The outlook has turned in favour of high interest rates in the foreseeable future. High inflation and RBIís commitment to reduce inflation through interest rate calibrations implies that the cost of borrowing would remain high and could even increase. Some of the major commercial banks raised their base rates in the last month. This would hurt the profits of the corporate sector because a change in the base rate impacts the full spectrum of borrowers from banks.
The corporate sector saw a sustained fall in the cost of borrowing during the period 1996-97 through 2005-06. The average cost of borrowing was 11.7% in 1996-97. This dropped to 6.7% in 2005-06. This fall in the cost of borrowing had a direct impact upon profits. Interest cost ate away 20-30% of the operating profits during the 1990s. In 1998-99, it took away 29% of the operating profits. But then, the fall in the cost of borrowings eased the interest pressure on profits substantially. Net interest costs accounted for only 1% of operating profits in 2007-08.
The cost of borrowings started increasing in 2006-07. It reached a recent peak of 8.2% in 2008-09 and then it fell back a bit to 7.4%.
Interest costs have risen in recent times for a variety of reasons. First, it was the natural outcome of an acceleration in investments and growth since 2004-05. Second, the financial crisis in 2008 led to a sudden spike in the cost of funds. And third, high inflation has kept policy rates high. The average cost of funds of the corporate sector during the four years since 2008-09 (i.e., 2008-09 through 2011-12) was 7.7%. This is about 10% higher than the 7% it was in the preceding four years. But it is much lower than the average rate seen in any preceding year.
Besides, in spite of the 10% increase in interest incidence, the interest cover has remained comfortable. As of 2011-12, it was 2.8. Till 2001-02, profits covered less than twice the interest payment obligations of the corporate sector.
However, a source of worry is the rate at which interest rates have been growing. In 2011-12, interest costs were up by 28% after having grown by 15% in the preceding year. Interest costs now eat away nearly 12% of operating profits.
A bigger worry is the impact of these rising interest rates on the smaller companies. Usually, the bottom 30% (by size) of the companies are unable