Bet on well-managed NBFCs

The recent developments around the Insolvency and Bankruptcy Code (IBC) will impact investors in various ways.  The Essar Steel case led to some consternation for financial creditors. The original allocation of funds from the Rs 42,000 crore offer by ArcelorMittal meant that financial creditors would have recovered over 90 per cent of their claimed dues. However on appeal, the allocation was changed to allow financial creditors to take roughly 60 per cent recovery of their claims, while operational creditors were also awarded about 60 per cent.

If this precedent had held, financial creditors would have to take larger haircuts in future IBC cases. However the Cabinet is proposing an amendment to emphasise the primacy of financial creditors. Another amendment could mean that IBC cases will be decided within 330 days, instead of 270 days. This is pragmatic in the sense that the current 270-day deadline has been overstepped multiple times and, as the law stands, liquidation is mandatory after the deadline is exceeded. However, there is the question of moral hazard in extending the deadline-it may be in somebody’s interest to drag things out.

While the IBC has not been as effective as envisaged, it still forces bankruptcy resolutions much quicker than the earlier process which dragged on for decades. Creditors hate taking deep IBC haircuts but that is better than losing 100 per cent in non-performing assets (NPA), which was pretty normal before IBC.

From an investor’s viewpoint, the IBC coupled to the new tougher norms on recognising non-performing assets, does make it easier to judge the true picture of a player in the financial sector. This is also better than the earlier situation where bad loans were obfuscated and concealed for years on end.

We have an interesting situation developing with both pros and cons for financial sector stocks. Banks have already recognised massive NPAs, and provisioned for some of these. But there is still a large overhang of NPAs to cope with. Meanwhile, non-banking financial companies (NBFCs) are in trouble with bad debts and liquidity issues. Since these are more lightly regulated, it is hard to know how bad the situation is for NBFCs.

Given poor corporate growth through 2018-19 and no apparent pickup visible in Q1, 2019-20, more bad loans are bound to surface. Indeed, a Business Standard study suggests that balance sheet stress has increased in the last year across the board in most sectors. This will inevitably mean more NPAs, for both banks and NBFCs.

As credit rating agencies and foreign portfolio investor (FPI) advisories have pointed out, the government’s determined milking of public sector units (PSUs) under the disinvestment programme could further increase stresses in that specific segment. Many PSUs have been stripped of their reserves and told to take cross-holdings, incurring large debt burdens in the process. ONGC-HPCL and PFC-REC are two deals that are worth pointing out in this respect.

The enforced recapitalisation of PSU banks in order to meet international norms may not be enough to stem the rot since there’s been no real change in the due diligence for new loans. The finances of the state power sector also started deteriorating again in 2018-19 after the DIPAM scheme had led to some improvements in earlier years.

Put it together and India is still struggling with an ongoing debt crisis and this could continue for several more years.  However, that very debt crisis, coupled to low consumption demand, has induced the Reserve Bank of India to start opening the liquidity tap. A combination of rate cuts and a more accommodative stance could mean more liquidity in the Indian economy. With the government transferring some of its sovereign borrowing abroad, crowding out in the rupee bond markets could reduce.

So on one hand, we have an ongoing debt crisis and real fears of more NPAs and possible contagion across the NBFC space. This has led to debt mutual funds writing off loans as well. These developments affect the debt mutual fund space negatively, and make equity investments in the financial sector risky.

On the other hand, we have the beginnings of transparency in bank balance sheets, and potentially better regulations for NBFCs. We also have a situation where interest rates should come down. That makes it easier to pick and choose the better finance sector stocks. The better managed NBFCs should be able to exploit lower rates and grab market share as well.