Friday, September 21. Time: 12.21 pm. The BSE Sensex was coasting at 37,370 points. And all of a sudden the market was quaking in fear. At 1.09 pm, the BSE Sensex had plunged 1,377 points to 35,993—travelling back in time to a milestone the index crossed on July 10. The tectonic shifting of values led to erosion of crores of rupees of public wealth. Ostensibly institutional moolah muscle was deployed to quell anxieties and restore order, propping up the index again to close at 36,841 points.
Alan Greenspan said amidst the Asian Contagion in October 1997 that if not the contagion something else would have been the cause for a revaluation. There were many triggers at play on Friday. There were the known knowns, the fault lines in the fragile financial sector—17 government-owned banks are in losses, of which 11 cannot lend as they are under prompt corrective action and laden with over `11 lakh crore of bad loans. Then there are the known unknowns—for instance, growing cost of money and suspense about the fate of stressed assets of `3.8 lakh crore in the power sector.
Fear has no bottom. The tremors of anxiety around the financial sector had already wiped out nearly `3 lakh crore in three sessions earlier in the week. The bifocal concern for the last few weeks has been focused on the interplay of currency and crude oil prices. The rupee on a secular slide reversed the gains of RBI intervention on Wednesday and Brent Crude threatened to hit the $80 per barrel level.
The headline provocation for revaluation was the sale of around `300 crore DHFL bonds by DSP Blackrock Mutual Fund. What was fuelling the sale? It was redemptions that needed to be funded. What triggered the fear was the sale of bonds allegedly at panic rates and rising fears of a liquidity crisis accompanied by shadow validation through anecdotes of higher short-term and interbank rates.
The epicentre of anxiety, however, is located in the state of rot at Infrastructure Leasing and Financial Services. The company has over `90,000 crore of debt—estimated to be over 18 times its equity. Project funding has been afflicted by pyramiding of debt and the returns cannot fund payments to creditors. Over 30 per cent of the borrowings are in bonds bought by private banks, public sector banks, 25 mutual funds and institutional investors.
The company is a classic case of mismanagement, alleged malfeasance, shareholder somnolence, reckless rating and regulatory forbearance. Its shareholders include India’s biggest financial institutions and global names—LIC, Orix Corporation, Abu Dhabi Investment Authority, HDFC, State Bank of India, Central Bank of India and funds. The creation of over 150 subsidiaries, the pendency of receivables from government, the build-up of debt and potential losses should have been flagged by the board. The regulator should have questioned the creation of subsidiaries.
The ballooning of debt and risks is symptomatic of poor audit and rating. Despite its balance sheet being afflicted with debt, leverage, incomplete projects and receivables, the shocking fact is that IL&FS enjoyed AA+ rating till September 9 this year, when it was downgraded nine notches to BB, which is basically non-investment grade, and this week the company and its subsidiaries were downgraded further to D on fears of further defaults.
The aggravating factor which led to the crash of indices on Friday was the issue of a letter by IL&FS to the Bombay Stock Exchange on Friday, September 21, 2018. The two-line communication informed that the company had failed to honour a Letter of Credit issued by IDBI Bank. The market is abuzz with speculation about multiple defaults. Over the weekend there is a raging rumour whether the LC has been honoured at all. That raises fears of cascading effect across the sector. Questions have been buried under the clause of client confidentiality. This opacity will only fuel anxiety when the market opens on Monday.
The crux of the issue is systemic apathy. It was known as early as February that institutions funding infrastructure were shackled in debt – and this is reflected in the continuing litigation and stalemate in the power sector. The first default of IL&FS was in July—followed by a series of defaults. The episodes signalled a need for the regulators, both RBI and SEBI, to take stock and bring the stakeholders to the table.
The regulatory framework is a strange cocktail of tolerance and opacity. There is a mistaken notion that regulators need not communicate. This is reflected in the handling of the CEOs of private banks—most recently in the case of Yes Bank. Is it enough for the regulator to say that it has acted—the timing of which is debatable? The regulator has an obligation to tell it like it is so that the delinquent players do not exploit the situation.
Critically, there is a need to evaluate and act to avoid systemic risk. The IL&FS website states, “As a Systemically Important Non-Deposit Accepting Core Investment Company (CIC-ND-SI) registered with Reserve Bank of India, IL&FS currently lends to and invests in IL&FS Group Companies”. The status of systemically important institution has not shaken the system. On Friday, the board and chair were allowed to quit. So who will address the rot? Without the management team, who will put together a rescue plan?
Textbook interpretations of moral hazard are subject to the hierarchy of moral imperatives and demand evaluation of greater common good. It pays to bear in mind that rescuing Lehman Brothers would have cost much less than the trillions that were needed to contain systemic fallout. Unless the government steps up to the plate and restores faith and order, this could well turn out to be India’s Lehman moment.
Author of Aadhaar: A Biometric History of India’s 12 Digit Revolution,and Accidental India