Contagion Risks Build in India’s Credit Market After Fund Freeze

India’s credit markets were jolted late last week when a major money manager halted withdrawals from mutual funds, adding to a worrying string of superlatives that have been piling up since well before the coronavirus pandemic.

Franklin Templeton’sdecision to wind up $4.1 billion of Indian debt funds was the biggest-ever forced closure of funds in the country. It immediately sent corporate borrowing costs soaring, with the spread on one benchmark index rising to a seven-year high. Fresh on its heels, the local venture of France’s AXA SA said it hadmarked down the value of some of its bond holdings.

“The problem is unlikely to remain confined to one mutual fund and there are already indications that other mutual funds are facing huge redemption requests,” U.K. Sinha, former chairman of the Securities and Exchange Board of India,wrote in an op-ed in the Indian Express. “The problem of the mutual fund industry can swiftly migrate to the entire financial services industry and might then soon spread to the real economy.”

The Covid-19 crisis has sparked unprecedented moves across global financial markets, and exposed risks that had been building up everywhere in recent years after borrowers binged on debt they’re now unable to repay. But the scope of problems in India’s credit markets is unique.

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One of The Smallest Credit Markets

Let’s start with this one: the country has long hadone of the smallest corporate bond markets among major economies. With that has come some of the worst liquidity -- there just aren’t enough parties trading company debt. That played a major role in the unprecedented move by Franklin Templeton, which cited “a dramatic and sustained fall in liquidity.”

“This episode once again highlights the weakness in the secondary debt markets in India as they tend to get illiquid by small bouts of micro and macro negative news,” said Deepak Jasani, head Of research, HDFC Securities Ltd.

Worst Bad Debt

India also has the world’s worst bad-debt ratio at traditional lenders. That loomed large in March, with thebiggest-ever bank failure in the country when authorities seized Yes Bank Ltd.

Efforts to help the finance sector have had unintended consequences. As traditional lenders pared soured loans, shadow banks rushed into the void, borrowing short-term funds that they lent out for longer periods in a classic mismatch. In late 2018, that came to a fore in the collapse of financier IL&FS Group, creating a crisis that the shadow banking industry was still trying to overcome when the pandemic hit.

There have been a round of measures to wean companies from reliance on the non-bank financing companies, but they’ve remained a crucial funding channel for everyone from small vendors to property tycoons.

The shadow banks themselves have often relied on yield-hungry mutual funds like Franklin Templeton to get funds, issuing them debt securities that have become increasingly hard for such investors to unload.Read more about that here.

Total assets managed by Indian mutual funds were at a record 28 trillion rupees ($366 billion) as of March 31, with about 29% invested in debt. The frozen Franklin funds account for about 1.4% of the sector’s total assets.

Record Shadow Bank Bond Bill

The mutual fund industry’s thirst for high-yielding shadow bank debt has added to another troubling superlative: non-bank financing firms came into this quarter witha record of about 1.1 trillion rupees of local-currency bond repayments due in the period.

An executive at one of those shadow banks, Bajaj Finance Ltd., recently warned of growing problems even before the Franklin Templeton surprise.

Bajaj Finance Managing Director Rajeev Jain said on a recent earnings call that consumers are in a “state of shock” and are rushing to seek delays in debt repayments, amid the pandemic. Even highly rated companies are looking to postpone repayments, he said.

What’s Next

Like policy makers elsewhere, Indian authorities have moved to keep credit markets from freezing up, and have so far helped avert worse damage.

After a market rout in March, steps to pump more liquidity into the financial system helped lift issuance of shorter-dated local corporate bonds to a record this month, and boosted returns on dollar bonds from the nation’s issuers to the most in Asia in April. Few expect the wild swings to abate, though, particularly after shocks like with Franklin Templeton.

Regulators have encouraged forbearance as businesses grapple with the pandemic and lockdowns. At least 328 borrowers have received or sought a moratorium on loan servicing as part of a Reserve Bank of India Covid-19 relief package, according to rating firm ICRA.

Many observers expect authorities will be forced to take further steps to keep credit markets functioning. And as the latest shock last week showed, the mutual fund industry will be a key focus, not least because of its importance for scores of individual savers.

“The RBI had provided mutual funds with a liquidity window to meet immediate redemption pressures in 2008, in the aftermath of the Lehman collapse,” said Lakshmi Iyer, chief investment officer for debt at Kotak Mahindra Asset Management Co. “In the current crisis due to the spread of Covid-19, any support from the regulators will boost the comfort for the funds and provide more confidence to the domestic financial markets.”

— With assistance by Rahul Satija, and Ravil Shirodkar

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