Business - India;There's no free lunch

Shobhana Subramanian

Last month the rights issues of Tata Motors and Hindalco were bailed out by promoters and underwriters because smaller shareholders didn’t think it worthwhile to subscribe. That’s despite the shares having been priced at levels which would have been unthinkable even seven to eight months back. It’s unfortunate that they were driven to sell their stock at these valuations but they probably have no alternative at a time when credit is both scarce and costly. Others too will probably have to do the same because it’s now clear that there’s not enough money to go around. Even if you can persuade a banker to loan you some, it won’t come cheap. What’s more, capital inflows from overseas markets are drying up in the wake of a huge shortage of global capital. According to strategists at Nomura, the de-leveraging attempts of governments, which are recapitalising bank balance sheets, are being met with staggering and unprecedented losses of banks. The total fresh capital infused has been of the order of $657 billion while the losses are estimated to be in the region of $680 billion (source: Bloomberg). Therefore, the system is actually re-leveraging. Nomura concludes that a multiple of the current allotted infusion of around $253 billion—possibly about $1 trillion, maybe $2 trillion—is needed to prevent a ‘deflationary mess’.

In the past, emerging markets have been dependent on foreign capital for growth—it has typically funded nearly half the money needed for growth in any year. Corporate Asia has been particularly reliant on US and European capital. With an estimated $800 billion flowing into emerging markets last year in various ways, including syndicated loans, bond issuances and IPO money, India too got its fair share. In the two years between FY07 and FY08, Indian companies raised around $55 billion through ECBs and Foreign Currency Convertible Bonds (FCCBs).

While in many ways the strong inflows helped companies push through their expansion plans, it now appears that the borrowing may have been overdone. Lured by the easy money that came their way over the past three years, when the global markets were awash in liquidity, Indian companies went on a borrowing binge. Some of it was used wisely to fund capacity expansions but much of it was used to finance costly acquisitions overseas—some firms have done three or four acquisitions because money was so easily accessible. At the time it seemed the right thing to do. But suddenly, with capital in short supply the world over and the Indian currency reeling, that same easy money is turning out to be an expensive liability. Balance sheets are looking more vulnerable because FCCBs are resulting in losses every quarter, with the rupee now having depreciated nearly 25 per cent since the start of the financial year. The losses may be notional today but that’s only if things don’t take a turn for the better in the next two to three years. In other words, if share prices don’t go up to levels at which the bonds are to be converted, companies will be forced to pay back the amounts borrowed. Many will need to replace these amounts with fresh borrowings and could become over-leveraged in the process.

It’s the smaller companies that have borrowed sums of $40 million and $50 million that could really be in big trouble—if the rupee doesn’t appreciate, many run the risk of their net worth getting eroded. The current market prices of more than 60 per cent of those who have issued FCCBs are way below the conversion prices — prices have to move by 400 to 500 per cent or even more to hit the conversion levels. Companies could, of course, persuade bond holders to convert at lower prices. But that depends on how well these companies perform because without growth, which investor would want to hold equity? It’s hard to say how these companies will perform in a downturn, but smaller firms will be hit harder. Already Morgan Stanley is concerned that companies will be hit by slowing revenues, high interest rates on domestic borrowings and the inability to roll over foreign exchange loans and losses on imprudent hedging. It is particularly concerned about smaller companies and says there’s a possibility banks could see rising defaults from small and medium enterprises.

That could well be true. A Motilal Oswal study shows that in the September 2008 quarter, mid-cap companies (a sample of 80 companies with a market capitalisation of less than Rs 100 billion) have reported a 4 per cent drop in earnings. The contribution to profits by large-cap companies has risen by 340 basis points over the last 12 months, and this is expected to go up further. Obviously, with the larger corporations in a bit of a spot, ancillaries and vendors are feeling the pinch; others too are finding the going tough. Over the past five years financial leverage helped earnings; it will now work the other way. In the process the returns from equity too could diminish