Why did IL&FS default and is its impact far beyond over?

IL&FS is often being referred to as a shadow bank these days. That is not exactly a charitable definition. In China, Shadow banks refer to quasi banks that operate outside the financial system. IL&FS is not exactly outside the finance system in India because the RBI does regulate it as Critical Investment Company (CIS). Although IL&FS does not accept deposits from the public, it is considered critical considering its size and its total debt of $12.5 billion with most of the large banks, mutual funds, insurance companies and even the EPF as its clients. First a focus on what is IL&FS and how it grew so big and so vulnerable. And if you think IL&FS may not really matter, remember that the markets wiped out nearly $100 billion of wealth since the IL&FS fiasco first broke out. So it is big; and really big.

Where the problem really started?

IL&FS is a 30-year-old infrastructure lending giant that has helped develop and finance projects worth $25 billion in India. Most of the marquee road projects were structured and funded by IL&FS. That is where the big question arises. If IL&FS deploys billions of dollars in infrastructure then how does it fund its balance sheet? You obviously need access to low cost funds so that you can fund infrastructure projects at financial viable rates of interest. Since IL&FS did not accept deposits from the public, its assets were entirely funded by short term loans, commercial paper, mid-term loans etc. Ironically, all these monies were deployed in long gestation infrastructure projects where returns would not start coming before the 8th or 10th year. Firstly, funds came back far into the future and quite often government delayed project payments. Secondly, this was fine as long as funds were available on tap.

The day banks started getting a little wary of lending to IL&FS it started defaulting on its CP payouts. The moment it started defaulting, rating agencies dropped IL&FS rating from AAA to Junk. That meant, at least 50% of the value of the bonds had to be provided for. As IL&FS was classified as Junk, the fund taps were shut and it could not access the CP market any longer. Therein began the real problems for IL&FS. The company recently defaulted on a few payments, which means it has run out of cash. This spells trouble not only for the firm but also for its investors, which include banks, insurance companies, and mutual funds. The situation is so grim that it is being compared to the 2008 Lehman Brothers crisis that triggered a global financial meltdown. Whether it is justified or not is hard to say, but one cannot deny that IL&FS is big enough to have a fairly large contagion effect on the Indian economy. And the sharp cracks in the Nifty and the rise in bond yields are an outcome of that fear factor.

IL&FS built opacity through a web of subsidiaries

That in a way was the real problem. Over the years, IL&FS had built a complex web of subsidiaries, associates, JVs and what not. For example, as of 2018 IL&FS sits atop a web of 169 subsidiaries, associates, and joint-venture companies that makes the default even more worrisome. In reality, nobody knows how big the actual hole is and how much of the contagion could really hit the financial markets. As we did state earlier, apart from envisioning and building infrastructure projects, IL&FS is also a “shadow bank.” That means it is a non-bank financial intermediary that provide services similar to traditional commercial banks. Since these are not deposit-taking companies, they are not as stringently regulated. That made it easier for IL&FS to operate but made it immensely risk to the system.

Is it that IL&FS has just run out of cash?

As we write, IL&FS has received a bailout commitment from LIC and SBI. But the fact remains that as of now it has simply run out of money and, therefore, has been unable to service its repayment obligations. That is evident from the series of defaults. It has already defaulted on around Rs450 crore of inter-corporate deposits (ICDs) to the Small Industries Development Bank of India (SIDBI). Earlier this month, IL&FS and its subsidiary, IL&FS Financial Services, also delayed payments on ICDs and commercial papers, instruments that mature in less than a year. In addition, it has nearly $500 million of payables in the second half with cash in hand of just $27 million. And forget about monetizing its assets anytime in the near future. Most of the group’s assets include financial claims on infrastructure projects such as roads, tunnels, water treatment plants, and power stations, etc. which cannot be liquidated at short or even medium notice.

How big will be the impact if IL&FS really goes under?

The stakes are just too high, so the government will not let it go down. But a lot would depend on the priorities of the government at the current juncture. IL&FS’s defaults can have a significant impact on India’s credit markets. The firm’s outstanding debt is nearly 3% India’s domestic corporate debt according to Moody’s Investor Services. Then there is the ownership worry for the investors. State-owned Life Insurance Corporation of India (LIC), which owns a 25.34% stake in IL&FS, is its largest shareholder, followed by Japan’s Orix Corporation (23.54%). Other key shareholders are the Abu Dhabi Investment Authority (12.56%), Housing Development Finance Corporation (9.02%), Central Bank of India (7.67%), and State Bank of India (6.42%). Its borrowings from banks stand at around Rs.57,000 crore and made up nearly 0.7% of banking system loans. Defaults will spell more trouble for Indian lenders, already battling a huge toxic loan pile.

Apart from institutions, it will impact individual investors too

Any default by IL&FS will affect individual investors, too. This is because mutual funds invest in CPs, which are generally supposed to be relatively secure investments. Even the value of unit-linked insurance plans, endowment plans, the National Pension Scheme, etc. will be hit. There may also be some indirect impact on project implementation. For instance, several projects, like the Bengaluru Metro could be delayed. But the bigger worry will be if this was to spread to other NBFCs and HFCs via the debt markets. Then it will be a clear case of contagion and may lead to large scale destruction of wealth. The government needs to move in fast and thrust a resolution down the neck.

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