Analysts worry GDP downgrade as bankers remain upbeat

In this edition of CNBC-TV18's Indianomics, Saurabh Mukherjea, CEO- institutional equities, Ambit Capital, Ananda Bhoumik, head- financial institutions rating, India Ratings and SS Mundra, CMD, Bank of Baroda (BOB) discuss the impact of the forecasts by brokerages which have cut the country's gross domestic product (GDP) .

While analysts Mukherjea and Bhoumik express concern about the impact of the gloomy forecast on the economy, especially on the banking sector, BoB's Mundra is hopeful that the economy will bounce back and record strong growth. Below is the verbatim transcript of their discussion on the channel Q: Return on capital employed (ROCE) in FY12 has gone below the cost of capital, what kind of stress does this mean for corporate India? Mukherjea: I agree with you that ROCE will be cyclical along with GDP, but also from the GDP part and the economic growth part, we are towards the fag end of the economic down cycle, so paradoxically the economy as a whole is not that bad in shape as the banking sector.
Banking sector finds itself in a peculiarly unprivileged position of having loaded up on assets from 4 or 5 specific sectors that have gone into trouble. At worse we have two more quarters of weak economic growth before the curve starts going upwards.
If monetary policy loosens from Q3 onwards, we will only have one more quarter of an economic down cycle and as the economic cycle improves ROCE should pick up, not dramatically, but it will pick up.
The challenge on the banking sector is all the more specific because they are focused on a subset of the Indian economy that finds itself in all sorts of trouble and these problems are only getting worse by the passing year. Hence the market's belated recognition of the challenges of the banking sector have come, unfortunately a bit too late for we have been underweight on banks for a long time, but gradually that recognition is coming through. Q: Interest cover for Indian companies that is earnings before interest tax depreciation and ammortisation (EBITDA) divided by interest has fallen to as low as three for the average of corporate India. For 45 percent of the companies interest is much higher than the EBITDA. Do you think this will mean dire consequences for corporate India? Bhowmick: You are right. Together with the impact of the GDP slowdown there is impact on tightening liquidity, increasing cost of money and currency fluctuations. So, there would be P&L impacts.
In September 2012 we were expecting that the upturn would start in terms of profit margin erosion. That hasn’t happen and profit margin erosions continue to happen. In this quarter and next because of movements of currency side they could actually accelerate and so, the pain would continue.
There are about 1.5 percent of total loans to corporates that have interest coverage of under 1 time. These are corporates not in position to pay interest cost and are virtually non-performing loans. It now jumps from 1 percent of loans to 5 percent of loans. So there is a wave of corporates who are sitting out there and are vulnerable to events such as depreciation or margin erosion because of liquidity that could slip into the stressed category or into the NPLs.
The way we see it from March 2013, I don't think that wave of stressed asset accretion is going to get over anytime soon. We are now going to see the wave of accretion certainly in restructured assets in this fiscal. Maybe this could reverse from next fiscal if things go right. But there is a wave sitting out there that could impact us.
_PAGEBREAK_ Q: You see corporates from close quarters, do you think economic recovery may come by the second half of this fiscal or do you think the slowdown could go well into FY15? Mundhra: I wouldn’t take such a pessimistic view. I am not denying the fact that there is stress, there are quite a few issues or problems that we have encountered in recent past and we are looking at it. But there is other side of the story as well. In the last five years the biggest driver of growth has been infrastructure. When there is infrastructural growth, there is growth in many other real sectors.
I would like to break the industry into four different components. One would be alluding to the demands persisting in the domestic economy. The other is the export oriented sectors, the third category is where there is both import and value added exports.
The fourth category is where there is only import but no export. I don’t think we are anywhere near a situation where we can say that demand is stagnant or there is no scope for introducing more supplies. Demand is no where stagnating and there are many sectors where supply can be increased. Supply will come when there is a pickup in manufacturing activities. Q: We all thought that the previous quarter would actually be the peak for NPLs, but the Q1 results are showing even more stress. How long will this cycle last? Mundra: The second quarter of the current fiscal, at least talking of my own book we would be witnessing stress and thereafter a position of improvement may come. Of course it is an evolving situation.
