Downgrades increased during the second half of 2022-23. What role did the hike in interest rates play in this?
Almost 70% of the overall downgrades were because of decline in profitability and/or liquidity pressure. Rising interest rates were not a key reason for the downgrades, per se. When RBI hikes the repo rate, the entire hike does not get transmitted instantly in the banking system; the transmission usually happens with a lag of 3-4 quarters. Most corporates are still dependent on the banking system for their funding as corporate bond market access is limited to AAA and AA-rated issuers. For companies rated below AA, what matters is the extent of transmission of policy rate hikes onto lending rates of banks.Does that mean the real impact of the rate hikes will be felt this year?
It is possible. There are two things. One, in 2022-23, the overall credit growth was around 15%, while deposit growth was under 10%. For 2023-24, Crisil Ratings has a credit growth forecast of 15%, but the deposit growth is going to be higher than 2022-23. As surplus liquidity in the banking system has normalised, we expect the gap between deposit and credit growth to be narrower. This means interest rates on deposits may have to be raised, which will be passed on to the lending rates.
The same trend plays out when RBI increases the interest rates and banks do that but with a lag. The full impact for companies in terms of the increase in their cost of debt in 2022-23 is to the tune of 100-150 basis points on an average.
Will this delayed transmission create pressure on the corporate balance sheet?
Over the past 5-6 years, we’ve seen a sharp improvement in debt metrics of corporates. For example, in 2014-15, the interest coverage ratio (ratio of ‘profit before depreciation, interest and tax’ to ‘interest and finance charges’) of Crisil Ratings’ corporate portfolio was around 2.7 times. This refers to the median interest coverage for almost 4,000 companies. From this level, it has been steadily increasing and is estimated at 4.8 times for 2022-23. So basically, the cash flow improvement in companies is higher than the increase in their debt levels, and this is driving the improvement in the interest coverage ratio. Corporate balance sheets have strengthened significantly, and gearing levels remain at decadal lows. The median gearing of the Crisil Ratings portfolio is expected to be 0.45 times by 2023-24 end.
Has the impact of inflation already played out or will we still see some effect?
In the last three-four years till 2021-22, we saw 4-6% inflation. However, if we go a little bit into the past, we saw higher inflation of even double digits. So, higher inflation is not a new phenomenon for Indian corporates. India Inc has navigated more severe inflationary cycles in the past. We believe the phase of heightened inflation is largely over. Our economic research team has a view of about 5% inflation for fiscal 2024.
In the past, when interest rates and inflation went up, what was the impact on profitability, especially in banking?
The banking system benefits when interest rates go up in the initial cycle. The main reason is loan rates tend to move upwards faster than deposit rates.Hence, there is typically an expansion in the NIMs. But if the inflation is stubborn and remains very high for long, then interest rates also remain very high for long. Then it starts impacting the broader economy, projects, project economics, and some stress starts building on corporates. That’s when it impacts the banking system, which may have to increase its provisions. The question is, are we anywhere close to reaching a situation where interest levels are posing a threat? No. The banking system health is robust, and the gross NPA levels have been on a declining trend. We are not anticipating any credit stress on the banking system currently.
How is the NBFC sector faring in this environment? Are its struggles over?
I think the NBFC sector has managed well through what we call LPC framework. They have bolstered Liquidity (L), hiked their Provisioning (P) levels, and also managed capital (C). Over the past four-five fiscals, NBFCs have reduced their leverage. You can also say that they didn’t actively pursue growth, which was challenging during Covid-19 times. What worked for these entities is they focused on improving their balance sheet resilience. NBFCs also defocused from lending to wholesale real estate and instead expanded retail lending in their portfolio. The real estate market itself has seen consolidation with larger, branded, reputed developers gaining share and these players are mostly reliant on the banking system and bond markets.
Why are we not seeing an uptick in capital expenditure by the private sector?
The biggest driver for any company to put up a large capacity or support expansion would be visibility of demand. In the beginning of 2022-23, the uncertainty over Covid-19 had waned, but then the Ukraine war started, and supply chains got impacted. Inflation was up. How would an entrepreneur look at this situation? Most would wait to see how things pan out and how the demand shapes up.
In sectors such as steel and cement, where demand is robust, India Inc is going ahead with capex. This is aided by significant push from the government. Infrastructure and allied sectors have been benefitting from government spending. Other sectors where there is still some uncertainty on demand, typically, companies would wait till capacity utilisations touch about 85-90%. It is then that these entrepreneurs would embark on the next wave of capex. Once the demand certainty emerges, we expect the pick-up in capex by the second half of this fiscal.
