INDIAN BOND MARKETS POST COVID- EMERGING CONTOURS

Vipin Malik, Chairman and Mentor, Infomerics Ratings

Dr. Manoranjan Sharma, Chief Economist, Infomerics Ratings

D. Suresh Pai, Regional Director, Infomerics Ratings (South)

Hope is important because it can make the present moment less difficult to bear. If we believe that tomorrow will be better, we can bear a hardship today.”

Thich Nhat Hanh

I. PERSPECTIVE

The COVID-19 pandemic has truly been a game-changer across the development spectrum in terms of the hit to the global economy, domestic economies and several segments and sectors of the domestic economy. The financial markets all over the globe are broiling under the threat of COVID 19 that has unleashed untold havoc. The UNCTAD estimated a $1 trillion hit to the global economy. But it now emerges that the damage caused to the global economy may be far higher than the initial estimates of USD 1 trillion. There have also been extremely disconcerting parallels drawn with the global financial meltdown of October 2008 and even the Great Depression of 1929. This is why several nations may take a longer time to resurrect after the ‘pandemic’ gets controlled.

In the wake of new stringent rules limiting people’s movement and closing non-essential businesses necessitated by an all-pervasive sense of fear and dread, there has been an increased awareness and heightened consciousness of the severity of the downturn. PMI indices in the UK, US and EU have all recorded historical lows. Unemployment applications are breaking all records. Fitch downgraded the UK sovereign debt because of the extremely debilitating impact of the Coronavirus on the public finances and the economy.

According to a new analysis by the United Nations Conference on Trade and Development (UNCTAD) entitled ‘The COVID-19 Shock to Developing Countries: Towards a ‘whatever it takes’ programme for the two-thirds of the world’s population being left behind’, the world economy will go into recession this year with a predicted loss of trillions of dollars of global income due to the coronavirus pandemic, spelling serious trouble for developing countries with the likely exception of India and China. With two-thirds of the world’s population living in developing countries facing unprecedented economic damage from the COVID-19 crisis, the UN called for a USD 2.5 trillion rescue package for these nations.

Commodity-rich exporting countries will face a USD 2 trillion to USD 3 trillion drop in investments from overseas in the next two years. Of late, advanced economies and China have put together massive government packages which, according to the Group of 20 leading economies (G20), will extend a USD 5 trillion lifeline to their economies. UNCTAD stressed, “this represents an unprecedented response to an unprecedented crisis, which will attenuate the extent of the shock physically, economically and psychologically”.

While the full details of these stimulus packages are yet to be out, an initial assessment by the UNCTAD estimates that they will translate to a USD 1 trillion to USD 2 trillion injections of demand into the major G20 economies and a two-percentage-point turnaround in global output. “Even so, the world economy will go into recession this year with a predicted loss of global income in trillions of dollars. This will spell serious trouble for developing countries, with the likely exception of China and the possible exception of India,” the UNCTAD maintained. The report, however, did not fully explain as to why and how India and China will be the exceptions as the world faces a recession and loss in global income that will impact developing countries. Further, given the deteriorating global conditions, fiscal and foreign exchange constraints are bound to tighten further over the course of the year. The UNCTAD estimates a USD 2 trillion to USD 3 trillion financing gap facing developing countries over the next two years.

In the face of a looming financial tsunami this year, UNCTAD proposes a four-pronged strategy that could begin to translate expressions of international solidarity into concrete action. Some of the basic elements of this development strategy include a USD 1 trillion liquidity injection for those being left behind through reallocating existing special drawing rights at the International Monetary Fund; a debt jubilee for distressed economies under which another one trillion dollars of debts owed by developing countries should be canceled this year and a 500 billion dollars Marshall Plan for a health recovery funded from some of the missing official development assistance (ODA) long-promised but not delivered by development partners.

The speed at which the economic shockwaves from this Black Swan event has damaged developing countries is dramatic, even in comparison to the 2008 global financial crisis. This is why the UNCTAD Secretary-General Mukhisa Kituyi said “the economic fallout from the shock is ongoing and increasingly difficult to predict, but there are clear indications that things will get much worse for developing economies before they get better”.

