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The Infrastructure Leasing & Financial Services (IL&FS) Debt Default: Privatize Profits, Socialize Losses?
by Sushovan Dhar
15 January 2019

Even when the Lehman Brothers collapse shook the entire financial world, the Indian political elites and the capitalist class were quite confident that the contagion would not spread to India. True, the Indian banks and financial institutions did not weather similar tsunamis as their Western counterparts experienced. The quantum of losses and write-downs that plagued famous banks and financial institutions in the Western world like Fortis, Merrill Lynch, Lehman Brothers or Washington Mutual did not have its Indian parallels. Does India seem to have its own Lehman moment now, exactly around the 10th anniversary of the catastrophe, with the crisis and bankruptcy of the Infrastructure Leasing & Financial Services (IL&FS), the Indian infrastructure development and finance company that operates through hundreds of subsidiaries?

A king in the infrastructure sector

Even though IL&FS was not a household name, it is supposed to be a king in the infrastructure sector having built quite a number of the largest infrastructure projects including the Chenani-Nashri Tunnel in Kashmir. Since the ushering of neo-liberal reforms in the country, a lot of emphases was put developing physical infrastructure viz. roads, highways, ports, energy, etc. This ambitious grand project was midwifed by an up-and-coming lender – IL&FS. Widely acknowledged as the pioneer in Public Private Partnerships (PPP) in India, the company is one of India’s leading infrastructure development and finance companies. Incorporated in 1987, it was initially promoted by public sector banks and financial corporations – the Central Bank of India, Housing Development Finance Corporation Limited (HDFC) and Unit Trust of India (UTI). Over the decades the shareholding patterns have changed to include State Bank of India, Life Insurance Corporation of India, ORIX Corporation Japan, and Abu Dhabi Investment Authority (ADIA).

Figure 1. Répartition des principaux actionnaires d’IL&FS (en pourcentage du total des actions)

This 32 years old infrastructure lending giant, IL&FS, is a shadow bank or a non-banking financial company (NBFC). NBFCs provide services similar to traditional commercial banks but are outside the system of regulated depository institutions. IL&FS includes subsidiaries like IL&FS Transportation Networks Ltd (ITNL) which builds transportation network; IL&FS Engineering and Construction Co. Ltd, IL&FS Financial Services Ltd, etc. The shadow banks have also assumed the notorious sobriquet of ‘shady’ banks due to their massive role in the US sub-prime mortgage crisis and the global crisis that followed it.


The Crisis

IL&FS defaulted on a few payments and failed to service its commercial papers (CP) on the due date signaling that the company ran out of cash or it was facing a liquidity crunch. The company accumulated too much debt to be paid back in the short-term while revenues from its assets are forthcoming in the longer term. The cracks were revealed when it was forced to defer the $350 million bonds issuance in March 2018 as investors demanded a higher yield. The demand for higher yield indicated that the company’s finances were indeed in trouble since investors were demanding a greater premium on their money. Investors typically demand a higher premium for high credit risks, i.e. for the risk of their money not paid back. Normally, the lower quality bonds offer higher yields since investors demand more compensation for taking on higher risks of non-recovery. This was true in the case of IL&FS and it indicated that the company’s solvency was in question.

The holdup of infrastructure projects these days and the conflict over contracts locking about INR 90 billion of payments due from the Indian government have further aggravated conditions. IL&FS Financial Services revealed on September 6, 2018 that the commercial papers which were due on August 28, 2018, could not be paid on due date and were settled in full on August 31, 2018. [1] IL&FS Financial Services has about $ 500 million in repayments which are due in the second half of this financial year, i.e. by March 2019, while it has only about $ 27 million available. IL&FS and IL&FS Financial Services had a combined $ 3.8 billion of debt rated as junk by CARE Ratings by September 2018, and a further six group companies had suffered downgrades with a negative outlook on another $ 1.7 billion of borrowings. [2]


Commercial papers

A commercial paper is an unsecured, short-term promissory note or a debt instrument issued by a company, usually for borrowing money to finance payments, inventories and meeting short-term liabilities. These short term loans are in almost all cases to be paid back within 270 days. A CP is usually issued at a discount from face value and is determined by prevailing interest rates in the market. Since such loans are not normally backed by any form of collateral guarantee, it is a form of unsecured debt. Therefore, only corporations with high credit ratings will easily find buyers without having to offer a considerable discount (higher cost) for the debt issue. As commercial paper is issued by large institutions, the denominations of the commercial paper offerings are substantial, usually $100,000 or more. It is bought by other companies, financial institutions, money market funds and wealthy individuals. India has witnessed an increased NBFCs borrowings through debentures and commercial papers (CPs) for the last 5 years. As per the latest RBI data, the borrowing through commercial paper, which was about INR 46,200 crore ($ 6.54 billion) in March 2014 rose to INR 1,26,700 crore ($ 17.94 billion) in March 2017. The rise for the year ending March 2017 was about 48 percent. The share of debentures and CP together accounts for over 40 percent in the resource mix of the NBFCs. [3]

