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This September marked the 10th anniversary of 2008 Global Financial crisis. Financial crisis have sprung from excessive leverage in either of three key balance-sheets - households, corporate and government. The 2008 crisis was due to exuberance in the US household balance-sheet, the 2011-12 Euro crisis from high government borrowings in peripheral EU countries and the 1998 Asian financial crisis was marked by high corporate leverage. And the common underlying base in all the bubbles is the financial sector, which lend out to them.
Risk-taking never disappears; it just changes shape, often to circumvent the institutional and psychological defenses erected after the last crisis. Hence, financial meltdowns are the feature of human history. Notwithstanding, the 2008 crisis was a unique one as it emerged from a developed market; and that too of such a high magnitude. As we know, it roiled the financial and the real economy across the world, creating a unique learning for every participant.
In the developed world, the crisis turbocharged the financial sector regulators. They beefed up oversight, revamped the pay policies and drew regulations to ensure adequate bank liquidity. Banks must now fund themselves with more equity. More checks were put in place for derivatives markets. But, the government, perhaps reluctantly, came in to bail out the big institutions which led to fuelling of public debt. In the process, debt has effectively changed hands- from the private sector to the public sector (central banks). Globally, the overall debt levels have rather grown since 2008. And for nearly a decade, we had ultra-loose monetary policy. The cheap money tends to create multiple distortions in the global economy or financial system. The US Fed is withdrawing accommodation, both by raising interest rate (up 2% in this cycle, more to come) and trimming the QE fueled balance-sheet. As other central banks follow suit, this could unwind painfully.
For now, bank resilience is mostly based on more and better capital and liquidity, but there has also been a rapid growth in lending by non-banks. The US government is now running a pro-cyclical policy. The economy is into ninth year of expansion and we are witnessing tax cuts and higher fiscal deficit. This could fuel the debt challenge in the future. A long period of growth and cheap money leads to complacency and stretches the borrowing palate to the brim. Liquidity vanishes in a crisis. And 2008 showed the real danger lies in the belief that things that are easy to trade will remain so, because in a crisis, they never are.
Even though last crisis emanated from US, the US dollar continues its hegemony as a reserve currency. No other currency comes closer. Eurozone had been slow to repair its balance-sheet. After experimenting with a bouquet of policy tools and failing to achieve the desired result, it commenced with QE only in 2015. And Japan continues to struggle still, to have desired level of employment and inflation. China has been flip-flopping on capital controls.
The emerging market participants learnt the lessons in their own unique way. They had started to shore up their dollar reserves and diversify their trade destination. That said, the dollar borrowings of the emerging market countries have risen over the last decade making them vulnerable to prospects of liquidity tightening.
In India, while the corporate sector has been running down the leverage, the households have stepped up debt. NBFC’s loan books have risen multi-fold over the last few years enabled by banks struggle with NPAs vacating the space for NBFCs, enhanced CIBIL structure, financial inclusion, Aadhar, undergoing formalization in the economy and low leverage in the household balance-sheet. But any segment that grows too fast too soon creates a unique set of issues. The challenges which came to the limelight last month further under-scores that.
The current challenge with NBFCs appear to be largely that of a liquidity mismatch. And to that end, the contagion effect can be limited by equity infusion and re-financing. Nevertheless, the issues in specific company (ies) have sparked the negative sentiment in the equity market. NBFCs depend more on wholesale borrowing to finance their activities vis-à-vis banks which have relatively stable and the lower cost CASA and term deposits as their liability franchise. Investors have been extrapolating risk on all the NBFCs with ALM mismatch, and the effect of NBFCs to financial sector in general. If there indeed is some spill-over, it could also have some ramifications for the consumption led Indian growth. Over the last several years, Indian consumers have been spending more than their income and one of the driving factors has been increased borrowing.
In 2016 and 2017, Indian economy had been in the monetary easing cycle and the demonetization added to ample liquidity in the system. As cost of funding continued to ease, investors focused on the financial entities which could capitalize on the opportunity and grow asset books faster. However, starting 2018, the cost of capital has been inching up and systemic liquidity tightening. In such an environment, beneficiaries would be financial entities with strong, well diversified liabilities franchise. Banking regulator is becoming increasingly assertive on corporate governance. Structurally a welcome development, though in near term, extracts a cost from the banking system.
Asking the OMCs to take a rupee hit on the petrol and diesel prices bore a sniff of some reversal in deregulation efforts of the past. It wasn’t perceived any pleasantly either. Indian equities have seen meaningful correction last month and YTD, even though it doesn’t appear in the headline index (YTD, NIFTY is almost flat). It is a handful of stocks which is holding up the index. If this is a temporary liquidity squeeze or a potential new credit shock remains difficult to gauge. Amidst macro headwinds (rising import bill, tightening liquidity, rising cost of funds and raw materials, fiscal pressure raising the probability of clamp-down on government capex) and upcoming political uncertainty, we remain cautious and focus on bottom-up stock selection. Notwithstanding the current hazy environment, the sharp sell-off is creating pockets in markets which have turned cheaper for investors with a long-term horizon.
Coming to the bond market, India has had benign liquidity over the last 3 years. All the drivers have reversed. Credit growth is picking up, demonetization impulse is behind us and RBI’s intervention to reduce rupee volatility is squeezing liquidity. RBI’s policy tilt is no longer accommodative. Recent liquidity squeeze is event-based but system liquidity is likely to deteriorate further led by higher currency withdrawals, cash build-up by government, and continued FX selling given the external account pressure. We expect around Rs. 2.0 trillion of OMO purchase in FY19 (Rs. 760 billion committed already). But even after accounting for the OMO, the liquidity deficit is given.
The reduced borrowing plan by the central government signaling the commitment to the 3.3% target, a tepid borrowing calendar by the states and RBI’s OMO purchase announcements provided a temporary relief to the G-sec yields. Government’s five-point action to contain the import bill and shore up the capital flows had limited impact. Having delivered two hikes in successive meetings with a neutral stance, the MPC left the rate unchanged but moved the stance to ‘calibrated tightening’ in its October policy meet. This is a welcome change from the ambiguity surrounding guidance in a tightening cycle. But at the same time, post policy briefings alluded to the RBI preferring market adjustments to the currency value.
Bond markets reacted positively to the pause in rates in October policy meeting. Yields corrected across tenors, with a larger move at the short end. However, the potential toleration for currency weakness has been under- appreciated. It opens up the possibility of additional policy tightening in the coming months. As we have always flagged, India’s macro fundamentals are extremely inter-twined to the crude prices. Overall, while the OMO purchases are expected to provide some comfort to the bond market, elevated crude oil prices, weakening rupee, tight domestic and global liquidity and expectations of tighter monetary policy are expected to cap the gains. We expect the benchmark 10-year to remain range bound. Investors should consider SIPs in fixed income funds as valuations are attractive and timing the market may not be easy.
CIO – SBI Funds Management Private Limited
(Mutual funds investments are subject to market risks, read all scheme related documents carefully.)