Corporate and Banking Sector Vulnerabilities in India1
Past deterioration in macroeconomic conditions and supply-side constraints—most notably in the infrastructure sector—have led to the build-up of corporate vulnerabilities in India. Firms’ debt repayment capacity has weakened, while leverage is among the highest across emerging market economies. Stress tests of corporate balance sheets confirm that exposure to potential shocks has continued to rise. The weaker position of domestic corporates has also translated into a substantial deterioration of banks’ asset quality. Stress-test simulations suggest that public sector banks (PSBs) may require capital injections in the coming years. Potential recapitalization needs should be manageable, even though they may require further fiscal outlays.
1. The sizable rise in corporate investment needs in the mid- to late-2000s was accompanied by an upsurge in corporate credit and the build-up of high leverage after the global financial crisis. Large capital investment requirements—particularly for infrastructure—were funded via a significant expansion of corporate lending by public sector banks (PSB). Bank credit to domestic corporates increased by an average of close to 30 percent a year during the mid- to late-2000s, while corporate lending by PSBs was up by 18 percent a year between end-FY2008/09 and end-FY2013/14. Prior to the global financial crisis (GFC), strong equity market performance also provided a good opportunity for corporates to raise financing via primary equity issuance.2 The slowdown of equity markets in the aftermath of the GFC and the rise in external commercial borrowings (ECB)—up by 107 percent between end-FY2009/10 and end-FY2013/14—coupled with continued credit growth, accounted for an increase in corporate leverage. Indian corporates now are some of the most leveraged across emerging markets (EMs). At end-FY2015, the median debt-to-equity ratio of the most leveraged Indian corporates (the top quartile) stood at 149 percent (Figure). While it has edged down marginally relative to end-FY2013/14 (156 percent), it is still higher than in most other emerging market economies.
Corporate Leverage, Selected EMs
Source: IMF, Corporate Vulnerability Utility.
2. The high aggregate leverage masks considerable differences across sectors and types of corporates. Both debt levels and leverage are highly skewed toward large corporates and select key sectors. The top one percent of firms in India accounts for about half of overall debt, as do corporates in two sectors: infrastructure (including power, telecommunications and roads) and metals (including iron and steel) (Figure).3 Both sectors were subject to strong credit growth in recent years, with loans rising by an average of 27 and 22 percent a year, respectively, between FY2008/09 and FY2012/13.4 Leverage in infrastructure-related industries—including construction; and gas, water and electricity—and in metal-related sectors has been higher than for other firms (Figure 1, left panel). At end-FY2014/15, the median debt-to-equity ratios in the three sectors fell in the 134 to 240 percent range, against 52 to 107 percent for other sectors. The leverage of the largest corporates (accounting for the top one percent in aggregate corporate sector assets) has also been persistently higher than for other firms. The median debt-to-equity ratio of the top corporates has been at more than 175 percent each year since FY2008/09, relative to less than 130 percent for other firms (245 percent and 113 percent, respectively, at end-FY2014/15) (Figure 1, right panel).
Figure 1.Corporate Leverage, by Sector and Size
Corporate Debt, by Industry, end-2015
Sources: Reserve Bank of India; and IMF staff estimates.