Figure 2. IL&FS Total des emprunts en roupie indienne (Source : IL&FS Rapport Annuel 2008)


Cascading effects

The company’s default will impact a series of investors, including banks, insurance companies, and mutual funds. It will have cascading effects as IL&FS sits atop a web of numerous subsidiaries, associates, and joint-venture companies. This makes the default even more worrisome as the company revealed a series of delays and defaults on its debt obligations and inter-corporate deposits. Could it be a bigger scam than Vijay Mallya, [4] Nirav Modi, [5] Mehul Choksi? [6] This NBFC enjoyed AAA [7] rating, i.e. a superior credit rating, helping it secure easy loans from the banks. In case of loans, the company’s properties were not mortgaged, it simply provided commercial papers, i.e. paper guarantee to the banks for the repayment of the loans. As public sector institutions held large shares of the company, the market trusted it. Sadly, within a week of default, this superior rating has assumed junk status, and the company has turned junk as well.

The worry is that the contagion might spread and those who have lent money might become junk. Money from the provident fund and pension funds are invested in it which is the hard earned money of many ordinary people. If this company dooms, all will doom including the savings of millions of workers. Mutual fund companies have also invested in IL&FS. Banks have lent to IL&FS and its subsidiaries on the basis of commercial papers. Now such pieces of paper are nothing but junk. Since August 27, 2018, when this non-banking financial company was unable to repay the loan at the scheduled time and missed deadlines, the share market reacted, NBFC stock prices started tumbling down.

The state-owned Small Industries Development Bank of India (SIDBI) has loaned nearly INR 10 billion ($141.31 billion) to IL&FS and its subsidiary companies. It has filed an application in the Insolvency Court to sell IL&FS assets and quickly recover its money. However, SIDBI does not have any security to invoke on its loan to IL&FS and the Insolvency and Bankruptcy Code (IBC) does not apply to NBFCs. [8]

This amount of default can sink SIDBI as well. Meanwhile, IL&FS and its subsidiary companies are trying to hide behind the arbitration claims of INR 70 million ($ 1 million) that it has with NHAI. It intends to connect the settlement of this arbitration with its loans. This means that unless the decision is made, the company will not pay its loan.

Seeing such large ships sink, the government has forwarded the Life Insurance Corporation (LIC) to save the company. This attempt is to cash on the goodwill of this state-owned insurance group and investment company and raise money from the market. The LIC already owns a large part of IL&FS shares. However, the rights issue was postponed as there were practically no responses from the shareholders. Earlier, in September 2018, the Reserve Bank of India asked the LIC not to infuse any more capital in IL&FS. The worry is that with the rights issue turning into a flop, the government might force the LIC to bail out the debt-laden company directly. The LIC - trusted by millions of Indians with people parking their entire savings in it - has carried on investing and raising its stake in a corporation which has a manifestly problematic and flawed model of operation that is based on funding long-term infrastructure projects through largely short-term borrowings. This type of operation lends what it borrows and thus might find itself unable to repay back loans at any given point in time. IL&FS operates very much like a bank without actually complying the regulatory framework that guides the banking sector.


How could the crisis overgrow?

This is not the first time that we observe such scams and defaults. In 2009, the country was rocked by the Satyam scandal. Another fraud case, that relating to the Sahara India Pariwar conglomerate, was revealed in 2012. In order to foreclose any repetition of such corporate collapses, a new Companies Act was passed in 2013. How could the IL&FS episode take place only five years later? Why were the glaring issues not detected earlier and a resolution attempted? How did the company run up such a high debt? Did it happen overnight? One assumes it didn’t, as it is obviously not possible to gather such huge unpayable debt in a short time. What were its major shareholders, viz. LIC, SBI, Oryx Corp of Japan, Abu Dhabi Investment Authority doing all this time? Why didn’t they intervene and change its management much earlier? If the shareholder directors were sleeping, were the independent directors too? How could two rating agencies, supposedly run by top industry professionals, continue to give IL&FS such high rating?

Unfortunately, an earlier detection could have been done by either the rating agencies or the independent directors — both are clearly guilty of turning a blind eye to developments that happened in front of their eyes.


