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On The Edge

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The most vital statistics often hide more than they reveal. As more firms find it increasingly difficult to service their bank loan obligations, the latest number on the amount of bank loans (as of end June 2012) under corporate debt restructuring (CDR) is over Rs 2 lakh crore, a figure rating agency Crisil had estimated in April. The number of proposals received by the CDR Cell housed in the Industrial Development Bank of India, the nodal agency tasked with managing the process for the banking system, was 392. Compared to the figure a year ago, that was an increase of over 150 per cent.

Scary as that is, there are many who believe those numbers do not tell the whole story. In 2011-12, there were 87 CDR requests, amounting to almost Rs 68,000 crore. In FY11, there were 51 cases, amounting to Rs 22,614 crore. In FY10, there were 31, accounting for Rs 20,175 crore in loans to be restructured under CDR.

As expected, in its June 2012 Financial Stability Report (FSR), the Reserve Bank of India (RBI) indicated that it was quite worried. Its relaxations in revenue recognition norms and impaired assets announced in 2008 helped tide over the impact of the global credit crisis, but that also resulted in a significant increase in restructured assets in FY09 and FY10, the pace of which decelerated in FY11. But in FY12, the growth in restructured assets outpaced the growth in bank credit and that of gross non-performing assets (NPAs, or loans gone bad).

"The texture of CDR cases has changed," says Yashraj Erande, principal at The Boston Consulting Group. "Before this particular round of restructuring, most companies entering CDR were not household names, but typically the bigger SMEs (small and medium enterprises). Now, there are the more famous ones." Think Kingfisher Airlines, JSW Steel, Essar Oil and Essar Steel, to name just four.

It's been known that wide swathes of corporate India have financially stressed balance sheets, and the roster of companies seeking refuge in CDR is growing fast. As the RBI's June FSR noted, the pace of companies going in for CDR is accelerating. Ask State Bank of India, ICICI Bank and Punjab National Bank. But just how much bigger and broader will it become? The other big worry is that distress seems to be seeping into their lenders' balance sheets, whose suddenly worsening asset quality is causing sleepless nights as well. Which begs an even bigger question: are we close to the cusp of our own financial crisis?

What Went Wrong
The story of how companies got themselves into debt distress has many strands. Take the iron and steel firms. Data from the CDR Cells show 31 entities, with a total debt of Rs 39,252 crore, account for over 26 per cent of the total restructuring cases at the end of March 2012. "Iron and steel is a cyclical business," says A.S.V. Krishnan, senior analyst at Ambit Capital in Mumbai. "During boom times, they go ballistic on expansion. Capacity addition leapfrogs suddenly." Which means they take a lot of debt.

When the economy slows, raw material and inventory move more slowly, and revenues do not grow fast enough to cover debt service payments. Look back to a decade ago, and the same pattern becomes evident. Even then, iron and steel firms were a big part of the CDR mechanism. Or consider the organised retail firms. Based on the consumption story and forecasts, they expanded rapidly. But revenues did not keep pace. Soon, Vishal Retail and Subhiksha, to name two, found themselves buried under a mountain of debt. Due to high real estate costs, excessive inventory and falling revenues, their balance sheets were awash in red, taking them down the road to a painful CDR.

Others have made it through without CDR – so far. Kishore Biyani's Pantaloon Retail was the fairytale story of the retail industry. But its humungous debt (more than Rs 6,000 crore) had made matters hard for India's best-known retail firm. But Pantaloon did not go in for a CDR; it sold the apparels business to the Aditya Birla Group (which has its own retail arm More), along with the debt.

Kingfisher Airlines (KFA) is among the most storied companies that fell victim to decelerating economic growth in the aftermath of the crisis, as did Air India. The company has already undergone one round of CDR. KFA's acquisition of Air Deccan, the budget carrier, was supposed to be a coup. "But you cannot run a full-service airline and a budget airline along the same lines," says an analyst with a leading brokerage firm. Apart from the debt, costs went up in running maintenance for two different types of aircraft fleets, and trying to provide the same level of service.
"Airlines have been a loss making business the world over for more than a decade," says the analyst. "That should have told KFA's management something." But apparently, it did not. While other airlines have not been in the same kind of trouble, or in CDR, their balance sheets are stressed too.

The Power Puzzle
By end-June 2012, another 27 cases with an aggregate debt of Rs 19,000 crore were referred to the CDR Cell. According to Macquarie Research, part of Australia's Macquarie Bank, that's a 30 per cent jump over the same period last year. That suggests the pace is not going to moderate any time soon. More recent names include companies such as Hindustan Construction Company and Hotel Leelaventure. In the investment banking community, the names of Parenteral Drugs and Jai Balaji Industries (a steel company) are also being bandied about. Another addition is the Tayal Group, whose main business is in textiles and real estate, and who is a major shareholder in the Bank of Rajasthan, an old private sector bank.

