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The Big Credit Freeze
Businesstoday.in  |  July 26, 2019

Anand Adhikari New Delhi

A decade after the Lehman Brothers crash, which triggered off a global financial contagion, central bankers and governments around the world are well aware of how quickly panic and tight liquidity can spread - and threaten the entire economy.

 

The government and the Reserve Bank of India (RBI) are working overtime to ensure that a similar panic and liquidity crisis does not get out of hand - and roil the economy that is already facing too many other pressures. After 10 months of liquidity deficit for banks, the RBI liquidity tap is back to surplus in the last two months, but will it stay there for long?

 

The events leading up to the current liquidity crisis in the Indian financial system started, ironically enough, with an attempt by the Indian banking regulator to clean up the system four years ago. In 2015, the RBI initiated the asset quality review (AQR) of banks to unearth the number of bad loans that were hidden in their balance sheets. As skeletons in the loan cupboards of many public sector banks - and a few private sector banks - came tumbling out, the RBI realised that close to a dozen banks did not have the wherewithal to continue lending without cooking books.

 

It put them under what it called the prompt corrective action (PCA) watch - and forbade them from lending afresh unless their capital adequacy was shored up. The government, also determined to clean up the financial Augean Stables, passed the Insolvency and Bankruptcy Code (IBC) to force lenders to take recalcitrant borrowers to bankruptcy court instead of giving them even bigger loans with which they paid back their earlier loans.

 

Meanwhile, as banks became supposedly more prudent about their lending, an even bigger storm was inadvertently triggered off. As banks focussed on cleaning up their books and lending more cautiously to troubled sectors and businesses such as real estate and infrastructure, the non-banking financial companies (NBFCs) and housing finance companies (HFCs) were making hay and experiencing growth like never before. They had stepped into the breach and started providing funds to not only troubled sectors but also small and medium enterprises that found it difficult to get project loans from banks. The problem was that the NBFCs and HFCs - often called shadow banks because they lend like banks but have fewer constraints of regulation - were actually borrowing short-term money from banks and mutual funds to lend for long-term projects. It was the perfect storm brewing in the financial sector.

That storm hit with full force when Infrastructure Leasing and Financial Services (IL&FS), which was both a lender and executor of infrastructure projects, got into trouble. In June last year, one of its subsidiaries defaulted, setting off a chain reaction. Suddenly, NBFCs that were happily raising short-term commercial papers (CPs) from banks and mutual funds to roll over their previous borrowings, found it difficult to access the money. Neither could they liquidate their assets - loans to projects that were long term and incomplete.

 

The credit squeeze in the financial sector is now rapidly spreading to the real sectors of the economy, and threatening to take them all down.

 

Direct Hit

 

The real estate and construction sector is bearing the brunt of the NBFC fund crunch. Credit to developers, which is wholesale funding, is vanishing fast. Parth Mehta, Managing Director of Mumbai-based Paradigm Realty, explains the dilemma that developers are facing. "The industry's bank loan repayment (dates) are nearing or are here but the market (sale of properties) is not catching up," he says. Banks and NBFCs are staying away from early and mid-stage real estate project funding (which are at land acquisition or initial build-up stage). Instead, they prefer to lend to a project once the building is half finished or where some sale has taken place. "These negative sentiments are also contributing to delays in disbursement," says Mehta.

 

The credit squeeze has hit everyone, says Niranjan Hiranandani, Co-founder and Managing Director of Mumbai-based real estate major, Hiranandani Group Senior Vice-president of industry association Assocham and National President, National Real Estate Development Council. "There is simply no money available even for good businesses to expand," he says.

 

The other sector that the liquidity squeeze has hit is automobiles, which was already reeling under a slowdown. The auto industry used to generate a lot of sales via the financing route. NBFCs, in fact, enjoy a 30 per cent market share in this with a lending book of Rs 1.22 lakh crore. "NBFCs fund our growth as new customers who are not serviced by the banking industry come through them. They bring in 15-20 per cent incremental sales. That has all gone now," says Ashish Kale, President of Federation of Automobile Dealers Association (FADA), and Managing Director of Nagpur-based Provincial Automobile.