In two months since the virus began spreading beyond China, developing countries have been severely impacted in terms of capital outflows, growing bond spreads, currency depreciation, and lost export earnings, including from falling commodity prices and declining tourist revenues. Lacking the monetary, fiscal and administrative capacity to respond to this crisis, the consequences of a combined health pandemic and a global recession will be catastrophic for many developing countries and halt their progress towards the Sustainable Development Goals (SDGs). Even as advanced economies are discovering the challenges of dealing with a growing informal workforce, this remains the norm for developing countries, amplifying their difficulties in responding to the crisis.

At this difficult juncture, it is important to remember, as Nelson Mandela stressed, “the greatest glory in living lies not in never falling, but in rising every time we fail”. This is why Richard Kozul-Wright, UNCTAD’s director of globalization and development strategies said “advanced economies have promised to do ‘whatever it takes’ to stop their firms and households from taking a heavy loss of income”. “But if G20 leaders are to stick to their commitment of ‘a global response in the spirit of solidarity’, there must be commensurate action for the six billion people living outside the core G20 economies”. The death toll from the coronavirus pandemic has soared past 40,000 while the number of confirmed cases breached a million mark globally.

In an important paper entitled ‘Economic Policies for the COVID-19 War’, Giovanni Dell’Ariccia, Paolo Mauro, Antonio Spilimbergo, and Jeromin Zettelmeyer, Español, Français, Português, Русский of the IMF have identified and isolated three objectives of the role of economic policy. These policy objectives related to guaranteeing the functioning of essential sectors, providing enough resources for people devastated by this crisis of epic proportions and preventing excessive economic disruption.

II. INDIA-THE CHALLENGE AND THE RESPONSE

The gravity of real and worrisome fault-lines is reflected in the fact that there have been 4643 reported cases in India, with the death toll at 141. Globally, the number of cases has crossed 1 million, standing at 1,034,098 with the death toll at 54,463. The BCG data suggests that the India lockdown started in line with China’s timing of the lockdown.

In the case of India, the economy has been in the midst of a marked macro-economic slowdown with the impact being pronounced on MSMEs, the unorganized sector, exports, and manufacturing. This global crisis was estimated by the UNCTAD to set back the Indian economy by $348 Million because of the devastation to not just firms but also industries across the development spectrum, e.g., airlines, road and rail transport, automobiles, hospitality, meat and poultry, films, music, sports, advertising, media, retailers, tourism, etc. and supply chain disruptions. There has also been a bloodbath on the bourses. But it is now being increasingly clear that these estimates could err on the lower side because of the devastation caused by the loss of income, output, and employment. Things don’t look too good but it is important as Martin Luther King Jr. famously said, “if you can’t fly then run if you can’t run then walk if you can’t walk then crawl, but whatever you do you have to keep moving forward”. Going ahead, this has to be the success mantra.

III. INDIA’S DIVERGENT GROWTH PROSPECTS-THEATRE OF THE ABSURD

Moody’s Investors Service sharply cut India’s growth forecast for calendar 2020 to 2.5 percent from 5.3 percent estimated earlier. Similarly, the Asian Development Bank (ADB) reduced its growth forecast for India for the financial year 2020–21, saying it is likely to slow down to 4 percent amid the global recession triggered by the COVID-19 pandemic.

Fitch Ratings slashed India’s growth forecast for the current fiscal to a 30-year low of 2 percent, from 5.1 percent projected earlier, as economic recession gripped the global economy following the lockdown due to COVID-19 pandemic. The initial disruptions to regional manufacturing supply chains from lockdown in China as the coronavirus spread have now broadened to include local discretionary spending and exports. Fitch now expects a global recession this year and recently cut India’s GDP growth forecast for India to 2 percent for the fiscal year ending March 2021 after lowering it to 5.1 percent previously, which would make it the slowest growth in India over the past 30 years. On March 20, Fitch had projected “India’s GDP growth for 2020–21 at 5.1 percent, lower than 5.6 percent estimated in December 2019”. Fitch also said micro, small and medium-sized enterprises, and the services segment are likely to be among the most affected amid reduced consumer spending. NBFCs’ business borrowers are typically smaller with more limited cash buffers, and any material fall in earnings is likely to affect their ability to repay their loans directly.

