Despite the external origin of the financial crisis, the potential impact on India’s corporate sector could be large, as India has become increasingly integrated with the global economy in the past decade. The Selected Issues paper discusses India’s economic development and policies. The impact on the corporate sector will in turn feed into India’s overall economic growth. The significant volatility in the exchange equity prices, and interest rates triggered by the global crisis, together with the decline in global economic activity and capital flows, will weight on India’s firms.

Abstract

Despite the external origin of the financial crisis, the potential impact on India’s corporate sector could be large, as India has become increasingly integrated with the global economy in the past decade. The Selected Issues paper discusses India’s economic development and policies. The impact on the corporate sector will in turn feed into India’s overall economic growth. The significant volatility in the exchange equity prices, and interest rates triggered by the global crisis, together with the decline in global economic activity and capital flows, will weight on India’s firms.

I. India's Corporate Sector: Coping with the Global Financial Tsunami1

A. Introduction

1. As is already obvious, the global financial crisis is unlikely to spare India's corporate sector. The perceived impact as reflected in financial markets indicators is acute: the Sensex lost over 50 percent and the rupee depreciated 23 percent in 2008, a sharp turnaround from the buoyant trend observed in the preceding years. The perceived vulnerability of India's corporates is also large. C DS spreads of some Indian firms have skyrocketed to some of the highest levels in emerging Asia. Despite the external origin of the financial crisis, the potential impact on India's corporate sector could be large as India has become increasingly integrated with the global economy in the past decade. The impact on the corporate sector will, in turn, feed into India's overall economic growth. For the past four years, growth has been fuelled by strong corporate investment supported by high profitability and increased reliance on domestic and foreign financing (Figure 1).2

Figure 1:
Figure 1:

India Saving-Investment Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2009, 186; 10.5089/9781451818659.002.A001

Source: CEIC Data Company Ltd.

2. In this paper, we assess the potential impact of the global crisis on the health of India's corporate sector. Using firm-level data, we employ two distinct and complementary approaches in evaluating the current state and vulnerability of the corporate sector (Brooks and Ueda (2007)).

  • The first approach relies on data from the balance sheets and income statements of about 7,000 listed and some unlisted firms to analyze the cross-sectional pattern and historical development of standard accounting ratios of corporate leverage, liquidity, and profitability. Stress tests of pre-crisis corporate balance sheets, with shocks to borrowing costs, the exchange rate, and profits (on the order of the changes already observed since the beginning of the current global crisis) shed light on the likely effect of worsening economic conditions on firms' financial health. This, in turn, can serve as an indicator of the prospective health of the banking system. This methodology is widely used in the literature (see for example Heytens and Karacadag (2001), Goldman Sachs (1998, 2000), Topalova (2004), and Jones and Karasulu (2006)) and has been shown to be reasonably accurate (ex-post) in foreshadowing corporate sector distress (Jones and Karasulu, 2006).

  • The second approach is based on indicators that measure the risk of default, using an approach similar to the Black-Scholes-Merton (BSM) option pricing model. Compared to simple accounting ratios, default risk indicators have two main advantages: (i) they are forward-looking and (ii) they combine various dimensions of risk into a single statistic, which gives the overall impact on vulnerability from potentially offsetting changes. The theoretical default risk of a firm is computed from both its balance sheet and equity price data, under the assumption that equity market prices should incorporate investors' estimate of the company's default risk. This approach is especially useful when the analyzed firms do not have publicly traded derivative securities, or if their market prices are unreliable because of low liquidity.3 Chan-Lau and Gabelle (2005) suggest that the default risk indicators provided early signals of distress for some Asian crisis-hit countries in the late 1990s. We computed these indicators for over 2000 companies listed in the Bombay Stock Exchange, providing a much larger coverage than Moody's KMV for India, which monitors only about 100 firms.4

3. Furthermore, we link corporate sector performance directly to overall investment and economic growth, to estimate the likely impact of the global crisis. The lack of data on actual corporate bankruptcies and debt restructuring in India prevents us from relating corporate vulnerability indicators to actual firm distress.5 Yet, it is possible to estimate the relationship between our vulnerability measures and economic activity. Historical data reveal that our vulnerability measures are indeed significant leading indicators of firm-level as well as macro-level investment and GDP growth. Using these statistical relationships, we can quantify the potential impact of the current global crisis on India's corporate sector health and future economic growth.