In fact, textile companies account for the largest number of all CDR cases — 59 of them amounting to nearly Rs 11,700 crore, or 8 per cent of the total. Lagging environmental clearances are a big worry in this industry. The plants need constant technology upgrades to meet emission standards, and thus they take on a lot of debt. In bad times, the ghost of a CDR comes back to haunt them.

But if there is one industry that sends shivers up lenders' spines, it's the power sector. Almost all of them face fuel supply linkage problems, and the inability of state-owned electricity distribution companies to hike tariffs. "It may not be a matter of if power companies will opt for a CDR, but when," says Ambit Capital's Krishnan. Bank exposures to the power sector — including the distribution companies — are almost equal to the net worth of the entire banking system, say some analysts.

On 11 July, reports said the power ministry was considering putting more state electricity boards (SEBs) and distribution firms through the CDR process; five states — Haryana, Madhya Pradesh, Punjab, Rajasthan and Tamil Nadu — had Rs 30,000 crore of their debt restructured in 2011. The total amount of the SEB debt that may be proposed for restructuring: Rs 2 lakh crore. For banks, that is a huge problem.

LENDERS: Banks that have taken a hit include giants such as as SBI, ICICI and the likes of IDBI, Bank of Baroda, Bank of India, Canara Bank and PNB. At the end of FY11, restructured loans on banks' balance sheets amounted to 5.5 per cent of total loan assets

Power companies apart, what do the prospects of more companies going in for CDR look like in the coming months? "Crisil believes that nearly 30 per cent of the restructuring is expected to be in the power sector," says Suman Choudhary, director, financial sector ratings, at Crisil. "The share of the power sector in the total restructured loans may increase further if the government approves specific packages for state power utilities."

Given the ‘policy paralysis' and the political equations between the UPA government and its allies, any tariff hike seems impossible, for instance, and discoms will not meet payment obligations to generating companies. And on the other hand, the gas-based projects launched after the promise of gas discoveries, which have since been belied, may have nowhere to go but for CDR, or become non-performing loans, say analysts. Think Lanco Infrastructure, for one.

The Missing Links
A curious omission in the CDR numbers is the real estate sector. "That's because real estate is not a sector, but an asset class," says Anil Khakhani, executive director, cross-border initiatives and investment banking at Anand Rathi Financial Services. That does not, however, account for the absence of real estate companies. According to Krishnan, housing companies such as Dewan Housing Finance and HDIL are being viewed as potential candidates for a CDR by many. The former competes with banks and margins can be extremely thin, says one analyst. As stress levels increase, they may succumb to the pressure of slower home sales and high interest costs.

Rs 2 lakh crore or more is the amount of bank loans under CDR programme

Here's what the CDR programme numbers also do not include currently: the state electricity discoms (about Rs 30,000 crore for five states is already being restructured) have about Rs 2 lakh crore that the power ministry intends to take into the CDR programme, and Air India, which has Rs 43,777 crore of total debt.

Analysts estimate that the current CDR Cell's statistics account for only about 40 per cent of total assets under restructuring. Another 50 per cent is in bilateral CDR, between individual banks and their borrowers. Housing loans and other retail borrowing account for the balance 10 per cent. Add it all up, and the potential debt that needs to be restructured comes to a whopping Rs 7 lakh crore.

That's nearly 15 per cent of the total loan assets of the banking system (of roughly Rs 47 lakh crore at the end of June 2012, according to RBI data). Already, at the end of FY11, restructured loans on banks' balance sheets amount to 5.5 per cent of total loan assets, notes a February 2012 report by rating agency ICRA.

Macquarie Research, in a June 2012 report, said that stressed assets would reach a decadal high in FY13, adding that most credit rating agencies estimate that stressed assets could be as high as 6-7 per cent of total assets by the end of this financial year. The report also says that default rates from restructured assets could also increase. That means they could well become NPAs. Banks account for 20 per cent default rate, but Macquarie Research puts the potential number at 30-40 per cent.

Credit quality pressures have intensified for India's corporates, says Crisil's Choudhary. "The annual default rate for Crisil-rated entities has hit a 10-year high of 3.4 per cent in 2011-12," he says. "Crisil's rating action ratio (RAR; an indicator of the relative frequency of upgrades and downgrades) declined to 1:01 in 2011-12 from 1:10 in the previous year."

