An Indian 2,000 rupee banknote is an arranged for a photograph in Bangkok, Thailand. (Photographer: Brent Lewin/Bloomberg)

Finance Ministry’s Reading Of How Big The IL&FS Crisis Is

India expected a potentially serious fallout of the defaults by Infrastructure Leasing and Financial Services Ltd., prompting the government to take over the systemically important company.

The Finance Ministry, in a note sent on Sept. 30 to the Ministry of Corporate Affairs before taking control of the group, underscored how IL&FS group’s high debt and exposure to its commercial paper in the debt market threatened to impact the financial sector.

The infrastructure conglomerate had a high leverage ratio of 13 times as the borrowing of about Rs 91,000 crore was on the base of equity and reserves of just Rs 6,950 crore, the note said. “The cascading impact of the default by the IL&FS group on the financial sector would be quite substantial as evidenced from the partial default of some of the companies in September 2018,” according to the note. BloombergQuint has reviewed a copy.

The National Company Law Tribunal earlier this week allowed the government’s petition to replace all board members of IL&FS as defaults by the infrastructure group and its subsidiaries triggered fears of a contagion in the financial markets. The newly constituted board named Uday Kotak, managing director and chief executive officer of Kotak Mahindra Bank, as chairman.

The board, which met for the first time on Oct. 3, said the IL&FS crisis is more complex than it was anticipated and it will take them longer to assess the “maze of 348 entities”, more than double of earlier assessment.

All options are being considered to manage debt, Kotak said. He, however, didn’t indicate how the board will manage the immediate defaults.

IL&FS, according to its 2017-18 financial report, has standalone debt worth Rs 16,468 crore. Of this, it had defaulted on Rs 3,761 crore as of Sept. 29. It subsequently failed to service principal and interest on loans from banks, inter-corporate deposit and commercial papers worth Rs 33.9 crore due for the period from Sept. 30 to Oct. 4.

Also read: Can A Satyam-Style Rescue Work For IL&FS?

The Finance Ministry’s report said there are a few repercussions of these defaults:

Redemption Pressure

Asset management companies having an exposure of Rs 2,800 crore to IL&FS bonds will face redemption pressures, the note said.

“A debt fund of DSP Mutual Fund, DSP Credit Risk Fund, was holding IL&FS commercial paper. After IL&FS defaulted, DSP faced redemption pressures from corporate clients,” according to the ministry. “This would have resulted in default by DSP and hence they had two options—sell government securities or sell DHFL bonds which are AAA-rated investment, at a loss. Since government securities investment is subjected to a loss due to hardening of bond yields, it is better to sell corporate bonds.”

Thus, due to the redemption pressure on DSP Mutual Fund, the note said, the asset manager had to sell DHFL bonds at a net yield of 11 percent compared with a coupon rate of 9.1 percent at the time of issue.

Fund managers have in fact turned cautious after they had to take write-downs on investments in IL&FS paper. After the default at IL&FS, mutual funds, which are the main buyers of corporate bonds, have completely stopped buying, the note said citing an exchange official. This, it said, has rendered the corporate bond market completely illiquid.

Debt Market Selloff

Asset management companies may need to sell government securities to meet redemption pressures, the ministry note said. This can raise yields to 8.30-8.50 percent or the Reserve Bank will have to opt for open market operations that will reduce the government’s spending ability by equal amount, it said.

To be sure, the government has already said that it would borrow lesser than earlier planned in the second half of the current financial year to ensure that bond markets remain calm and liquidity remains comfortable.

Impact On NBFCs

The RBI has been weeding out small non-banking financial companies that have been unable to meet capital requirements by tightening norms since 2014. Since April, the central bank has cancelled nearly 400 licences, data compiled by BloombergQuint show.

The Finance Ministry said the IL&FS defaults will only add to such closures. Of the banks’ total exposure to non-bank lenders, the infrastructure group contributes 16 percent, according to the note. So, the cost of funding for NBFCs, it said, will increase and impact their profitability. As a result, “as many as 1,500 smaller non-banking financial companies may lose their licences due to the crisis at IL&FS because they don’t have adequate capital.”

Also read: India Should Have Learned From Walter Bagehot