4. Our analysis suggests that the ongoing global crisis could have a serious impact on the Indian corporate sector and near-term growth. The significant volatility in the exchange rate, equity prices, and interest rates triggered by the global crisis, together with the decline in global economic activity and capital flows will weigh on India's firms. For a reasonable set of shocks (which have largely already happened) the number of firms facing problems in servicing their debt obligations could more than double. Despite fairly strong corporate sector balance sheets as of March 2008, lower equity prices and increased equity market volatility imply a much lower buffer against distress. The estimated economic growth impact could be over four percentage points; with GDP growth rate in 2007/08 at 9 percent, these estimates imply a deceleration to around 5 percent.

5. The rest of the paper is organized as follows. Section B describes the results from the analysis of accounting ratios. Section C presents the default risk analysis, while Section D explores the corporate vulnerability and growth nexus.

B. Accounting Ratio Analysis

6. The data used in this analysis are from a firm-level database on India's corporate sector (Prowess), compiled by the Centre for Monitoring the Indian Economy (CMIE). The database contains standardized balance sheet and income statement data of listed and unlisted companies, which account for about 70 percent of the economic activity in India's organized industrial sector. The sample size of non-financial firms ranges from about 2000 in the early 1990s to about 7000 for fiscal year 2007/08 (ending in March 2008, when the majority of companies file their annual reports). The database is substantially richer than global corporate sector databases, such as Worldscope, in terms of number of companies, coverage of smaller firms, and detail of information (for instance, foreign currency borrowing).

7. India's non-financial corporate sector balance sheets appeared healthy as of March 2008. 6 According to a number of financial indicators, India's corporates were at their strongest since the early 1990s. They also compared favorably with emerging market peers (Panel Figure 1).

A01ufig01

Panel Figure India's Non-Financial Corporate Sector is facing the crisis from a strong position 1/

Citation: IMF Staff Country Reports 2009, 186; 10.5089/9781451818659.002.A001

Sources: CMIE; Prowess database, and authors' estimates.1/ “Aggregate” series show ratios taken after aggregating across firms for a variable. For instance, the debt-equity ratio is computed by first summing up debt and equity across all the firms, and then by taking the ratio.
  • Profitability: Profitability and profit margins improved substantially during the recent economic growth upturn across the entire distribution of firms, supporting strong gains in corporate saving. The profitability of India's firms also stands out internationally. Based on the IMF's CVU, which uses the Worldscope database, the market capitalization weighted 7 return on assets (ROA) for Indian companies in 2007 was 17 percent compared to 12 percent in emerging Asia and emerging America, 17 percent in emerging Europe, and 7-10 percent in developed economies.

  • Leverage: Corporate leverage has declined substantially since the early 1990s. While firms increased their leverage somewhat recently, as ambitious investment outpaced retained earnings, the debt-to-equity and debt-to-asset ratios remain at comfortable levels by historical standards and in line with India's peers in emerging Asia and emerging America. The market capitalization weighted average of the debt-equity ratio is 0.6 for India, comparable to 0.6 for Asia and 0.8 for America in 2007 (CVU). The ratio for emerging Europe is lower at 0.4.

  • Foreign borrowing: Despite a steady relaxation of restrictions on foreign borrowing, the use of such financing has been concentrated in a limited subset of large companies. In 2007/08, only 15 percent of the companies in the sample had borrowed from abroad, and the share of foreign debt in total debt by all companies in our sample was about 20 percent.