 

Most dealers borrow from banks for working capital and inventory management but a slowdown in the auto sector means dealers are strugglling to liquidate stocks and loan defaults have gone up. A record 271 dealers have shut shop over the past 18 months, which has made bankers more cautious. They have now resorted to seeking high collateral for inventory funding, sometimes to up to 100 per cent of the loan amount.

 

The gems & jewellery sector is also gasping for funds. The squeeze started with the twin shocks of demonetisation and GST, followed by the Nirav Modi and Mehul Choksi frauds in the banking sector coming to light. In the last four years, the outstanding bank credit to the sector has been stagnant at Rs 72,000 crore.

 

The infrastructure industry saw lending from banks dry up. Even though the government is pumping in crores, the average 2 per cent growth in banks lending to infrastructure in the last four years shows a heightened risk perception. "We are not going to finance green field infra projects," Axis Bank CEO and Managing Director Amitabh Chaudhry had announced when he took over in January this year. IDFC First Bank Managing Director and CEO V.

 

Vaidyanathan has taken a decision to completely wind down the bank's infra book in the next five years. Similarly, others like ICICI Bank and public sector banks (PSBs) have turned extremely cautious in lending to the infrastructure where one-fifth of the total loans are currently under stress.

 

"There was some stability in February and March but again in April there were challenges: there was liquidity crunch and demand was not forthcoming, except in the retail segment which gets a push due to elections. Project construction or big infrastructure projects have come to a standstill," says Anil Kumar Chaudhary, Chairman, SAIL. "People do not have money to make the purchases even though they are out of stock and want to make the purchase. They are waiting for the right time," he adds.

 

Small and medium enterprises are running from pillar to post to find project finance. "Banks are considering only small-value proposals up to Rs 1 crore. Their focus is more on micro loans, especially Mudra loans. The SMEs have been completely left out," says Chandrakant Salunkhe, Founder and President of SME Chamber of India. Further to this, banks are not considering restructuring proposals either. "They are aggressively placing SME promoters in the 'wilful defaulter' (category) for technical reasons like utilising working capital loans for buying land or plant and machinery," he adds. If an account gets classified as a wilful defaulter, its credit lines are stopped.

 

NBFCs had stepped in to lend to SMEs in the past few years, evident from the high levels of loan against property (LAP) given by them. Non-banks have actually emerged as the biggest players in the LAP market with 53 per cent market share and outstanding lending at Rs 1.85 lakh crore as of March 2019. However, the liquidity squeeze has closed the doors to this source too for SMEs.

 

Crisis of Confidence

 

A series of events snowballed into the current cash crunch. The sudden discovery that IL&FS - which had been classified by the RBI as a systematically important financial institution - was in a sorry mess and might not be able to pay up almost Rs 90,000 crore of loans it had taken, was what triggered the events that led to strict scrutiny and the resultant liquidity tightening in the NBFC sector. That, in turn, set off a domino effect.

 

Dewan Housing, a large HFC, is on the verge of a collapse because it had aggressively borrowed to lend and grow, but suddenly found the money sources turned off. It defaulted on one loan, and then another, and is now in discussions with its lenders to stave off a collapse.

 

Other players like Anil Ambani-led ADAG Group companies Reliance Home Finance and Reliance Commercial Finance, Indiabulls Housing Finance (post-merger announcement), Edelweiss Financial Services and Piramal Capital have either seen a downgrade in their long-term or short-term ratings or have been put under rating watch for a possible downgrade later. Even some of the biggest names are trying to sell off portions of their loan portfolios or other assets, or bring in strategic investors.

 

There are dozens of mid-size NBFCs that have been facing severe resource constraints. Rating agencies have also turned cautious: they are downgrading and putting many companies under a rating watch.

 

The genesis of the current crisis is somewhat similar to the 2008 US credit crisis - a phase of indiscriminate lending and higher reliance on short-term debt followed by defaults by institutions, financial panic and a crisis of confidence in the credit market.

