Yield differentials look bad for a huge emerging market heading into a recession
The spread of the coronavirus in India is showing no sign of abatement. Unless it catches a lucky break, Asia's No. 1 pandemic hotspot is still a month or more away from a peak in infections (currently above 165,000) despite a severe lockdown. Tricky as the situation is for the country's patchy healthcare infrastructure, the disease won't be India's only curve to flatten.
The squiggly line that joins the cost of money at different maturities — the yield curve — deserves just as much attention. It's unhealthy in an economy headed for a recession that 10-year funds cost nearly 5.75%, almost 275 basis points more than the three-month treasury bill yield. The central bank is slashing short-term rates and flooding banks with liquidity, and yet the long-term cost of capital is refusing to head lower.
In large developing economies deeply challenged by the virus, from Brazil to Indonesia, the yield curve, or the excess of longer-term bond yields over shorter-term bill rates, has steepened appreciably from a year ago. In the U.S., Europe and Japan, as well as in China, where the outbreak started, the difference has either remained at similar levels or gone down. Bond investors are more comfortable with fiscal expansion as a strategy to deal with the pandemic in countries that can issue large amounts of debt in their own currencies without facing exchange-rate instability or runaway inflation.
The surge in India's yield differentials has been both pronounced and problematic: Capital wasn't cheap to begin with for corporate borrowers, and it's getting more expensive. This comes just as migrant rural workers have been driven out of urban production centers because of shuttered factories, unpaid wages, and — in many cases — no food or shelter. Even if this labor is safely put back on, say, road construction, concessionaires might still go bankrupt before completing any projects. That's because their annuity payments from the government are linked to falling short-term policy rates, whereas their long-term borrowing costs are both high and sticky.
To face a downturn with a stubbornly elevated cost of borrowing is a recipe for a vicious cycle in which the economy produces and earns little, consumes less, and fetches meager taxes for the government. This limits avenues for purchasing faster growth with fiscal pump-priming. About 10% of real gross domestic product may be permanently lost, according to Crisil, an Indian affiliate of S&P Global Inc.
Official data released Friday pegged GDP growth at 3.1% in the March quarter from a year prior, slowing sharply from 4.1% in the previous three months. Worse is yet to come. Getting stuck in a slow-growth, deflationary rut is a real possibility because capital was already expensive. Credit spreads, or what businesses have to pay over and above government bond yields, were wide even before the pandemic. Creditors' trust in corporate borrowers — especially real-estate developers and shadow banks — was ebbing. Now, when 30%-plus of most credit portfolios are taking advantage of a six-month moratorium, nobody knows what delinquencies will be like when lenders finally get to demand repayment of the interest accumulating through the freeze.
One thing is certain. The thriving consumer credit culture that was driving India in the absence of corporate investment before Covid-19 is on its last legs. Almost 360 million people who earn between $130 and $260 a month are staring at a 56% drop in April incomes from February, says research firm CreditVidya, which estimates this mass-market segment will be unlikely to fulfill its installment obligations beyond two months.
India's legacy corporate bad loan problem is far from resolved. According to Credit Suisse Group AG, accelerating ratings downgrades pose a refinancing risk for $33 billion in loans. Thanks to the lockdown, unsecured consumer credit is also toast. At the very least, Prime Minister Narendra Modi's government will have to rescue state-owned banks. Credit Suisse estimates a recapitalization bill of $13 billion. Amid rising welfare expenditure, collapsing tax collections and fading hopes of privatization revenue, the falling debris of a broken financial system will hit India's budget hard.
Shutting down congested cities doesn't defeat a contagion in the absence of aggressive testing. India's untamed Covid graph demonstrates that. Unruly yields underscore the difficulty of convincing markets that the government will somehow limit the supply of new debt by using its fiscal firepower sparingly.
The 6.5% of GDP in budgetary resources that Team Modi has committed to support the Covid-hit economy is heavily centered on credit guarantees. The deficit needle will move higher by just 0.8% of GDP, Nomura Research says. The pusillanimity is making investors nervous.
New Delhi was less than sensitive to migrant workers' precarious existence before launching its hasty lockdown in March. Now, when it comes to restarting the economy, the government is too fearful of a fragile currency, sovereign downgrades and capital outflows to spend boldly and pay for it by printing money. The strategy is simply not credible, and the yield curve shows that.
Andy Mukherjee is a Bloomberg Opinion columnist covering industrial companies and financial services. He previously was a columnist for Reuters Breakingviews. He has also worked for the Straits Times, ET NOW and Bloomberg News.
Disclaimer: This article first appeared on Bloomberg.com, and is published by special syndication arrangement.