Given IL&FS crisis, MPC should hold rates

The Monetary Policy Committee (MPC) meeting this week comes under the shadow of the massive IL&FS default that has shaken the markets, added to the current set of macro concerns and raised new questions on the regulatory framework. The complexity of the IL&FS set up with its 169 direct and indirect subsidiaries, joint ventures and associates, the size of total debt on its books and the uncertainty of interlinkages carries all the burdens of a systemic risk. The default inevitably will impact the money markets and the credit market channels, and so becomes a direct and immediate concern of liquidity management in the system. It is true that the MPC is guided by the legislative mandate of keeping the inflation rate (measured in terms of CPI combined) at an average rate of 4 per cent with a band of +/- 2 per cent. However, the adverse repercussions of the IL&FS default in the financial markets and in turn on liquidity management will have an important bearing on the MPC resolution this week.

Consider that the default has been an occasion for two key regulators – the Reserve Bank of India (RBI) and the Securities & Exchange Board of India (SEBI) – to issue a joint statement. The two together should be more than the sum of parts; instead they have come more as helpless observers with a statement that says almost nothing: “The RBI and SEBI are closely monitoring recent developments in the financial markets and are ready to take appropriate action, if necessary.”  

As a Systemically Important Non-Deposit accepting Core Investment Company (CIC-ND-SI), IL&FS is registered with Reserve Bank of India. It lends to and invests in IL&FS group companies.  But strictly speaking, neither the RBI nor SEBI has any regulatory mandate over the IL&FS. When IL&FS announced its series of defaults in mid-September on interest payments of non-convertible debentures, LC payment to banks and payment of Commercial Paper, apart from reported delays and defaults in serving inter corporate deposits, the markets shook and rating agencies woke up. The total size of the IL&FS debt is of the order of Rs.90,000 crores, with a junk status reached almost overnight, bringing memories of the huge worldwide defaults and bankruptcies during the 2008 global financial crisis.

Such a massive earthquake would have implications for the financial health of not only the NBFCs but the entire banking and financial system with implications for the nation’s ability to manage and regulate the environment. Technically, the default happens because of unsustainable cash flows coupled with asset–liability mismatches. The way the rating agencies issued permissible ratings but downgraded it to junk status post the default raises questions on due process and the very purpose of a rating. Questions are going to be asked on whether the rating agencies and the authorities had an inkling that this is in the offing and if they were exercised enough to alert the system to the coming quake. If they did not even know, why not? If they knew, what did they do?

LIC and SBI have been brought into the picture for a bailout package, which may be required as a crisis management measure given the ramifications of the default. But it suffers from moral hazard problems. The bailing out institutions do not have any money of their own. They manage the money of ordinary citizens. Insurance premia and small deposits of the public should be invested in return-oriented assets with least risks, and not be wasted on such bail out packages. Thus, a complex set of issues, notably in the areas of regulation, investor protection and liquidity management have come to the fore. What should the MPC do in these circumstances?

Already, there have been two consecutive hikes in the policy repo rate in June and August resolutions by 25 basis points each. Accordingly, the policy repo rate is placed currently at 6.50 per cent with reverse repo rate at 6.25 per cent and the Marginal Standing Facility (MSF) rate at 6.75 per cent. Recent episodes of CPI combined revealed that there has been some relief in the headline part though the core segment (headline excluding food and fuel) has been somewhat rigid in downward movement.

The authorities are still working on addressing the liquidity crisis mainly through a bailout package. The full picture has not been transparently put in place in the public domain. Moreover, pressure on maintaining the neutral liquidity management stance could be difficult as the market could have some pressure on rupee liquidity while addressing the IL&FS default. 

To the extent the financial market and particularly money and credit market has been adversely affected, there are broken links in the transmission channel of the monetary policy. These damages need to be corrected and addressed. Given the volatile nature of the situation and that all its implications are not fully grasped, a safer course would be to hold the rates and wait and watch while offering support to the extent required to stabilise the markets.  The MPC will likely take cognisance of the adverse developments in the financial market and likely look for status quo on the policy repo rate.

Effective October 1, the RBI move to supplement the ability of individual banks to avail liquidity and to overall improve distribution of liquidity by allowing a higher carveout from SLR for the Liquidity Coverage Ratio is helpful. It will address nervousness in the market but will be unable to address critical issues like infrastructure lending. The approval and disbursement of credit to the infrastructure sector by the credit institutions thus would face an ‘inverted U’ phenomenon going forward. Therefore, there is need to look at long-term issues of infrastructure financing in terms of credit rating, financial leverage, cash flow and above all the regulatory architecture. 

The MPC will also have to consider the implications of collateral damages in the currency markets as two important shareholders of ILFS are non-resident entities. One is Orix Corporation, Japan, and the other is Abu Dhabi Investment Authority.   Already there have been substantial outflows from the Indian capital market by foreign institutional investors and this has contributed to the fall in the value of the rupee. The ILFS default could fuel more outflows, complicating an already difficult situation and adding to macro worries.

Regulatory developments which are usually set out by the RBI as an accompanying document with the MPC resolution, bear critical importance this time.  RBI should address the concerns surrounding the IL&FS default squarely. It must set the path to dealing with the causes of the default, the proposed measures by the authorities and future guidance to prevent such happenings. This is a good time to come out boldly on issues that have been under the carpet for far too long.

(Pattnaik is a former Central banker and Rattanani is a journalist. Both are faculty members at SPJIMR)