The Indian economy has slowed to its lowest for a decade, and one sector that will feel the pain is the country’s banking system.
For the fiscal year ending March 31, the economy clocked a 5 per cent GDP increase, the smallest rise in 10 years. During this period corporate India’s debt levels reached a 10-year high, even as profits continued to be under pressure.
State-owned banks make up 75 per cent of the banking system and are the major lenders to corporations. Over the past few years they have provided the loans to fund India’s dreams to build more power plants, highways and airports.
Many of these projects, however, are way behind schedule. Now high debt levels, a slowing economy, a crashing rupee and decreasing profits have left many companies unable to service their debt, in turn stretching the banks’ balance sheets.
Amid all this, the central bank – the Reserve Bank of India (RBI) – increased interest rates to tighten liquidity to control inflation and a depreciating rupee. These moves have made loans from the domestic market expensive, and increased the chances of debt default by companies with already stretched finances.
In its analysis, the investment bank Morgan Stanley looked at the market capitalisations of the BSE 500 companies and compared them with their net debts to see if they had the ability to raise capital to reduce debt and replace it with equity.
It created a sample size of 72 companies whose net debt this year was double their respective market caps. The data showed that almost half the companies in the sample set have net debt that is more than five times their market capitalisation (cap).
One key reason behind this increase is the sharp decline in market caps of these companies – from about US$100 billion in 2010 to about $25bn this year.
“This collapse in the market value of these companies will make it very tough for them to raise any meaningful amount of equity to reduce the stress of repayment,” Morgan Stanley said.
During the same period, the debt at these companies increased from $70bn to about $115bn, making matters worse.
With profits greatly under pressure, the ability of these companies to pay the interest on these loans has been at their lowest level in a decade, and close to those in the late 1990s during the Asian financial crisis.
At these levels, “the picture is clearly not pretty”, says Morgan Stanley. “The stress among large corporates is clearly going up very sharply. With Ebitda [earnings before interest, tax, depreciation, amortisation] growth slowing and interest rates spiking up, we would expect more corporate balance sheets to look weaker and turning into potential problem loans for the banking sector.”
RBI’s move to increase interest rates also spells trouble for the banks’ asset quality. This was already visible in the past few years, when bad loans nearly doubled from 5.4 per cent in 2010 to 9.2 per cent this year. Morgan Stanley now predicts that this could reach 15.5 per cent in the next two years.
Problems run deeper at some sectors such as infrastructure, iron and steel, construction and textiles – which the RBI says are under potential stress.
According to Morgan Stanley, these sectors make up about 25 per cent of loans and on an incremental basis have contributed 31 per cent to loan growth since 2009.
“The interest coverage in all these sectors has been falling very sharply, which in our view will cause more and more of these corporates to default,” says Morgan Stanley.
For instance, last year the property company DLF generated $480 million in operating cash but paid nearly $580m in interest and guarantee charges, leaving it with no free cash flow to reduce its high net debt.
Similarly, at Lanco Infratech, a construction and power conglomerate, interest cost rocketed 130 per cent, while its earnings before interest and taxes rose a minuscule 14 per cent. Similarly at GVK Power & Infrastructure, interest costs increased 55 per cent while pre-tax earnings declined 32 per cent.
In a separate report, Credit Suisse looked at the debt levels of 10 Indian corporate houses with businesses in these troubled sectors. These companies also happen to be among the biggest debtors in the country. The Swiss bank found that their already elevated debt levels had increased by an additional 15 per cent in the past year. In some cases – specifically at GVK, Lanco Infratech and at the billionaire Anil Ambani’s Reliance ADA Group – the gross debt levels were up 24 per cent from last year.
What is accentuating an already severe problem is the fact that in the past five years several companies raised debt externally. Because of this foreign exchange debt doubled from $112bn to $224bn, and this accounts for 20 per cent of the total loan book for Indian banks, says Morgan Stanley.
Adani Enterprises – which builds and runs ports and power plants – Jaiprakash Associates – the group that built India’s first Formula One track – and Reliance Communications are among the worst hit as they have the largest percentage of borrowings through foreign-exchange loans, says Credit Suisse.
The RBI has said that nearly 60 per cent of this external debt is unhedged. Given that the rupee has depreciated by nearly 13 per cent in the current financial year, this implies that corporations are likely sitting on $7.5bn of mark-to-market losses (Indian accounting does not require mark-to-market losses on forex exposure for corporations). This could actually mount pressure on these companies when loans come up for maturity.
“Unless currency comes under control, we believe we are likely to see meaningful losses for corporates on these loans. This is especially true for the infrastructure developers, who are sitting on fairly levered balance sheets at home too,” says Morgan Stanley.
Where does all of this leave the state-owned banks? In a not very good place.
With bad loans already at more than 9 per cent and rising – and mostly concentrated in the state-owned banks – analysts predict a further increase in the number of non-performing loans given the stressed balance sheets of these borrowers.
And things do not look like they are going to improve any time soon. With a sluggish economy and persisting policy bottlenecks, the chances of companies taking on more loans to expand business are low.
If the RBI is unable to reduce rates for a protracted period, given currency declines and high inflation, Morgan Stanley predicts that bad loans will increase by more than 4 per cent to 5 per cent over the next two years, and several companies might be forced to restructure their loans.
State-owned banks are running mostly with stretched balance sheets and net impaired loans at some of these banks are now almost 100 per cent of equity, says Morgan Stanley. What it means is that some state-owned banks are not adequately capitalised when compared to the bad loans that they are racking up.
With bad loans further likely to increase, and the government unable to inject a massive dose of capital, Morgan Stanley predicts that the loan growth at these banks will struggle.