3. Supply-side bottlenecks and weak past economic growth have continued to account for high corporate vulnerabilities. The bottlenecks, particularly in infrastructure and the iron and steel sector, are largely structural in nature—including delayed project approvals; land acquisition hurdles; and previously coal supply disruptions—and have continued to affect negatively corporate profitability. The median return on assets (ROA) of Indian corporates continued to decline in FY2014/15 and, at 4.6 percent, was the lowest over the past decade (Figure 2, left panel). Corporates’ debt-repayment capacity also showed signs of marginal deterioration, following an improvement in FY2013/14. Corporate debt-at-risk—the share of debt owed by firms with an interest coverage ratio (ICR) below one—edged up to 10.8 percent in FY2014/15, following an improvement to 10.2 percent in FY2013/14.5 Market-based indicators of credit risk also continue to indicate elevated risks for vulnerable firms. Moody’s KMV default probabilities show a broad decline and leveling off of perceived risks in FY2014/15, but at a high level (an average 20 percent) for the weakest corporates (the 90th percentile of distribution) (Figure 2, right panel).67
Figure 2.Corporate Health Indicators
4. Stress tests, based on tail-risk balance sheet approach, are used to assess the soundness of India’s corporate sector.8 The approach evaluates debt-repayment capacity (i.e. the availability of profitability buffers to fund interest payments on outstanding debt) under financial stress. Potential shocks were applied both individually and jointly, and include a rise in domestic and foreign interest rates, a depreciation of the Indian rupee, and a decline in profitability. 9 As in Lindner and Jung (2014), three of the four shocks were calibrated to mimic the impact of the “taper tantrum” of the summer of 2013, and the decline in profitability in the immediate aftermath of the global financial crisis (FY2008/09). The shocks include a 250 basis-point (bps) increase in domestic interest rates; a 400 bps increase in foreign interest rates; and a 29 percent rupee depreciation (all assumed to affect non-operating income); and a 25 percent decline in operating profits. The debt repayment capacity of the corporate sector under each shock was assessed based on the share of aggregate debt of firms with an ICR below one relative to total corporate sector debt.
Share of Debt of Indian Corporates with ICR < 1
Source: Orbis and IMF staff estimates.
Note: Based on data for 1,542 corporates with available data for all years between FY2011 and FY2015.
5. The stress tests of corporate balance sheets confirm that exposure to potential shocks continues to be high. In extreme stress conditions—captured by the unprecedented combination of extreme adverse shocks calibrated to India’s experience in the aftermath of the global financial crisis and the 2013 “taper tantrum”—the corporate sector’s debt-at-risk could reach 42 percent (Figure). An upward shift in domestic interest rates continues to be a key risk for Indian corporates, with the share of debt-at-risk estimated to increase to 17 percent in case of a 250 basis point rise in domestic rates. Indian firms are now also more vulnerable to profitability, foreign currency (FX) and foreign interest rate shocks. Importantly, corporate sector risks continue to be considerably higher than in the aftermath of the Global Financial Crisis, when debt-at-risk even under the largest risk factor (domestic interest rates) was at levels comparable to the FY2014/15 baseline.
6. Dependence on external funding continues to expose Indian corporates to foreign currency shocks, despite an increase in hedging activity. FX-denominated funding—including external commercial borrowings (ECBs), trade credits, and bonds—accounts for about one-fifth of total corporate funding.10 Corporates are, thus, exposed both to rollover risks (of not being able to renew funding) and to the risk of rupee depreciation, if FX funding is insufficiently hedged. FX hedging across Indian corporates has increased considerably over the past year, now up to about 45 percent, from approximately 15 percent in July-August 2014. This increase largely reflects regulatory efforts by the Reserve Bank of India (RBI) to incentivize hedging through higher regulatory provisioning and capital requirements for banks’ exposures to entities with unhedged FX exposures (see Reserve Bank of India, 2014). However, uncertainty about the ability of FX hedging to fully mitigate potential risks—including due to possible maturity mismatches between FX hedges and underlying positions; a potential rise in hedging costs, particularly in cases of large depreciations; and the recent decline in natural hedges in view of the recent weakening in exports—leaves corporates exposed to FX risks.
7. The weaker position of domestic corporates has also translated into a substantial deterioration of banks’ asset quality in view of the strong corporate–bank nexus in India. Corporate credit accounts for a high share (over 80 percent) of Indian banks’ (particularly PSBs’) lending portfolios, pointing to a tight link between banking sector soundness and the financial performance of the corporate sector. The weakening of corporates’ debt repayment capacity has, thus, accounted for a significant rise in PSBs’ stressed assets, whose share in total advances increased to 13.5 percent at end-FY2014/15 (of which NPAs of 5.4 percent) from 11.9 percent a year earlier. Indian banks’ asset quality is now weaker than in peer EMs (Figure 3, left panel).11 A large share of stressed loans—more than 41 percent—is in the infrastructure, and iron and steel sectors, which have been affected adversely by the domestic supply-side issues and by export headwinds (Figure 3, right panel). With recent reform measures to address structural bottlenecks, new NPA formation may decelerate. However, the accumulation of restructured loans, which accounted for 6.4 percent at end-FY2014/15, poses a challenge. These loans, while not classified as non-performing, have modified terms to ameliorate possible borrower debt-repayment difficulties, and hence imply substandard quality. Further transition of restructured loans to an NPA status, and the need to provision new restructured loans at the NPA provisioning rate are expected to require capital injections in the PSBs in the coming years.
