Coming Age Of Default

Traditional banks in the West never thought twice about lending to their rich clients. They understood that rich people’s incomes went up or down while their desires brooked no waiting. If a country house caught a client’s eye or he felt like sailing to Grenada with his paramour, all he had to do was to take his banker out for lunch; everything could be settled in an hour. Though not so readily at their clients’ service, Indian banks took an equally benign view.

That suddenly changed after the 1971 nationalisation. Favours to personal clients came to be frowned upon, and close relationships with them looked on with suspicion. Nationalised bankers soon learnt the lesson, that they were serving the great socialist god and must finance projects of national development. Consumption was evil; financing it was treason. An occasional overdraft might be given after an old depositor had kowtowed suitably and given solid collateral; but it must be recovered before too long.

This new patriotic morality was first diluted when the government issued licences to a few private banks in the early 1990s. They found it difficult to penetrate the longstanding relationships between nationalised banks and their clients; few businessmen would have dared to enrage the government bank that had been his principal source of credit for ages and move to an untried little private bank. Thus frustrated, some of the private banks started to consider personal loans against solid security.

The 1990s were also the time when credit cards began to catch on in India; and since the Reserve Bank made it difficult for others to enter the business, banks captured the credit card business. It involved personal credit, but under restrictive conditions. Most of it was for less than a month; if a customer did not pay in time, he would soon find his credit card cancelled.

Then came the slowdown of 1997 and after; business borrowings could no longer keep up with banks’ lending capacity. Businesses stopped repaying loans. The hard way was to write off bad debts; banks naturally preferred the soft way, which was to give more loans — they brought down the ratio to credit of ‘nonperforming assets’, in other words, bad debt.

In the late 1990s, the balance of payments began to improve, and foreign exchange reserves started rising. As they rose, domestic money supply increased. Businesses’ cash balances went up, and they needed to borrow less. The government grew more relaxed, and allowed businesses to borrow abroad; so they needed domestic banks less. As business loans slowed down, banks began to give personal loans. The growth in personal credit was phenomenal. Its share in new loans was roughly a quarter in the early 1990s. It went up to a third by the end of the decade. By 2005-06, it had risen to an astonishing two-thirds. Its share in total credit rose from about 9 to 23 per cent.

That was the time the government dismantled the barriers it had created in the financial markets, which had reserved housing loans for specialised institutions. Banks took to housing loans with relish; their fervour increased when the housing boom began in 2002. By 2005-06, half of the banks’ personal credit was going to real estate. Car loans also caught on, though banks faced competition from the car manufacturers, who set up their own car finance arms.

The number of credit cards has gone up from 3.7 million in 2000-01 to 27 million. But the business remains relatively small. Indians are typically cautious borrowers. They are aware of the extortionate interest banks charge on credit card debt. Most of them got credit cards from obscure sales agents who make themselves scarce once they have collected their commission; and credit card holders are scared of unauthorised collection agents. So they borrow little on credit cards.

Now, a downturn is beginning. If the economy turns down, bad debts cannot be far off. As early as in 2007, there were stories of banks engaging hooligans to repossess cars; the courts frowned on them, and they seemed to have slowed down. But personal loans will turn bad as surely in the coming slump as business loans did in earlier downturns; and banks will find it even more difficult to deal with personal borrowers than they did with businessmen. For there are many more personal borrowers, and being more numerous they are more difficult to pursue and have more political influence. Amongst those who worry about this is Asset Reconstruction Corporation of India, which has prepared a white paper on retail lending. Good luck, Arcil!
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The worst is yet to come

Let's begin with some good news. Large companies with proven track records haven't disappointed the market. In fact, the third-quarter results of Reliance Industries, Infosys, ITC and ICICI Bank have been either along expected lines, or better than the Street's estimates. But that's not true for the rest of India Inc. The earnings of most mid- and small-cap companies have deteriorated alarmingly.
The net sales of 450 firms, which declared Q3 results till 23 January, have grown at a healthy 19.34% compared with the same quarter in the previous fiscal. But their net profits have fallen by 22.15% during the same period. The steep drop in profits is worrying because these companies registered a robust 40.29% growth in profits in the third quarter of 2007-8. The real problem is with the small and mid-sized firms, whose net profits in Q3 2008-9 have fallen by a massive 39%.
"Most large corporates haven't really disappointed us. The stress is more pronounced in case of midcap firms, where some of the results were worse than the already toneddown expectations," says Gaurav Dua, head of research, Sharekhan.
So, should you invest across stocks as the indices fall to attractive levels? Or should you look only at blue chips? To answer these questions, one needs to figure out what is likely to happen in the next few quarters.
The third quarter of 2008-9 was expected to be one of the weakest in recent years. By November 2008, analysts had scaled down their expectations and the markets had discounted the prices of most stocks. Profit margins were under pressure during Q2 due to inventory losses as most companies were saddled with raw materials purchased at the peak of the commodity cycle in July-August 2008.
Sadly, there may not be any respite in Q4. Reasons Dua: "Though some of the companies will begin to show relief on margins due to lower raw material costs, the demand environment will remain muted." This will happen because of several factors. Fragile sentiments, cash crunch and falling exports will take their toll on the Indian companies. As firms curtail investments, cut costs and reduce production, it will lead to a slump in economic activity.
"Industrial growth will slow down to 2.5% this year, against 9% in the previous fiscal. Given that the business confidence will remain low, the slowdown will spill over to 2009-10," predicts Anubhuti Sahay, associate economist at the Standard Chartered Bank.
In such a scenario, even sectors such as IT and banking, which were insulated from the drop in demand so far, can face problems. Commenting on the Q3 results, Wipro chairman Azim Premji said, "We are living in tough times; the macro-economic challenges are impacting businesses across segments." Both Infosys and Wipro have cut their annual guidance.
"The revenue visibility across companies appears to be, at best, limited to a quarter," says Abhiram Eleswarapu, analyst at BNP Paribas. Therefore, in the case of IT stocks, existing and potential investors need to wait and watch before taking investment decisions.
The same is true for banks, which posted an amazing profit growth of over 30% in Q3. But this is not likely to sustain. Moderate credit growth, lower interest rates on government bonds and rising NPAs will put pressure on earnings. "We foresee a slowdown in banks' earnings over the next few quarters as the G-Sec gains become muted," says Sonam Udasi, vice-president of research at Brics Securities.
Analysts say that despite low interest rates and the government's intention to trigger a demand-led growth cycle, the situation might improve only in the second half of 2009-10. "Once the impact of the interest rate cycle is passed on and firms begin to reduce their working capital requirement, the bottom line growth is expected to improve," says Sankaran Naren, CIO, equity, ICICI Prudential AMC.
Among sectors, while realty and commodities might slip, FMCG and pharma may continue with their growth story. Cash-rich companies with low or negligible debt are likely to outperform. "Investors should avoid aggressive or leveraged sectors, and focus on companies with excellent financial and operational management," concludes Naren.

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