What has caused the current liquidity crisis in mutual funds? And what needs to be done to prevent its recurrence?
Short-term debt funds are under tremendous redemption pressure. It is important to understand the way these funds have positioned themselves. Operating on wafer-thin margins (the expense ratios are 30 basis points or less) and offering efficient service (redemptions before the current crunch was t+1), liquid and liquid plus funds provide access to short-term markets to a large cross section of investors. The hassle in the model was that liquid funds ended up providing liquidity intermediation for clients. Even while their underlying portfolio of CPs, CDs, PTCs and T-bills are essentially illiquid, liquid funds offer their clients a t+1 redemption. This they manage, in normal times, by laddering the portfolio, so that some redemptions routinely happens every day, and funds are there to meet client redemptions. When redemption pressures increase, as has now happened, the underlying portfolio, though good in quality, simply cannot be liquidated. Mutual funds do not take on asset-liability mismatch like banks. They don?t take short term funds and deploy them in long-term assets. The portfolios of liquid funds are in short-term assets, but illiquid ones, which is the problem. The dominance of buy-and-hold investors in debt markets is an issue that remains long unresolved, and the current crisis is a fall-out of that inertia.
Expensive loan not the solution
I have always wondered if the lack of presence in Delhi (no chairman appointments by the ministry), and the dominance of private sector players, works against the interests of the mutual fund industry. There are many instances of policy not addressing the real problems of the industry. Consider the response to the liquidity problem. Mutual funds have been asked to borrow from repo markets to meet their liquidity needs, which means you add high-cost liability to the existing portfolio, making the NAV worse than before, and adding fuel to the fire. Little wonder mutual funds did not use that window.
The NAV of a liquid fund is made up only of the acquisition price and accrued interest income. There is no capital gain or loss in the portfolio. The loss in NAV comes when there is a distress sale of a liquid asset. What is needed is not a loan at a high cost, but the ability to sell a CP, CD, or T-bill in the portfolio at current cost plus accrual (that is, at fair value). Liquidity discounts from distress sales can kill the product, and so can high-cost loans. If banks have LAF (liquidity adjustment facility) to seek liquidity, mutual funds need a temporary liquidity provider that will exchange the short-term instruments at current value for cash.
Allow layoffs
The layoffs in the airline business might just be the proverbial tip of the iceberg. The economic boom saw a huge rise in low-skill jobs across aviation, retail, BPOs and such service-delivery focused sectors. Those who sought these ne wly opened job avenues were barely graduates; some quit studies to work. The fancy salaries lured several into joining the bandwagon. ?Training? institutes teaching them a range of skills from English speaking to etiquette sprang up. Jobs seemed easy to get, salaries enabled spending and indulgence, and young India celebrated its financial freedom in its early twenties.
What is going wrong now and why? Most of these new businesses are volume-driven; they have very low and ultra-sensitive margins; and therefore they are completely cyclical. These are not ?career? opportunities but ?seasonal? employments available in the up-cycle and quite amenable to vanishing in the down cycle. Rather than protest against the retrenchments, the kids need to go back to school and prepare better for the next boom. Politicians will see an opportunity, and the kids losing jobs seem to have fallen for the bait. If politics makes retrenchment difficult, we can be sure that cyclical businesses will not hire in the next upturn, and we will have a large young population frustrated at not being able to find work.
Optimisation or car-telisation?
The Jet-Kingfisher alliance is more than just optimisation of capacity. As has been rightly pointed out, it is the only option to save them from going bankrupt. The realisation has come belatedly. But as this column has pointed out several times before, it makes little sense for businesses with high fixed costs to indulge in a price war. The alliance will put an end to that. If they go ahead and begin to increase air fares, we will know that the alliance was actually a cartel. Questionable practice or survival tactics ? we will know only when passenger traffic slows down even further.