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Covid-19: Is this a wound that would heal or a scar that would last forever?

By V Srinivasan

As all of us continue to be locked down in our homes, the million dollar question that keeps ticking in our mind is what lies ahead of us? Everyday we read numerous articles from experts in various fields on how behaviours are likely to change and consequently business models. Right now, as we think about changes galore in our life from how we can better reorganize our lives after this ‘do it yourself’ experience and beginning to question why do we need so many things, it’s interesting to take a close look at what direction the financial system and markets could take as we navigate the current Covid and post Covid phase. Touchwood, the Indian Covid scenario has been benign and hence for almost all market stakeholders there has been little hardship other than mobility being an issue to grapple with. However, the second and tertiary order impact is yet to surface and that’s when the markets will respond to the ‘real thing’. Right now, it’s forecasts based on expectations, which is equivalent to tossing a coin.

What’s the base case scenario that is being priced in by markets across the globe? The pandemic is worse than the GFC with every individual and business impacted adversely. However, it is unlikely to have long-term structural implications if we can contain the damage through a tsunami of stimulus, targeting all constituents. Even in India, the expectation is that this phase will pass over in a 3 month timeframe and a large number of players would be bruised and battered but would be back to normal business after this phase. Equity markets are, therefore, sensing superior value after the sharp correction we have had over the last month. This is the Goldilocks scenario for us but we need to make sure that financial conditions facilitate such a trajectory. Herein lies the catch. Extrapolating the events that have taken place over the last eighteen months, is there confidence of that happening?

Banks have had a torrid time navigating the corporate asset quality cycle and their risk appetite today is possibly at its nadir. The target portfolio of any fund manager would comprise only companies that have little or no debt on their balance sheet. Retail and small business lending were the ones that were the favoured lending segment for banks and NBFCs but Covid is going to reduce additional lending to these constituents to a dribble. There is hope and prayer on every bank’s lips that the retail delinquency cycle does not get triggered due to the pandemic.

Looking at the above, it is clear that debt has become a four letter word!!! Most corporates, SMEs, small business and individuals have a certain amount of debt going into the pandemic. Both the lenders and the borrowers believed that the debt was capable of being serviced based on expected future cash flows. To facilitate the Goldilocks scenario to play out, a moratorium of 3 months for debt repayments has been put in place. But is that good enough? Having to bear all fixed and operational costs including interest with zero revenues would imply that the existing debt becomes a much bigger burden in the coming years. As the system becomes more and more risk averse, it would require a booming economy and much better pricing power to claw one’s way out of the current hole. And with equity markets punishing entities with debt on their balance sheets, the survival instinct would take over. Entities would start shunning debt and thereby growth. No entity would want to have the ‘scar’ of debt on their books and settle for less than potential growth. This debt scar would equally be applicable for individuals also as they would hold back consumption to ensure that they do not run the risk of being flagged as delinquent credits and becoming a ‘pariah’ to all lenders.

This has implications for overall GDP growth and Government finances. Any stimulus from the Government would factor in a healthy growth pickup from where we are today. If all stakeholders (lenders and borrowers) think of leverage as ‘evil’ and gravitate to a lower level of activity, the Goldilocks scenario will quickly die out. The interconnected nature of businesses and the financial system will imply that expected future cash flows for everyone would fall and there would be quite a few financial corpses to deal with.

India is a capital starved economy, both debt and equity. Financing our future growth through equity is not a feasible proposition and leverage has a very important role in making sure we attain our potential growth. It is important to recognize this and have institutions and policies in place to provide this leverage and not treat debt as evil, especially in the current context.

In these testing times, it is important for Government and policy makers to take steps to underwrite (or sub underwrite) risk when the existing financial intermediaries balk at doing them. This is the only way to heal the wound that has been festering for 18 months and now in a breathless state on a ventilator. What are some of the steps that need to be done:

  • No admissions to IBC for the next one year
  • Designate select existing financial intermediaries as ‘Covid Care’ institutions. Pump in capital into these institutions and give them a specific mandate to address issues the system is grappling with.
  • These institutions can have specific policy dispensations and exceptions for this portfolio of assets
  • There could be one such institution for each customer segment, wholesale, SME, retail.
  • These institutions should be able to provide ‘restart’ capital and additional leverage to enable customers to revert to pre-Covid state. The institution should take equity in assisted entities to participate in the upside
  • Bond markets need to given a lot of handholding and just providing liquidity at a system level is not enough. The Covid cares institutions should have an explicit mandate to devote capital and risk to capital market instruments
  • All types of financial intermediaries have been performing a specific function and it is important that any policy dispensation is applicable in the same manner for all to ensure that any disruption does not fuel contagion in the system

Not taking steps such as the above would risk leaving the onus of healing the wounds to the system at large and letting markets find their own equilibrium in such a dislocated environment. This would invariably leave a scar on all current stakeholders forever and consequent survival instincts will make sure that growth will never be the same again!!

(The writer is former deputy managing director of Axis Bank)

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