Figure 3.Bank Asset Quality
8. The phase-in of Basel III capital requirements would also necessitate further capital infusions. Implementation of the Basel III capital framework is progressing and is expected to be completed by end-March 2019.12 All banks currently meet the minimum 8 percent capital requirement under Basel III and its Indian equivalent of 9 percent (Figure). However, the agreed introduction of a 2.5 percent capital conservation buffer (CCB), coupled with potential changes in risk weights would require further capital infusions. Under a baseline scenario of ongoing implementation of Basel III, the needed cumulative capital injection is estimated to be at 0.8 percent of FY2018/19 GDP over four years, with a 0.3 percent government injection in line with its ownership stakes in PSBs.13
Basel III Capital Adequacy Ratios: Distribution by Bank Type
Sources: Reserve Bank of India; and IMF staff estimates.
9. Simulations of the impact of further PSB asset quality deterioration suggests that potential capitalization needs should be manageable, but may require further fiscal outlays. The simulations assumed a 15 percent transition of restructured advances to NPAs in each year to end-FY2018/19, and minimum 60 percent provisioning against NPAs. The analysis was carried out on a bank-by-bank basis, with slippage, recovery and write-off rates calibrated on banks’ most recent performance (in FY2013/14 and FY2014/15), and using the Tier 1 capital ratio as a hurdle rate (including the 2.5 percent capital conservation buffer (CCB) and additional buffers of up to 2 percent). Even in a severe scenario of continuous deterioration of PSBs’ asset quality on a scale commensurate with their recent experience, recapitalization costs should be manageable, at 2.9 percent of FY2018/19 GDP (cumulatively over four years, including a 2 percent extra buffer; left panel, Table 1). Costs are more modest, at 1.8 percent of FY2018/19 GDP, in the case of further reforms (right panel, Table 1). Altogether, potential stress is associated with an about 6 percentage-point decline in PSBs’ median Tier 1 ratio and a 3.2 percentage-point rise in the median NPL ratio (4 and 1.7 percentage points under milder stress—see Figures). However, these estimates may be subject to downward bias, given some remaining forbearance on the classification of certain restructured loans.
|Assumed Credit Growth||Assumed Credit Growth|
|(0.9 × GDP growth)||(1 × GDP growth)||(1.1 × GDP growth)||(0.9 × GDP growth)||(1 × GDP growth)||(1.1 × GDP growth)|
|Government Share||Government Share|
|6.125 - 8(0)||1.31||1.39||1.50||6.125 - 8(0)||0.63||0.71||0.81|
|7.125 - 9(1)||1.61||1.71||1.83||7.125 - 9(1)||0.94||1.03||1.14|
|8.125 - 10 (2)||1.91||2.02||2.16||8.125 - 10 (2)||1.24||1.34||1.47|
|Total Bank Recapitalization||Total Bank Recapitalization|
|6.125 - 8(0)||1.95||2.07||2.24||6.125 - 8(0)||0.91||1.03||1.18|
|7.125 - 9(1)||2.40||2.55||2.74||7.125 - 9(1)||1.37||1.51||1.68|
|8.125 - 10 (2)||2.86||3.03||3.24||8.125 - 10 (2)||1.82||1.98||2.18|
|Source: IMF staff estimates based on FitchRatings; Bankscope; World||Source: IMF staff estimates based on FitchRatings; Bankscope; World|
|Economic Outlook; and bank annual reports.||Economic Outlook; and bank annual reports.|
|Note: Column to the left shows range of minimum CET-1 + CCB requirements.||Note: Column to the left shows range of minimum CET-1 + CCB requirements.|
Basel Committee on Banking Supervision, 2015, “Regulatory Consistency Assessment Programme (RCAP) Assessment of Basel III risk-based capital regulations – India,” June 2015. www.bis.org/bcbs/publ/d320.pdf
International Monetary Fund, 2014, Global Financial Stability Report: Moving from Liquidity- to Growth-Driven Markets,April 2014, (International Monetary Fund: Washington).