  • Liquidity: High profit growth and declining interest rates provided ample liquidity to Indian firms. The interest coverage ratio (ICR)—defined as earnings before interest and taxes over interest expenses; and measuring the debt-servicing capacity for a firm—rose sharply in recent years across the distribution of firms and for private, foreign, and government-owned firms. Using the CVU, the market capitalization weighted average of ICR for India in 2007 was 100, much higher than the weighted average (10-50) in other emerging markets and in developed markets (around 20-60).

8. While the state of the corporate sector in early 2008 appeared healthy, stress tests could uncover its vulnerability to various shocks. In addition, since complete balance sheet data are available only annually, the stress-test framework can shed light on the impact of very recent financial market developments on firms' health. Following the standard practice in the literature, firms with ICR below one, in other words, firms that are unable to generate enough cash to cover the interest payments on their debt, are classified as distressed or in theoretical default. Previous studies have demonstrated that stress tests on the ICR can effectively detect corporate sector distress: for instance, Jones and Karasulu (2006) illustrate that this framework would have flashed warning signs for the Korean corporate sector before the onset of the 1997 crisis, had it been used at the time.

9. Moreover, the weaker financial performance among firms as a result of various shocks can be linked to the financial system's asset quality. If firms with ICR below 1 cannot find additional sources of funds, they are likely to delay interest payments, and if the delay persists, loans to those companies would eventually be classified as non-performing assets in banks' balance sheets. This corporate-financial link is important in India: almost half of the total borrowing of non-financial corporations come from domestic banks, and two-thirds of total non-food bank credit goes to the corporate sector (including commercial real estate and property developers). The remainder goes to the agricultural and household sectors in the form of personal and retail loans. As of March 2008, about 22 percent of the companies had an ICR below 1, accounting for 15 percent of the total debt of the companies in our sample. These numbers are much higher than the non-performing assets (NPAs) data reported by banks (the overall gross NPA ratio of scheduled commercial banks was only 2.4 percent). There are many reasons why the implied NPAs derived from ICRs differ from banking data NPAs. 8 Having said this, the relative changes in the ICR could signal the future trend in NPAs. The correlation between the level of NPAs reported in banking sector data over the past 11 years and the implied NPAs estimated from the Prowess database is 0.78.

10. We analyze the sensitivity of the corporate sector and the implied NPAs in the financial system to various macroeconomic shocks. We consider four separate shocks (on domestic and foreign interest rates, the exchange rate, and profits) as well as the combined effect of the three shocks on the individual firms' balance sheet/income statement. The post-shock financial indicators are used to recalculate the interest coverage ratio of each firm (Figure 2). The figure below, which presents a stylized version of the balance sheet and income statement of a firm, depicts the channels through which each shock impacts the financial condition of a firm. An increase in interest rates directly raises the firm's interest payments; however it also raises the returns on its financial assets, such as bank balances. A depreciation of the currency automatically inflates the foreign currency debt of the firm when expressed in local currency and raises the interest payments on foreign debt. However, it may also raise the income of the firm, depending on its net foreign currency exposure and currency composition of its revenues and costs. Finally, a decline in profits reduces the resources available to the firm to service its debt obligations.

Figure 2.
Figure 2.

The Effect of Shocks on Firm's Balance Sheet and Income Statement

Citation: IMF Staff Country Reports 2009, 186; 10.5089/9781451818659.002.A001

11. In an attempt to quantify the impact that the evolving crisis has already had on India's corporate balance sheets and financial sector asset quality, we consider shocks that are roughly equal to the observed change in relevant macroeconomic variables in 2008. These shocks also correspond to approximately one standard deviation of the respective variables.

  • For interest rate risk, we consider an increase in the domestic interest rate by 500 bps, and in the foreign interest rate by 700 bps corresponding to the observed increase (from the minimum to the maximum in 2008) in domestic commercial paper rates and the EMBI Global spread.

  • For foreign exchange risk, we consider a rupee depreciation of 25 percent (the rupee depreciated by 23 percent in 2008).