Infrastructure boom

There is a growing skepticism around the world around One Belt One Road (OBOR, now also known as the Belt and Road Initiative – BRI), the Chinese state’s non-transparently financed global infrastructure ambitions. A lot of scrutinies is currently on around those energy, infrastructure and transportation projects. The IL&FS project was India’s version of OBOR though it wasn’t called in such name. Like everywhere else, in India too, we witnessed a high degree of infrastructure investments covered with infinite financialization. This includes energy, transport, communication, irrigation, storage and distribution. Sadly, these large infrastructure projects – treated as a national priority, in reality not – have stripped off the Indian banking system of its assets by way of unpaid loans.


The risk of shadow banking

The Indian banking system is in deep crisis with ever-growing Non-Performing Assets (NPA). [9] About half of it comes from the public sector banks. Another quarter comes from private banks, some of which are claimed as among Asia’s best-run lenders. The rest is from a motley crew of shadow banks that have grown exponentially. These are quasi-unregulated and they lend in particular areas such as real estate. As they are usually prohibited from taking deposits, they depend solely on loans to fund themselves.

The seeds of the present problems were sown between 2005-12, when public sector banks went on a lending spree, extending loans to dubious tycoons like Vijay Mallya, Nirav Modi, Mehul Choksi, and others as well as to infrastructure projects whose viability was always in question. In February 2018, PNB, the second-biggest public sector bank, disclosed a $2 billion fraud involving diamond tycoons.

The next phase started after 2012 and by 2017 India received more capital than what flowed out. Interest rates began falling in 2015. In November 2016, the notorious demonetization took place with the government replacing a major stock of banknotes overnight. People were forced to deposit their physical money into banks, and into debt mutual funds. With huge deposits coming into the banks combined with low interest rates, banks looked for ways to lend the money out again and part of the answer was to fund the shadow banks, which went on a binge—the top 50 have doubled their debts and assets in the past five years. Perhaps as much as $ 50 – 100 billion of their debts comes due within 12 months. [10]

Borrowing short and lending long is a high-risk game as the IL&FS collapse amply manifests. In the aftermath, the government has taken it over though it already indirectly owned 40% of it. There is a huge mistrust in the financial market with mutual funds and banks are reluctant to lend to NBFCs. In spite of reports of solid capital ratios, there is a great deal of apprehension about the possible time-bombs buried in their balance sheets. For months now, NBFCs have been facing a liquidity crunch.

Defaults by such NBFCs are fatal enough to damage India’s entire financial system with mutual funds - which are sold to the public - having $ 55 billion of exposure to them, or 11% of total assets under management. Traditional banks have loaned $ 70 billion to NBFCs which approximately equals to 40% of the banks’ core capital.

NBFCs should be fully regularized as per banking rules. Otherwise, they can spell further disaster for the financial sector in addition to the severe banking crisis.


Lehman Brothers or more to it?

In 1997-98 the world’s largest hedge fund Long-Term Capital Management (LTCM) in the US was going bankrupt. This hedge fund management firm led by Nobel prize winning economists and famous Wall Street traders enjoyed enormous clout in the US administration. Bill Clinton, in his frenzy to get re-elected despite the ignominy around the Monica Lewinsky affair, was confronted with the LTCM crisis. He forced 14 investment banks to lend money to the hedge fund to keep it alive, till elections were done and dusted. LTCM was allowed to perish quietly thereafter.

It’s some of these 14 lenders to LTCM who went bankrupt in the 2008 crisis, the seeds of which were sown in 1998 in the LTCM crisis. Perhaps, IL&FS has the potential to be India’s LTCM and not only Lehman Brothers. I think by now readers will agree what the initials IL&FS really stand for. Internal Looting and Fraud Syndicate? Finally, that leaves the ‘watchdog’ of democracy, the media. Did it too fall asleep?


Footnotes :

[4A business tycoon and a former member of the Upper House of the Indian parliament. Involved in massive financial fraud and money laundering, he left the country in 2012.

[5Involved in a $2 billion fraud case of Punjab National Bank, India and is also being sued in the State of California for US$4.2 million for defrauding Los Angeles entrepreneur, Paul Alfonso.

[6Indian fugitive businessman, residing in Antigua and Barbuda, who is wanted by the Judicial Authorities of India for criminal conspiracy, criminal breach of trust, cheating and dishonesty including delivery of property, corruption and money laundering.

[7Rating agencies, ICRA, India Ratings and CARE had rated it AAA, indicating the highest level of creditworthiness and these ratings were in place till June 2018.

Sushovan Dhar

CADTM India