Corporate leverage is the biggest threat to Indian economy
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The just-concluded earnings season indicates that the fundamentals of listed firms in India have improved somewhat in the past quarter. Sales and profits have both grown at a faster pace in the three months ended December than in the past few quarters, and aggregate profit margins have risen significantly after several quarters of decline.
The modest bounce in earnings suggests a gradual recovery in demand, but latent risks in over-leveraged sectors such as power, infrastructure, and construction—which have clouded earnings prospects of the banking sector—suggest that the road to a full-blown recovery will be a long one, and involve considerable pain.
In the December quarter, net profits of 21 Sensex companies (excluding financial and energy firms) grew 38% over the year-ago period on the back of sales growth of 12.2%. The trend in the broader market has been similar. Net profits of 320 firms in the BSE-500 universe (for which past data is available, and excluding financial and energy firms) grew 25% on the back of sales growth of 9.1% over the year-ago period according to Capitaline data.
To be sure, just as in the past couple of quarters, much of the earnings growth has been led by export-oriented sectors such as IT, pharma and textiles rather than firms catering to the domestic economy. Nonetheless, the earnings revival is more broad-based in the December quarter than earlier. For instance, even excluding IT firms (which earn most of their revenues from abroad) the 299 firms in the BSE-500 universe saw profit growth of 12% and sales growth of 7%, the best in five quarters.
Although the recovery in sales is still modest, the chances of earnings downgrades seem to have diminished after the earnings season. The improvement in fortunes of manufacturing firms lend credence to the slight increase in the manufacturing Purchasing Managers Index (PMI) figures, and contradict the slowdown reported by the official gauge of factory output. The improvement in earnings prospects of Indian firms, growing exports, and narrowing current account gap explain why the Indian currency and stocks have been less badly hit in the latest emerging markets sell-off, unlike in July, when Indian markets were among the worst hit. The depreciation of the rupee has had an expected impact though: it has helped engineer a smart revival in export-oriented sectors, by making Indian products more competitive.
Still, the recovery in the broader economy is only modest, and remains fragile. The biggest risk to the economy lies in an overleveraged corporate sector. Both external and internal debt levels are at uncomfortably high levels.
The ratio of short-term debt (by residual maturity) to total external debt which scaled a peak of 43% at the end of fiscal year 2013, has fallen only by a percentage point to 42% in the first half of fiscal 2014, according to the latest review of the economy by the Reserve Bank of India. Even during the 1991 balance of payments crisis, the proportion of short-term debt was much lower although reserves were also much lower then. Still, short-term debt now accounts for 61% of India’s forex reserves.
The deterioration in asset quality of Indian banks over the past few quarters shows that even rupee debt is emerging as a key problem area now. The combination of bad loans and restructured loans of the banking industry, at Rs58 trillion now, exceeds 10% of their loans, and roughly equals the net worth of the sector. The problem is most acute in state-owned banks, where lending decisions have been influenced more by politics than by economics in the past. It does not appear to be a coincidence that a small set of politically-connected corporate groups operating in the power, infrastructure, and construction sectors account for most of India’s internal and external debt vulnerabilities.
Even State Bank of India (SBI), arguably the best managed state-owned bank, faces a steadily worsening pile of assets. SBI’s earnings declined 34% in the December quarter, well below expectations. The worst is yet to come for the nation’s largest lender. A significant chunk of SBI’s earnings is accrued interest from stressed sectors and, hence, symbolize notional income. Bad loans and restructured assets already account for 9% of SBI’s loan book but this basket comprises mostly of loans to small and medium-sized enterprises. If adequate provisioning for large corporate loans is made, SBI’s balance sheet will look even weaker. Little wonder then that a recent qualified institutional placement issue by the lender found few takers, and was ultimately rescued by the state-owned Life Insurance Corporation of India (LIC).
The debt-fuelled excesses of Indian corporations in the past few years have begun to take a toll on the health and stability of the Indian economy. Even though sales of stressed assets have picked up in recent months, most of the heavily indebted corporate groups continue to witness falling interest coverage ratios. A long torturous process of deleveraging seems to lie ahead for them.
How should India deal with overleveraged corporations?