Excess liquidity and benign interest rates, over the last couple of years (2003 - 2005), facilitated the Indian corporates to realise the expansion dreams that they had waited to fructify all these years. While most AAA-rated corporates chose to raise capital funds overseas and also arm-twisted banks for their working capital loans (at sub-PLR rates), the SMEs (small and medium enterprises) and smaller corporates capitalised on the opportunity to strengthen their balance sheets. Not to mention that the 'opportunity' was also used by debt-burdened corporates to get rid of the same.
The excess liquidity has, however, begun to wind-up in the past few months. The decline in excess liquidity is primarily due to a slowdown in forex reserve accretion. The foreign inflow that was being pumped into the economy over the past couple of months has now witnessed a trend reversal. The following could be rationales attributed to the same.
Narrowing rate arbitrage and lower net foreign debt inflows: Given that the interest rate differentials between India and the US have narrowed and the rupee has begun to depreciate, interest arbitrage has become less attractive. As a result, while SBI redeemed US$ 7.3 bn of non-resident deposits (in the form of India Millennium Deposits) in December 2005, a negligible amount was reinvested by the non-residents. Foreign Institutional Investors (FIIs) have also reduced their exposure in government bonds. As a result, the net foreign debt inflows are estimated to have declined by US$ 3.1 bn during 9mFY06 when compared to US$ 7.9 bn in FY05 (source: RBI).
Rising current account deficit: India's current account balance posted a deficit of US$ 7.7 bn (4.2% of GDP, annualized) during 1HFY06, compared to a deficit of US$ 3.5 bn (2.2% of GDP) during the same period in FY05. Apart from higher oil prices, increasing domestic absorption (rise in domestic consumption) has been the key factor behind the widening current account deficit. The rise in current account deficit in India has, however, been much higher than in its other Asian counterparts, thus making it relatively unattractive destination for foreign investments.
Transitioning from excess liquidity to tight liquidity
Although the policymakers appear to be brushing aside liquidity concerns, indicating that this is a one-off issue due to significant debt redemption by SBI, bankers believe that the underlying trend of slower forex reserve accretion and high liquidity absorption will continue to put pressure on interest rates. Also, at the same time, the domestic demand for credit does not seem to be abating. In fact, with foreign capital remaining no longer as cheap as earlier, Indian corporates are increasingly looking at domestic resources (bank funds/ capital markets) to satiate their funding needs. We see the following to be the fallouts of liquidity crunch.
Rise in domestic cost of capital: Indian banks have increased their corporate lending rates by approximately 200 basis points without tampering with the benchmark PLR. Banks have had to increase their lending rates for the first time in three years to protect against weak treasury income and a sharp rise in cost of funds, as reflected in the short-term benchmark rate (91 day T-bill), which has risen to by 40 basis points in the last 6 months. The same is thus indicative of higher cost of capital for Indian corporates waiting to access debt funds.
Reduced debt servicing ability: Not denying the fact that corporates in India today have much leaner balance sheets and are in a relatively better position to service their loans than in the late 90's and early 2000's, the sustainability of the same in a rising interest rate scenario is a concern. Unless the corporates' operating margins and operating cash flows continue to accelerate at the same pace as earlier, the debt service coverage ratio will be one to watch out for.
Retarded economic growth: This rising cost of capital trend might also have implications on the country's economic growth. India's aggregate debt to GDP ratio has increased by 28% (to 35% in FY05) over the last five years, largely to fund government and household consumption growth. We believe that this debt-funded consumption growth, which has been at the heart of the upward trend in GDP growth over the past three years, will be hit by the rise in the cost of capital.
Although India seems to be well poised to catch up with the developed world in the longer term, the materialisation of such a possibility rests on the success of the country's economic drivers i.e., the industrial behemoths. Depriving them of the much needed funds at viable costs and a slowdown in infrastructural growth, may lead to our target of 8% GDP growth, being after all, a 'wishful thinking'!