt paper, according to Credit Suisse.
Debt mutual funds also saw large outflows in August and September. That means unless there is a large increase in inflows in October, it is difficult to see how mutual funds can pick up more or even retain the same NBFC exposure without breaching statutory limits. In any case, this will lead to an increase in interest rates on NBFC debt paper.
The second channel is bank funding, which is more of a medium-term problem. Bank lending to NBFCs has been growing at 40 percent. Recently, the State Bank of India said that it will triple its purchase of NBFC assets to Rs 45,000 crore this year. But banks will be very selective in buying such assets.
For instance, they may prefer to buy only retail assets that qualify for their priority sector targets. That’s because a prolonged liquidity stress can shake up NBFCs' business model and cause them to default on their loans.
Thus, if the liquidity stress continues, there is a real danger that NBFCs will cut back on lending and affect economic growth. The default of the likes of Supertech would create its own set of problems. As NBFC lending to sectors such as commercial real estate gets crimped, it could lead to asset quality problems for them, further constraining overall credit and economic growth.
What can policymakers do at this instance?
The Reserve Bank of India (RBI) has limited space for increasing system liquidity. Its monetary policy is calibrated tightening, which calls for system liquidity to tend to a deficit. Although the central bank is going infuse durable liquidity to the extent of another Rs 36,000 crore this month via bond purchases, the sharp depreciation of the rupee ties its hands.
Second, although system liquidity may ease, it may not find its way to NBFCs. Some sort of targeted liquidity infusion or a refinancing window may be in order. Note also that the NBFC sector – apart from some bad apples like IL&FS – is not facing any solvency threat now. It is up to the RBI to restore confidence and ensure that the liquidity crisis doesn’t spiral into a larger mess.At the time of the monetary policy review on October 5, RBI deputy governor Viral Acharya advised NBFCs to rely on equity and other modes of long-term finance for funding long-term assets. Perhaps the central bank could follow up by framing clear asset-liability and debt-equity norms for NBFCs.