Interest rate cut: Small relief for indebted firms

Some of India’s most indebted firms will get only a partial benefit from the recent cut in lending rates by banks, thanks to the continuing deterioration in their financial metrics.

While banks’ average lending rates have declined by 400 basis points (bps), according to data from Reserve Bank of India over the past 10 years, Corporate India’s effective interest rate was up 60 bps during the period. One basis point is one-hundredth of a percentage point.

In financial year 2015-16, BSE 500 companies (excluding financials) paid an effective interest rate of 6.9 per cent on their outstanding debt up from 6.3 per cent in FY07.

In the same period, commercial banks’ average lending rates declined from 13.5 per cent in FY07 to to 9.5 per cent in FY16. (See adjoining charts)

Bankers say it will not be a rate cut across the board for India Inc. According to a senior State Bank of India (SBI) executive the annual appraisal (review) of corporate borrowers based on the balance sheets of 2015-16 commenced in third quarter and will continue till February.

“The quantum of benefit that a corporate will get from the MCLR cut will depend on the bank’s call on our internal rating, whether we upgrade, downgrade or retain existing rating.”

The analysis is based on the financials of a constant sample of 389 BSE 500 companies, excluding banks and non-banking finance companies since 2006-07.

Leverage ratio is the ratio of a company’s average gross debt to net worth. In FY16, the sample had a combined debt of ~24.9 lakh crore, up from FY07 average of ~4.3 lakh crore.

Two-third of all private corporate sector debt in FY16 was accounted for by 23 large companies such as Reliance Industries, Tata Steel, Bharti Airtel, Jaiprakash Associates, Vedanta, Adani Enterprises, Tata Motors, GMR Infra, Hindalco and Videocon Industries, among others.

The wedge between cost of funds and banks’ lending rate coincided with a steady deterioration in corporate India’s financial metrics. The average debtequity ratio of BSE 500 companies (ex-banks and financials) went up from 0.6x in FY07 to 1x in FY16. The deterioration in loan servicing capability was even worse with interest coverage ratio (ICR) for the sample falling to 4.9 in FY16 from 12.2 in FY07. ICR is a ratio of operating profit (Ebitda) to interest payment, and is used to gauge a firm’s debt servicing capability. A higher ratio is desirable.

A back of the envelope calculation indicates that interest cost (or cost of funds) is more sensitive to changes in a firm’s financial metrics than market interest rates. For example, there is an inverse relationship between corporate cost of funds for our sample and their ICR, while there is a positive relationship between cost of funds and debt to equity ratio.

For most large banks, MCLRlinked loans currently account for 15-20 per cent of total loans, with the exception of SBI, where the proportion of MCLR-linked loans is 40 per cent. The rest of the floating loans are based on the earlier system of base rate, which will move to MCLR-based rates over time. Since base rate-linked loans form 40-50 per cent of banks’ loan books, MCLR cuts don’t automatically affect yields of base rate-linked loans.

Ratings agencies say that a company’s credit rating has a bearing on its cost of funds. “Corporate borrowers are expected to benefit from the recent reduction in lending rates by banks, but the quantum of gains would vary. The risk premium reflected in the spread over MCLR varies based on the individual credit quality of borrowers,” says Rakesh Valecha, senior director and head-credit and market research, India Ratings. Karthik Srinivasan, head–financial sector ratings, Icra, says, “There is no one-toone correlation between banks’ rate cut and corporates’ cost of funds.”

Public sector bank executives said asset quality is already bad. In that situation, passing on the benefit of rate cut to existing stressed corporate customers will be challenging. Senior executives with IDBI Bank and Punjab National Bank said the new MCLR rate will become applicable on the date of renewal.

Analysts also say that even if banks pass on the interest rate cut to companies, it may not have meaningful impact on corporate profitability in the second half (H2) of FY17 or FY18 due to the demand shock created by demonetisation. “The decline in profitability due to lower demand in H2 FY17 and FY18 from demonetisation would more than offset whatever little savings corporates may have from decline in lending rates,” says Dhananjay Sinha, head-institutional equity, Emkay Global Financial Services.

According to Sinha, the recent cut in lending rates signals a glut of funds with banks, due to the deposit surge in an environment of low credit demand. “The cut in interest rate is due to weak demand, which should be a cause of worry for both banks and corporates rather than good news,” he adds.