  • For earnings risk, we assume a decline in profits of 25 percent (the advance corporate tax payments in the 4th quarter of 2008, which registered a 22 percent y-o-y decline, suggest that this is a reasonable assumption for the likely impact of the crisis on corporate profits).

12. Table 1 summarizes the results of the stress tests. The first column shows the share of companies with ICR below one (bottom row), and the share of total corporate sector debt that is held by these “ICR below 1” companies (top row). For each shock, as well as the combined shocks, the table shows the resulting increase in the share of companies with ICR below one and in the share of implied NPAs. For example, a 500 basis points increase in the domestic interest rate raises the share of debt borrowed by companies with ICR below one by 8 percentage points, suggesting that the total implied NPAs in the banking sector would rise to 22.6 percent from a baseline of 14.6 percent observed in March 2008.

Table 1.

India: Stress-Test Results on the Non-Financial Corporate Sector

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The stress test highlights the following vulnerabilities.

  • Indian firms seem to be more sensitive to interest rate shocks (especially the domestic rate) compared to rupee depreciation shocks. This is not surprising given that access to foreign borrowing is limited to a relatively small number of companies in the sample. This suggests a limited trade off in the nonfinancial corporate sector between lowering interest rate (injecting liquidity to stimulate the economy) and exchange rate depreciation (increasing foreign currency debt burden), and could simplify the task of balancing different objectives in the conduct of monetary policy.

  • Banks' credit portfolio could be significantly affected by the potential deterioration in the financial conditions of the corporate sector. The share of troubled debt owed by companies with insufficient earnings for debt service could more than double, under a very likely scenario with combined shocks of a magnitude already seen in 2008. This could mean that financial/banking sector stress testing should incorporate at least a doubling of non-performing loans as a baseline shock to credit quality, and more extreme shocks need to be considered in order to examine tail risks.

13. While the doubling of troubled debt is worrisome, in a historical context India's corporate sector seems to be less vulnerable to extreme shocks than in the past (Figure 3). First, as the ICR has improved since the late 1990s, the actual amount of implied NPAs declined (baseline scenario in Figure 3). Second, as balance sheets improved, the sensitivity to the combined shock seems to have diminished as well.

Figure 3.
Figure 3.

Share of debt of companies with ICR<1 Sensitivity to Combined Shocks, 1991-2008

Citation: IMF Staff Country Reports 2009, 186; 10.5089/9781451818659.002.A001

C. Default Risk Analysis

14. We estimate the BSM default probability and distance-to-default for each firm in our sample following the methodology adopted in the IMF's CVU.

  • Distance-to-default (DtD) measures the extent to which the firm's total assets (at market value) need to fall for a firm to default within a year. According to the methodology used in this section, a firm defaults when the market value of its assets falls short of its debt liability (namely, default barrier 9), or alternatively, the market value of equity falls to zero. DtD-one-year-ahead is the difference between the market value of assets and debt adjusted for the expected change in firm assets and normalized by the standard deviation of the asset return. This implies that if the DtD takes on a value of 3, a firm has enough assets not to default as long as the asset return does not drop 3 standard deviations from its current level within one year. 10

  • The BSM default probability represents the theoretical probability of default one-year-ahead using the standard cumulative normal distribution and the DtD as a threshold. It is reported in a way that, if the reported DtD is three, the default probability becomes 50 percent. Both DtD and default probability depend on (1) how far away a firm is from its default barrier; and (2) how risky a firm's asset return is, measured by asset return volatility. Since the mean and volatility of the firm assets at market value are not directly observable, equity value and volatility are fed through the BSM option pricing formula to estimate those variables (see Brooks and Ueda (2007) for details).

15. Both balance sheet and equity price data are from Prowess. As we need equity price data, we focus only on listed companies, which amounted to about 2400 companies in 2007/08. Due to inadequate equity price data in the early 1990s, we estimate the BSM measures of default starting in 1993/94.

