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The impact of higher interest rates on the BSE-500

The impact of higher interest rates on the BSE-500
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First Published: Sun, Jan 16 2011. 09 34 PM IST
Updated: Sun, Jan 16 2011. 09 34 PM IST
This year has seen a sharp correction in Indian equity markets. The bellwether Sensex index on the Bombay Stock Exchange shed around 9% from its high of 20,621 points in a fortnight. The fear of interest rate hikes to rein in inflation and its consequent impact on corporate growth and profitability looms large over the markets.
Data analysis of the BSE-500, excluding banks and oil, companies shows that interest cover, or ratio of profits earned to interest cost, in fiscal 2010 at 2.33 was higher than 2.19 in the previous year and the low of 1.89 in 2001.
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Improved interest cover in the last two years implies one positive trend—a higher operating profit growth compared with the growth in interest costs. But 2010 figures were not as robust as those in fiscal 2005 to 2008, the most robust years in revenue and profit growth for the Indian corporate sector.
Nevertheless, growth and strong domestic demand for goods and services has seen most firms in the manufacturing sector such as cement, auto and auto components and capital goods raise debt to finance capex in the last 12-18 months.
In fact, higher borrowing is reflected in the increase in BSE-500 aggregate debt-equity ratio, which went up from 0.54 in fiscal 2008 to 0.58 in 2010. However, interest cost as a percentage of sales rose marginally during the period, as interest rates were relatively subdued and net revenues of companies were soaring.
Even the Sensex firms’ aggregate data on interest cover and debt to equity ratio mirror the same trend as the BSE-500 basket. Only sectors where the profit clocked did not match the rise in costs such as cement, hotels and real estate saw interest costs eat into net profit.
A Motilal Oswal Securities Ltd report says that “the most significant trend has been the phenomenal increase in net profit margin to about 9% in 2010, up 5.1 percentage points from 3.7% in 2000. This is to a large extent driven by decline in interest costs from 5.8% of revenues in 2000 to 2.6% in 2010 through a combination of lower borrowing costs and improved balance sheet structures”.
However, present concerns are not unwarranted. A Citigroup report states, “We expect RBI (Reserve Bank of India) to raise rates by a minimum of 75 basis points by 2011.” One basis point is one-hundredth of a percentage point.
The moot question is: Will Indian industry’s profit growth be able to service further rise in interest costs? Rajat Rajgarhia, director, research, Motilal Oswal Financial Services Ltd says, “Corporate balance sheets are strong enough to service interest rates. But, when interest rates climb in a short period, it affects demand for funds as the cost of capital goes up. It also impacts profitability.”
A fallout may be in terms of lower capital formation. Of course, the silver lining in the cloud is that Indian firms have not only proved their mettle in overseas acquisitions and establishing global market presence, but also in raising low-cost money overseas.
Worries stem from the moderation seen in industrial output and the rise in inflation that could impact profitability. If growth moderates and interest costs firm up, then the estimated earnings growth of 22-23% until 2013 maybe get watered down.
These factors pose a risk to market valuations, which are around 22 times past earnings for the broader market.
Graphic by Ahmed Raza Khan/Mint
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First Published: Sun, Jan 16 2011. 09 34 PM IST