Can India Inc take another rate hike?

DEBATE

While a rate hike pushes companies to international capital markets, they still largely look forward to banks for funds.

PRABAL BANERJEE,
Group President (Finance) & Group CFO, Hinduja Group

"It has made corporates to look outward for borrowing, and helped the domestic capital market to open up and mature"

Under normal circumstances, it will be difficult for anyone from Indian corporates to argue in favour of interest rate hikes. We can possibly explore the positive sides of rate hikes as mitigant from an overall perspective, rather than the impact on profitability alone. There is no denying the fact that corporates get adversely affected by interest rate hikes, but the silver lining is the "tax shield" which they seldom recognise in their analysis. For companies with a huge tax outgo, the tax-shield is important for determining their capital gearing and appropriate leveraging of the balance sheet. This mitigates the impact of interest rate hikes, which needs to be considered.

As is the norm everywhere, financially strong companies get the best of everything "" and from interest rate hike also. They normally have substantial cash surplus, which earns them higher interest income and impact them positively. In addition, organisations that deal in money, such as non-banking finance companies (NBFCs) and banks, greatly welcome such a move.

The biggest positive of interest rate hike for the Indian corporate sector has been: One, looking outward; and two, opening up and maturing the domestic capital market.

Before the latest series of Fed rate hikes, when Indian interest rates were unaligned with the international ones, Indian corporates had to pay interest at about 16 to 22 per cent per annum on borrowing. For them, necessity became the mother of invention, and they perforce looked outside the country for forex borrowing at much cheaper costs "" despite the currency risk. Floodgates opened and today they are at ease with raising resources from international capital markets. One wonders if it would have been possible without the pressure from rate hikes in India.

Such high rates also forced companies to look at the equity capital market rather than debt. Corporates who were not comfortable with forex liability in their balance sheet, resorted to the domestic equity market and others followed suit. Today, many companies raise money from domestic equity markets and the market is becoming mature. If we go by the type of corporates "" manufacturing or service "" we may find that successful companies in any sector are hardly affected. Service companies having steady cash flow, hardly borrow, and hence, are minimally impacted. It is only manufacturing companies, with thin operating margins and high investment programmes, that are vulnerable. Accordingly, such companies have also started replacing their debts through equity like quasi-equity, private equity and so on, rather than blaming interest rate hikes. Even with such hikes, debt costs are much cheaper than equity costs, and hence, corporates may not have such a big reason to complain. The Indian rate hikes have been marginal compared to the US interest rate hikes in the last couple of years. If the US can achieve a steady economic and corporate growth, while Fed rates moved up from 1 to 5.5 per cent, Indian corporates have much lesser reasons to worry, if at all.

SIDDHARTHA ROY,
Economic Advisor, Tata Group

"Corporates will depend on banks for about 45 per cent of the funding. Any hike in the cost of funding will have a ripple effect across the economy"

The prime lending rate for premier banks in India is currently at around 11.5 per cent. Taking into account an inflation rate of 5 per cent, the real rate of interest works out to around 6.5 per cent. To put it in context, the real rate in China is 2 to 2.5 per cent, in Indonesia it is close to zero, in Thailand and Malaysia the real rates are negative. Currently, there is a lot of focus on improving Indian competitiveness; in that connection, cost of funds would continue to be an important issue. While raising interest rates in order to maintain the so-called parity with international rate hikes, it is important to examine the real rates. The RBI's macro econometric model published in the Report on Currency and Finance, 2000-01 shows real rate increase has a significant negative impact on private manufacturing investment.

The next question that arises is how important is bank funding for corporate India? One examines the funding pattern of Indian corporates, around 35 per cent of the requirement comes from internal sources, around 4 to 5 per cent is raised through capital issues, about 15 to 17 per cent comes from external sources and external commercial borrowings. In other words, in the near future, the corporate sector will continue to look forward to the banking sector for about 45 per cent of the funding. Should the internal generation get adversely affected due to pressure on margins, the requirement of bank funding can only go up.

In 2004, when corporate India emboldened by growing demand and improvement in capacity utilisation started giving shape to its investment plans, the real rate was around 4.4 per cent, that is, about 2 per cent less than the current rate. One can certainly argue that large corporates borrow at sub-PLR rates. This is an outcome of competition amongst banks, and is indeed a welcome development.

However, in view of the increase in the base rates, that is, repo and reverse repo, the sub-PLR rates too have gone up. By and large, these rates are pegged at five-year government securities prevailing rate plus 50 to 75 basis points.

At this stage, it is important to take into cognisance the industrial restructuring that is taking place in many sectors. Any hike in the cost of funding will have a ripple effect across the economy. When the investment cycle started accelerating in 2003-04 and 2004-05, a large part of the funding came out of internal resources; to an extent this was also buttressed by external commercial borrowings. However, in the last one year, raw material cost, particularly energy and commodities, have gone up, labour costs are inching up, and at the same time, greater competition has ensured that the final price of manufactured items be maintained around the same level. As operational efficiency cannot be pushed beyond a point, this will have an adverse impact on margins and retained earnings, albeit with a lag. On the other hand, further rate increase in consumption-related loans would have a negative impact on demand.