The Deleveraging may have begun

Even as valuations have risen rapidly, investors remain optimistic about the current situation. However, overvaluation and bubbles are attributed to extensive credit and leverage, feeding on each other in a vicious cycle. Unlike in the United States, where the financial system has fostered extensive innovation, the Indian financial system is much more tightly regulated and less complex. The advantage of this lies in the ability to identify precise points where risks may be hidden. I have previously discussed global risks, along with financial sector risks in India, but a recent development may indicate the start of the deleveraging process.

As asset prices rise, lenders consider the borrower more creditworthy, with the asset serving as collateral, providing cover for additional borrowing. This resembles a house of cards. During bubbles, this system exacerbates itself exponentially. The human brain tends to perceive only vivid risks; for example, higher interest rates, war, etc., are perceived as risky and elicit knee-jerk reactions. However, hidden risks are the ones that lead to crashes and rapid deleveraging with margin calls. When the cards are toppled, the reverse of the vicious cycle happens even faster. Assets lose value, leading to margin calls, which result in the sale of assets, further depreciating their value. The cycle turns, just when the system needs more credit exponentially to sustain the bubble. Identifying this inflection point is usually challenging.

Returning to India, banks have lent to NBFCs significantly, portraying their books as clean. NBFCs, in turn, have lent extensively to AIFs, apart from loans against securities and personal loans. It's safe to assume that most of this money has found its way into the stock market, contributing to extreme valuations. AIFs have played a significant role in evergreening defaulters, supporting banks and NBFCs. Such behavior is a feature of any financial system, as institutions attempt to hide risks under the rug and portray a rosy picture due to the scale and number of people involved, along with the incentive system. The bubble and credit are sustained for a long time, but the RBI's recent decision to control evergreening tricks by financial market participants may expose the risks within. More importantly, this will subject financial institutions to a credit crunch. A mere halt to credit is often all it takes for the process to reverse and enter a vicious cycle, as discussed above. Moreover, the short time span and extensive provision requirements will cause second and third-order exposure effects on financial participants. Institutions involved may attempt to downplay the risks and resolve them with minimal impact, but once the deleveraging process begins, it gains momentum, forcing multiple institutions to raise liquidity simultaneously. Another significant aspect is the expected surfacing of delinquencies and failed borrowers, in addition to forcing real estate valuations to correct due to a credit crunch. High provisioning also leads to lower lending, impacting the real economy.

While the risks of this scenario playing out seem extremely high, I reiterate that investing conservatively is all that’s needed to grow wealth. High valuations are always risky. Human beings repeat the same patterns even as markets and debt always work in cycles.

– Dr. Siddarth.K.J

Fund Manager

Kyng Capital Management Pvt Ltd