In a series of articles in the run up to the Budget 2015 I had pointed out on the weak financials of the Indian corporate sector. The consequential debilitating impact on the economy, especially in the finances of our nationalised banks, too was explained in these pieces.
Last week the International Monetary Fund published the Indian Country Report [IMF Country Report 15/62 published in March 2015] more or less echoed my views on the depressed state of the Indian Corporate sector. Chapter VIII and IX of the said Report are instructive. Let me summarise the findings of this report for the benefit of the reader:
- Based on four common indicators of corporate financial conditions [interest cover, profitability, liquidity, and leverage], a historically-highshare of corporate debt is owed by corporates with relatively weak financials.
- Stress tests of corporate balance sheets derived from four economic shocks [domestic and foreign interest rates, the exchangerate, and profits] demonstrate continuing high vulnerabilities.
- Both median profit margins and investment increased substantially starting in 2003, reaching a peak in 2007. After a recovery in 2010–11, both variables declined to levels roughly where they started out in 2003
- Domestic credit to corporates continued to rise prior to and after the global financial crisis, driven by growth in lending by public banks, mostly for infrastructure projects. In addition, external commercial borrowings rose by 107 percent between March 2010 and March 2014
- This has exposed Indian corporates to external shocks, as they rely on foreign sources for more than one-fifth of their debt financing [primarily through external commercial borrowings, trade credits, and bonds]. This increased exposure to non-rupee debt has led tolarge foreign currency repayment obligations by India’s corporates.
- The mean ratio of debt to equity for Indian nonfinancial companies increased from 40 percent in 2001 to 81 percent in 2013. Indian corporates are now among the more leveraged when compared with their emerging market peers, with quite large cross-sectoral differences in leverage across sectors—specifically in manufacturing and construction.
- The IMF analysis suggests that the share of corporate borrowing accounted for by companies with extremely weak financial health indicators mentioned above has increased over the past few years
- The percentage of debt owed by loss-making firms reached 23 percent in 2013/14. Indian companies whose leverage exceeds two [that is, debt exceeds twice equity] account for more than 31 percent of borrowing by Indian corporates.
- Corporates in the manufacturing and construction sectors, plus the infrastructure sector, contributed notably to banks’ NPAs. Between 2002/03 and 2013/14 corporate debt increased by 428 percent for a sample of 762 firms.
What does this imply?
In short, the IMF Report based on a study of 2000 major Indian Corporate for 2013-14 points out that approximately 14 percent corporate debt earned profits insufficient to even pay interest, 23 percent of debt were held by loss making corporates, 20 percent had current assets that were less than current liability by 50 percent and more than 31 percent of debt were held by corporates whose leverage exceeded two.
Naturally all this have profound consequences on the domestic economy. As the number of firms with weak financials have been increasing since the Global Financial Crisis, the overall financial system in general is coming under some pressure while the finances of our Public Sector Banks [PSBs] in particular are now coming under some acute consequential stress.
This naturally affects the risk appetite of banks as well as the ability of the banking system to finance economic recovery by further investment, especially in infrastructure.
The absence of an internal mechanism within banks to deal with extant issue raises concern that the presence of a significant debt overhang in these sectors could hinder investment going forward. It is in this connection the IMF Report maps a one-third decline in India’s corporate investment-to-GDP ratio since 2011-12 when compared to the previous decade. This can be attributed to the overall corporate performance.
The economic significance of the fall incorporate investment has been large, with corporate investment as a share of GDP falling from approximately 13 percent in 2010 to 9 percent in 2012, which in turn has lowered gross investment in the economy in the past few years. As investment slows, elementary economics will reveal, growth too slackens.
What needs to be done?
This weak corporate performance has kept the retail Indian investor out of the Indian stock markets. But inexplicably the Foreign Institutional Investors [FIIs] have conjured reasons to invest in these very Indian corporates whose collective performance is labelled as “weak” by the IMF.
Are FIIs ahead of the curve? Or are they oblivious to the data collated by the IMF in its Report – a classical case of a willing suspension of disbelief? Are their investment process disconnected from fundamentals? Are our stock markets driven mainly by liquidity, mostly foreign investment, and consequently less by performance?
Whatever be it, the fact remains that our stock markets are excessively dependent on foreign money. But should the FIIs turn around and link their investment to performance and earnings, certainly the copious FII flow of the past year or so could well evaporate. Forget inflows, worryingly, that could even turn into an exodus from India.
The possible depreciation of the Rupee on account of the exit of these foreign investors is a larger macroeconomic imbalance that needs to be cognised and tackled by our policy framers upfront.
Readers may be aware that we run gargantuan trade and current account deficits. To finance these deficits we need significant and continuous forex flows – year after year. FII flows, it must be noted, counterbalance our current account deficits. That explains why there is always a policy bias in favour of foreign flows into India. This structural weakness of the Indian economy is in fact its Achilles Heel.
On the positive side over the years the country did leverage the balance sheet of its corporates in the aggregate to finance its trade deficits by liberalising FII flows. On the other hand chronic trade deficit implies Indian businesses were defeated by imports even within India, most of which were from China and other developing countries. This explains substantially if not wholly the poor financial performance of our corporates now.
Moreover, policy paralysis ensured that several projects were stalled. The net effect of all this was that while corporate performance did not match the corporate debt build up.
That is not all. Indian corporates have investment in excess of USD 100 Billion outside India. Again in the run up to the Budget 2015 I had pointed out to the fatal flaw in the outbound foreign direct investment program of Government of India.
Surely, weak corporate performance is a cause of worry. As corporate performance come increasingly under scrutiny I am sure foreign investment may well dry up. This in turn could add to the pressure on the Balance of Payment position. Needless to emphasise exit by foreign investors even marginally could add to the downward pressure on the Rupee.
The IMF Report on the functioning of our corporates is a wakeup call for our Government.
At the root of the conundrum is that our corporates are highly leveraged. Theoretically the prescription for firms that have become highly leveraged is deleveraging. Government obviously have to work out on this to ensure that the banking system has sufficient resources to fund economic recovery.
What is interesting to note here is that some of our leading corporates have invested significant sums abroad. The returns from such investment in several cases have not been commensurate with the hype associated with such investment. Likewise several promoters have commenced projects in India which are beyond their immediate competence to ensure financial closure.
Let us not be shy of defining the problem – Approximately two-thirds of India’s top corporates are overleveraged and consequently have a weak financials. It is quite easy to name them and frame them as non-performing. It is precisely here that the government has to identify such corporates and assist them in deleveraging without significant pain – either to corporates or to the economy.
Of course in the process we need to shift the chaff [wilful defaulters] from the cheese. But to paint every corporate as a villain of the piece and tar all of them with the same brush would do us no good. Ideally Budget 2015 was expected to precisely carry out this exercise.
Remember our entrepreneurs are our assets. We have to stand by them in their hour of need. Allowing our corporate to be on a downward spiral could well be counterproductive as exit of FIIs could, as explained above, have a serious implication on the Indian Rupee.
The way out is for the Finance Minister to set up a robust internal mechanism within his ministry that helps corporates in deleveraging both within India and abroad. That would instantly make balance sheet of our corporates better. And that would revive the investment cycle as corporates are the only vehicle for infrastructure investments.
Else we can continue to breast beat on the state of economy, analyse it and get further paralysed.