Is it time to re-rate corporate India?

DEBATE

Finally it boils down to whether rating firms took a life-cycle approach while rating India Inc or did they think easy money and high demand were here to stay.

D R DOGRA,
Deputy Managing Director, CARE

"In a situation where demand is slowing while costs are rising, credit rating firms will need to introspect and look at the ratings that have been given a lot more closely"

Rating agencies follow a 'through the cycle' approach to minimise rating migrations during the tenure of an instrument. This takes into account various economic cycles and factors in the borrower's capability to service the loan during the likely downside scenario as well. If everything goes the way the credit analyst believes, there cannot be any significant change in the credit ratings. However, the credit profile of a company is not static. It changes with significant movements in the economy which cannot be ascertained most of the times.

In an era of the high growth rates, low interest rates, declining leverage and favourable capital markets, both in India and abroad, many companies have expanded both organically and inorganically in the past. Fortunately, most of these expansions have come either from internal accruals or from fresh equity finance, thus improving credit profile of these companies especially in a favourable demand-supply scenario.

But, now with the change in global and domestic economic conditions, the credit profile of companies is suddenly taking a turn. Oil, food and commodity prices have already gone through the roof and most economies are facing pressure. As India imports 70 per cent of its oil requirement, it will be adversely affected. The fiscal deficit is already rising, inflation is shooting up, the economy is slowing, and the current account deficit is widening. Both currency and equity markets have become volatile; the RBI has hiked the CRR from 6.5 per cent to 8.75 per cent, and the repo rate from 7.75 per cent to 8.5 per cent, all within a year. GDP, which was growing at around 9 per cent for some time, could even fall to below 7.5 per cent this year.

In a scenario where demand is decreasing and borrowing costs are increasing, companies which have indiscriminately spruced up their capacities through borrowings will face the heat. There appears to be clear evidence of slower industrial growth due to rising borrowing costs, slower consumer demand and the possibility of further tightening of monetary policy to tame the double digit inflation. Some companies may cut down their expansion plans in the event of an economic slowdown, unavailability of credit and shooting interest rates. The working result of companies for the quarter ended June 2008 will reflect all of this.

In such a scenario, investments will take a back seat for some time. All these events call for introspection and will compel rating agencies to look at ratings more closely. Besides current market developments, rating agencies also consider various factors like the quality of management and the promoters' record, the state of the market and the projected financial parameters before arriving at a rating decision. Of course, the measures taken by the RBI and the government may bring some sanity to the market and10:31 PM 7/15/200810:31 PM 7/15/200810:31 PM 7/15/200810:31 PM 7/15/2008 there may not be any cause for panic. A good monsoon and comfortable food production will bring some cheer.

PK CHOUDHURY,
Vice-Chairman & Group CEO, ICRA Ltd

"If things continue like this, the fundamentals may get affected and some downgrades are likely. In the longer term, however, the potential and corporate financials look good"

Typically, rating agencies are expected to factor in cyclical uncertainties and the consequential impact on future cash flows. Rating agencies carry out sensitivity analyses to take into consideration different scenarios under adverse circumstances so as to assess the inherent protective strength of future cash flows of the entity. These are based on assumptions in respect of adverse changes "" the purpose is to examine the likelihood and severity of the impact if such changes actually take place. The purpose is to assess how the cash flows are likely to behave vis-a-vis debt servicing obligations under such changing business environments as may be reasonably foreseen. Revisions typically happen if the conditions change more than expected and cause a structural or fundamental adverse impact on entities.

Continuous surveillance throughout the life of a debt is an integral part of the rating process. This is a regular process and is not necessarily dependent on changes in the economic circumstance or business environment.

Business entities in India at present are going through a difficult phase and are facing certain challenges. It is time for rating agencies to be cautious in their approach. If the present conditions persist or deteriorate, they may impact fundamental strengths of many entities beyond what was expected and factored in; the vulnerability of the entities at the lower end of the rating scales could be relatively higher.

The combination of rising cost of inputs (particularly wages and rents) on the one hand and the sluggish demand on the other is a major cause of concern. Business entities are finding it more and more difficult to pass on these cost increases to consumers. The purchasing power of consumers has eroded considerably consequent to inflationary pressures.

All these are impacting the profitability and future cash flows of business entities. Also, entities that are in a significant expansion/investment phase may be unable to achieve financial closure and, in turn, may face liquidity stress or may increase short-term borrowings impacting asset-liability matching. Again, if there is significant deterioration in the real sector, there may be an adverse impact on the financial sector as well in terms of credit offtake and delinquency rates.

Sectors like real estate are expected to face greater liquidity pressures due to a slowing in demand which is itself the result of rising property prices combined with the erosion of purchasing power in the hands of potential buyers due to both inflation and rising interest costs. The projects under construction are also likely to suffer due to lack of funding options.

As a result, some downgrades are likely to happen in case of entities with relatively weaker protective factors. However, on a longer-term perspective, the economic potential and corporate fundamentals look good "" this may be a critical but transitory phase.