Simply put, until recently, rating upgrades were greater than downgrades. Choudhary expects rating action ratio to decline further to less than 1 (more downgrades than upgrades) over the near term. "The important reasons are pressure on profitability, slowing economy, continued high interest rates, delays in project execution, and exchange rate volatility," he says.

Capital Punishment
Where does that leave the banks? For many firms, acting before debt distress takes them into near bankruptcy and getting into CDR is a way of staving off non-bank creditors, getting some respite from high interest costs and buying time. If a CDR proposal is approved, interest rates payable on existing debt drops to the bank's base rate (about 10 per cent). There is also a moratorium on principal repayments, which can go up to three years.

Take KFA; Rs 750 crore of its loans were converted into 7.5 per cent convertible preference shares. Another Rs 553 crore was converted into 8 per cent preference shares redeemable after 12 years. Repayment on the rest was rescheduled, with no principal payments due for two years, but stepped up repayments over the next seven years. Its interest rate was cut by 3 percentage points, and additional loans of Rs 770 crore (funded) and Rs 445 crore (non fund-based) were granted; its nearly Rs 300 crore working capital loan was converted into a term loan. Despite this, the company is in trouble again. Now banks are being less accommodative and trying to sell off company assets.

"But a lot of promoters resist going in for CDR," says Praveen Chakravarty, CEO, investment banking and institutional equities at Anand Rathi Financial Services. "Indian firms are associated with the promoter family, and having to go in for debt restructuring taints the family name. They don't go into it willingly." Bankers, however, believe otherwise. At various meetings of the Empowered Group of the CDR Cell, bank chiefs have expressed their concern about the CDR process being used by firms to cut interest costs. They have insisted on promoters bringing in a significant amount of their own equity as additional funding.

There are two kinds of approaches to corporate debt restructuring. The first is a centralised one, in which the government plays a key role. Examples of this include Sweden and Hungary. The second, decentralised approach (the US is where it was most used), being voluntary, became the preferred method. The so-called London Approach was probably the first attempt at informal workouts between banks and borrowers in the 1970s. In the 1990s, it became fairly successful. After the Asian crisis in 1998, Thailand and Korea chose to use this approach. Then the UK, based on its experience in the early 1990s, formed a model where creditors and firms worked in close coordination with the Bank of England. In 2000, INSOL International, an association for restructuring, insolvency, etc., published a set of ‘principles for a global approach to multi-creditor workouts', which summarised eight principles based on global best practices.

Several company owners have said they would like to do so, but an equal or larger number may not. Many of them have already pledged significant amounts of their stakes with non-banking finance companies, getting only a third of market value (the rest is collateral). And bad markets impose higher margin requirements, if they don't want to lose their company.

Other Routes
If not CDR, is there another way out? Analysts say that a lot of restructuring occurs outside a formal CDR; some intrepid investors provide capital that could be used by promoters who buy out their loan — or a part of it — from banks seeking an exit. Case in point: again, KFA.

In end-June and early July, Srei Venture Capital, a firm that manages a debt fund with a corpus of about Rs 1,400 crore, gave KFA a loan of about Rs 430 crore. "It is fully securitised, even overcollateralised," says Hemant Kanoria, chairman and CEO of Srei International Finance. Perhaps coincidentally, around the same time, ICICI Bank said it had no exposure to KFA. Credit market analysts suggest KFA owed ICICI Bank almost the same sum of money, and say the loan was bought by Srei Venture Capital.

Several other mid-sized companies —  such as GATI, the logistics company — have preferred to do their debt restructuring outside the banking system. In many cases, the buyers of this restructured debt are debt funds like Srei Venture Capital. "Yes, interest rates will probably be higher, and the collateral will usually be the promoter's shares in his company, but many family-run businesses prefer that anonymity," says another investment banker. "Their future ratings do not get affected this way." But as noted earlier, so many firms' promoters have already pledged their shares to a considerable degree. Will getting additional capital be possible if the economy gets worse?

John Paul Getty, the US oil millionaire, once famously said that if you owe a bank $100, it's your problem. If you owe the bank $100 million, that becomes the bank's problem. For Indian banks, that looks like almost becoming a truism. "The CDR system is biased towards lenders," says Nirmal Gangwal, managing director of Brescon Corporate Advisors, a consultancy that specialises in debt restructuring. "The CDR Forum and the CDR Empowered Group are bankers. The technical evaluation consultants (the firms that develop the CDR packages) are the likes of SBI Capital Markets, IDBI Capital Markets, etc."

