Illustration. Jayachandran/Mint
Illustration. Jayachandran/Mint

Opinion | Debt market worries for the stock market

The equity market will closely track the debt market as the higher cost of funds, partly due to risk aversion, will also affect non-financial firms

The financial sector dominated the Indian stock market last week and is likely to remain in focus in the near term. Starting with the announcement of the merger of three state-owned banks, the week ended with panic on select counters. Yes Bank, for instance, plunged about 29% after the Reserve Bank of India (RBI) denied an extension to its managing director and chief executive officer Rana Kapoor. However, by the end of the week, the bigger story was playing out in the non-banking financial companies (NBFC) space.

There are multiple issues here. On the one hand, there are concerns about the rising cost of money; on the other, defaults by Infrastructure Leasing and Financial Services (IL&FS) are affecting sentiment. The problems in the debt market are spilling over to the equity market. For example, the shares of Dewan Housing Finance fell by about 60% on Friday and ended the day with losses of over 40%. Panic was triggered by the news that a fund house has sold its one-year paper worth 300 crore at 11%. Although the fund house and Dewan Housing Finance executives came out to explain their position, it was not enough to calm the market. The nervousness led to a sell-off in other NBFCs as well.

The macroeconomic environment is also not supportive. The liquidity condition in the market is expected to remain tight in the near term. The selling by foreign investors and the anticipation that RBI might increase policy rates in its October meeting is pushing yields up. The yield on the 10-year government bond has also gone above the 8% mark. Since NBFCs don’t have a sticky deposit base unlike banks, some of the highly leveraged entities might find it difficult to roll over debt. This could be a risk, as higher funding costs will affect margins. Things might become more difficult for companies with weak asset quality. These risks will be reflected in stock prices.

But the bigger worry at the moment for the market is IL&FS. It is facing a cash crunch and has missed several payment obligations. Rating agencies have cut its credit ratings. It has over 90,000 crore in debt and more than half of it is from banks. There are other financial institutions such as mutual funds that hold its paper. Theoretically, the fear of losses could lead to redemption pressure for mutual funds. It is likely that mutual funds will sell more liquid assets to meet the redemption demand, putting pressure on prices of those assets. Falling prices and rising rates would further increase redemption demand. Therefore, it is important that a problem like this is quickly addressed to minimize the impact on the broader market. 

However, at this stage, it is not clear as to how things would move forward for IL&FS. It has a large public sector holding. The Life Insurance Corp. of India (LIC) owns over 25% in the company, while the State Bank of India holds over 6%. Reportedly, LIC is preparing for a bailout. The company is also planning to sell assets to raise cash.

However, the fact that IL&FS has reached this situation highlights failure at various levels. For one, it reflects management failure. It created a complicated structure of operation and could not properly evaluate the risk of accumulating debt.

It is also a failure on the part of the regulator that allowed the buildup of leverage to a position where the group is unable to meet its obligations. A large number of subsidiaries and the complex structure of operation were enough to warrant greater oversight. Had the company raised equity or sold assets in time, the uncertainty could have been avoided. RBI is reported to have ordered a special audit after the company defaulted.

Now that IL&FS has defaulted on its financial obligations, there is no clear roadmap as to how the issue can be resolved with minimal damage to financial markets. It is likely that LIC and other large shareholders will come to its rescue. This could perhaps be the least damaging option at the moment. However, at a broader level, as the economy grows, the financial sector will require greater regulatory oversight. The government would do well to work with financial regulators to strengthen the overall regulatory framework. It should also work to create a mechanism to deal with possible defaults by firms in the financial sector.

Meanwhile, the equity market will closely track the debt market as the higher cost of funds, partly due to risk aversion, will also affect non-financial firms.

What can be done to reduce the stress in IL&FS? Tell us at views@livemint.com 

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