Sustained high banking systemic liquidity, coupled with limited avenues for deployment, is pushing lenders to expand their risk appetite, says a research note, adding large corporates, in general, have been on a deleveraging path because of their muted capital expansion (capex) and working capital requirements.
In the report, India Ratings and Research (Ind-Ra) says, "A few large corporates having access to commercial papers (CPs) at the cheapest cost at sub 4% have started using the arbitrage opportunities by increasing use of CPs and enhanced drawings from some banks, thus opening up risks in the system."
"A revised calculation of drawing power, which excludes sundry creditors, is encouraging corporates to deploy in financial assets for interest rate arbitrage, thus opening up refinancing risks in the system. The risks are presently limited to a few cases, but if not addressed could accentuate and spread to wider baskets," the ratings agency says.
Ind-Ra says it observed that the wide gap between short-term funding rates and rates in the banking system has been providing arbitrage opportunities for borrowers, especially those with access to the CP market at the lowest cost.
Accordingly, large, higher-rated corporates in the AA and above categories are gradually increasing their CP borrowings to take advantage of the lower short-term rates.
"To facilitate higher short-term borrowings, some banks have relaxed the drawing power calculation methodology by not factoring in creditors. This results in a possibility of higher CP borrowings though still within the revised drawing calculations or if outside the drawing power, backed by available liquidity which we evaluate in line with its criteria for commercial paper ratings," Ind-Ra says.
In times of healthy liquidity and a limited number of such practices, the situation is unlikely to pose a risk. However, the ratings agency says this increases the risk of deploying short-term funds into arbitrage opportunities and could pose a challenge, especially considering surging commodity prices or potential threats of COVID spread.
Ind-Ra believes that this practice has not been followed widely, but sustained easy money could encourage this spreading to other market participants and borrowers, thus amplifying the magnitude of risk at the system level.
"We also believe excluding creditors in the calculation could pose refinancing and liquidity challenges in the event of a slowdown or expansion in working capital. Ind-Ra draws comfort that this practice is presently limited to issuers rated in the AA and higher category and having strong business and financial risks profiles to tide over such rollover risks," the ratings agency added.
Ind-Ra opines that the high banking system liquidity does not ensure strong balance sheet liquidity for all entities within the system. It says, "While the high banking system liquidity does facilitate easy conversion of assets into liquidity, the nature of assets and perception of risk ensure easy conversion. Therefore, it will not be prudent to assume that the high banking system liquidity is a panacea for any liquidity risk at the micro-level."
According to the ratings agency, easy money is a precursor for corporate capex, especially in the aftermath of the crisis. However, owing to the tepid domestic demand, large capex activities are still not visible, barring a few pockets, it says, adding, "The main challenge is when easy money fails to induce demand for long-term investments in a meaningful way. Conversely, sustained cheap money encourages various arbitrage opportunities in the financial system at the cost of stability in the financial market, a prime example being funding for initial public offers. This could feed into mispricing across market segments."
"Apparently, the excess liquidity is not causing overheating in the economy, but that does ensure no risk even though credit growth remains muted. The ill-effect of unprecedented system liquidity amid a muted credit demand could distort the mechanism of risk assessment and market pricing of products," Ind-Ra added.
The ratings agency sees high input costs to propel higher working capital requirements. It says, "We believe a surge in input costs, especially commodity prices, will necessitate a higher demand for working capital. Domestic commodity prices have increased by 20% to 50% from pre-COVID-19 levels. The high inventory cost of finished goods will also boost the financing requirement.
"Additionally, the economic recovery and tapering-off pandemic risk could boost aggregate production in the economy, albeit at a slow pace. Thus, higher production would further push up working capital demand. In totality, high input cost and rising production are likely to drive demand for working capital financing," Ind-Ra says.