A series of defaults by India's key infrastructure lender, Infrastructure Leasing and Financial Services Limited (IL&FS), has sparked fears about the health of other non-bank lenders and led to a squeeze in India's corporate debt market that these lenders have relied upon. This event is likely to dampen credit growth and decrease private sector investment in infrastructure, which will significantly worsen India's economic outlook in the short to medium run.
On October 1st, the Indian government announced that it was effectively bailing out the IL&FS by replacing the existing board with a new handpicked one. This came after the group defaulted on a series of payments late last month. These defaults dented confidence in Indian financial markets and sparked fears of contagion through India's shadow banking system given IL&FS's systemic importance.
The group has a debt pile of around $12 billion and accounts of approximately 3% of outstanding corporate bonds. While the government action staved off an immediate financial crisis, shares of other non-bank lenders have fallen as concerns about their ability to service short-term debt remain.
The roots of the crisis
In recent years, India's largely state-owned banks have been increasingly reluctant to lend as they have been hampered by the accumulation of non-performing loans on their balance sheets. These bad loans were estimated to amount to $130bn by the end of March this year. As the banking sector works to repair its balance sheets, non-bank lenders (institutions that lend money but do not take deposits) or "shadow" banks have stepped in and fuelled credit growth.
A Boston Consulting Group report estimates that from 2014 to 2017, the non-bank lending sector's share in total loans rose from 21% to 44%. These lenders in turn have relied on the corporate debt market and have issued short-term corporate bonds to fund their activities. However, the infrastructure projects that the IL&FS funds are often beset with delays due to land disputes and implementation bottlenecks. The reliance on short-term debt while lending to fund long-term infrastructure projects created a maturity mismatch and led to the IL&FS's liquidity crisis.
Moreover, the crisis has dented investor confidence partly because of the decisions of the ratings agencies. Up until late August, IL&FS enjoyed a AAA credit rating, but just a month later it was dramatically downgraded straight to junk status. This steep downgrade in such a short period of time has led to investors questioning the assessments of Indian rating agencies and reevaluating the health of other non-bank lenders.
Economic risk outlook in the short to medium-run
The IL&FS default is highly likely to worsen India's economic outlook in the short run. As noted earlier, non-bank lenders have heavily relied on short-term debt. After the IL&FS default, there is likely to be less money flowing into the corporate debt market. This will make it more difficult for non-bank lenders to roll over their short-term debt. Given the dip in confidence in the ratings agencies, cost of funding is likely to increase even for supposedly healthy lenders, which in turn will decrease credit growth in the economy and lead to an economic slowdown.
Furthermore, the default has also highlighted the persistent problem of funding India's infrastructure projects. The government is unlikely to be able to close the infrastructure funding gap on its own, given its narrow tax base and other spending priorities like health, education and rural welfare. Previous governments have tried to involve the private sector by forming public-private partnerships whereby private sector companies complete infrastructure projects on behalf of the state for a part of the revenue the project generates.
However, uncertainty over contract enforcement and government corruption rendered the model unsustainable. Instead, organizations like the IL&FS have tried to act as private sector intermediaries by amalgamating private sector money from institutional investors like mutual funds to fund risky infrastructure projects. However, the IL&FS liquidity crisis has highlighted the shortcomings of this model. Without improving land acquisition procedures and cutting bureaucratic red tape needed to get projects completed on time, private investors are unlikely to be attracted to India's infrastructure sector.
Therefore, the knock-on effect of the IL&FS crisis is that many of the government's infrastructure development targets are unlikely to be met. This will severely dent India's growth potential in the medium run, rendering it a less attractive investment bet among the emerging market economies.