Provide Equity, Not Debt
Why equity financing by the government may be an important step to get India Inc. back on track
Covid-19 has taken an extraordinary toll on businesses around the world. In India, business confidence is at its lowest since the 2009 financial crisis: 72 per cent of firms have reported adverse effects on operations, 90 per cent are facing supply chain disruptions and 53 per cent anticipate a decline in sales over the next two quarters. Industrial output in key sectors could fall by up to 15 per cent and GDP growth by 10- 20 per cent during the April-June 2020 quarter, with ripple effects continuing for an uncertain period of time.
The government’s immediate policy priority was, rightly, to support low-income households through cash and in-kind transfers worth ` 1.7 lakh crore, or 0.8 per cent of GDP. This is well below the fiscal packages committed by other national governments, though the amounts are bound to increase in the coming weeks. Support to businesses has been extended through monetary and macro-financial policy – the RBI has directly injected ` 2 lakh crore through refinancing operations, given firms a three-month moratorium on loan payments and reduced interest rates across the board.
However, as one of us recently proposed in the context of Europe and Singapore, rather than offering debt financing, businesses can be better supported through the direct injection of ‘quasi- equity’ finance by the government. The government should offer to make direct investments in businesses by taking a ‘ minority stake’, which will be recovered through higher taxes on profits over a number of years. By making payments conditional on profitability, rather than saddling firms with repayable debt, equity finance will be more sustainable in the long term.
Weak Balance Sheets
Sustainability in the long run is particularly important since many firms were struggling even before coronavirus hit India. GDP growth for FY20 has been projected at 5 per cent, the lowest in a decade, and bank credit growth at 6.5- 7 per cent, the lowest in 58 years.
More worryingly, one in 10 bank loans is currently stressed. Total nonfinancial corporate debt is 44 per cent of GDP, well below emerging market economies’ average of 91 per cent. But much of this debt in India is of low quality, with 45 per cent of all corporate debt held by firms with interest coverage ratios of less than one, that is, firms that are unable to service their interest obligations. The table shows median debt- equity and debtEBITDA ratios of 1,624 firms listed on the National Stock Exchange by sector. While the median debt- equity ratio of 0.70 has improved in the last 10 years, firms in the top tercile are highly leveraged, with a median debtequity ratio of 6.70, which is clearly unsustainable even in normal times. This represents a significant weakening of their balance sheets compared to 2016, and even compared to just after the financial crisis in 2009.
Adding to this debt during a global crisis will hurt long- term growth prospects of highly leveraged firms, which struggle to raise debt and face higher interest rates. They also suffer incentive problems associated with a large debt overhang, whereby undercapitalised firms pass on profitable investment opportunities since much of the returns will accrue to creditors. For the same reason, highly leveraged firms tend to choose riskier projects as creditors bear a higher share of risks. Studies have found that higher levels of corporate debt are associated with lower corporate investments, and highly leveraged firms cut more jobs during downturns.
Equity Financing
For cash- strapped firms, particularly in sectors such as aviation, infrastructure, steel and aluminium, shipping and construction, equity injections are more attractive. However, an increase of only 10 per cent in total capitalisation of the highest tercile of firms alone will require about ` 1.8