Covid-19: Policy Soft-landing of Corporate Debt Explosion

• As everyone looks at the stock market crash due to Covid-19, the tremors are far greater on the larger economy and particularly on sustainability of corporate debt.
• Persistently falling profits have made a majority of firms incapable of debt servicing with the interest coverage ratios of Indian corporates amongst the lowest when compared to emerging market peers.
• Conjoint revival of investment and consumption demand would be the imperative in preventing an otherwise imminent recession, which might lead to an explosion of corporate debt pile up.
• Focusing on the containment of spiralling corporate debt and resultant impact on economy and livelihoods should be on policy priority list.

There is never a good time for a global pandemic like a Coronavirus outbreak. More so for corporate India, this couldn’t have happened at a worse time! While the bloodbath witnessed on the stock market has garnered attention, the tremors of this pandemic are far ranging on the Indian economy and more so on the sustainability of corporate debt. Already, corporate India has been through a palpable economic slowdown seriously hurting its bottom line.

Profit margins of private domestic non-financial firms fell from an average of 4.2% to 2.5% during the years 2009-13 to 2014-18. The massive debts accumulated before the global financial crisis (GFC) on the back of rapid economic growth only surged higher after the crisis, as companies borrowed heavily to reboot the business and economy.

While the average non-financial corporate debt during pre-GFC (10 years) was 31.4% of GDP, the same has increased to 47.4% during the post-GFC decade. This was even after the companies engaged in a deleveraging exercise post-2009 through massive asset sales. Even though the debt figures look modest when compared to major economies like US (74.4%) and China (153.3%), the composition of this debt along with poor repayment ability of a majority of Indian corporate firms makes the Indian case different.

Given that the corporate bond market is thin and underdeveloped, a majority of firms turn to banks as their primary source of lending. Moreover, lack of credit rating, incomplete knowledge in accessing financial markets and economies of scale enjoyed by bigger firms, make market borrowing for smaller firms impossible; leaving banks as their only source of credit. Close to 45% of the total corporate debt is being financed by banks. The other two major sources of finance are debt instruments (bonds and commercial papers) and foreign currency borrowing in that order. Even though the large borrowers’ share in total loan portfolios was 51.8% as of December 2019, the usual premise that only large firms are responsible for India’s banking and corporate sector stress is not true.

Persistently falling profits have made a majority of firms incapable of debt servicing with the interest coverage ratios of Indian corporates amongst the lowest when compared to emerging market peers. This points to either low EBITDA margins or high interest expenses. In either case, the corporates find themselves unable to cover the interest expense, let alone the principal. The effect has been more pronounced among the smaller firms. Amidst falling investments, dwindling export growth and subdued consumption, which were already weighing down heavily on various industries with the automotive industry amongst the worst hit, the outbreak of the Coronavirus pandemic has heightened the debt-default risk further. The economy should brace itself in the near-term for both supply as well as demand shocks bringing down the output considerably and choking off future revenue streams of the firms and thereby drying up their cash flows.

Global and national supply chain disruptions will cause severe harm to the trade sector with an outstanding bank loan of Rs 5.19 lakh crores. The retail services with a loan of Rs 2.82 lakh crores will fall victim to the twin supply-demand shocks. The lingering effects will be felt more in tourism, hotels and restaurants, which are already reeling under a debt of Rs 45,394 crores as of January 2020. However, the highest risk exposure would be faced by MSME industries saddled underneath a debt of a whopping Rs 4.79 lakh crores. The liquidity crunch has further handicapped MSMEs with small and micro firms facing soaring credit gaps. Many analysts have already red-flagged MUDRA loans as another NPA mess in the making. Without any rescue, the huge job losses arising out of these could further worsen the already grim employment scenario. The export sector would face further headwinds with India’s top export destinations like US and China being the epicentres of the pandemic.

India’s corporate debt market has a lower concentration of low-rated bonds as compared to most other economies. The proportion of AAA rated bonds stood at 61.74% in 2017-18, which can be attributed to the low bandwidth of the market and risk averse nature of a typical Indian investor. However, it is the proportion of non-investment grade bonds (below BBB), which, even though they constitute a small proportion of 18.6%, pose a significant challenge. These non-investment grade bond holding companies have raised finances for their businesses by selling riskier securities and are most likely to default in case of a black swan event like Coronavirus.