16. In line with the trends observed in firms' accounting ratios, as of March 2008, corporate sector health according to the BSM default vulnerability measures was near historic heights. DtD indicates that Indian firms were well cushioned to withstand large shocks: even a 3 standard deviation shock to assets would not cause firms (especially those with larger market capitalization) to default. 11 Looking at the more limited sample in the CV U, the market cap weighted average DtD for India stands at about 13½ in 2007, which is comparable to other emerging and developed markets. 12 The estimated default probability paints a similar picture, but it seems to accentuate the distress in the mid-1990s and early 2000s around the collapse of India's first investment boom and the recession after the bursting of the global tech bubble.

Figure 4:
Figure 4:

India: Distance to Default, non-financial firms

(In standard deviation of assets)

Citation: IMF Staff Country Reports 2009, 186; 10.5089/9781451818659.002.A001

Figure 5:
Figure 5:

India: BSM default probability, non-financial firms

(In percent)

Citation: IMF Staff Country Reports 2009, 186; 10.5089/9781451818659.002.A001

17. The default risk indicators are reasonably correlated with India's macroeconomic and external conditions and exhibit some clear cross-sectional patterns. Table A1 shows the contemporaneous correlation between the default risk indicators and various macroeconomic and firm-level characteristics, including financial data and industry and ownership information similar to those presented in Cavallo and Valenzuela (2007). As expected, a firm has lower default risk if it is larger, less risky (lower asset return volatility), and less leveraged, and has better growth opportunities. Younger firms seem less vulnerable as well. Compared to private individual (as opposed to group) firms, foreign firms seem to have lower default risk, while Indian private group companies or public sector companies seem to have higher default risk after controlling for their size. An upturn in GDP growth and inflation is associated with lower default risk in the corporate sector. Increases in global risk perception, as reflected in the VIX—a measure of the implied volatility of S&P 500— coincide with heightened default risk. While the exact mechanism underlying the observed correlation cannot be uncovered in the present analysis, the positive association may reflect spillover channels from world economic/financial conditions to India. Overall, the Indian corporate sector's vulnerability seems to have moved in line with India's macroeconomic and global conditions.

Table A1:

Distance-to-default and Default Probability

This table presents results from regressions using data excluding companies with less than 24 weeks observation for active equity price data. All models include industry dummies (not shown) and ownership dummies set against private independent companies. Dependent variable are estimated distance to default and Black-Schorles-Merton default probability. Estimated market value of total asset is used to calculate independent variables. Sample includes firm-level panel data from fiscal year 1993/94 to 2007/08. Standard deviation is adjusted for within company serial correlation.

article image
***, **, and * denote significance at the 1percent, 5 percent, and 10 percent levels, respectively. T-statistics are given in brackets.

18. The default risk indicators are also highly correlated with earnings-based measures of actual default. DtD is positively correlated with ICR from the previous section after controlling for other firm specific characteristics, illustrating the underlying strong link between the theoretical model-based measures of default risks and accounting-based measures of default. However, the lack of actual bankruptcy data prevents us from translating theoretical (risk-neutral) default risk into real world default risk and testing the predictive ability of our measures for bankruptcies.

19. Using the default risk indicators, we examine the potential impact of the rapid deterioration of the financial markets, which has been actually observed since March, 2008 on corporate sector health. By feeding updated equity price and volatility data and March 2008 balance sheet data into the BSM option pricing model, we re-estimate the default risk indicators to capture the vulnerabilities reflected in recent equity price changes. In order to highlight the implication of the current global crisis at its deepest point, we take the lowest equity price for each company between January and November 2008. As an estimate of equity volatility, we used the highest annual standard deviation observed for each company since 1993/94. The choice of this measure is reasonable given that benchmark equity volatility according to VIX remains at historic heights. 13 Furthermore, we consider the direct, first round impact of a 25 percent rupee depreciation, which is equivalent to the actual depreciation of the rupee vis-à-vis the U.S. dollar in 2008. A depreciation increases the domestic value of foreign currency debt and hence reduces the value of equity. If a firm has a relatively a small equity cushion, the shock immediately brings the equity value below 0, causing default right away. 14

20. The impact of combined shocks on the implied default risk could be significant. Table 2 shows the impact of individual shocks on the rupee, equity valuation, and volatility, and then the impact of their combined shocks on the average DtD. 15

  • Despite the appreciable size of the shocks, exchange rate depreciation and equity valuation per se seem to have a limited impact on corporate vulnerability.