The challenges for India’s non-bank financial institutions (NBFI) will intensify as local measures to contain the spread of the coronavirus exert pressure on their operating performance and financial profiles. Government-imposed activity restrictions in India will raise operational complications for the NBFIs, while any escalation in local infections would dent economic sentiment. “These developments threaten to derail the incipient recovery in India’s credit environment following the NBFI crisis in 2018–2019, and Fitch has taken negative action on our rated Indian NBFI portfolio in light of these risks”. The RWN (Rating Watch Negative) placed on the ratings of Fitch-rated Indian NBFIs reflects heightened uncertainty over their credit profiles because of the tough measures to contain the spread of COVID-19.

It is, however, interesting to note that India Ratings and Research (Ind-Ra) -Fitch’s India outfit — still holds on to a growth projection of 3.6 percent because of the spread of COVID-19 and the resultant nation-wide lockdown imposed till 14 April 2020, crippling most economic and commercial activities. Ideally, both Fitch and Ind-Ra should be on the same page and even in the worst case, there should not be such a wide divergence. This reflects poorly on both these institutions and shows that there are loose ends at different points. This wide divergence in growth prospects reminds us of the powerful Shakespearean observation in his play Hamlet- “there is something rotten in the state of Denmark”!

India announced an economic stimulus package worth 1.7 trillion rupees ($22.5 billion) on March 26, 2020, designed to help millions of low-income house-holds withstand a 21-day lockdown due to the coronavirus outbreak. The package will be disbursed through food security measures for poor households and through direct cash transfers. India’s Finance Minister Ms. Nirmala Sitharaman maintained that the food security measures will affect 800 million people.

Under an existing scheme, low-income earners get 5 kilograms of rice or wheat per month at a heavily subsidized rate. Now, the government will top that up with an additional 5 kg of either rice or wheat per person for the next three months, and 1 kg of pulses per household for this period — for free. Cash transfer measures are set to benefit farmers, rural workers, poor pensioners, construction workers, low-income widowers, etc. Further, India will provide a medical insurance cover of 5 million rupees per person for front-line workers, viz. nurses, doctors, paramedics, and sanitation workers in government hospitals. States have also announced various measures to support the local economies.

There is a compelling case for massive intervention by all stake-holders and extending the reach of the state, particularly when there is little risk of spiraling inflation in these straitened times. Given the debilitating impact on the GDP growth for Q4 19–20 and FY 20–21, weakening of aggregate demand and uncertain and negative future outlook, the RBI acted decisively on March 27, 2020, by reducing the Repo rate by 75 bps to 4.4 percent and reducing the Reverse Repo by 90 bps to 4 percent, three-month moratorium on payment of installments of Term Loan outstanding and deferment of interest on WC facilities by 3 months. This deferment will not be considered for computation of NPAs and revised DP calculations will be done by reassessing the credit history of the borrower.

The CRR has been slashed by 100 bps to 3 percent to release 1.37 lakh crores to the banking system. The requirement of minimum daily CRR balance has been reduced from 90 percent — 80 percent till June 30, 2020. Thus, liquidity of Rs, 3.74 lakh crore has been injected into the system. The total liquidity injection works out to 3.4 percent of GDP. This combination of moratoriums, liquidity enhancing measures and the steep Repo rate cut would prevent a freeze in credit/debt market as also a crisis of confidence. All these measures by the Government of India and the RBI are of considerable contextual significance not just for leveraged sectors and companies but also for the larger macro-economy. These measures would help to partially alleviate the pain and suffering caused by the Coronavirus outbreak.

Going ahead, heightened risk aversion, pronounced macro-economic slowdown, wholesome impact on the balance of payments because of the free-fall in oil reaching hitherto inconceivable levels and greater uncertainty caused by marked domestic slowdown and negative global cues are important. While there may be light at the end of the tunnel, there is no clarity yet on the length of the tunnel. As Vivian Greene pithily said life isn’t about waiting for the storm to pass…It’s about learning to dance in the rain”. This too shall pass but how. In the interregnum, there could be large-scale misery, deprivation, and devastation necessitating coordinated and concerted measures with a sense of urgency.

