Ouch! It’s hurting.
Two stories published in 27 August edition of Mint show how rising interest rates have started pinching companies and banks—borrowers and lenders, that is. This will hopefully temper the irrational exuberance about the ability of Indian companies to maintain their recent profit margins and financial health despite the rising cost of money.
Domestic interest rates have been climbing since 2005. The best and biggest Indian companies then went to the international markets to seek low-interest debt, either in the form of syndicated debt or convertible bonds. But now global interest rates, too, have climbed in response to the credit crunch in the developed markets. Borrowing costs of Indian companies are likely to climb by between 100 and 200 basis points.
Our analysis shows that many companies have low levels of interest cover, or the extent to which earnings before interest, taxes, depreciation and amortization (or Ebidta) is more than the annual interest payments. Besides, Indian companies have raised billions of dollars through convertible bonds that, if not converted into equity, will end up as interest-demanding debt.
Though most companies still continue to be in rude health, rising interest costs and a turn in the business cycle could leave many of them struggling to service their debts.
In their classic Security Analysis, the bible of financial valuation, Benjamin Graham and David Dodd say the real test of a bond is its ability to meet its interest obligations during periods of duress rather than when the going is good. It will be worth seeing whether the debts of Indian companies pass this test in the quarters ahead.
Meanwhile, there have been some warning signals flashing on the profitability of banks as well. Icra Ltd, a credit rating agency, has said in a report this month that higher interest rates could lead to growing bad loans in the years ahead. This is not entirely unexpected, whatever bankers may claim.
Bank credit has been growing at an annual rate of 30% over the past three years. It is highly unlikely that such torrid loan growth will not leave mistakes in its wake. Many of us know from personal experience how keen bankers have been to dish out home loans without adequate due diligence. There are growing problems in two-wheeler loans. A milder version of the problem could be taking root in many types of corporate loans as well.
Icra estimates that all the banks which have seen a rise in bad loans of 3% or more this year could end up with total bad loans of close to 5.5% by March 2010, which is nearly double the current level. More bad loans—or non-performing assets in banker speak—will need higher provisioning and leave less behind as profits.
These are merely early signals, and it is possible that financial officers in banks and companies will cap the growing problem. India is miles away from any sort of generalized financial malaise. But that should not allow us to sit back and ignore the fact that leverage is growing, interest costs are climbing and bank loans are getting contaminated in small bits.
Every economy goes through this cycle in some form or the other. A prolonged period of low interest rates tends to lead to a spurt in borrowing by companies and households. This borrowing is, at the end of the day, based on the rather comforting assumption that financing costs will not go up by much and that cash flows or asset values will rise to service and eventually pay-off this growing debt. India, too, has seen this happen since 2001.
The turn in the interest rate cycle is a challenge to both lenders and borrowers. How they manage the challenge will be a test of their managerial competence.
Are rising interest rates a major threat to corporate profits? Write to us at firstname.lastname@example.org