Indian corporations have been cheering the Reserve Bank of India’s (RBI) policy rate cut, the first reduction since May 2013. After a prolonged fight, the central bank has finally been able to contain inflation in Asia’s third-largest economy, and its 15 January action marks the beginning of a series of rate cuts that we may see. However, if companies think that getting cheap bank loans will be a cakewalk now, they are mistaken. Many of them are not in the best of health, and the balance of power has clearly shifted to the lenders.
RBI deputy governor S.S. Mundra hinted at this in December when he said banks may demand higher equity from companies that are highly leveraged before offering fresh loans to such firms. As a precondition to giving them loans, the banks may demand higher equity to correct the leverage; they may decide on the debt-to-equity ratio individually for companies.
High leverage is also a concern for Moody’s Investors Service, as this could prevent any meaningful recovery in asset quality of Indian banks. Moody’s estimates that India’s corporate sector has an average debt-to-equity ratio of more than three times and only a stronger economic recovery can bring down the leverage.
Banks are wary of giving loans to companies, as they need to continue to set aside money for bad assets which affect their net profit as well as capital and hence their capacity to give fresh loans. Two years of relatively subdued economic growth has crimped cash flows and made it difficult for corporate borrowers to repay debt. The gross non-performing advances (NPAs) of Indian banks rose to 4.5% of total advances in September from 4.1% in March and the net NPAs increased to 2.5% in September from 2.2%. Along with restructured assets, stressed loans of the banking system crossed 10% of total loans in September.
RBI’s bi-annual Financial Stability Report, released in December, points out that 20 banks, with a market share of 43% of the total loans of the banking system, account for 60% of the total stressed assets. According to the stress tests conducted by RBI, if macroeconomic conditions deteriorate, the gross NPAs of the banking system may rise and, under a severe stress scenario, they could be as much as 6.3% by March 2016. Gross NPAs of 40 listed banks grew 17.5% to Rs.2.69 trillion in the quarter ended 30 September from Rs.2.29 trillion a year ago. Banks have also restructured a cumulative Rs.3.67 trillion of loans until 30 September. India Ratings and Research Pvt. Ltd expects Rs.60,000 crore to Rs.1 trillion of additional NPAs in the system and corporations can take five to six years to reduce their leverage ratio to a healthy level.
Dwelling on corporate leverage and pledging of shares, the Financial Stability Report warns that there is a need to examine practices related to multi-layered structures and pledging of shares. The holding company structure often leads to double leveraging and banks need to capture this in risk assessment. In a typical double leveraging, a holding company raises debt on its balance sheet and infuses it as equity in special purpose vehicles or SPVs. From the lenders’ perspective, a debt-to-equity ratio of 2:1 at the holding company level could transform into a leverage of 8:1 at the SPV level.
As banks are reluctant to give loans, the next port of call for companies is non-banking financial companies who are willing to give money, at a higher price. Corporations are also going for external commercial borrowings. Between January and October 2014, 607 companies raised $26.38 billion through this route. Companies have been raising money through overseas bonds but unlike borrowing from banks, this is not easy money as investors in bonds, increasingly concerned about higher leverage of companies, are insisting on meaningful covenants to protect their interest. The conditions include a cap on total borrowing of a company, limiting capital expenditure at a certain amount in case of a default, restricting a company’s ability to make distributions—whether in the form of cash, assets or securities—to shareholders, among others. Such covenants impose greater discipline on companies. Drug maker Wockhardt Ltd learnt it the hard way when a group of foreign currency convertible bond holders, led by Singapore-based hedge fund QVT Financial LP, dragged it to court after it defaulted on redemption of $110 million of bonds in October 2009. Wockhardt had to clear its dues after the unsecured creditors successfully asserted their rights for the first time in Indian corporate history.
Slower economic growth in the past couple of years may have contributed to the rise of bad assets of Indian banking system but none can overlook the cosy relationship that many banks have developed with their corporate borrowers.
Some of them do not have the expertise to assess credit risks and monitor a loan account and often they are more eager than their borrowers to restructure a loan as it saves them from setting aside money for bad assets. All that will change now. RBI has already tightened the screws on bank customers who default on loans despite having the ability to repay their debts, creating a new category of borrowers classified as “non-cooperative” and asking banks to set aside higher provisions for incremental lending to such companies and their founders. Non-cooperative borrowers are separate from those classified as wilful defaulters, a category first introduced under RBI guidelines in July 2012.
The over-leveraged companies are being treated even more aggressively by the investment banks who are arranging money for them. It’s painful for the companies but ultimately, they will benefit as the system will be purged and corporations will return to health. Credit discipline is the key to economic health but, pampered by lazy bankers, many Indian companies have forgotten that. They need to accept the new reality for their own good.