  • The direct balance sheet impact of changes in the exchange rate seems to push only a small number of companies into immediate default. The impact on average default risk for the surviving companies is also relatively minor, consistent with the accounting ratio analysis. 16

  • The large impact of shocks to equity volatility seems to reflect the importance of the risk factor reflected in equity volatility in explaining the potential rise in corporate vulnerability. The implied decline in DtD is extremely large in a historical context: in the high volatility scenario, the average DtD would reach historical lows, registering the largest annual decline. Nonetheless, firms still appear to have good equity cushions against additional shocks.

  • Combining all types of shocks (Combined Shock B) would lead to a particularly large increase in vulnerability. However, this could be an overestimate as the impact of the rupee depreciation could be already reflected in equity valuations and volatility. Therefore, we focus on Combined Shock A to investigate the link between corporate sector health and economic activity. 17

Table 2.

Scenario: Distance to default, non-financial firms

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A rupee depreciation shock increases the market value of foreign currency debt immediately, reducing the market value of equity. If a firm has a small equity cushion, this could bring the market value of equity below 0 immediately, causing default right away.

100 percent implies a one standard deviation shock.

Excluding the companies that lose all the equity value and go in default immediately as a result of a shock. A negative equity value causes computation problems in calculating asset value and volatility.

D. Corporate Sector Health and Economic Growth

21. What does the increase in corporate sector stress mean for India's investment and economic growth in the near future? When companies are in distress, they are likely to cut investment and production, weakening economic growth. In addition, the expected economic downturn heightens corporate sector vulnerability. Even though causality between firm vulnerability and economic indicators likely runs both ways, we can apply a leading economic indicator framework to quantify the impact of higher default risk on near-term investment and growth. We first establish whether default risk measures are useful leading indicators for firm-level investment. We then estimate the link between average corporate sector default measures and macro-level investment. Finally, we show the implication of the deterioration in DtD considered in the previous section on GDP growth.

22. At the firm level, we estimate a standard panel investment model based on Tobin's Q, controlling for macroeconomic conditions and industry/ownership specific factors. We extend this baseline investment model by including default risk indicators. The dependent variable is capital expenditure normalized by firm asset size. The following regression model is estimated using annual data from 1993/94 to 2007/08 with indicating individual firms and t indicating time.

Capext,i = α + β1 DefaultRiskt−1,i + β2 Tobin'sQt−1,i + β3 Controlt,i + β4 CompanyFixedEffects + β5TimesD + εti

Default risk indicators include either DtD or default probability. Tobin's Q is approximated by the market-to-book ratio. The model includes company level fixed effects to control for the effects from other company specific characteristics and time dummy variable in order to control for macroeconomic and external conditions. For robustness checks, some firm specific control variables, including the opening cash balances (in order to consider the impact of possible borrowing constraints), leverage, firm size, lagged equity volatility, and lagged asset volatility are included.

23. Default risks indicators have strong predictive power for corporate investment at the micro level (Table A2). Both DtD and default probability explain future capital expenditure (with the correct sign) and the coefficients are statistically significant. The default risk measures remain statistically significant and stable when other firm-specific variables are added to the estimation.

Table A2:

Micro-level investment regression

This table presents results from regressions using data excluding companies with less than 24 weeks observation for active equity price data. All models include firl fixed effects (not shown) and time dummies. Samples with extreme capex variables (top 5% and bottom 5%) are excluded.

