by Akash Baruah
There has been a turmoil in the Indian financial markets over the past few weeks with the Sensex falling from 38,896.7 on August 28 to 34,000 on October 11, registering a negative growth of 14.40%. This sudden shock was mainly attributed to the massive sell-offs in the markets by the foreign portfolio investors (FPIs) against the backdrop of the depreciating rupee. The consequences of the depreciating rupee were the rising bond yields and further depreciation of the currency.
If we have to trace the problem to its origin, the depreciating rupee is the reason which made the investors nervous about their dwindling profitability and made them cover their losses. The view was that the rupee will stabilise soon enough which will calm the markets down. But the situation worsened with newer problems coming to the limelight in the form of mounting current account deficit, problematic solvency position of Infrastructure Leasing and Financial Services (IL&FS) etc.
We will try analyse some of the recent problems looming over the Indian economy and suggest what could happen in the near future.
The Current Account Deficit
Indias current account deficit (CAD) expanded to a massive 15.8 billion USD (2.4 per cent of GDP) in the first quarter (Q1) of 2018-19 as compared with 13 billion USD in Q4 of 2017-18 (1.9% of GDP). This widening of the CAD is also a factor driving the sentiments of the foreign investors and is closely monitored. Furthermore, this adds to the supply of the rupee in the foreign exchange markets, causing the rupee to depreciate, while becoming the factor lowering market confidence. This also brings with it the fear of inflation, as importing goods at higher prices will eventually percolate into rising prices domestically. This outlook has been a major reason for the investors wanting to liquidate their positions before further loses due to lower asset valuations.
Policy normalisation in the developed world
There has been a steady rise in the interest rates by the US Federal Reserve since the later half of 2015 and has continued the same till now. This has been an action which reflects the improving situation in the United States and is expected to remain strong in the future as well. All the money chasing interest rate differentials in the developing markets, due to the ultra low monetary policy adopted for so long, is now slowly starting to reverse. Thus, this will make the US Dollar stronger in comparison with the Indian Rupee causing the rupee to depreciate. The foreign portfolio investors (FPIs) have started to factor this in their valuations and have therefore liquidated much of their positions recently. The latest depository data states that the FPIs have sold equities amounting to rupees (Rs) 17,935 crores (Cr) and bonds worth Rs 26,580 Cr from October 1 to 12. This has created a sense of panic in the capital markets resulting in massive sell offs and loss of wealth.
IL&FS and the larger non- performing assets (NPAs) Problem
India is grappling with a severe bad assets problem and had a total NPA of Rs 10.03 lakhs Cr as on June 30, 2018, amounting to 11.6% of the total lending of the banking industry. This has already impacted the lending behaviour of banks, making them more cautious in providing capital. Slowing down of financial intermediation also results in the slowing down of the economy and can reduce the momentum of private investments. Amidst this situation, India now faces the problem of IL&FS eventually filing for bankruptcy, to which the banks have a total exposure of Rs 57,000 Crs. The group as a whole has total outstanding liabilities of Rs 91,000 Crs comprising of term loans, debentures, commercial papers, cash credits etc. The trouble for the markets and the economy as a whole increased when the company started defaulting on its obligations due to extreme cash crunch. The defaults ranged from term loans, inter-corporate deposits, commercial papers, letter of credit etc which rattled the markets completely. IL&FS defaulting would mean that the NPA situation further worsens to a great extent, all the mutual funds who were holding CPs issued by the company would be at loss, while the NBFCs who had lent money to the company would also require to face loses. This would have a cascading effect on the whole economy and the financial system will also have to bear the burnt of it. Investors factored this growing volatility into their valuations and resulted in massive sell offs across asset classes.
Here’s what the future looks like
If India has to come out of this situation of increasing volatility in the markets, subdued investments and continuous depreciation of the rupee, its has to go through a painful adjustment process.
Firstly, the banks would require to clean their books and adjust their inflated balance sheets to whatever amount required. This would mean that the banks have to resort to steep haircuts in terms of their and reduce their net worth. The further consequences would be that the lending would slow down and remain the same until the banks renew their confidence. This behaviour of the banks will lead to a recessionary economic slowdown.
Secondly, the markets would adjust themselves according to the new revealed economic scenario and have a correction. The prices would, in accordance with the new cash flow forecasts, revise downwards and a new equilibrium will be achieved.
Thirdly, the currency will also depreciate until the uncertainties in the market and the broader economy are resolved. This will also be decided as to how quickly the global oil prices stabilize as rising prices is a big dent to Indias import bill.
The extent to which this situation continues depends upon how quickly are we able to resolve our issues and find long-lasting, permanent solutions.
Akash Baruah is Assistant Professor at the Indian School of Business and Finance.