Liquidity problems at Dewan Housing Finance Corporation Ltd (DHFL) and its reported failure this week to pay coupons highlight the funding challenges faced by India's non-banking finance sector, Fitch Ratings says.
"Issues in the non-banking financial companies (NBFCs) were already known to the market but DHFL became a focus point after the failure of Infrastructure Leasing & Financial Services Ltd (IL&FS) in September 2018," the ratings agency says, adding, "This also contributed to a sector-wide liquidity squeeze as investors became more risk averse. Indian NBFCs' liquidity is sensitive to market sentiment as their business models rely on short-term wholesale funding, which can dry up fast if market sentiment turns negative. Funding models of housing finance companies and NBFC loan companies, which have become increasingly reliant on short-term funding to fund longer-term assets, have been particularly affected by the liquidity squeeze."
According to the ratings agency, the liquidity pressures in NBFCs are in stark contrast to the banking sector, which has not faced significant liquidity pressure or deposit withdrawals, despite asset-quality and capital adequacy weaknesses.
The sector pressures have led India's top NBFCs to explore other sources of funding and to start positioning themselves to tap the US dollar bond market. "We expect Indian NBFIs to become more regular issuers in the offshore bond market as they seek to diversify their funding sources. If prudently managed, this should be credit positive as funding profiles are strengthened," Fitch says.
The funding squeeze has contributed to higher funding costs and a slowdown in loan growth for India's NBFC sector. NBFCs are an important channel for extending credit to the wider economy, given their extensive distribution networks, which are often more far-reaching across rural India than those of banks. The sector's role as a credit-provider became outsized as the Indian banking system was forced to deal with its weak asset quality.
Banks, particularly public sector banks (PSBs), were undercapitalised and had limited capacity to lend more. NBFCs now account for nearly 20% of credit to the economy compared with about 15% five years ago.
Indian NBFCs fast loan growth in an environment of relatively benign interest rates was increasingly funded by short-term funding, in particular, commercial paper issued to the mutual fund sector. The banking system also is an important source of funding for NBFCs, driven in part by the regulatory push for banks to provide 'priority lending', with NBFCs being an important conduit for this.
Fitch says, "Both of these funding sources for NBFCs have become more risk-averse, which means that the sector is likely to face higher funding costs and a period of deleveraging, although the better-positioned NBFCs should still be able to achieve loan growth. The sector's reliance on short-term funding has reduced since late 2018 and some stronger NBFCs have shifted towards longer-term funding, such as term loans or negotiable certificates of deposit."
"We expect credit growth in India to remain slow, despite this week's interest-rate cut, as most banks are capital-constrained and NBFIs face tighter funding conditions," the ratings agency concluded.