In view of the recent development, if the liquidity condition persists as it is today and ultimately translates into a little escalation in interest rates then the time period that we are talking about may get extended by a quarter or two and that would be a realistic assessment. Q: Will we see bad loans rising in the next three 3-4 quarters? Mundra: Due to pickup in economic activities in the second half and number of measures that have been put into action, they will start throwing the beneficial impact. So as we enter into the last quarter of this year, we will see some sign of recovery or improvement. Q: What is your sense about the economic slowdown? Bhoumik: Banks will face two issues. One is the credit issue. We have numbers of NPLs going up from 3.5 percent in March 13 to 4.2 percent in March 14, restructured from 6 percent in March 13 to 8 percent in March 14 and higher in March 15. So that progression would continue with corresponding impact on the credit cost. Q: Do you also think 40 percent of restructured asset could become NPLs? Bhoumik: Our view is slightly granular. About half of the book restructured currently at the incremental level is infrastructure where the conversion or the mortality would be low on the underlying premise that these are viable projects.
Mortality on the rest could be high, maybe as high as 40 percent. If you blend it together with infrastructure it could end up with historical numbers paradoxically. The other premise is on the funding structure side and clearly the system is not geared out to handle the sort of liquidity pressures that the regulators were forced to impose. I do not think these shocks will go away. I think they are the new reality.
A stable currency is a bit of wish and therefore, the regulators maybe forced for global or local reasons to step in periodically. I do not think the balance sheets are geared up. There is just over-reliance at the short end and unfortunately we have run out of time to correct that and so banks have to live in with a period for the next couple of years of volatile names. Q: India Ratings is expecting that this year bad loans will rise from 3.4 percent to 4.2 percent of total book. Some brokerages say it will rise further in FY15 to 5 percent and if we add the restructured assets, total stressed assets could rise to 11-12 percent by FY15. Mundra: Ultimately when we talk in terms of percentage it would relate to the growth in credit and addition. The way things are, there would certainly be addition in total stock and if there is an addition in total stock, recovery and upgradation will have its own pace. So in that sense, there maybe some uptick as far as this year is concerned, but as we enter into the next year there would be an improvement, that is as far as the non-performing loans (NPLs) are concerned, but I would not like to bracket the NPL and restructuring into the same corridor.
_PAGEBREAK_ Q: Restructured assets plus NPLs are already higher than net worth for many state-owned banks, but as Mundra points out you cannot count all restructured assets as bad loans, What is your assessment? Mukherjea: The easiest way to conceptualise this is if you look at banks today their non-performing assets (NPAs) are creeping up to 5 percent of system assets and the restructured assets are also slightly north of 5 percent of system assets. So NPAs plus restructured are close to 10 percent of banks' loans which is pretty much the entirety of shareholders' equity. But how much of this will be a write-off? Some simple ratios can come into help here.
NPA-to-write-off conversion ratio of something like 50 percent will not be unreasonable given both the extent of the economic downturn and the current challenges facing the economy.
With regards to restructuring, whilst the banks keep saying 20 percent of restructured will go sour, the number is closer to 40 percent rather than 20 percent.
If you combine half of NPAs and 40 percent of restructured, you are getting 50-60 percent of shareholders' equity of 5-6 percent of system loans potentially getting written off banks' balance sheets over the course of a couple of years. That places significant demands on shareholders in terms of recapitalising the banking system.
The government of India as the biggest shareholder will have to step up with recapitalisation sometime next fiscal, but I don’t think the top private sector banks will be entirely immune from this journey. Over the last 2-3 years, they have been seen as somewhat in a different class of their own.
I am sure some of that is merited, but the valuations there have been overdone and as the realisation sinks in that the banking system as a whole including the top private sector banks are exposed to this sort of loan write-offs the de-rating for banks will continue. Q: Current bankers say that 15-20 percent of restructured loans have become NPLs. Saurabh thinks it can get as bad as 40 percent for some sectors. What is your take, how much worse can it get? Mundhra: Historically, the ratio has been 12-13 percent. We now say it is 15-20 percent. Why restructuring has been converting into NPLs are issues such as delay in commissioning and case flow issue. As things improve, I would still believe that 15-20 percent is normally the range that should happen. Q: When do you think the NPL cycle will peak out and at what level? What is the peak level of NPLs? Bhowmick: It is difficult to time some of these things but clearly the peak might not happen in FY14 because the economy is drifting so the peak might happen in FY15. One important point is that the accretion of NPLs from the corporate sector should start slowing down. We should be able to identify weak customers and these are either restructured or should be in the pipeline this year.
The increment should start coming down from next year. If we are seeing a pickup of 2 percent in restructured books from 6 percent to 8 percent this year, in FY15 it will be one more percentage point. NPL accretion can go up from 4.2 or 4.3 to 4.5.
The caveat here is the small and medium enterprises (SME) and the agriculture. So far we have focused on corporates because they are very impactful. But SME may keep contributing to march. So while restructuring accretions may slow down, FY15 peak NPLs could be closer to 5 percent.