 

Tight Squeeze

 

How big is the Indian credit squeeze? Big. Here's how. Banks - with Rs 80 lakh crore lending book - turned cautious a few years ago. The Rs 29 lakh crore NBFC sector stepped in to give retail loans and fund real estate, construction, MSMEs players, and others. But post the IL&FS crisis, the NBFC book is shrinking. Their share in credit flow has shrunk from close to 40 per cent last year to 26 per cent in 2018/19. The new bankruptcy code, too, has had a role to play - close to 2,000 defaulters are facing National Company Law Tribunal (NCLT) proceedings.

 

There was a chain reaction, from financial creditors to operational creditors, from dealers or even customers. In addition, the money flow from large investors like mutual funds, insurers, HNIs or those who borrow from NBFCs to invest in the real estate and the secondary stock market is down to a trickle. As a result, many mid-size companies are not getting the right valuations in the primary market. For instance, resource mobilisation by way of public and rights issues fell drastically from Rs 83,000 crore in 2017/18 to Rs 16,000 crore in 2018/19. "Good companies will turn bad because of liquidity shortages," warns Hiranandani.

 

Are Indian policy makers proactive enough to douse the fire? A fortnight ago, the Union Budget proposed that PSBs buy asset portfolios of financially sound NBFCs with Rs 1 lakh crore guarantee coverage of first loss up to 10 per cent. The government has also allowed foreign investors to invest in debt securities of NBFCs.

 

Will any NBFC be bailed out? "The question is how it (the gap) is to be bridged to restart the lending," says Jaspal Bindra, Executive Chairman at Centrum Group, a diversified financial services firm.

 

The Clogged NBFC Tap

 

At the centre of the crisis are NBFCs, which have been one of the largest sources of funds for corporate India as they pool in resources from mutual funds and insurers. When banks' balance sheets were being cleaned, NBFCs supported the key industries. In fact, banks chipped in with lending to NBFCs (currently, the level is in the region of Rs 6 lakh crore). "This situation completely changed after the IL&FS crisis," says Hiranandani. Banks withdrew credit as did the mutual funds (which were lending through short-term CPs). This shortage created asset-liability mismatches.

 

The CP issuance data for the past five years shows the dangerously high dependence on short-term funds by NBFCs. CP issuance jumped to Rs 25.96 lakh crore from Rs 11.50 lakh crore five years ago (see: Raising Resources From Market). NBFCs were not bothered about redemption because supply was much more than the demand. "They rolled over CPs whenever there was a liquidity issue," says a mutual fund manager who did not wish to be named. But this stopped after the IL&FS and Dewan Housing debacle. Corporate treasuries as investors into liquid funds were also watching the quality of mutual funds' short-term portfolios.

 

The Economic Survey, in the beginning of July, pointed out that the mutual fund deployment of CPs was at negative 12 per cent in April 2019. Banks, too, stepped away en masse. As a result, most NBFCs are facing asset liability issues because money has already gone into long-term loans or to developers. "One set of NBFCs has taken short-term loans for long-term lending, whatever their reasons may be. The other set has large exposure to builders, who are unfortunately not able to sell their inventory, and because they are not able to sell their inventory, they are not able to pay," says Sanjay Chaturvedi, CEO, Shubham Housing Development Finance.

 

"There is also a sentiment play to liquidity. There have been surprises (defaults) and more surprises in quick succession in the past," says Bindra. This sentiment play has affected the bonds market too, where the resources are available to the privileged few that have investment grade ratings of at least AA.

 

However, in all fairness, the ability of India Inc to raise funds from the market has also been affected by over-leveraging, low capacity utilisation and disruption caused by demonetisation and GST.

 

Banking flows run dry

 

Banks have played a very significant in role in the credit crunch saga. PSBs, the biggest supplier of credit, especially large loans, turned risk-averse post the regulatory push by the RBI four years ago to clean up their balance sheet. More recently, big private banks like ICICI Bank, Axis Bank and Yes Bank joined the list. While the demand for credit was already weak, those who did need money, like real estate, jewellery, infrastructure (especially roads), power and SMEs, found it difficult.