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***, **, and * denote significance brackets. at the 1percent, 5 percent, and 10 percent levels, respectively. T-statistics are given in brackets.

24. At the macro level, we see whether default indicators have any predictive power for an economic activity variable over its own past value. We estimate the following model:

Yt = α + β1DefaultRiskt−1 + β2Yt−1 + εt

Various measures of economic activity, including corporate investment as a share of GDP, corporate investment growth, overall investment as a share of GDP, overall investment growth, and real non-agricultural GDP growth are used as dependent variables. Default risk indicators are cross-company average/median/market capitalization weighted average DtD or default probability for each year t. Only the results with average default risk are presented, as they seem to have more robust and stable relationships with the dependent variables. 18

25. Default indicators have statistically significant predictive power for key macroeconomic variables (Table A3). Also, these results are robust to the inclusion of other macroeconomic variables for India or the world. Therefore, these estimated coefficients could be applied to the estimated deterioration in default risk measures from the previous section to provide an estimate of the deceleration in GDP growth rate implied by the corporate sector indicators. Since the DtD seems to be a stronger predictor of firm behavior than default probability, we focus on average DtD in the following exercise.

Table A3:

Macro level analysis

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***, **, and * denote significance at the 1percent, 5 percent, and 10 percent levels, respectively. T-statistics are given in brackets.

26. India's economic growth could be severely dented in the near term (Table 3). The implied impact of a 2.0 decline in DtD (such as estimated in the Combined Shock A scenario) on overall economic growth ranges from −2.8 percentage points to −4.4 percentage points. With GDP in 2007/08 growing at 9 percent, these estimates imply a deceleration to 4.6-6.2 percent growth. The latter is indeed in line with the IMF's and consensus forecast for 2009/10 growth as of January 2009. These estimates should obviously be taken with a grain of salt. In addition, financial and economic conditions in India and the world could change the conditions of the corporate sector and/or the economy significantly and in unexpected ways: the degree of uncertainty is indeed very large. However, this model-based approach does indicate a potentially a significant impact of the current global crisis on India's corporate sector, investment, and growth.

Table 3:

Impact of corporate sector distress on investment and growth

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Assuming a multiplier effect of 1.

Contribution to GDP growth, assuming a multiplier effect of 1.

References

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1

Prepared by Hiroko Oura and Petia Topalova.

2

While Indian companies finance the majority of their investment using retained earnings, Oura (2008) finds that they had been increasing their use of external funds (including domestic bank and capital market financing as well as overseas financing) to finance considerably larger investment during the recent period of 9 percent economic growth. As a result, India's corporate sector is increasingly exposed to global financing conditions.

3

Chan-Lau (2006) provides an excellent survey of the techniques analyzing corporate default risks.

4

We thank Kenichi Ueda for providing the Matlab code used in the IMF's Corporate Vulnerability Utility (CVU) to estimate default risk indicators. While the CVU also provides BSM default risk indicators, the sample for India is smaller and the aggregated and annual nature of the data prevents us from updating indicators to incorporate the latest equity market information and from relating individual firms' default risks to economic activities. Unlike Moody's KMV, our default risk indicators are theoretical (risk-neutral) indicators, and hence not comparable to actual default frequency. Still, the trends and sensitivity of the estimated default risks capture how the health of the corporate sector evolves over time as well as the relative vulnerabilities of the companies it comprises.

5

Indeed, cases of corporate bankruptcy in India are extremely rare partly owing to the cumbersome legal framework. Bankruptcy procedures under the Sick Industrial Companies Act, which governs financial reorganization of distressed companies, continue to be time consuming and burdensome, owing to indefinite stays on creditors' claims. Liquidation under the Companies Act is even more complicated and long court delays are common. Since the early 2000s, out-of-court corporate restructuring mechanisms such as the Corporate Debt Restructuring forum and the SARFAESI Act (2002) have facilitated the restructuring of distressed assets. Unfortunately, data on corporate debt restructuring undertaken by banks are not publicly available.

