The twin balance sheet problem

Volume 2 of the Economic Survey (ES2) talks about three sectors central to the Twin Balance Sheet Problem (TBS) — high unserviceable corporate debt and  high non-performing assets (NPAs). These are obviously related.

ES2 has a focus on the power and telecom sectors. Power has long suffered from poor management of state-owned discoms (distribution companies) and poor state policy. Discoms are forced to sell power at unviable rates, taking large losses. They also have high transmission and distribution (T&D) losses, meaning units generated are unbilled. In turn, generators, many being private players, don’t get paid and can’t service loans.

Some structural changes have increased short-term stress. Renewables (solar and wind) have seen a secular trend of falling prices. Solar reduced in cost from Rs 18 a unit in 2011 to Rs 3 a unit in 2017. In part, this is due to subsidies but is also driven by better technology and more scale. This is good, given climate change, and enables easy micro-level backups for corporates and even households. But, it has led to more pressure on thermal generators to back down on generation, and to negotiate reduced prices. The ES cites data that show even private thermal capacity has climbed to 83 gigawatt Gw in 2017, from 20 Gw in 2011. And, plant load factors (PLF) have dropped from 75 per cent of rated capacity in 2011 to 55-57 per cent in 2017.

Roughly speaking, thermal tends to be unviable at below 60 per cent PLF. According to Central Electricity Authority data, about 50 per cent of the current capacity is unprofitable. This is reflected in an assessment by Credit Suisse, which estimates the share of power sector debt owed by corporates with an interest coverage ratio of less than one is now around 70 per cent. The vulnerable debt amounts to Rs 3.6 lakh crore or about 2.5 per cent of Gross Domestic Product (GDP). 

Interest cover (IC) is operating profit (Ebitda or earnings before interest, tax, depreciation and amortisation) divided by interest owed for the given period. An IC below one implies the company cannot service debt from normal operations.

The telecom sector was already stressed by September 2016. Growth had flattened and operators had to shell out huge spectrum fees. Then, Reliance Jio entered, with six months of free voice and data. This drove huge expansion, since telecom demand is very price-elastic. Data consumption shot up 650 per cent—India is now the world’s largest data market by volumes.

Average revenue per user (ARPU) has dropped 36 per cent since September. As a result, the telecom sector debt held by corporates with an IC below one has more than doubled since late 2016.  Credit Suisse estimates  Rs 1.5 lakh crore of telecom debt is held by operators with an IC below one, about one per cent of GDP.  More than half of telecom companies are at risk.

Overall, banks hold 9.5 per cent of GDP worth of stressed loans. Public sector banks, by far, are worse-affected. They saw credit reduction during the 2016-17 financial year. Even private banks have seen rising NPAs. 

This is, by any standards, a crisis.  It could lead to years of slow growth — financial crises are notoriously hard to resolve and always affect the broad economy. At the same time, valuations across these sectors, are by and large, much higher than the financials warrant.

There are two ways to look at this. One, since these sectors have hit crisis point, policy resolutions will be found quickly. But, it’s a massive problem. If half the telecom sector goes bankrupt and 70 per cent of thermal capacity is unprofitable, new owners who are adequate managers must be found, and policy changes made to ensure this doesn’t recur. Banks will need Rs 15 lakh crore one way or another, via loan recoveries and new equity subscription, to recapitalise adequately.

If there’s resolution and those problems are solved, the high valuations will be justified. There would be major improvements in TBS. The other assessment is more pessimistic: wait for the market to recognise the sheer magnitude of the trouble, and then look for value as stocks are beaten down.