IL&FS and the Indian Economy

The infrastructure lender IL&FS has raised concerns about the risk of loan defaults, causing a sharp drop in the benchmark Nifty index. As a major player in India’s non-banking financial sector, IL&FS’s difficulties in repaying its debts has significant consequences. Highlighting the systemic risks and liquidity problems with IL&FS has impacted the money markets, where shadow lenders are jolted by the risk of failure by a lender seen as too big to fail. This shock is amplified by the weakened rupee, which has further reduced liquidity.  Refinancing risks are also rising, adding to the concerns about India’s bad debt ratio, which is highest in the world after Italy.

The Infrastructure Leasing & Financial Services Limited (IL&FS) is an Indian infrastructure development and finance company. IL&FS was originally promoted by the Central Bank of India, Housing Development Finance Corporation (HDFC) and Unit Trust of India (UTI). Currently, its institutional shareholders include State Bank of India (SBI), Life Insurance Corporation of India (LIC), ORIX, Abu Dhabi Investment Authority and Greenspring Associates. IL&FS has enjoyed an open field when it comes to massive development programs. Gift City, Indian Prime Minister Narendra Modi’s pet project in his home state of Gujarat, saw the state government lease land at minimal prices to an IL&FS-controlled company.

As of 2018, IL&FS has over 300 group companies, including subsidiaries, joint ventures, and associate entities. IL&FS has several projects in different sectors including Transportation, Area Development, e-Governance, Health Initiatives, Cluster Development, Finance, Power, Ports, Water and Waste Water, Urban Infrastructure, Environment, Education, and Tourism

The Reserve Bank of India and national security regulators released a joint statement indicating that they are closely watching the financial markets are prepared to intervene if necessary. These efforts to calm markets and investors turned out to be fruitless as fears about IL&FS impacted domestic bonds, stocks and the Indian rupee. The risk of defaults has also been detrimental to domestic rating agencies, which previously gave favorable ratings to these non-banking lenders. 

The government appointed members to a board of directors with the intention of rescuing IL&FS. The board has stated to the National Company Law Appellate Tribunal that have created a plan to address the challenges of repaying its debt. However, the longer it takes for the IL&FS crisis to be resolved, the longer the economy’s growth will be stalled. The Tribunal has set the date for the hearing for 15th December, when it will have the chance to decide on the new repayment plan. 

Another significant concern is the similarity of the IL&FS situation with the American financial crisis in 2008. The rising instability and risk of failure by a shadow bank could spark financial contagion and cause large-scale damage to the Indian financial system. The real estate sector has already been struggling to recover from the effects of the 2016 demonetization and the implementation of GST. The failing IL&FS sector has also created a liquidity crunch. As developers face more challenges to raising funds, the economy is adversely affected. Additionally, the slowing demand for infrastructure projects and weakened rupee have expedited the negative impact on the economy. 

With state elections at the end of this year and national elections next May, a major correction in equity markets could be detrimental to Prime Minister, Narendra Modi’s, reelection campaign. The dearth of jobs and rising fuel prices has already resulted in growing discontent with the current Prime Minister and his political party, the Bharatiya Janata Party (BJP). Compounded by the shock to equity markets, Modi and the BJP will have a harder time maintaining their electoral base. 

The IL&FS crisis also raises concerns about the efficacy of Indian rating agencies. The rising risk of loan default took the market by surprise, leading to questions about their credit rating. Credit rating agencies (CRAs) changed IL&FS’s AAA rating to D, suggesting that they were also surprised by the high risk of default. The CRAs should have been monitoring the developments at IL&FS more closely to allow for a more gradual change of rating, which would have also eased out the shock to the larger economy. 

In addition to their inability to change quickly in response to market trends, the fundamental business model of CRAs results in a conflict of interest. CRAs get their revenue from the very companies whose securities they rate. This system is also widely used by other countries. India has yet to test out any model wherein CRAs would be paid by investors or the government, but the failure of the CRAs to adequately respond to the iL&FS crisis suggests that it might be time to test out a new business model. 

However, CRAs point to their obstacles to access of information, particularly with unlisted companies. In those cases, both banks and companies are reluctant to share information, thereby hamstringing the CRAs ability to effectively rate the company’s securities. Tighter regulations requiring companies to share this information with the CRAs would eliminate this problem and ensure more comprehensive ratings. 

As the various stakeholders and IL&FS themselves look for effective repayment plans, it is also important to address the wider impact on the economy. The liquidity crunch, drop in infrastructure projects and inadequate CRAs are all factors that will affect the economy, alongside IL&FS. Attending to the long run and short run impact and will be key as the country sees to rebound from this crisis in its financial system.

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