Experts urge caution on low interest rates, warn of liquidity crisis

Ultra-low rates run the risk of enticing firms to borrow too much, they say

The abundance of liquidity and ultra-low interest rates have surely averted a liquidity crisis in the market, but could be brewing another one, experts are warning.   

Ultra-low interest rates, on the face of it, looks good for now for the firms. They now could raise as much funds as they want without making a hole in their balance sheets. But are they borrowing too much? Experts think so, and as former Reserve Bank of India (RBI) deputy governor Viral Acharya warned earlier this week, it may come back to “haunt us.” The key concern here is that the borrowings will have to be rolled over when they mature. In the meantime, if interest rates move up, the same corporates will find it difficult to find enough replacement funding at a reasonable cost. This is precisely what had happened to non-banking financial companies (NBFC) after the demonetisation period when the banking system found itself slushing in liquidity. NBFCs borrowed cheap, but by the time they came to replace their matured bonds with fresh funds, interest rates had started moving north. Lack of rollover funding, and subsequent drying up of liquidity in the system parched the funding stream of NBFCs too. A few top rated NBFCs defaulted as a result, and the sector as a whole is still suffering from those fallouts.   

Given India’s macro constraints, where the government is spending more relative to the Indian households’ savings, “if you go along with the global liquidity glut and simply load debt on the corporate balance sheets without fixing the macroeconomic vulnerability, this could come back to haunt us," warned Acharya.  

Indian firms, mostly NBFCs and public sector units, have so far this calendar year have raised about to Rs 8.5 trillion through bonds. In 2019, they had raised Rs 7.46 trillion, and in 2018, the total corporate bonds raised touched Rs 5.88 trillion. There is an additional Rs 3.89 trillion of commercial bonds outstanding that the corporates have raised to manage their finances at an interest rate of as low as 3.09 per cent.  

But this is not something that is limited to the corporates alone. Low rates are perhaps problematic for the whole system.   

Swaminathan Janakiraman, deputy managing director (finance) at country’s largest lender State Bank of India (SBI) said there is a rush for certain asset classes. “Many lenders are offering ultra-low interest rates. If the spell of low interest elongates, it may impact the P&L, followed by asset quality," he said, adding, “the asset pricing is not risk-based but driven by liquidity."  

Low interest rate dissuades depositors from keeping money in banks. And as inflation is higher than the policy rates, India is already running a negative interest rate of more than 2 per cent. That technically means keeping money with banks eats its value away over time.   

The huge liquidity overhang has also given to a 'peculiar conundrum’, where even 15-year-old bank loans were given at a negative spread of 60-70 basis points over equivalent rated corporate bonds.   

"Such type of irrational pricing, because of abundant liquidity, can impact banking sector profits and initiate asset liability mismatch, if the spread is more prevalent for lower-rated borrowers, a sure recipe for financial instability in the future,” SBI Group’s chief economic advisor Soumya Kanti Ghosh wrote in his report late last month.   

Even more concerning was that even low rated borrowers, such as AA rated ones, were being provided repo rate-linked loans at near 6 per cent interest rate, indicating significant risk underpricing.  

With this kind of pricing, “any adverse movement in interest rates could impact bank profitability and hard-earned financial stability,” Ghosh said.  

According to Krishnan Sitaraman, senior director at CRISIL Ratings, in prolonged low interest regime, people tend to be more risk takers.   

“They feel the cost of funds is so low then let us take some more risk on the asset side. This will happen if rates stay this way (low) for an extended period of time and when on the asset side there are not many other risks.”  

"However, today, that is not the case. There are many challenges like economic growth and rising delinquencies,” Sitaraman said.