A 3 percentage point hike in the cost of funds has lowered profits by more than R80,000 crore

Reversing India?s growth slowdown will require reviving investment, which has fallen quite sharply. While other structural bottlenecks are being addressed, the forthcoming monetary policy is being seen as the first boost. Despite the growing calls for aggressive monetary policy easing, there is increasing skepticism about the extent to which rate cuts and liquidity injections will help in achieving the intended objective. In plain English: when there are so many impediments, getting land, environmental clearances, fuel linkages, procedural frictions, how will a 25 or 50 basis points cut in the repo rate (a basis point is a hundredth of a percent), from the current 8.5% to 8.25%, help? How much are higher interest costs hurting investments? Does the fact that a company or project?s debt financing is costed at 18% make the project unviable?

Costs of borrowing have increased more than the increase in the policy repo rate in 2011, both for corporates and banks. To recap briefly, the policy repo rate had been raised from 4.75% in March 2010 to 8.5% (375 bps). In tandem, the benchmark base rate of India?s largest bank had increased from 7.6% to 10% (240 bps). But, as a result of liquidity tightening, both induced by policy (the CRR was raised from 5% to 6% over 2010) and other structural factors, 3-month Commercial Paper rates moved up from around 5% to close to 10% over this period (500 bps). The cost for lower rated corporates have obviously gone up much more, given the lower ratings (on average) that these companies are likely to have.

So how do these increasing costs affect corporates? That increasing interest rates are bound to have impacted profitability is a non sequitur. Back of the envelope calculations suggest that with a bank credit base of R27 trillion, (excluding 40% priority sector, assuming minimal rate increases in this portfolio), a 3 percentage point increase in cost of funds would have reduced profits by more than R80,000 crores.

This article attempts to understand a bit of the microstructure underlying this broad brush estimate. Using a sample of 2,500 non-financial companies, we look at the cost dynamics and the potential impact incidence of a reduction in cost of funds for corporates. The sample stratifies (non-financial) companies with sales above R5,000 crores (92), R1,000?5,000 crore (330), R500?1,000 crore (250), R100?500 crore (750) and with sales less than R100 crore (1,130). Of course, the bulk of revenues come from the largest corporates, many of which are public sector. However, the 3 mid segments account for a third of the total sales in the sample.

As might be expected, interest costs as a proportion of sales are the highest for smallest companies, having gone up from less than 7% in 2009-10 to close to 9% in 2011-12. The interest cost share of the three middle segments range around 5%, up from 4% in March 2010.

How much of the higher costs they have managed to pass on to consumers is indicated by profit margins, although this is the result of multiple factors including labour and commodity input costs. The reduction in margins is evident in the chart below, across the sales segments, with an average drop in margins of around 3 percentage points. What stands out is that the profit margins of the smallest companies have been negative for the past year and a half, and indicates a deteriorating prognosis for impending defaults, given the continuing negative cash flows that the negative margins indicate, particularly if they are being bridged by working capital loans. A reduction in rates is critical for this segment, since their access to funds other than bank credit will be very limited.

Obviously, the impact of higher cost of funds will also depend on the degree of debt buildup of individual corporates. Excessive indebtedness, fortunately, does not yet seem to be a systemic problem, although obviously select sectors and specific companies might have high leverage.

Bottom line? While the impact of lower cost of funds (via monetary policy actions) for large borrowers will be lower than for smaller ones, the amount of interest payments freed up due to lower costs will be significantly larger for the former group, which, for a given level of sales, would allow them to invest more. As is now becoming an incantation, rate cuts are a necessary, even if not a sufficient condition for increasing investment. Then, debottlenecking measures will need to be speeded up.

The author is senior vice-president, Business and Economic Research, Axis Bank. Views are personal