III. INDIAN FINANCIAL MARKET-THE NEW NORMAL

With nations devasted by the cascading economic problems, lockdown is the way to ensure social distancing and contain the Coronavirus. But this requires limiting the economic impact and buffering the impact on the small, marginalized and the vulnerable sections of society-what Mahatma Gandhi called “the teeming millions of India”. The unorganized sector and the MSMEs with very limited staying power have been particularly hard hit by this crisis, in some ways similar to the financial meltdown of October 2008 and even the Great Depression of 1929. The slew of measures announced by the Government of India in tandem with monetary action support from RBI shall bring some respite to the financial markets, albeit at a slow pace.

Indian Bond market is dominated by institutional participants like banks, mutual funds, insurance companies, pension and superannuation funds like EPFO, ESIC, etc. Retail participation is very less except for the tax-free bonds or through mutual funds. Scheduled commercial banks (SCBs) are driven by a statutory requirement to hold Government bonds, the demand for bonds by other participants, both issued by the Government & Corporate largely depends on the nature of liquidity available with them, others are guided by their respective regulatory authorities to decide the pattern of securities held in their investments portfolio.

Banks have been parking funds with RBI to the extent of Rs.2.86 lakh crores from the beginning of March 2020. With RBI announcing a 1 percent reduction in CRR with effect from March 28, 2020, resulting in an inflow of Rs.1.37 lakh crore, the amount now stands in excess of Rs.6 lakh crore as on 30.3.2020 indicating easy liquidity condition for the banks. However, this position is not likely to persist for long as a slight pick-up in credit and dollar demand could upset the skewed liquidity position suddenly.

Most of the banks have surplus SLR position (the growth in SLR was 11.80 percent against deposit growth of 9.10 percent in 2019–20). Further, they have also been permitted to dip into MSF to the extent of 1 percent of the DTL for their immediate liquidity requirements, there is little possibility of a major shift in demand for G Sec/ SDLs. There could be potential MTM losses while migrating to the new accounting standard regime for the banks.

Allocation of Rs.15,000 crore for fighting COVID 19 & the package of welfare measures to unorganized sector especially dedicated to the urban-rural poor and daily-wage laborers, to the extent of Rs.1.70 lakh crore may upset fiscal deficit targets. But given the magnitude of the funds required and the stimulus package announced, adhering to the mandated fiscal deficit level is not required at this juncture because of the severe hit to income, output, and employment in the country.

This thesis can be substantiated by the fact that the IMF’s Managing Director Kristalina Georgieva and WHO Director-General Dr. Tedros Adhanom Ghebreyesus have inconvertibly demonstrated an effective mechanism of tackling the pandemic. Towards this end, they have demolished the false dilemma of a choice between saving lives and saving livelihoods. To quote Georgieva and Dr. Ghebreyesus, “getting the virus under control is, if anything, a prerequisite to saving livelihoods”. “Paying salaries to doctors and nurses, supporting hospitals and emergency rooms, establishing make-shift field clinics, buying protective gear and essential medical equipment, and carrying out public awareness campaigns about simple measures like hand washing are critical investments to protect people against the pandemic”.

Further, IMF published a new World Pandemic Uncertainty Index for 143 countries, which clearly brings out the unprecedented level of uncertainty triggered by the coronavirus. As of March 31, it is three times the size of the uncertainty during the 2002–03 SARS epidemic and about 20 times the size during the Ebola outbreak. As the problem gets worse, the stakes rise higher necessitating boosting confidence and providing stability to the global economy in these tumultuous times.

The IMF is also regularly updating the global policy tracker to sensitize the member countries of the global experiences in addressing the challenge of COVID-19. The tracker now covers 193 economies and focuses on discretionary actions that supplement existing social safety nets and insurance mechanisms, and summarizes key economic responses governments are taking to limit the impact of the pandemic.

