India’s economic growth remains resilient, with official estimate of the FY17 Gross Value Added (GVA) growth at 6.9%, and RBI forecasting an uptick in FY18 growth, to 7.4%. The pressing issue now is to sustainably accelerate growth to up to 8% and above. The only way to do so is to reinforce consumption growth (which has been growing at a steady 5-6%) with renewed investment. A dominant reason that investment growth has been languishing is due to what the 2016 Economic Survey labels as the “festering twin balance-sheet problem”—the over-leveraged companies and bad-loans-encumbered banks.
In order to revive investment, both demand- and supply-impediments of credit offtake need to be tackled. While India has significant external commercial debt (about $181 billion), the bulk of the debt is owed to Indian banks (although, incrementally, a significant part of this debt for the best credit-rated companies has been raised through corporate bonds). Thus, to materially address the bad-loan problem of banks (and consequently revive risk appetite for project investment and supply of credit), deleveraging of corporate balance-sheets is a necessary condition. This article looks at one of the causes for a drop in demand for credit—the rapid rise in corporate debt over the past five years—to get a sense of the underlying stress.
A measure of the sustainability (and the extent of excess) of leverage is the total debt-to-equity (D/E) ratio. The total D/E ratio of 76 (non-financial) companies in the NSE100 Index rose from 0.8 in FY12 to 1.0 in FY15. The encouraging part is that there is already an improvement visible in 2016, which is likely to have accelerated in FY17.
However, the stress of “excess” leverage can only be meaningfully understood in relation to cash-flows to service the accumulated debt. An indicative metric of corporate health is the Interest-Cover (IC) Ratio.Whatever the debt level, if a company has the cash-flow strength to pay interest and principal, it remains creditworthy. The IC ratio is essentially the ratio of the Earnings Before Interest and Tax (EBIT) of a company to its interest liability (with EBIT measured as x times the interest).
The stress in IC is also evident when comparing the current situation (the past five years ending FY16) with the five high-growth years till 2008. The accompanying graphic shows that rising growth and corporate profitability since FY04 steadily improved corporate IC from 8x to over 13x, before dipping sharply to 9x in FY08 (precursor to the financial crisis). In the four years after that, the situation was likely distorted by various stimulus measures. Picking up the thread again in FY12, IC was still much lower (6x in FY12) and has steadily deteriorated to half that level by FY16.
The graphic also shows the distribution of this stress across companies. Of a sample of 792 companies reporting results in FY16, 101 companies had negative equity which, barring exceptions, have ceased to be going concerns. Another 170 companies had IC less than 1 in FY16, and consequently were likely to be very stressed in meeting interest payment obligations. The rest 520 companies were better, with 353 of these having a strong cash-flows with IC greater than 2.
Note that the distribution of companies with the above IC classifications had improved a bit in FY16, after a steady deterioration since FY11, but the change was at the extremities. The number of companies with strong cash-flows (IC > 2) increased from 312 in FY15 to 353, but the movement in the other buckets actually deteriorated. The number of companies in the IC > 1 bucket (i.e., those with tolerable cash-flows) went down, with most of these improving to the IC > 2 bucket and some moving up 2 slots from the IC < 1 stressed bucket as well. At the other end, however, there was a deterioration with about 20 of the stressed companies transitioning to the negative equity group. At the same time, the better cash-flow companies have also increased their debt holdings in FY16, which is a positive development.
On the flip-side, the debt holdings of the stressed group (IC < 1) had also risen, and this is contrary to the reduction in the number of companies in this group, as noted before. This apparent paradox—of rising debt in stressed companies—might be because of additional funds to maintain debt servicing ability.
This corporate debt servicing difficulty is reflected in stressed assets of banks, with a steep rise in Gross Non Performing Assets (GNPA) in the third quarter of FY16. Of course, it is difficult to disentangle this sharp rise of the effects of cash-flow deterioration from the improving recognition of NPAs post RBI’s Asset Quality Review (AQR), but both would have contributed.
A combination of asset selloffs by leveraged firms, improving cash flows of minerals-based companies and RBI and the government’s steps to speed up resolution of stressed assets is gradually beginning to show results. This will be the first step towards boosting private sector capex.
With research inputs from Abhay More.