A disquieting bargain3 min read . Updated: 24 Jun 2012, 10:20 PM IST
A disquieting bargain
A disquieting bargain
The official macroeconomic data gives a broad sense of how the economy is doing. This data is, however, generated within a predetermined accounting framework that makes it internally consistent but in the process a lot of valuable “noise" gets concealed.
A more dynamic data series is generated from the uncoordinated actions of billions of economic agents. In a market economy, it is not only inverted yield curve, spreads, valuations or multiples that matter: macroeconomic information is embodied in every transaction. The trends in this transactional data are rich, albeit in a different way, in communicating the extant and emerging state of the economy.
Consider the following: it has been estimated that more than Rs2 trillion of corporate debt has been restructured. Not only is this a staggering 150% rise over the previous year, it is also the highest ever corporate debt restructuring (CDR) carried out by Indian banks. And, by all accounts, it is an underestimate.
Commercial banks are rarely interested in swapping debt for equity. They are not geared for equity control and they tend to play for time by agreeing to extend the maturity of bonds or change the terms of debt. They do it largely to show lower non-performing assets, and window dress their results with low provisions and coverage.
The real worry in all this is not that these facts will show up as an increase in impaired assets thus bringing the balance sheet and stability of banks under stress. This will happen, inevitably. More worrisome for companies and managements today is the issue of equity in relation to debt being at a discount. This is anomalous and flies in the face of received entrepreneurial wisdom.
In other words, the promoters of Indian companies are treating their equity as being less valuable than debt. It gets worse. Most of the swaps are such that the equity valuation is at a discount to the comparable market price. This at a time when the general market valuations are at all time lows. It is virtually a distress valuation of equity that goes into the swap.
At an operational level, this swap does give a much-needed stimulus to the stressed company by relieving it of the burden of loan and at the same time giving it another chance to turn around.
However, at an analytical level it indicates that the promoter is willing to forgo the “growth premium" associated with equity returns. This is so because he doesn’t see any growth occurring even in the medium term. With no upside to equity, the downside of debt is being limited.
Financially, debt is a cheaper source of capital than shareholder equity because it has first call on the borrower’s cash flow and, unlike dividends, interest payments are tax deductible.
So when a promoter swaps his more “higher return" financial asset in terms of “equity", for a “cheaper" financial instrument, something has to be wrong somewhere in the economy. That it cuts across size and sectors indicates the problem is macroeconomic rather than corporate.
In a normal economic situation, debt in a company’s capital structure increases equity’s return potential because it is a cheaper financing source. It appears that, at present, it is perceived that debt increases equity’s risk of loss as interest and principle payments are fixed costs that reduce the amount of cash flow available for reinvestment or distribution to equity investors. Hence a paring of debt is considered attractive.
In a situation of poor growth prospects it makes sense for the shareholder to reduce the contractual obligation of the issuer to make interest and principal payments over a specified period by swapping it with an option which is not only open-ended but also potentially limited.
When growth is slowing, operating and financial leverage increases risk by contributing to fixed costs. Although both kinds of leverage are similar in their effect on the cost of debt and equity capital, financial leverage tends to be more discretionary. As such, debt policy at these times is a tool for managing increasing risks.
Which is the other message coming through very clearly: the risks of doing business in India have increased substantially and significantly in the last year or so. These are not just global and domestic business and market risks but also country specific regulatory and political risks. These enhanced risks have changed risk profile of India, making it a far greater investment destination. This has implications on the risk return matrix for the Indian economy.
Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice. Comments are welcome at firstname.lastname@example.org
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