 

Those rated BB or lower saw banks cutting their exposure. For many corporate and SME borrowers, only the working capital tap was left open.

 

A dozen weak banks (identified by the RBI for prompt corrective action) have been part of the problem. These banks had continuous losses, lower capital and growing NPAs. For instance, a large bank like Central Bank of India reported de-growth of about 5 per cent in its loan book in 2018/19. Many weak banks shifted their lending focus from infrastructure, steel and textiles to agri, MSMEs and retail (mostly unsecured). In the past few months, half the weak banks are back in the market to restart lending as the government has promised to pump in capital but the lending activity is very ive.

 

Banks themselves are facing asset liability management (ALM) issues as most of the deposit resources are short-term in nature. "Apart from credit risk (in long-term projects), there is also an ALM risk that the bank takes into account before lending money," says Krishnan Sitaraman, Senior Director at CRISIL. In addition, weak balance sheets restricted the ability of some banks to raise resources through certificates of deposit (CDs), another source for banks to mobilise resources from mutual funds and other institutional investors. CD issuance showed a fall to Rs 5.65 lakh crore from Rs 7.72 lakh crore five years ago.

 

Bankers suggest that there is a secular decline in the deposit growth if one takes a longer period. Deposit growth, despite the presence of many new private banks, has actually declined from 20-25 per cent levels in early 2000 to single digits (see: Fall In Deposit Growth). "Deposit growth has not kept pace with credit growth," admits Sitaraman. Investors' comfort with investing in mutual funds, insurance and even equity, is one of the reasons for lower deposits, says Rakesh Kumar, Research Analyst-Banking at Elara Capital. Higher interest rates means postal savings are more attractive for rural and semi-urban investors.

 

Current account deposits from companies has been affected by high levels of stress - almost one-fifth of these accounts are either NPA or classified as stressed. Some weak banks are discouraging term deposits or keeping away from competing on rates because of the higher interest cost they will have to bear and lack of avenues to deploy the deposits profitably. "Credit drives deposit growth as a fundamental concept of monetary system," says Arvind Chari, Head-Fixed Income & Alternatives, Quantum Advisors, which caters to institutional, HNIs and retail investors.

 

Domestic Savings Leakage

 

A credit squeeze in sectors like real estate and construction has a spill-over effect on the larger economy. The recent Economic Survey has pointed out that the fall in the household savings is mainly due to a decline in physical savings (real estate, gold) by households, and only a marginal decline in financial savings.

 

The overall savings rate in the economy has fallen from the levels of 33 per cent-plus of GDP in 2012/13 to 30 per cent. The biggest reason for this is households' savings rate falling from 23 per cent to 17 per cent in the same period (see: Household Savings).

 

The two other elements of gross domestic savings - savings of private and public sector companies - are also not encouraging. The corporate savings rate looks better despite GST and other disruptions mostly due to the benefit that consumption driven companies got from lower commodity prices, says Nikhil Gupta, Chief Economist, Motilal Oswal Financial Services.

 

There is not much hope from PSU savings as the government is asking PSUs to manage their capital requirements by borrowing directly from the market. Many would have to dip into their savings to partly fund the expenditures.

The net financial savings are also falling - 7.2 per cent in 2011/12 to 6.6 per cent in 2017/18. The rise in financial liabilities (loans, credit cards) of households is shrinking financial savings.

 

In a scenario of falling household savings, low level of financial savings, and a high level of government borrowing to bridge fiscal deficit, private investment was suffering. But the government's proposed Rs 60,000-70,000 crore sovereign global bond issuance to partly finance its Rs 7 lakh crore borrowing would certainly provide some relief to the domestic market. Experts suggest that the pressure on interest rates would ease, there will be better transmission of policy rates and also leave domestic savings for the private sector.

 

System Liquidity Deficit

 

A broken credit system, decline in deposit growth, and a falling domestic savings rate all reflect in the liquidity crunch. The liquidity in the system was in a deficit mode since July last year, peaking at Rs 1 lakh crore in December last year. This showed that banks were not getting adequate liquidity from the RBI window for their daily mismatches (see graph: Currency: Inadequate Currency in Circulation), which affected money flowing from banks to NBFCs and to other key sectors of the economy. The other two factors that also contributed to liquidity deficit are currency in circulation post-demonetisation and the intervention by the RBI in the foreign exchange market to protect the rupee's value against the US dollar.