6

In this section, we focus on the non-financial corporate sector as the stress tests in this section consider the impact of non-financial firms' distress on banks' non-performing loans.

7

Market capitalization weighted averages are best suited for cross country comparisons. By assigning higher weights to the economically more important companies, the market cap weighted averages focus on systemic risk and mitigate cross country differences in coverage.

8

First, ICRs do not necessarily account for all the resources that the companies have at their disposal to meet debt servicing obligations. For instance, companies may acquire additional funds from shareholders, take credits from other non-financial companies, draw down reserves, and sell assets. Therefore, as long as poor financing conditions do not persist for too long, the theoretical default may not translate into actual default and a rise in bank NPAs. Second, while credit to corporates accounts for a significant share in total bank credit, banks do lend to other sectors. Similarly, not all firm debt comes from banks. Third, loans that are restructured are not classified as NPAs according to RBI guidelines. Banking sector NPA data augmented for the restructured debt (or disposal of distressed assets) would likely be more closely related to our vulnerability measures; however such data are not publicly available. A study by Goldman Sachs (2000) points out that for Korea, Taiwan Province of China, and Thailand, the reported NPA ratios for the financial system were 18, 5, and 25 percent, respectively in 2000, while their implied NPAs calculated using ICR were 37, 16, and 44 percent, respectively.

9

Following the CVU, the default barrier includes short-term debt, one half of long-term debt, and interest payments.

10

Under the normality assumption for the asset returns in BSM, an event measuring 3 standard deviations from the mean is extremely rare, with cumulative density of one percent.

11

However, it should be noted that the BSM methodology depends on the normality assumption of asset returns. If the true return distribution has fatter tails, the likelihood of severe corporate distress could be larger than what BSM default risk indicators suggest.

12

At the time of the Asian crisis in 1997, the market capitalization weighted average DtD for emerging Asia was about 7.

13

This approach could be considered as a sensitivity test similar to the stress tests of the previous section.

14

This is also a shorthand way to analyze the impact of a sharp depreciation. The BSM default risk analysis is built on the assumption that investors are pricing default risks—including the impact of depreciation—correctly in equity prices. A fuller analysis of the impact of depreciation could include a factor analysis linking equity prices and the exchange rate: an exchange rate shock could be translated in terms of equity valuation and volatility shocks, and then fed into default risk indicator calculations. Furthermore, a volatile exchange rate is likely to require relaxing the normality assumption in the benchmark BSM model, and would require modifying the pricing model as in Chan-Lau and Santos (2006). Having said this, our simple analysis can still give some idea about how the direct impact of rapid depreciation compares to what is implied by actual changes in equity prices and volatility, and whether an exchange rate depreciation is cause for worry or not.

15

As discussed in the next section, the simple average DtD seems to be the best predictor for macroeconomic performance.

16

However, our analysis does not include losses owing to derivatives and other contingent liabilities, which could underestimate the overall rupee depreciation impact.

17

All the analyses maintain the same expected returns from assets as in the baseline. Adjusting expected returns in line with what is implied by the shocks would further increase the impact.

18

Ex ante, one would expect the market capitalization weighted average to be better correlated with macro variables as it tends to reflect the trends for larger, more economically important companies. However, in India, the share of the formal sector is very small (employing only 10 percent of the labor force). The simple average might do a better job as it can better represent the trend for a large number of small companies that, nonetheless, represent a large share of total economic activity.

India: Selected Issues
Author: International Monetary Fund
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    India Saving-Investment Balance

    (In percent of GDP)

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    Panel Figure India's Non-Financial Corporate Sector is facing the crisis from a strong position 1/

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    The Effect of Shocks on Firm's Balance Sheet and Income Statement

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    Share of debt of companies with ICR<1 Sensitivity to Combined Shocks, 1991-2008

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    India: Distance to Default, non-financial firms

    (In standard deviation of assets)

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    India: BSM default probability, non-financial firms

    (In percent)