Given this overarching environment, providing some relief and succor to the distressed sectors and segments is the need of the hour today and the concerns of prudence in fiscal management can be addressed at a later stage when things get back on rails. Further, the free fall in oil prices with WTI Crude reaching a level of USD 22 and a distinct possibility of the price of oil plummeting to hitherto inconceivable level would provide a bonanza to the government in terms of the cost of oil imports and the position of the balance of payments.

With most of the business establishments and factories closed, the GST & other Tax collection during 2020–21, may fall well short of their targets. The advantage India is currently gaining through the free-fall at oil prices can get partially moderated by the declining demand during and post COVID 19 contagion. The aggregate fiscal deficit of India could slip by over 100 bps.

Yields in the government bond market have started rising again as bond dealers fear an increase in government borrowing due to the stimulus packages and other expenses due to the rapidly spreading Coronavirus pandemic. Consequently, the actual borrowing is likely to overshoot the planned one. The larger than expected borrowing programme by the Central Government & State Governments would lead to excess supply. Accordingly, there could be a small spike in the sovereign yield curve. The yield curve can steepen with the nearer term to compress by 40–60 bps from the current level, in consonance with the cut announced in recent monetary policy the repo/reverse repo rates. Rates of money market instruments like T bills/CP/CD have already compressed by 40–60 bps as explained above.

IV. COPORATE BONDS

Except for some PSU banks and private banks, Commercial banks have not been major participants in the Corporate Bond market and therefore, the excess liquidity may not find its way to this class of investment. The ILFS & DHFL episodes have created irreparable dents in the corporate bond market — risk-averse mutual funds & insurance companies, wary investors and a fragile NBFC industry. Against this backdrop, the kind of regulatory forbearance is ‘necessary but not sufficient’.

Mutual Funds have been the main saviors of the debt market with an incremental net investment of Rs.5,31,329 crore during the calendar year 2019 (source SEBI), while the AUM increased only by Rs.3,15,684 crore, clearly indicating the investor preference for debt. Commercial Banks’ contribution to the Government Securities segment was slightly above Rs. 3 lakh crore during this period. The year saw 32 public issues of Rs.14,659 crore from 18 companies as against 25 issuances for Rs.36,679 crore in 2018–19. All the public issues during the current year came from finance companies, very much like in the previous years. Rating wise details are furnished below:

In the private placement segment, the amount raised is similar to the previous two years. There were 2075 issues till March 17,2020 aggregating to Rs.6,23,895 crore against 2,706 issues in 2017–18 amounting to Rs.5,99,147 crore and 2,358 issues for Rs.6,10,318 crore in 2018–19. While the number of issues has come down, the average issue size has substantially increased to Rs. 300 crore in 2020 as against Rs.258 crore in 2019 & Rs. 221 crore in 2018.

However, the average volume of trades reported on exchanges increased from Rs.5602 crore in 2017–18 & Rs.4,506 crore in 2018–19 to Rs.5,967 crore in 2019–20. As the tempo of FPI divestment heightened post-COVID 19 spread in February 2020, the average AAA spread started widening. AAA bonds of less than 1-year maturity started with a mark-up of 120 bps during the beginning of March steepened to >200 bps during mid-month. Short tenor bonds up to 5 years were also witnessing sell-off with mutual funds finding hard to get an exit.

AA-rated bonds were getting traded at 350 bps to 500 bps spread over underlying sovereigns. For lower-rated bonds, the spreads widened even higher. State Bank of India perpetual bonds that were traded at 7.95% at the beginning of the month saw the yield going up to 9.75% in trade reported in the last week of March, unprecedented rise of 180 bps within a couple of weeks.

In this pandemonium, the moratorium on Yes Bank Ltd and consequent write-down of more than Rs.8,000 crore of AT 1 Perpetual Bond have ended the prospects of lower-rated banks to raise quasi-equity through the issue of Basel III-compliant Tier I Bonds. The withdrawal of the issue of such bonds by Indusind Bank Ltd is a pointer towards the same. The spread of Tier II bonds issued by banks can also rise. Tier I /Tier II bonds had a captive investor base in the form of mutual funds & a small segment of other investors who had risk appetite for such instruments. Current developments in these instruments may push them away from future investments. As the capital market is also on the downturn, banks may struggle to raise CRAR through an infusion of fresh capital.

