Ind-Ra: Rising Headwinds for Credit Availability & Cost

India Ratings and Research (Ind-Ra) believes the prevailing tight financial conditions could intensify the impact of ongoing credit events unless liquidity of financing channels is at least partially reinvigorated. Ind-Ra views the adverse conditions in the interest rate market, increasing risk aversion by public sector banks (PSBs), volatile external environment and limited access to alternative financing options as critical drivers for corporate credit quality in FY19, especially for weak entities (rated BBB+ and below). Collectively and concurrently, these could pose risks for the system's financial stability.

Increase in Corporates' Need for Liquidity and Refinancing: The rising risk aversion in the market indicates that sourcing credit for issuers who are rated below 'A' category is increasingly becoming difficult. Ind-Ra's recent analysis of the top 500 corporate borrowers which comprise about 78% (INR43.6 trillion as of FY17) of the overall banking system's corporate exposure indicates that around INR7.60 trillion debt is on the books of the non-public sector entities rated in 'BBB' category and below (sample set) or have no rating outstanding. (Corporate Risk Radar FY19: Deleveraging led by Metals, Broad-Based Recovery to Take Longer)

Consequently, Ind-Ra estimates that in the absence of favourable liquidity/market conditions, refinance pressure (working capital renewals and replenishing run down of existing debt) could impact INR3 trillion-4 trillion exposures (Vulnerable Set) of the sample set. These would remain reliant on banks for refinancing, given that in most of these cases, free cash flows would be inadequate for debt repayments.

Elevated Credit Costs and Limited Capital Buffers could Limit PSBs' Lending Ability: Ind-Ra expects the Indian government's substantial infusion of INR1.53 trillion (FY18: INR0.88 trillion; balance expected in FY19) to be adequate to cover credit costs emanating from stressed assets. Baring three-four healthy PSBs, the FY20 CET1 may be below the current regulatory requirements. This could increase banks' risk aversion and could skew incremental lending towards better rated corporates, leaving lesser space for small and weaker credits.

NBFCs Remain Reliant on Banks: Ind-Ra opines in absence of PSBs, private sector banks and non-banking finance companies (NBFCs) could fill the gap with higher market penetration subject to their risk appetite. However, 50%-60% of 'AA' category NBFCs' liabilities are sourced from banks, and this goes up for those rated in lower categories. Also, some banks could approach sectoral limits on exposure towards NBFCs. Consequently, NBFCs would capitalise on these opportunities and fill the credit gap to a moderate extent.

Market Borrowings not Fully Resilient: Ind-Ra believes the dependence on market-based financing is not free from headwinds, given the inadequate depth and skewed preference for investments. Also, given a sectoral cap for mutual fund investments, crowding out by large borrowers would reduce investor appetite for funding medium to small borrowers.

Rising External Vulnerabilities: Ind-Ra believes the domestic financing market could be impacted by rising externalities: i) elevated global yields and pressure on the Indian currency, ii) impact on input costs iii) abrupt outflow of funds from the country and iv) volatility in the currency markets.

Frontloading of Bank Re-Cap and OMO Purchase could Address Tight Financial Condition: Ind-Ra believes excess system liquidity has become necessary to absorb the short-term financing challenges without stoking an irrational credit culture in the near term. Moreover, amid idle system capacity in various sectors with limited ability of banks' lending, scope for an overheated economy appears to be limited. Importantly, liberalisation and deepening of financial markets increases the interest rate elasticity of demand, thus, overall growth could be affected if this condition continues for long. While recapitalisation will partially restore PSBs' ability in normal lending, frontloading and early infusion could address credit tightening to a certain extent.

Ind-Ra believes rising trade deficit, volatile capital flows and elevated cash in circulation necessitate an infusion of base money through open market operations. The requirement of base money creation is anything above INR2 trillion, given the expected nominal GDP growth of 10.9% in FY19. This will also alleviate undue volatility in short-term money markets rates. While the base money creation by the Reserve Bank of India could be done by back loading, a pre-emptive action will be judicious to reduce inter-temporal consequences. Thus, for the medium term, a well-capitalised banking system with efficient allocation of capital would be essential for sustainable economic growth.

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