It is worrisome that India Inc has stopped, for all practical purposes, investing into the creation of new capacities. We have chronicled in several brief essays over the past nine months, this unusual abdication. Links to these are provided at the end of this one.
Investments is an expression of confidence on the future. And, the corporate sector as a whole has never, since the 1991-92 liberalisation, been so reticent in betting on the future. In this sense, this is an unusual situation.
What brings us here? Is there a problem with the health of the corporate sector? Has it so weakened its balance sheet through reckless borrowing such that it cannot invest anymore? Is this a case of a continuation of the Twin Balance Sheet (TBS) problem articulated in January 2017 in Economic Survey, 2016-17? TBS problem was an incorrect diagnosis of the problem then and it is irrelevant today as well.
The TBS postulated that a surge in borrowing leads to over-leverage which in turn leads to debt-servicing problems. It drew a picture of corporate distress based on the aggregated financial indicators of a select set of companies in 2016. A criticism of that analysis is that it was based on a purposively selected set of companies and therefore was not necessarily an accurate representation of the state of the corporate sector as a whole.
Without similarly cherry-picking only distressed companies we can see that the debt-equity ratio of all non-finance companies in the Prowess database (over 20,000 companies) in 2013-14 and 2014-15 had reached a decadal peak of 1.16 times. But, a gearing of this order is not alarming. A decade earlier, the ratio was regularly more than 1.16 times. So, the increase to 1.16 times was not exceptional and so does not lend itself to the argument that the corporate sector was over-leveraged.
But, more importantly, the ratio was down to less than 1 in 2017-18. Preliminary estimates suggest that it could have remained under 1 even in 2018-19. Evidently, the corporate sector as a whole is not over-leveraged. It can borrow and grow but, it doesn’t.
What about financial stress?
An interest cover less than 1 is a clear sign of financial stress because this indicates an inability to even pay interest from its pre-interest and pre-tax profits. An interest cover less than 1.5 is also stressful because it leaves little buffer after paying interest and principal.
An interest cover between 1.5 times and 2i times is workable but, ideally it should be over 2 times.
In 2014-15 and 2015-16, interest cover stood at 1.9 times. So, it wasn’t too bad even when the Economic Survey was painting the sector red. By 2017-18, interest cover had climbed up to 2.2 times.
Evidently, the corporate sector as a whole does not have difficulty in servicing its debt. Of course, it is always possible to find companies that are stressed. But, the corporate sector as a whole is not stressed on servicing its debt obligations. Yet, the corporate sector as a whole, has walked away from investments.
A useful way to understand the depth of financial stress (without cherry-picking the sample) is to study the distribution of interest cover by the size of companies and see how this distribution has changed over time. To do this, we divide the full set of sample companies into ten equal bins reflecting their size and estimate the interest cover for each bin.
We label the size-bin with the largest 10 per cent companies as Decile 1 and then progressively label them through Decile 10 which represents the size-bin of the smallest companies.
We see that size-bins of smaller size companies either do not make profits or do not make adequate profits to service their debt. This is true for five smallest size-bins (Deciles 6 through 10). Interest cover in these bins is almost always less than 1. But, even Decile 5 has an interest cover that is less than 1.5 times. This is true throughout the nearly 3-decade history of the corporate sector captured by the Prowess database.
So, the depth of financial stress is best seen in its travelling to the larger companies – to Deciles 4, 3, 2 and even 1.
This data tells us that the worst years of the corporate sector in terms of its inability to repay loans were between 1997-98 and 2003-04. During this period even Decile 2 companies were barely able to service their debt obligations. The best period begins in 2004-05 and ends in 2011-12.
From 2012-13, we see stress building up to Decile 4 and sometimes higher but not decisively higher than Decile 4. This was not anywhere as bad as it was during the late 1990s and over the turn of the century. More importantly, the stress started showing signs of receding in 2016-17 when the Economic Survey was painting a gory picture of the same. In 2017-18, interest cover stress had clearly receded leaving all the top four Deciles back in good health.
But, in 2017-18, the corporate sector refused to invest into new capacities.
Evidently, the problem with the corporate sector is not in its balance sheet.
The flip side of the TBS is the health of the banks. Following the Asset Quality Review mandated by the RBI, the reported non-performing assets of banks soared. As a result, the capital adequacy ratio of commercial banks dipped to 13.3 per cent by the end of March 2016. It was 13.9 per cent as of March 2013. But, thanks to some write-offs and some re-capitalisation of public sector banks, capital adequacy ratio had climbed to 14.3 per cent as of March 2019. This is the highest CAR recorded in at least 20 years.
Evidently again, banks are well-stocked and the problem is not in their balance sheet either.
In fact, the problem regarding the current investments slowdown was never in the balance sheet of the corporate sector or the banks. It was never a Twin Balance Sheet problem. Compared to the mid-to-late 1990s when Indian corporate sector saw its earlier growth compression, both balance sheets in the recent years were reasonably strong on the aggregate. Corporate balance sheets allowed them to borrow and bank balance sheets allowed them to lend. But, both did not.
To understand this slowdown, we need to look elsewhere.
- January 18, 2019: Corporate asset growth falters
- January 18, 2019: Subdued animal spirits
- January 30, 2019: Productive growth falls in 2017-18
- March 25, 2019: Corporates not interested in investments
- June 12, 2019: Cut in interest rates unlikely to spur investments
- June 26, 2019: A deceptively low gearing ratio
- July 26, 2019: India Inc stalls
- September 6, 2019: A grim picture from the vanguard