DHFL's liquidity problems and its reported failure this week to pay coupons highlight the funding challenges faced by non-banking financial companies (NBFCs), Fitch Ratings said in a report.
The cash crunch is in stark contrast to the banking sector, which has not faced significant liquidity pressure or deposit withdrawals, despite asset-quality and capital weaknesses, it said.
NBFC issues were already known to the market but DHFL became a focus point after the failure of IL&FS in September 2018 contributed to a sector-wide liquidity squeeze as investors become more risk averse, it said.
NBFC's liquidity is sensitive to market sentiment as their business models rely on short-term wholesale funding, which can dry up fast if market sentiment turns negative, it said.
Fitch further said funding models of housing finance companies and loan companies, which have become increasingly reliant on short-term funding to fund longer-term assets, have been particularly affected by the liquidity squeeze.
The sector pressures have led India's top NBFCs to explore other sources of funding and to start positioning themselves to tap the US dollar bond market.
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"We expect NBFCs to become more regular issuers in the offshore bond market as they seek to diversify their funding sources. If prudently managed, this should be credit positive as funding profiles are strengthened," it said.
The funding squeeze has contributed to higher funding costs and a slowdown in loan growth for NBFC sector, Fitch said.
NBFCs are an important channel for extending credit to the wider economy, given their wide distribution networks, which are often more extensive across rural India than those of banks, it said.
The NBFC sector's role as a credit provider became outsized as the Indian banking system was forced to deal with its weak asset quality, Fitch added.
Banks, particularly public-sector banks, were undercapitalised and had limited capacity to lend more. NBFCs now account for nearly 20 per cent of credit to the economy compared with about 15 per cent five years ago.
"We expect credit growth in India to remain slow, despite this week's interest-rate cut, as most banks are capital-constrained and NBFCs face tighter funding conditions," it said.
NBFCs' fast loan growth in an environment of relatively benign interest rates was increasingly funded by short-term funding, in particular, commercial paper issued to the mutual fund sector, it said.