Gangwal says a business that is viable and sustainable after restructuring may require a bigger haircut than banks are willing to allow. That leads to the almost obvious question: when do banks and companies talk about liquidation or the equivalent of a US-style Chapter 11 process? For banks, the incentive to go in for CDR is strong, and avoids treating unviable and unsustainable businesses as NPAs. So, often unreasonable assumptions are built into the packages. Cases in point: KFA and Kouton Retail. In 2011, KFA had the first round of restructuring. Barely a year later, it has needed a second round. Similarly, Kouton's debt was restructured in 2010. But it's been unable to maintain viability, and is on the verge of becoming an NPA.

The CDR system is a three-tiered one in India. The first is the CDR Standing Forum, which includes lender and borrower representatives. It lays down policies for the process. A core group of the standing forum takes policy decisions. The second tier is the Empowered Group, made of top bank executives, which decides on individual cases and ensures policy execution. The third is the CDR Cell. It helps the other two tiers prepare detailed rehabilitation proposals. The first step in the process consists of considering the proposal, brought to the CDR Cell by the leader in the lending consortium or the company. The process takes about 30 days, and all lenders agree to the terms. Next, the CDR Cell scrutinises the proposal, which also can take 30 days. Then there is a review presented to the Empowered Group (90-180 days). The review considers financial parameters such as return on capital and debt service coverage. Once okayed, the case goes into restructuring mode.

Does the CDR system have the capacity to manage this scale of cases, and without independent inputs? Not likely, say most folks. "In a consortium, two or three banks monitor activity, but have little audit capability to ensure that firms comply with CDR conditions," says BCG's Erande. "That's a separate capacity."

It's also time consuming. In a classic pattern, the promoter may be in denial about the cash flow mismatches, and cuts costs and scrounges to meet debt payments from operating cash flow for two or three quarters. When he goes to the bank, he is persuaded to do more, gets a little additional finance that keeps things going for another 2-3 quarters. Finally, he goes in for a CDR where the approval process takes another 2-3 quarters. All in all, he has lost two years.

The Spanish Way
The incentive for banks to be optimistic is understandable. Apply default rates to the total amount of corporate debt included in the CDR referrals, and gross NPAs of the banking system (currently 2.9 per cent) may go up by about Rs 70,000 crore. That would take the gross NPA ratio to total assets of the banking system to almost 8 per cent. Provisioning requirements and the impact on bank balance sheets could well blow a big hole in them.

Not everybody agrees, however. "Our banking system's NPA ratios are much better than those in several developed economies," says Deepak Singhal, chief general manager at the RBI's department of banking operations and development. But he admits the new Basel III requirements could put a lot of stress on banks' capital needs. "It could come from the government, capital markets and internal accruals, or a combination of all three."

Rs 68,000 crore is what the 87 CDR requests received in 2011-12 amount to
Rs 2 lakh crore debt the power ministry plans to take into CDR programme

R.K. Bakshi, executive director at Bank of Baroda, one of the standing members of the CDR Forum, says CDR is a better option for all lenders when they agree on a common package. "Our bank added about Rs 1,800 crore to the amount under CDR in FY12," he says. "The total amount under CDR is Rs 4,000 crore, or just 2 per cent of our domestic loan portfolio."

Most banks believe they have the capital adequacy to be able to handle even the escalated level of assets under CDR. "But they seem to forget that CDR is like evergreening their loan portfolios," says an analyst from an international firm. "What about some sort of recognition of the risk of default, in additional provisioning over just the 2 per cent they are required to maintain?"

But the NPA problem is far more serious than it appears. At a potential 8-10 per cent (Morgan Stanley and other investment banks put that as a likely figure), additional capital will be needed. For a fiscally stretched government, finding the money to capitalise these banks — in the fourth quarter of FY12, many of them reported lower  capital adequacy ratios, though overall they are still high — both for growth and for meeting Basel III norms may be very hard. "The government, together with Life Insurance Corporation of India, infused capital of around Rs 43,000 crore in the PSBs between FY09 and FY12, with the bulk of this infusion consisting of equity capital," says Choudhary. "The government has announced fresh infusion of equity of around Rs 16,000 crore in banks for FY13 to support their growth plans." Yes, but is that enough?

Choudhary is not alone in that view. Most people believe that the government, fiscally stretched or not, will step in with capital, though no one wants to hazard a guess as to how. By an odd coincidence, Indian banks are using dynamic provisioning like the Spanish banking system, which was considered among the best at the time it was introduced. And look at the massive crisis that Spanish banks find themselves in today. Could we be headed that way, too?

srikanth (dot)srinivas(at)abp (dot)in

(This story was published in Businessworld Issue Dated 23-07-2012)