Breathe easy

The rise in Corporate India's interest costs in the fourth quarter of FY 2005, after falling for 13 quarters, should normally be reason for concern.

Thankfully, however, that is far from being the case. There is precious little evidence that the rise in interest cost has led to lower profits, because of several factors.

One, the interest cost has increased in only the last quarter, and that increase has been more than offset by declining interest cost in the previous quarters. For FY 2005 as a whole, therefore, interest costs would have declined.

Two, the increase is too small to bother about at the moment. Three, companies still have large amounts of cash in their balance sheets, which reduces the need for borrowing. And since this cash is parked in investments, often in debt funds, rising interest rates could actually benefit those companies that have a lot of investment income.

Finally, companies have been going in for external commercial borrowings (ECBs) in a big way, which reduces their interest cost. For all these reasons, the rise in interest cost hasn't yet begun to worry the corporate sector.

Nevertheless, it's true that some sectors have already been affected. The oil companies, which have been denied higher product prices and yet have to pay more for crude oil, have no option but to borrow, and their interest costs are bound to increase.

Steel companies too have seen higher interest costs. And while these costs have not yet started hurting, there's no doubt that the extra boost provided by substituting high-cost loans with low-cost borrowing is no longer available.

In other words, the scope for margin expansion through reducing interest cost no longer exists. With much of the payoff from leaner staffing and inventory having already been realised, Corporate India will have to increase volumes to increase profits. That, in turn, calls for capacity expansion.

And that's when higher interest costs should start to bite, because the large number of expansion projects lined up by companies would normally mean more borrowing at a higher cost.

As noted, however, companies have large amounts of cash, they can tap overseas bond markets, and they can access the equity markets.

This is especially true for the larger companies, and, as usual, it'll be the smaller companies that will feel the pinch of rising interest rates.

Interestingly, interest rates in the money market have moved down once again, with the benchmark 10-year government paper trading at a yield of around 6.9 per cent, well below the 7.2 per cent reached last month.

Long bond yields have been moving down in the US as well, while emerging market bond funds are flush with funds, making borrowing overseas easy for companies. Note also that the rate of inflation has been trending down, commodity prices are softening and liquidity is still comfortable.

To be sure, the risks exist in the shape of higher oil prices and strong credit growth. But the Reserve Bank of India, as well as the government, seems to be intent on holding down interest rates for as long as possible. For the present, companies can breathe easy.