Market Outlook- May 2019 by Navneet Munot,CFA

Contributed By : Navneet Munot, CFA, CIO, SBI Funds Management Pvt Ltd and Chairman, CFA Society India

Market Outlook-
India has had a long NPA cycle playing out in its banking system starting 2012. Just as the market was getting hopeful on withering away of banking sector stress, the other financial arm, namely NBFC sector saw the signs of stress. Default by the IL&FS acted as a catalyst and increased the concerns on liquidity and asset-liability management (ALM) mismatch for other NBFCs and HFCs.

The non-banking financial sector was a beneficiary of formalization, digitalization and financialization of the economy at a time when banking sector was facing challenges. Surplus liquidity conditions post demonetization helped the sector immensely. Consequently, we saw a handsome increase in credit disbursement by them. In the last one year however, the re-monetization was rather fast and the inter-bank liquidity gyrated from surplus to deficit by 2H 2018. Further, crude prices rose, foreign capital inflow weakened and rupee depreciated prompting RBI to hike rates in 2018. Combination of these factors sucked out cheap money, creating challenges on managing both liability and asset side for these entities.

If global history is any guide, liquidity crisis not handled well can translate into some sort of solvency crisis. Since the IL&FS default in September 2018, nearly Rs. 7 trillion of debt has been downgraded by various rating agencies. A handful of them have seen steep downgrades in a very short span of time. A part of corporate India, particularly promoter entities with higher leverage, is also facing the stress. The real challenge for markets will be when liquidity risk intersects with default risk, which could then amplify credit risk into a downturn and have contagion effect.

Presently, the risk aversion has heightened amongst all the key market participants and policy makers need to act swiftly. The system needs three-pronged approach at macro level, a) reduction in cost of funds, b) massive liquidity injection and c) backstop arrangement for the illiquid assets. Thankfully, benign inflationary environment offers ample space for easing. But transmission of monetary easing can only happen in the environment of easy liquidity.

The US adopted Troubled Asset Relief program during 2008 crisis wherein the government purchased toxic assets and equity from the financial institutions to strengthen the financial sector. Similarly, the Eurozone had longer-term refinancing options (LTRO) which enabled cheaper funds to financial institutions by keeping these troubled assets as collateral. India too needs to think fast, bold and creative and provide some sort of backstop arrangement.

Simultaneously, at a micro level, this needs to be complemented with entity level resolution. For example, during 2008 crisis, some entities had to go under (Lehman), while swift solutions were found for rest of the system (for example, Wachovia was bought by Well Fargo, Goldman Sachs and Morgan Stanley saw capital infusion by influential investors, Government infused capital in AIG and CITI).

Over the years, with improved digitalization, the access to credit has improved. But we still have a long way to go. India’s credit as (% of GDP) is low and financial system will need to deepen a lot more. The NBFEs have played a significant role in financial inclusion. Some of them successfully have grown into Small Finance Banks and Scheduled banks. These non-banking players are typically seen to have stronger niche in credit origination, credit appraisals, risk assessment and recovery. They have built a network, systems and processes for origination, particularly in the unorganized sector. But they face challenge on building a stable liability side. Further, the refinancing options and the line of liquidity to them are not as strong as the banks. India’s wholesale funding market has not grown in line with the size of the economy.

On the other hand, the banking system, particularly the PSU banks have a very strong liability side. While the banks benefit from cheap and relatively sticky liabilities base, the non-banking financial entities have displayed better expertise in building asset side and reaching out to the unbanked individuals and entities.

The policy makers need to capitalize on the differentiated skill set of both these entities. The development of securitization market can help. The assets originated by NBFCs/HFCs can be pooled together and subscribed to by banks, insurance, mutual fund and pension funds as per their risk taking ability. Globally, ABS/MBS are a very large market supporting the growth of the economy.

Concentration of risk and ALM mismatch has landed India into the NPA issues time and again, be it the NPAs in DFIs, late 90’s and the current cycle of NPA in banking system and the recent challenges with NBFEs. Even the credit risk funds in the mutual fund, which take exposure to illiquid assets are vulnerable to redemptions at short notice.

Turning to the global experience again, the solution lies in developing the Alternate Investment Fund (AIF) market, where we have patient capital with highly specialized skill-set. These funds can channelize a part of long-term savings with higher risk appetite which in turn will fund the kind of assets that had so far been funded by banks/
NBFCs/ mutual funds. Apart from private equity and venture capital, we are witnessing higher participation of AIFs in other illiquid asset classes like distressed debt and commercial real estate. This is a healthy shift, but we need a substantially higher size and diversification in their participation.

As we said, the current solution lies in improved and cheaper availability of funds and a more targeted approach at entity level. We also need to revive the growth momentum. Currently, the lack of robust profitability in the corporates had lengthened their deleveraging process. Particularly, the challenges in the real estate sector had kept
the asset prices stagnant and hence the relative debt levels higher. Hence, a focus to revive real estate sector and the overall economy in general is also much needed.
After the system is back to normal, we should not lose focus on the long-term structural reforms, better capitalization of financial entities, right set of prudential regulation, stricter supervision, and a robust risk management system. Structural reforms and further development is needed in money market, corporate bond market space and also at the institutional level (including banks, mutual funds, pension funds, insurance, auditors, NBFEs and rating agencies). Greater access should be given to the foreign investors who will bring in not only much needed savings but also best practices. Good reforms of the recent years like JAM trinity and MPC framework can structurally catalyze the financialization of household savings in India. India is a capital deficient country with large infrastructure and long-term investment needs. Against this backdrop, people’s faith in capital market should not be allowed to falter under any circumstances. A focus on long term picture instead of knee-jerk and piece-meal reactionary response is critical.

India needs disintermediation. If the intermediation between savers and lenders is done by banking system alone, then we may end up concentrating the risk in the banking system where there is “implicit” guarantee by the sovereign (given the public perception that a banking entity will not be allowed to default). A growing, large economy actually needs an efficient risk sharing mechanism and not hyper concentration.

Financial sector and a part of corporate India are facing tough times while the economic growth has also slowed down. Pro-active measures taken swiftly and boldly can reverse the ongoing challenges and put India back on a much-awaited cyclical uptick. India has a host of positives to its side such as relatively lower credit to GDP for the system as a whole (the extent of leverage was much higher in US, Eurozone, China and other EMs facing similar issues). Corporate non-financial sector has deleveraged their balance-sheet over last four years and has both the need and ability to undertake capex activity, thus propelling growth. Inflationary environment is benign and favor monetary easing. The positives of the recent structural reforms are yet to play out and there is an inherent support to demand in India. Financial stability is more important than ever to keep growth trajectory right.
Navneet Munot
CIO – SBI Funds Management Private Limited
May 7, 2019