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Mumbai: Weak balance sheets of large, debt-heavy companies may pose a risk to financial stability despite recent improvements in some profitability indicators, the Reserve Bank of India (RBI) said in a report.

The RBI Financial Stability Report, published on Wednesday, highlighted the fact that nearly a fifth of all listed companies have levels of debt in excess of what is considered prudent. The risks to the Indian banking sector have risen, the report said, as many of these borrowers are saddled with debt that they are finding difficult to service.

“Corporate sector vulnerabilities and the impact of their weak balance sheets on the financial system need closer monitoring," governor Raghuram Rajan wrote in his foreword to the report that is published by the central bank twice a year. It gives an assessment of how Indian banks are withstanding stress and takes stock of developments in the financial sector.

The gross non-performing assets (GNPAs) ratio for advances to such large borrowers showed a significant jump but mostly in the case of state-run lenders whose gross NPAs from the segment jumped to 8.1% as of 30 September from 6.1% in March. The share of the top 100 large borrowers in gross NPAs of all banks increased sharply to 3.1% in September, from 0.7% in March.

“The sharp increase in the share of NPAs of large borrowers to the total GNPAs from 78.2% in March to 87.4% in September is a major concern to the lending institutions and other stakeholders," the report said.

Saswata Guha, director at Fitch India Services, said that while he doesn’t expect too many large corporate borrowings to turn bad from here on, it still remains a tall risk. Banks may choose to invoke strategic debt restructuring rules where they can convert debt into equity in some large cases where viability is an issue, Guha added.

RBI analysed a sample of 2,711 publicly traded non-government, non-financial companies. As many as 19.4% of these companies either have a negative net worth or a debt-to-equity ratio of more than two, which puts them in the leveraged category. About 15.3% of the sample are over-leveraged, meaning they have a debt-to-equity ratio of three or more. The number of both leveraged and over-leveraged firms has increased over the last one year.

Of the 2,711 companies, 15.8% had weak balance sheets, with an interest coverage ratio (ICR) of less than one. ICR, or the ratio of earnings before interest, tax, depreciation and amortization (Ebitda) to interest payments due, is a benchmark of a company’s ability to service its debt.

“In the corporate sector, declining profitability, high leverage and low debt servicing capacity continue to cause concern with their attendant adverse impact on the financial sector, notwithstanding a marginal improvement observed during the first half of current financial year," RBI said while commenting on the broader universe.

The pain points get worse when privately held companies are scrutinized.

RBI for the first time analysed the financials of unlisted companies in the report, using data from the ministry of corporate affairs.

The analysis showed that 23.8% of public limited companies and 24.1% of private limited companies were considered weak. The debt-to-equity ratio for both sets of firms deteriorated between 2012-13 and 2013-14. Data beyond 2013-14 was not available for this set of firms. Weak companies are companies with ICR of less than 1.

“Debt servicing capacity measures in terms of the interest coverage ratio declined in the case of public limited companies. Among the private limited companies, ICR of medium-sized companies increased though the same declined marginally in the case of small companies," the report said.

The central bank noted that leveraged weak companies with lower debt servicing capacity may put pressure on the already deteriorated asset quality of bank loans in adverse situations. Leveraged weak companies are defined as those which have negative net worth in addition to an ICR of less than 1.

If all these leveraged weak companies were to default, the impact could be to the tune of 7.3% of total bank credit. “However, a portion of bank credit to these companies could already be a part of the existing stressed advances of banks," the report said.

Bank asset quality

The central bank expects GNPAs of commercial banks to rise to 5.4% by September 2016 from 5.1% as of September this year as a baseline case. Under different levels of stress, the jump in bad loan ratio could be bigger. Under severe stress, GNPAs of banks can shoot up to 6.9% by March 2017, RBI said.

The ratio of stressed advances (which include restructured loans and gross bad loans) to total advances rose to 11.3% as of September 2015 from 11.1% in March. Stressed assets in public sector banks were at 14.1% in September.

“When the RBI points out that the gross NPA level has gone beyond 5% then it is a bit overwhelming. The level of NPAs has been growing as restructured assets are also failing," said Madan Sabnavis, chief economist at CARE Ratings. “We need external as well as internal measures to manage the level of stressed assets in the economy."

The report noted that profitability of public sector lenders has declined. In this context, the central bank questioned the rationale behind public sector banks paying high dividends to shareholders, saying that their weak balance sheets do not justify such dividends.

“This also reveals a cross-subsidisation by better banks given their relatively higher payouts, but a disproportionately higher capital infusion into weaker banks by the government," the report said.

Even though part of the dividend payment to the biggest shareholder, the government, comes back to the lender through capital infusion, there is still a large payout to the public shareholder, the report said. The report added that dividend payouts must be strategic business decisions.

According to data compiled by Mint, listed public sector banks paid just under 20% of their profits as dividend in fiscal 2015 and fiscal 2014.

Economic outlook

Commenting on the domestic economy, RBI highlighted the need to balance higher public investment with fiscal consolidation.

“Despite improved macroeconomic fundamentals, sluggishness in domestic demand and private investment call for higher public investment at a time when government is committed to fiscal consolidation," it said.

It added that a continuous thrust on structural reforms and an unambiguous policy stance, especially in tax matters, would be critical to drawing capital flows.

The central bank underlined the importance of goods and services tax and said that GST is an “immediate necessity" in order to move towards the country’s potential growth rate.

In his foreword, Rajan highlighted the challenges that could emerge from the global environment.

“The recent Fed fund rate hike and the developments in China call for a careful calibration of domestic policies to withstand global headwinds, even as managing ‘volatile’ volatility has become a big challenge for the guardians of financial stability across the world," said Rajan. He added that while India appears to be relatively better placed, the country must prepare to take on emerging risks from areas such as corporate leverage.

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