 

For instance, currency in circulation increased from Rs 13.35 lakh crore during the demonetisation year 2016/17 to Rs 21.36 lakh crore in 2018/19. The currency with public, which used to be around Rs 1 lakh crore for each of the five years before demonetisation, has jumped to Rs 4.95 lakh crore in 2017/18 and Rs 2.92 lakh crore in 2018/19. Chari of Quantum says that the currency in circulation has followed a seasonal pattern for decades, but not so last year.

 

Outflow of dollars and the consequent pressure on rupee value against the US dollar has been another part of the puzzle. "The RBI had to intervene with over $30 billion to protect the rupee's value at a particular level," says a forex dealer. This intervention actually meant selling dollars and absorbing the rupee liquidity from the market.

 

In addition, the general elections, too, absorbed some liquidity, while government balances with the RBI increased because of a slowdown in its expenditure as the Model Code of Conduct kicked in.

 

Some question whether the economy was fed with less cash post demonetisation to meet digitisation objectives? One view is that the currency in circulation has always been 12 per cent of the nominal GDP. If one takes the nominal GDP of Rs 190.10 lakh crore in 2018/19, the currency in circulation should be Rs 22.81 lakh crore. But the actual currency in circulation by March 2019 stood at Rs 21.36 lakh crore, showing a likely deficit of Rs 1.45 lakh crore.

"It seems that the economy hasn't been able to adjust to lower cash levels as was assumed," says Chari of Quantum. At present, system level liquidity has been back in surplus mode in the last two months, but will it stay there for long?

 

Lessons for policy makers

 

The steps taken by the government and the RBI to infuse liquidity would surely help. Rajkiran Rai, Managing Director of Union Bank of India, terms the pooled assets Budget proposal as a good confidence building exercise. "NBFCs need a boost as they play a crucial role in financial intermediation in the economy," says Rai. Many experts suggest that the need is to repair the NBFC engine and bring back confidence in money markets. Sanjiv Bajaj, Managing Director and CEO of Bajaj Finserv, recently said that the top 10 NBFCs have assets in excess of Rs 50,000 crore each. "They are responsible for over 25 per cent of the incremental credit that is driving our economy over the last five years," he said.

 

Finance Industry Development Council, a representative body of NBFCs, has been asking the government and the regulator for a dedicated liquidity window through the banking channels. Raman Agarwal, Chairman, FIDC, had recently said, "We need a permanent liquidity window for NBFCs on the line of the National Housing Bank."

 

The real estate industry is expecting the loan repayment schedule to be extended. "The government can also start accepting housing inventory in place of the various charges levied to ease the pressure on the real estate industry," suggests Mehta of Paradigm Realty.

 

Uday Kotak, Managing Director and CEO of Kotak Mahindra Bank, put the liquidity issue in perspective by linking it with the "price of liquidity". The cost of liquidity or funding has gone up substantially, which would impact the business models of NBFCs.

 

There is also an issue of financial stability. Solvency contagion losses to the banking system due to idiosyncratic NBFC or HFC failure show that the failure of largest of these can cause losses comparable to those caused by the big banks, states the RBI Financial Stability Report.

 

The economy and the financial system are two sides of the same coin. Ben Bernanke, former Chair of the US Federal Reserve, has a lesson for policy makers in his book, Firefighting: The Financial Crisis And Its Lessons, which he has co-authored with two other key policy makers of that time. He suggests that even aggressive measures to stabilise the financial system cannot succeed if the economy is imploding, while aggressive measures to revive the economy cannot succeed if the financial system is collapsing. "Crisis fighting and macroeconomic policies have to work together, and a government's ability to limit the intensity of a financial crisis depends on its macroeconomic room for manoeuvre," advises Bernanke. It's time to act now on both fronts.

 

Inputs from Dipak Mondal and Sumant Banerji