With the free fall of rupee due to a sharp reversal of short-term capital flight to advanced economies covering up for the heightened risk, the external commercial borrowings, which have more than doubled during 2017 to 2019, now stand exposed to the cross-currency headwinds of foreign exchange risk. In times of such heightened uncertainty, the usual chain of events is excessive sell-offs in the equity market and complimentary buying in the debt market, as investors move towards less risky instruments. The Indian markets followed the same course, until 6^th March. However, corporate bond yields since then have seen an upward movement by 90-175 bps.

The most secure 10-year government bond yield witnessed a rise pointing to softening prices. The safe haven of glittering gold has also fallen victim to the virus. This “sell everything” mindset in the market has further dried up the liquidity, destroying the money needed for investments. Extraordinary circumstances call for extraordinary measures and if the corporate India’s debt bomb is to be diffused, an urgent and appropriate policy response on both the fiscal and monetary front is required.

RBI’s operation twist to spur long-term investments needed the urgent support of appropriate policy rate cut by at least 75-150 bps with food inflation softening further. This coupled with the lagged transmission of the significant fall in international crude oil prices around and below US$ 30 per barrel due to the breakdown of OPEC oil cartel in the wake of the feud between Saudi Arabia-led OPEC and Russia provided RBI the room for rate cuts. Massive injunction of liquidity was the need of the hour. Slashing the reverse repo by 90 bps is a welcome move aimed to nudge the banks in lending or investing in debt markets rather than providing surplus funds to the central bank. The targeted long-term Refinancing Operations (TLTROs) will provide liquidity relief to banks, which they are supposed to pass on to the corporate debt market by investing in corporate bonds, commercial papers, etc, thereby easing some pressure on the debt market. Directing the nationalised banks to purchase corporate bonds and then allowing them to reduce equal amount from their CRR would have provided banks with some sense of security as compared to an outright reduction in CRR.

Even though all these announcements are welcome, a lot still needs to be done. In prolonged periods of tepid demand and supply chain distortions, corporates’ recourse to cost cutting measures to remain afloat, limiting the role monetary policy can play. The adage remains: monetary policy can only pull on the strings but cannot push on the strings! Even after the Rs.1.7 lakh crores stimulus announced by the government focused largely on welfare measures, comprehensive fiscal policy actions should follow up in terms of immediate sector-specific debt relief packages.

Public sector banks face far more exposure to MSMEs because of the strict implementation of priority sector lending with NPAs in priority lending reaching as high as 10% against a meagre 2% in comparison to their private counterparts.  Bailouts of the MSME sector are essential to prevent these large-scale defaults and the unemployment that follows. Aggressive public investment will be one sound pillar on which the reconstruction of the economy could begin with a hope for the crowding in effect!

Interestingly, the “helicopter money” and direct cash transfers a la universal basic income, once considered anathema, are suddenly gaining currency around the world. While these measures require massive fiscal expenditure, the revenue earned from the increased excise duty on crude oil can partly compensate; moreover, the immediate imperative is to stabilise the financial market and quarterly growth turnaround. Quintessentially, conjoint revival of investment and consumption demand would be the imperative in preventing an otherwise imminent recession, which might lead to an explosion of corporate debt pile up.

The first and foremost priority in the wake of a global health coronavirus pandemic is to minimize the damage to life by protecting livelihoods. For that, appropriate economic responses are to be phased out to mitigate the medium- and long-term effects it can have on people’s livelihoods. Focusing on the containment of spiralling corporate debt should be on policy priority list.

Prof. D Tripati Rao (e-mail: tripati@iiml.ac.in) is currently Professor of Economics in the Business Environment Area at Indian Institute of Management Lucknow. He has obtained his Ph. D. from the Department of Economics, University of Mumbai under the auspices of RBI Monetary Economics Endowment Research Fellowship and M.Phil degree in Applied Economics from CDS, Trivandrum, JNU. His research areas of interest are Monetary-Macroeconomics, Indian Macroeconomy and Open-Economy Macroeconomics (Trade, Capital Flows and Exchange Rate). The views expressed here are his own.

Article has been co-authored by Ishan Mittal, MBA, IIM Lucknow.