Moneycontrol Pro Panorama | Leverage is a party only few can enjoy

The leverage should not be fat in a way that it is difficult to move.

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Leverage can be traced back to this seminal quote from the Greek philosopher Archimedes, “Give me a lever long enough and a place to stand, and I shall move the earth.” Any investor worth his salt will be willing to hold a placard saying, “Give me enough leverage and I shall move capital across borders.”

In simple terms, leverage is using borrowed funds, or debt, to gain outsized returns from your investments. If your returns pay you more than you expected, chances are that you will repeat the process and set off a trend that will be adopted by others. Corporations use leverage, a synonym for debt, to set up factories, open new shops and grow their revenue. Households borrow to consume or meet emergencies. Investment funds borrow simply to move capital from a place of excess to a place of deficit and earn hefty returns in this process.
But here is a catch that Archimedes knew about leverage, and we sometimes ignore. The lever (or leverage) should not be fat in a way that it is difficult to move. Too much of leverage can kill the balance sheet it is resting on. Howard Marks, investment guru and co-founder of Oaktree Capital Management, wrote in his latest memo, reproduced by FT here and free to read for Moneycontrol Pro subscribers, that investors must exercise caution in using debt. “The most important adage regarding leverage reminds us to “never forget the six-foot-tall person who drowned crossing the stream that was five feet deep on average,” Marks wrote.

The heavier the burden you carry, the higher are the odds to sink. This was on display during the 2008 global financial crisis and India’s debilitating bad loan cycle of 2016-19. Is something similar happening right now?

While governments may not sink, they will certainly hurt their economic growth if they are leveraged to the hilt. The world’s largest economy comes in this category. Market experts are already warning that the US government’s debt could keep the Federal Reserve from cutting policy rates quickly. An unprecedented amount of fiscal stimulus has been pumped into markets in the past decade and economists fear this is partly behind the US economy’s resilience in the wake of historically high interest rates. That does not mean the Fed is not hurting the economy, in fact it is killing parts of it. Bankruptcy filings have surged, and a mini banking crisis was displayed last year from the collapse of Silicon Valley Bank.

Many thousands of miles away in India, the story is dramatically different. Leverage on corporate balance sheets is near historic lows, bad firms have been weeded out. Indian firms are primed to borrow now, and banks are more than willing to accommodate them. Credit growth around 16 percent is far higher than nominal gross domestic product (GDP) growth, a sign that India’s economy would sustain the current growth levels. The country’s largest lender, State Bank of India (SBI) reported one of the best sets of profitability metrics for the fourth quarter. Chief Dinesh Khara wants to push corporate lending and is confident that the bank would continue to boost its profitability in FY25, too. Read our piece to make sense of the numbers. SBI is, however, going slow on unsecured retail loans because of the hike in risk weights by the regulator last year.

This brings us to the worry of the Reserve Bank of India in credit risk pricing and leverage. It increased risk weights on unsecured lending because of concerns over pricing by lenders. In all probability, some lenders were pushing unsecured loans onto already leveraged individuals who may not be able to pay back later on. Indeed, leverage on Indian household balance sheets has increased dramatically over the past decade. This is helping private consumption, but may not be good beyond a certain point. Our Chart of the Day explains how private consumption is becoming two-speed as affluent households borrow to fulfil their desires upfront.

Yet another leverage nightmare is infrastructure project financing, the spark that lit the fire of bad loans in the previous cycle for India. The RBI wants banks to make additional provisions for projects under construction, a fair ask given its experience, and most banks have indicated these provisions can be absorbed. That said, lenders want to haggle for a more diluted provisioning requirement as this may increase the cost of borrowing for projects. Our columnist Ananya Roy explains why too much of a bitter medicine may harm banks here.

While we see how it shapes up, India’s equity investors are already punishing banks for having a pile of project loans. Shares of public sector lenders have fallen about 6 percent since the rules were proposed on May 3 with some lenders losing as much as 8-10 percent of their valuation. Infrastructure-focused lenders have met with an even nastier reaction. As such, India’s equity market is walking on eggshells worrying about whether the US Federal Reserve would serve rate cuts this year or not.

Why should an economy, which is poised to deliver sustained high growth, has healthy balance sheets of both private and government, and a strong banking system, worry about policy rates of a nation thousands of miles away?

The answer is: leverage. As we started this conversation with leverage makes capital go around, Indian markets have boosted their valuations with foreign institutional capital and when investors begin to see their home markets giving higher returns, they would take their dollars back.

Leverage can be enjoyed by only a few and also for only a select period.

Investing insights from our research team

SBI – solid FY24, offers favourable risk-reward

Tata Power: Powering ahead both in traditional, RE businesses

Weekly Tactical Pick –This private bank major offers big value

Asian Paints Q4 FY24: Dull show despite strong volume growth

Intellect Design Arena: Soft quarterly numbers, but outlook is bright

Vijaya Diagnostic Centre: Sustaining strong margin profile

SRF: Volume-led revival to accelerate in H2 FY25

Escorts Q4 FY24: Softer input prices came to the rescue

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Are modern media incentives distorting our sense of the economy?
(republished from the FT)

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Aparna Iyer
Moneycontrol Pro