New Delhi: Indian companies fared the worst in a stress test conducted by the International Monetary Fund (IMF) for possible worsening of borrowing costs and earnings in case the dollar continues its recent strong and sustained appreciation.
In a report titled Spillovers from Dollar Appreciation released last week, the multilateral lending agency also warned that debt at risk from India’s state-owned enterprises could increase significantly, amounting to more than 5% of the country’s gross domestic product, or GDP.
For the stress test, IMF surveyed 4,797 Indian firms with total assets worth $1.5 trillion. The test assumed that borrowing costs will go up by 30%, earnings will decline by 20% and domestic currency will depreciate 30% against the dollar.
The IMF’s findings come against the backdrop of an increase in total stressed advances at scheduled commercial banks to 11.1% of total advances in March from 10.7% in September, according to the latest financial stability report released by the Reserve Bank of India (RBI) last month.
Bad loans at state-owned banks, which account for about two-thirds of the Indian banking sector’s assets, have climbed as growth in Asia’s third-largest economy slowed in recent years and projects stalled by delayed project approvals and land acquisition problems, among other reasons, crimped corporate cash flows and made it difficult for borrowers to repay debt.
One analyst said the situation may not be so dire as thought. Indian companies have been under stress over the last two or three years, and the probability of a further deterioration remains low, especially as RBI reduces interest rates and some sectors benefit from a revival in demand, said Vibha Batra, senior vice-president and group head of financial sector ratings at rating company Icra Ltd.
“As for the impact of higher defaults on bank’s core tier 1 (capital), operating profits are likely to provide first level of cushion (before capital starts depleting), therefore we may not see a reduction in core tier I (capital) as mentioned in the report. However, a better capitalized banking system could provide an impetus to a sustainable recovery," she added.
The IMF stress test showed that the median interest coverage ratio (ICR), which determines how easily a company can pay interest on outstanding debt, declined significantly in most countries surveyed, reflecting the shocks to borrowing cost and earnings to a large extent.
For India, the ICR is already below 1.5—a level at which debt is considered at risk—and is expected to further deteriorate.
“In a few countries (Brazil, India, Malaysia), debt at risk from state-owned enterprises could increase significantly. Debt at risk from state-owned enterprises could amount to more than 5% of GDP in India, Hungary and Malaysia," the report added.
IMF said countries such as Brazil, Bulgaria, Chile, Hungary, India and Malaysia with high forex leverage, or forex debt relative to total income, would be more susceptible to exchange rate volatilities. “Accordingly, in our stress test scenario, increases in forex leverage would be the largest in Brazil, Chile, India, Indonesia, and Malaysia," it added.
IMF said banks’ buffers to withstand losses from a scenario with questionable debt-servicing capacity by firms appear low in a few countries, including India. “Higher corporate default would erode banks’ asset quality, and the ability of banks to withstand losses will depend on the extent of available buffers. Assuming that the aftershock corporate debt-at-risk owed to banks were to default with a probability of 15% suggests that buffers comprising tier I capital and provisioning appear low in Bulgaria, Hungary, India, and Russia, when benchmarked against Basel III’s minimum capital requirement," it said.
“In some cases, bank buffers may be overstated due to lax recognition of doubtful assets and loan forbearance. In such instances, loan losses in a severe downturn and higher corporate default could overwhelm what were thought to be adequate levels of equity capital," it added.
In April last year, IMF had warned that high debt in some Indian companies may pose a risk to the country’s economic stability. One-third of corporate debt is owed by companies in India that have a debt-to-equity ratio of more than three, the highest degree of leverage in the Asia-Pacific region, IMF said in its Asia Pacific Economic Outlook released in April last year.
A high debt-to-equity ratio indicates that a company has been borrowing to fund expansion instead of raising money from the market. This can harm the health of a firm if interest rates rise and economic growth falters, it added.
RBI’s financial stability report said though the indebtness of Indian firms has declined since the global financial crisis in 2008, concerns remain about their ability to service debt, which may have adverse impact on banks’ balance sheets and may hinder the transmission of monetary policy impulses as companies may not be in a position to benefit from falling interest rates due to high levels of debt.
Macro stress tests carried out by RBI suggested that current deterioration in the asset quality of commercial banks may continue for few more quarters, and public sector banks may have to bolster their provisions for credit risk from present levels, to meet the ‘expected losses’ if macroeconomic environment were to deteriorate under assumed stress scenarios.
“The falling profit margins and decreasing debt repayment capabilities of the corporate sector add to these concerns, though overall leverage level in Indian economy is comfortable when compared to other jurisdictions," the financial stability report said.
In its external sector report released on Tuesday, IMF said India’s low per capita income, favourable growth prospects, and development needs justify running current account deficits, but too great a reliance on debt financing and portfolio inflows would create significant external financing vulnerabilities.
“Despite a reduction in external vulnerabilities, there is need for vigilance given commodity price volatility and the recent Real Effective Exchange Rate appreciation. Given the potential risks to corporate balance sheets, including from significant unhedged forex exposures, further relaxation of limits on external commercial borrowings (especially for sectors without natural hedges) should be implemented cautiously," it added.