In the last few years, especially after the 2016 demonetisation exercise, there was excess money sloshing around in the system.
That is because a lot of cash was deposited with banks and investors parked more money with mutual funds. As fund managers of debt schemes deployed the funds in money markets, NBFCs were able to access cheap funds easily. They were able to grow their loan portfolios at double the pace of banks. On the flip side, mutual fund managers were chasing high returns for their investors. This led them to take risky positions.
The trouble is that the NBFC business model itself is flawed, to begin with. It relies on raising short-term funds which are then lent out as long-term loans. This leads to a situation called an asset-liability mismatch. For example, an NBFC raises money by selling 6-month debt papers and forward-lends this as a car loan with a tenure of 5 years. This leads to a situation where the NBFC has to roll over (or renew) the 6-month debt paper or raise fresh loans to repay the debt paper. In good times, this happens as a matter of course. But when times are tough, this cycle is broken.
The cycle was broken by a default firms of the IL&FS group.
The NBFC crisis has already hit consumption. As mentioned earlier, since the IL&FS fiasco, banks have raised the cost of funds to NBFCs by about 1.5%, in turn pushing up their lending rates to customers. There is already a reduced flow of car and personal loans, reflected in the fall of car and two-wheeler sales to an eight-year low. Analysts expect this dip to continue and further engulf some other sectors, like consumer electronics.
Ever since IL&FS defaulted, the economy is on the ropes. Mutual funds, a key lender to the segment but without reliably long-term funds, have frozen because of redemption pressures. So NBFCs, a key intermediary that lent to millions of small firms and individuals to buy cars and motorcycles, are unable to meet the demand. SMEs account for 8% of India’s GDP.
There is no easy, quick way out. The NBFC mess has been allowed to be built over decades. The clean-up will take some time. The worst hit will be the infrastructure, real estate and MSME sectors, which, to think of it, will increase the unemployment rate in India.
ArthaNiti 