Liquidity crisis and its impact on the economy

The views and opinions expressed are of Mr. Arun Thukral, MD & CEO, Axis Securities.

A robust financial sector is the backbone of a progressive economy. By fostering an efficient mobilization and distribution of resources, the financial sector plays a crucial role in improving per capita income and consequently the quality of life. The growth of the financial sector, therefore, becomes imperative in order to elevate the overall growth of an economy. 

The financial sector in India is currently undergoing a rapid growth phase which in turn is facilitating the phenomenal economic growth. The key elements of the sector - Banks, Financial Institutions, Instruments and Markets - are evolving and getting stronger to sustain this growth. These entities, however, work cohesively, implying that any development in one affects the whole sector and subsequently the economy. The recent liquidity crunch in the economy triggered by a crisis in ‘Financial Institutions’ unit is a glaring example of this cascading effect.  

The genesis of the liquidity crunch 

The Non-Banking Financial Companies (NBFCs) in India have been in the eye of a storm recently. A closer look at the functioning of NBFCs provides clarity about this controversy.  

As a commonly accepted practice, NBFCs in India secure about 30-40% of their funds by issuing debt instruments such as debentures and commercial papers (CPs) while the rest is secured as loans from banks. Insurance companies, pension funds and mutual funds, invest in these debt papers offered by NBFCs. These fund raised by NBFCs are then channeled as loans to the clients. The competitive interest rate offered by NBFCs made them a preferred choice for customers seeking loans in consumer durable, credit cards and affordable housing segment, to name a few. 

IL&FS is one such NBFC specializing in infrastructure financing. To capitalize on growth opportunities in infrastructure development, IL&FS pursued more projects than viable. They started financing long-term projects, of over 10 years, with borrowings of a lesser duration, which widened the asset-liability gap. They started defaulting on their short-term debt repayments including the commercial paper redemption obligations. The debt amount eventually mounted to over INR 90,000 crore creating panic among the investors. 

With the default in repayment, corporates, mutual funds and insurance companies that invested in debt papers of IL&FS got their short-term funds locked-up for long-term. This created a liquidity crunch in the market. Between the Central Bank’s efforts to bolster a weak rupee and the corporate tax payments mopping up the liquidity, IL&FS crisis left lesser cash in the system.

Consequences of the NBFC crisis  

Banks and mutual funds, the primary source of financing for NBFCs, have become cautious, leading to a rise in the cost of funds. With a high borrowing cost and limited sources to secure finance, NBFCs are slowing down their lending business. Below are the few ramifications of this slowdown on various investors, market sectors and the economy:

Liquid funds & Retail investors 

Retail investors opt for liquid funds to stash away their savings for the short term. Liquid funds, in turn, invest in debt instruments, like IL&FS debt papers to offer high liquidity coupled with safety to retail investors. With a downgrade in the commercial papers of IL&FS, retail investors in even 5-star rated liquid fund suffered a loss of as much as 5% in a day and over 8% in three weeks. The only consolation for debt investors is that such sharp credit downgrades are rare and primarily affect funds with higher exposure to low-rated debt.

Auto volumes 

NBFCs play a vital role in financing commercial vehicle sales in India. Relatively smaller loan size and shorter loan duration made auto a priority lending sector for NBFCs. However, liquidity crunch at NBFCs led to a decline in the commercial vehicle order placed by fleet operators in November. According to the data by the Society of Indian Automobile Manufacturers (Siam), sales of medium and heavy commercial vehicles (M&HCV) this year dropped by 11% from November last year. 

Home sales 

Housing Finance Companies (HFCs) have cut down their disbursements in the wake of the liquidity crunch. Most HFCs are now being selective, focusing primarily on affordable housing. Real estate sector, which is already reeling under the pressure of rising inventory is now grappling with the issue of a further slowdown in sales due to higher home loan interest rates. 

Impact on MSMEs

Finance from NBFCs is a lifeline of lakhs of medium and small enterprises in India. As the MSMEs were recovering from the impact of demonetization and implementation of GST, they were hit by the cascading effect of a liquidity crisis at NBFCs. Credit availability to MSMEs has gone down, putting a break on their growth plans. 

Thus, if we look at the larger picture, the crisis that initiated in one component of the financial market is having a far-reaching impact on the economy as a whole. Business activities are slowing down due to demand constraints resulting from sluggish credit-flow. The rate of economic growth will eventually feel the pinch of this crisis. With the government stepping in to remedy the situation, the only hope is that the impact of this crisis will not be long-lasting.