Lindner, P. and S.Jung,2014, “Corporate Vulnerabilities in India and Banks’ Loan Performance,” IMF working-paper WP/14/232 (International Monetary Fund: Washington).
Moody’s, 2004, “MOODY’S KMV™ RISKCALC™ V3.1 UNITED STATES,” June 1, 2004. https://riskcalc.moodysrms.com/us/research/docs/Americas/RiskCalcv31US.pdf.
Oura, H.,2008, “Financial Development and Growth in India: A Growing Tiger in a Cage?” IMF working-paper WP/08/79 (International Monetary Fund: Washington).
Oura, H. and P.Topalova,2009, “India’s Corporate Sector: Coping with the Global Financial Tsunami,” India: Selected Issues, IMF Country Report No. 09/186 (International Monetary Fund: Washington).
Reserve Bank of India, 2014, “Capital and Provisioning Requirements for Exposures to Entities with Unhedged Foreign Currency Exposure,” RBI/2013-14/448, January 15, 2014. https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=8694&Mode=0.
Prepared by Silvia Iorgova.
Bombay Stock Exchange Sensex Index (BSE) increased more than five-fold between end-FY2002 and end-FY2008. See Oura (2008) for more on this.
The share of debt of the top one percent of Indian firms (by assets) in aggregate corporate debt accounted for 48 percent at end-FY2014/15, based on a sample of 2,848 firms with available balance sheet data, and 54 and 52 percent at end-FY2011/12 and end-FY2013, based on larger samples of 20,280 and 18,811 firms, respectively (based on data from Orbis – Bureau van Dijk). Under a smaller sample with consistent firm coverage between end-FY2010/11 and end-FY2013/14 (2,314 firms with available data for each year in this period), the top one percent accounts for 46-47 percent between end-FY2010/11 and end-FY2014/15.
Estimates are based on data from the Reserve Bank of India, “Handbook of Statistics on the Indian Economy”.
All statistics of corporates’ debt repayment capacity and stress test results are based on a sample of 1,542 firms with consistently available balance sheet and income statement data between FY2010/11 and FY2014/15 (sourced from the Orbis - Bureau van Dijk database) to avoid coverage and survivorship bias.
Moody’s KMV default probabilities are estimated based on the Black-Scholes-Merton (BSM) model. For a detailed description of the methodology, see Moody’s (2004).
Moody’s KMV default probabilities, thus, also confirm the high concentration of risks among a small share of domestic corporates. Conceivably, the dip in market perceptions of corporate risks in the second half of FY2013/14 may also be related to rising equity prices and lower volatility, rather than balance sheet fundamentals. The decline in default probabilities in late 2015 likely reflects positive market reactions to the authorities’ steps to relax existing bottlenecks.
The approach is akin to that used in IMF, GFSR (2014); Lindner and Jung (2014); and Oura and Topalova (2009). The analysis is based on data from Orbis (Bureau van Dijk), most recently as of end-FY2015, and covers about 2,000 companies.
Due to the lack of firm-by-firm data on corporates’ foreign currency (FX) liabilities and expenditures, estimates for the aggregate corporate sector were applied in the analysis.
IMF staff estimates based on data from Haver Analytics, Dealogic, and CEIC.
Stressed assets include gross non-performing assets (NPAs) and restructured assets. Asset quality deteriorated further between March 2015 (end-FY2014/15) and September 2015. At end-September 2015, stressed assets were up to 14.1 percent (of which NPAs of 6.2 percent), compared to 13.5 at end-March 2015 and 12.9 percent at end-September 2014.
A recent assessment under the Regulatory Consistency Assessment Programme (RCAP) of the Basel Committee on Banking Supervision finds India’s framework for implementation of the Basel risk-based capital standards compliant with Basel III regulatory requirements (see BCBS, 2015). An important remaining element on credit risk is the need for banks’ adoption of the Internal Ratings-Based (IRB) approach.
This estimate, as well as the subsequent simulations assumes no dilution of government ownership in PSBs, currently at about 61 percent.