How to resolve Indian corporate vulnerability to COVID-19 through policy options

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The immediate response of Indian policymakers should be to ensure the survival of the broader corporate sector and facilitate its early revival from the adverse shock

The ongoing COVID-19 pandemic, which is expected to affect millions around the world, comes as a rude shock to the Indian economy that had considerably slowed down in the past few years. Even without COVID-19, in January 2020, the IMF had slashed India’s GDP growth forecast for both FY 2019-20 and 2020-21 by nearly one per cent compared to its estimate in October 2019, reflective of India’s stiff growth challenges.

The anaemic economic growth of India prior to the COVID-19 outbreak reflects the inherent vulnerabilities in the Indian banking and corporate sectors. The slowdown in the corporate sector was partly contributed by challenges in GST implementation, disruption induced by demonetisation, the ongoing NPA crisis in the banking sector, and the funding crunch faced by NBFCs. The troubles in the financial sector had already resulted in a deceleration in credit growth to the industrial sector.

Now, owing to the uncertainties and disruptions induced by COVID-19, the medium-term GDP growth is likely to be sharply lower. The shock to aggregate demand due to COVID-19 could deal a blow to an already fragile Indian corporate sector, weakening its profitability and cash flows. Such a scenario would make it even more difficult for firms to service their debt and may lead to large-scale debt defaults, adversely impacting jobs and livelihoods. In this fast-evolving situation, we assess the preparedness of the non-financial Indian corporate sector in terms of their liquidity needs and solvency, and discuss possible policy responses.

Liquidity needs

Are the Indian firms sufficiently liquid to avert a serious contraction of output and employment in the short-run? An analysis of FY 2019 data on non-financial Indian firms from CMIE Prowess shows that about one out of four firms do not have sufficient earnings before interest and taxes (EBIT) to meet their interest obligations. Alarmingly, about 60 per cent of these firms reported operating losses in the 2019 financial year.

Given the unfolding COVID-19-induced likely business contraction amid a nation-wide lockdown, a 20 per cent decline in EBIT appears very likely in the 2020-21 financial year. Such a contraction would lead to a drastic decline in the interest coverage (pushing it below one where the earnings fall below interest expenses) for three out of every ten firms. In the event of a more protracted downturn lasting two or more quarters that results in a significantly greater earnings deterioration of 50 per cent, the interest coverage ratio would fall below one for two out of five firms. Firms in aviation, construction, telecom, infrastructure, and power appear to be particularly vulnerable.

When we broaden the definition of liquidity to include current liabilities, commitments toward short-term debt repayments and lease charges, due within a year, the liquidity situation appears much worse. Out of 23 industries that together account for about two-thirds of overall corporate sector assets, only in four sectors 50 per cent of the firms will have sufficient liquidity to meet one quarter of liquidity needs in such a scenario. Overall, only three out of 10 firms have enough liquid resources to meet their current liabilities over a quarter. With the likely contraction of cash flows on account of Covid-19 in the medium-term, a large fraction of Indian firms would not have adequate financial resources to fulfil their immediate obligations.

Solvency issues

Over the recent years, the balance sheet of Indian firms in many sectors came under severe stress on account of a combination of demand slowdown and high debt obligations. As most financial market analysts seem to agree today, if the adverse impact of the pandemic were to last for more than a quarter, the liquidity problem would morph into a serious solvency concern for a large number of firms. With the median debt-to-EBITDA ratio above 2.5 (a widely used metric of solvency) in seven out of the 23 sectors, many sectors do not have adequate solvency to access financial markets. At their current level of debt, only three out of five firms have debt-to-EBITDA ratio of 2.5 or below.

In a scenario with a one-fifth contraction in EBITDA, one out of every two firms would be in financial distress, when judged by the widely accepted solvency metric. Aviation, construction, automobile, and power sectors may face serious solvency issues. Further, given the significant foreign currency borrowings of a sizeable fraction of Indian firms, any sharp deterioration in the rupee can compound the concerns about the solvency of firms. With the large correction in the equity market, the pledgeability of ownership stake as a collateral for bank borrowing has also eroded considerably for most promoters of Indian firms.

Judging by the global standards, the proportion of cash positive NIFTY Indian firms is quite low (about 17 per cent). A recent report suggests that 50 per cent firms in the Japanese TOPIX index are net cash positive.The corresponding figures for Germany’s CDAX and the S&P 500 are 33 per cent and 16 per cent respectively. Against the backdrop of the high degree of debt overhang faced by the Indian firms, the ability of firms to invest and expand looks quite challenging in the post-COVID scenario.

Way forward and policy measures

The weak liquidity and solvency situation of India’s corporate sector make it imperative for policymakers to address the fallout of COVID-19 stemming from global and domestic demand decline, disruption in supply chains, and a sudden rise in global risk-aversion.

Against this backdrop, the government could consider several financial assistance options including bailouts, loan guarantees, and wage subsidies. The bailouts could take the form of equity infusion in the strategic sectors that face high degree of debt overhang. Loan guarantees could be extended to firms in sectors that face shortage in credit supply given the sharp increase in risk-aversion in the credit markets and the on-going banking and NBFC crises. The loan guarantees could be limited to medium-term loans and be subjected to a ceiling on the loan amount. In highly labour-intensive sectors such as construction, in order to protect jobs, wage subsidies can be considered. The above measures can help to contain further exacerbation of the "twin balance sheet" problem plaguing Indian firms and banks.

Past bailouts, however, have raised concerns of moral hazard, where management may take excessive risk at the expense of taxpayers. During the 2008 Global Financial crisis, the bailouts of several American corporations had raised moral hazard issues, however, policymakers made a conscious choice to bail out large firms to preserve employment. For instance, the auto sector firms, General Motors and Chrysler, received generous financial assistance from the US Federal government to protect about three million jobs that were at risk.

The potential for moral hazard can be minimized in several ways. It should be announced that the bailouts would be strictly temporary. Firms that receive government assistance should be disallowed from undertaking share buybacks or dividend payouts. Wilful defaulters of bank loans should be excluded from any of the loan assistance schemes included as part of the loan guarantees. Further, firms that are insolvent and are currently under proceedings under the Insolvency and Bankruptcy Code (IBC) should be excluded from the purview of any financial assistance.

Faced with a global pandemic, the immediate response of Indian policymakers should be to ensure the survival of the broader corporate sector and facilitate its early revival from the adverse shock, while mitigating the possible moral hazard concerns.

(Balagopal Gopalakrishnan is a faculty member at IIM Kozhikode and a Ph.D. from IIM Ahmedabad. Joshy Jacob and Sanket Mohapatra are faculty members at IIM Ahmedabad. The views expressed in this article are those of the authors and do not reflect the views of their respective institutions)

Published on March 26, 2020

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