India Ratings and Research (Ind-Ra) does not expect a meaningful deleveraging of corporate borrowers in FY18. Broader macroeconomic indicators suggest improving demand conditions; however, the recovery in the operating profitability levels of Indian corporates is likely to be moderate in FY18.
The agency expects corporates operating in consumption and export-oriented sectors to exhibit a moderate improvement in their credit profiles. However, the credit profiles of corporates in investment-oriented sectors are unlikely to meaningfully improve in the near term. Although better demand conditions will support an improvement in manufacturing activity, service sector corporates will continue to outperform manufacturing sector corporates.
Although global trade continues to improve despite rising protectionism and political uncertainty, the possibility of an escalation in trade protectionism and rising populism in Western countries remain the key risks for the global economy, as well as for Indian corporates.
EBITDA Growth to be Limited in FY18: Ind-Ra expects EBITDA levels of corporate borrowers to grow 6%-8% in FY18 on an aggregate basis (FY17 estimate: 3%-5%; FY16: 6.4%). This will be driven by increased consumer demand, higher commodity prices and improving demand for exports. Operating performance, however, will vary across industries. Despite improving demand conditions, corporates in sectors such as infrastructure, telecommunications, and iron and steel are unlikely to exhibit major improvements. Ironically, sectors, where corporates have a relatively better credit profile, are likely to register better improvement compared with sectors where entities have a highly stressed credit profile. As a result, the recovery in the overall credit quality of India Inc. will remain limited.
Varied Impact of Rising Commodity Prices: At end-March 2017, the World Banks’ non-energy price, energy price and base metal price indices were up 9.3%, 38% and 22.4% on a year-on-year basis, respectively. Higher commodity prices are likely to have a varied impact on Indian corporates. In addition to commodity producers, merchandise exporters will benefit from higher commodity prices, as global reflation will support an improvement in demand conditions, particularly in emerging markets, thus boosting global trade.
However, heavy users of commodities, which previously benefitted from a decline in input costs, will witness the benefits of improving demand being offset by higher commodity prices. The agency expects commodity prices to remain range-bound over the next 12 months. However, if uncertainty over global economic growth arises, commodity markets could exhibit further volatility, which could dampen the expected recovery in operating profits.
Corporate Leverage to Remain High: Corporate leverage continued to remain high in FY16, as the aggregate EBITDA moderately increased (up 6.4% yoy). The aggregate net leverage of the largest 420 borrowers analysed by Ind-Ra remained high at 5.43x (FY15: 5.42x). At FYE16, 29.5% of the total debt (INR8.56 trillion of INR29 trillion) of the entities in this sample set belonged to companies with an interest coverage below 1x. An additional 12.7% of debt (INR3.5 trillion) was held by companies with an interest cover of 1x-1.5x.
The agency estimates a similar situation for FY17, as aggregate EBITDA is likely to have grown 3%-5%. A meaningful credit quality improvement will still take time, as about two-fifths of the borrowing by the largest 420 borrowers remain with entities with weak ROCE levels (< 5%). Stressed corporates with large refinancing requirements are likely to face severe challenges in raising debt, as the balance sheets of mid-sized PSU banks remain stretched due to high NPA levels.
Capex Activity to Remain Muted: Capex, as measured by gross fixed capital formation (GFCF), registered a sequential decline in three consecutive quarters (4QFY17-2QFY17), as capacity utilisation levels continued to remain range-bound (about 70%). In addition to muted private sector capex activity, the capex activity of PSUs remained limited. In the absence of capex growth, corporate EBITDA growth will remain moderate, with the only triggers being consumption and exports. Furthermore, private corporates have shifted their focus to productivity improvements and will continue to refrain from capex in the near term. Ind-Ra believes that low capacity utilisation levels will lead to higher M&A activity in the near to medium term. As a result, the revival of the capex cycle is unlikely in the near term.
External Risks Could Delay Recovery: A potential rise in global protectionism remains one of the most likely risks that could delay recovery in earnings and consequently credit profiles of corporates. Although global economic recovery continues, economic policies of the new government in the US and the monetary policy stance of central banks worldwide could have a bearing on capital flows and currency markets.
Ind-Ra studied the impact of currency volatility on the credit profiles of corporates and found that nearly half of the top 100 listed forex borrowers’ EBITDA levels have a negative sensitivity to FX movements. The agency’s study indicates that in addition to depreciation, an appreciating Indian rupee affects corporate borrowers. At FYE16, borrowers in the sample set analyzed had 64% of the gross FX exposure unhedged, indicating sharp volatility either ways could have an impact on cash flows.
(*The economic data on India mentioned above and in the report is based on the old GDP series compiled using the old IIP and WPI series. New GDP figures released on 31 May 2017 have been compiled using the new series of the IIP and the WPI.)