Indian Demonetization Highlighted a Significant Liquidity Risk
Moody's Investors Service recently looked into the types of transactions by country that pose the greatest liquidity risk. Their findings? Indian structure finance transactions, particularly as highlighted during the demonetization process.
"This higher liquidity risk occurs because most Indian transactions pay both interest and principal to investors on a predetermined periodic basis—known as timely payment—whereas in other countries, principal payments are typically only passed through to investors once they are received from the underlying borrowers," said Siddharth Lal, a Moody's analyst. "Furthermore, the characteristics of the underlying borrowers in certain Indian transactions—such as auto asset-backed securities (ABS)—accentuate the liquidity risk posed by such deals."
In the ABS markets for instance, the earnings of borrowers tend to be volatile, as can the level of cash collections from borrowers, Moody's said.
In fact, when cash flows to a transaction are briefly disrupted, cash reserves that support the related notes have to be used at a heightened pace to pay off principal to investors, even when it's not received from the borrowers, analysts said.
But there exist several mitigating factors to this liquidity risk, such as cash reserve facilities that support rated notes and are fully funded at closing and don't amortize over the transaction term, Moody's said. These usually cover up to three months of principal and interest payments at closing, and the coverage grows as the notes amortize.
Excess spread, or the amount of interest collected from the portfolio that's in excess of the aggregate amount of interest due on the notes, as well as other fees and expenses payable each month help mitigate liquidity risks.
During Indian demonetization, as in November 2016, the government withdrew all INR500 and INR1,000 notes from circulation—about 85% of all currency notes at that time, Moody's said. "As a result, collections for the Indian auto ABS Moody's rated at the time dropped by an average of around 1.3%," Moody's analysts said. "The average utilization of cash reserves was less than 1%, while the maximum was 1.4%. However, if the drop in collections had been more severe and prolonged, it could have led to a significantly higher utilization."
– Nicholas Stern, managing editor