Avoiding India's Lehman redux...

Indian finance industry has been agog with rumours over last fortnight, with default of a large financial services company with AAA rating reviving memories of a similar event 10 years back in US. Some are comparing it to India's Lehman moment and some suggesting this needs a Satyam like rescue. Hopefully a lot of those concerns are overblown and reality is far more sanguine. However, India's economy is at a critical juncture now, having just gotten back on track after the twin shocks of demonetisation and GST; and can hardly afford even partial derailing at this juncture. Thus it pays to be cautious, and also focus on path out of a potential quagmire. This post is an attempt to go to the roots of the present situation as well as chart out a possible solution.

Not many would remember now, but the entity at the epicentre of the crisis was credited with turnaround of Satyam's engineering business, Maytas in 2009 in the aftermath of Lehman, when Satyam Computers spectacularly imploded. They showed exemplary efforts in reviving a potential failed enterprise by sheer hard work, willpower and hustle and manouvering to retain old business and acquiring new. So what changed in last 10 years, that the saviour has turned into a potential systemic vulnerability? The answer to this is more nuanced, and more generic than the specific instance. There are 3 forces at play here, creating a perfect storm, which in hindsight looks painfully obvious. First is the continued weakness in infrastructure sector plaguing banking sector credit quality, second is the sudden developments in some private sector banks and third is overoptimism in the new areas of affordable housing / LAP loans going sour. The combined effect of these vulnerabilities can be potentially disastrous if not managed deftly, urgently and decisively. Lets look at each in detail.

While the US economy undoubtedly brought the world into crisis in 2008, the exemplary crisis management done then by Fed and Treasury also nursed the economy back on tracks eventually. As a result, US Fed was able to take back its emergency support to its banks, and aided by an all time high sentiment and economic growth is on course to fully recover its accomodative policies over next 12 months, both on liquidity and rates. On the other hand, while India also pump primed the economy to bring it back from the crisis, it never was able to address the mismatches in the financial sector. Thus while US housing prices which collapsed in 2008 bringing home the crisis in subprime that spread across the banking sector like wildfire given linkages have fully recovered, and in fact, posting new highs; the Indian infrastructure sector, which was similarly recipient of large amounts of investment pre-crisis has never fully recovered. And this sector was also the one that was prominent in banking sector debt. Thus over last 5 years, while we have heard major bank chiefs stating that worst is behind us several times, the real extent of the underlying malaise as shown in reported numbers keeps expanding. Its like the veil is getting lifted slowly, with many banks showing NPAs in excess of their underlying equity, making them technically bankrupt! The widespread scale of this malaise has no parallel in history of Indian capital markets. As a result, the stakeholders, including boards and rating agencies, auditors etc are certainly behind curve in estimating potential threats of solvency in the event of market shock to this fundamentally weak constituent structure. As famously attributed to Warren Buffet, You only know who is swimming naked when the tide goes out. Exactly such a time maybe around the corner.

Second is the developments in private sector banks. While the issues of bureaucracy, competency and appropriateness of public sector banks decision making, especially opening up purse strings in aftermath of crisis 10 years back is well chronicled, the recent developments in private sector banks has taken all by surprise. The possibility that the rot could also affect vaunted names that earlier invoked professionalism and respect brings possibility of potential loss of trust, akin to big names like Bear Sterns or Lehman, once storied firms. All said and done, financial services industry, which largely represented by public and private sector banks has potential to support growth as well as disrupt growth, given its strategic importance to all economic activities. The behavioural impact of depositors/ investors in banking system shying away and/ or the credit officers taking unduly cautious approach in extending fresh credit given historical baggage can bring the recovery in fortunes to a halt. As has been widely covered, GST and demonetisation, while being long term positives had huge short term negatives and the economy is just climbing out of the woods onto somewhat safe ground. A freezing of credit markets, which is pretty much the lifeblood of the economy at this stage can derail the potential recovery. This is like a train-wreck in slow motion. Something needs to be done to yank the system onto a firm footing to support future growth.

Third is developments in certain micro financing markets in more recent years. As infrastructure credit froze over last 5 years, initially blindsided banks and NBFCs founded a new asset class to leapfrog into, the affordable housing and LAP (loan against property) loans for businesses, apart from huge bulging in retail loans. While this provided avenues for growth for otherwise stalled credit system, clearly, some of the enthusiasm was uncalled for. A lot of hype, especially in loans backed by real estate collateral in some shape or form is being unwound. Storied bankers are on record talking about LAP growth having become unsustainable, with NPAs potentially building up. At the base of this is the prospects for real estate sector, which went through its own shock in the form of RERA, akin to the wider shock on GST/demo. As the sector is adjusting to new realities, the loans made on the back of stable or rising real estate prices to individuals or businesses have to re-adjust too. A lot of listed equity and private equity money went into these new segments, causing somewhat of overoptimism about future growth which is not sustainable. This is causing a dent in sentiment in credit markets shifting to equity markets and vice versa, which are invisible links, shifting the pendulum from greed to fear.

So what is needed to avoid this. Clearly solutions are not simple, but at the minimum, this needs a crisis cell working overtime to a) provide adequate liquidity keeping system well oiled, ensuring that the liquidity is not being misused to fill unsustainable holes b) reset the bank managements to very reputed and strong hands and c) ensure equity losses do not lead to a wider contagion into the real sector of the economy. These are easier said than done obviously, but not attempting it makes the task of potential rebuilding tougher by the day. Markets are unfortunately not known to be mature in the face of possible losses, with herd behaviour of trying to fight the exit door becoming more critical than cool'ly analysing how bad the situation is. Thus this is an acid test in PR and management of the economy, as confidence in wider stakeholders the famous 3-idiots's dialogue "Aal izz well" is as important as the actual actions being undertaken. Moreover the access to capital to productive sectors of economy, which are backed by strong cashflows needs to be protected.

All in all, we are in for some interesting times. Hopefully, none of the worst case scenarios come true. After all, risk is what is not known; and as long as all stakeholders keep that in mind and work round the clock collectively and seamlessly to ensure greater good prevails, all will indeed be well setting the stage for a strong recovery. The global scenario of shifting of investor sentiment, whether financial or direct/ strategic; from China to India is now reaching critical proportion, and save for accidents like above, on way to bring a huge change in potential growth of the country that lifts millions out of poverty every month.