V. FOREIGN PORTFOLIO INVESTORS

RBI, through its two separate notifications dated 30th March 2020, opened up avenues for higher foreign investment in the Indian Debt market:

i. Fully Accessible Route (FAR) for investment by non-residents in securities issued by the Government of India, wherein FPIs, Non-Resident Indians (NRIs), Overseas Citizens of India (OCIs) and other entities permitted to invest in specified Government Securities without any quantitative limit.

ii. The limit for FPI investment in corporate bonds is increased to 15% of outstanding stock for FY 2020–21. Accordingly, the revised limits for FPI investment in corporate bonds, after rounding off, shall be as under:

When the global economy is in turmoil and the FPIs have already divested from the debt markets in India to the extent of Rs.42,357 crore in 2018–19 & Rs.48,710 crore during the current year, the above announcements look optimistic. As of March 30, 2020, the FPIs have utilized only Rs.1,73,173 crore out of the current limit of Rs.3,17,000 crore (54.63%) for corporate bonds. There is an unutilized limit of Rs.1,43,827 crore still available to the FPIs or investment in corporate bonds (source NSDL). In this context, the intent to attract forex inflows through an increase in investment limit for FPI in corporate bonds also looks ambitious.

VI. TARGETED LONG-TERM REPO OPERATIONS (TLTRO)

As a part of the liquidity management measures, Reserve Bank of India announced infusion of Rs.1 lakh crore through auctions of targeted term repos of up to three years tenor of appropriate sizes for a total amount of up to ₹ 1,00,000 crore at a floating rate linked to the policy repo rate. The funds raised by banks trough TLTRO are to be mandatorily invested in primary market issuances to the extent of 50% and the remaining fifty percent from the secondary market. Relaxations permitted for the investments made by banks under this facility are:

(a) It can be classified as held to maturity (HTM) even in excess of 25 percent of total investment permitted to be included in the HTM portfolio.

(b) Exposures under this facility will also not be reckoned under the large exposure framework.

This step has given a new lease of life to the corporate bond market and mutual funds who were struggling to find the exit for corporate bonds on the face of the onslaught from the FPIs who were exiting at all levels. The illiquidity in the corporate bonds resulted in an unimaginable hike in yields, with the AAA spreads soaring over 300 bps in the money market segment and the yield curve becoming almost flat. Now that the market got support in the form of TLTRO, the spreads are likely to compress to the pre-pandemic levels soon.

The first repo auction for Rs.25,000 crore was conducted by RBI on 27th Mach 2020 which attracted bids to the extent of 2.42 X times. These funds are to be deployed by the successful bidders within 15 days from the date of the auction. The second tranche of Rs.25,000 crores is announced for April 3, 2020, and the period for deployment is 30 days.

The immediate reaction to this measure has been the relief to the supply side, as a number of issuers who were holding up the issues in view of higher cost, would now line up with primary issuances during April. Reliance Industries Ltd. has already an NCD issue of Rs. 25,000 crore in tranches. Banks are likely to lap up the issues from AAA institutions like NABARD, IRFC, REC or other AAA-rated PSUs & corporate to encash the opportunity provided for a decent carry over the cost of funds, without any mark to market risk. The demand for lower-rated papers is likely to be muted in view of the capital adequacy requirement of banks. The secondary market trades are also expected to be mostly in AAA & AA-rated bonds.

The illiquidity of had almost killed the appetite of risk-seeking investors as pricing of lower-rated bonds was almost non-existent. Now that the corporate bond market is looking up, a reasonable revival of the market space for such issuers can be expected.

VII. ROADMAP AHEAD

The buoyancy created is expected to be short-lived until the life of TLTROs is over. Given the current situation where the lives and income of the entire population of the country are affected and the Government itself conceding a time frame of at least 3 months to recover from this medical-cum-economic emergency, corporate/personal savings and the mobilization by the intermediaries shall slow down while the fund starved corporates would be looking forward to raising funds from all sources. The resultant demand-supply mismatch may result in the risk-reward ratio in favor of the investors, i.e., spreads widening from the current levels by the end of the current quarter.

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Chief Economist at Infomerics Ratings, New Delhi