IN THIS EDITION

 
     
 

 

 
     
 

 

 
     
 

 
 

The pace of gross value added (GVA) growth for Q3 FY2018 reached a four-quarter high of 6.7%, only modestly behind the 6.9% revised estimate for Q3 FY2017. ICRA expects the full year GVA growth for FY2018 to be pegged at 6.5%. The pick-up in service sector growth, to 7.7% in Q3 FY2018 from 7.1% in Q2 FY2018, reflected a favourable base effect, as well as the improvement in various indicators like cargo handled at major ports, passengers carried by domestic airlines, foreign tourist arrivals and so on. As anticipated, manufacturing GVA growth too recorded a substantial improvement to 8.1% in Q3 FY2018 from 6.9% in the previous quarter, supported by the restocking of inventories after the festive season, a catch-up effect after the muted volume growth in H1 FY2018 and the healthy expansion of corporate earnings in that quarter. However, notwithstanding the double digit growth in capital goods, since the value of the new investment projects and the value of projects completed recorded a contraction in Q3 FY2018, it may be premature to conclude that a broad-based revival in investment activity has commenced.

We also briefly discuss the implications of the recall of AT-1 bonds, initiated by some public sector banks (PSBs). ICRA feels that despite the recent re-capitalisation by the Government of India (GoI), if banks, currently under the prompt corrective action (PCA) framework, were to recall their AT-I bonds, then some of them may not be able to meet the Tier I regulatory requirements as on March 31, 2018. Of the Rs 60,385-crore AT-1 bonds outstanding of PSBs, about 60% totalling Rs 37,600-crore can be prematurely recalled, based on ICRA’s assessment of banks already under the PCA or those which are likely to come under the PCA. Accordingly, despite re-capitalisation, some banks can potentially be lower than the regulatory Tier I capital requirement level (including capital conservation buffer) for March 31, 2018.

We also take a look at the domestic steel industry, where the prospects will continue to be favourable, driven by both an improvement in domestic demand as well as impending consolidation in the industry. Additionally, remunerative prices in both the international and the domestic markets, and lower growth in imports are likely to support domestic steel production growth in the near term. For a sample of companies accounting for about 60% of the current domestic capacity, the operating margins improved to 18.8% in Q3 FY2018 from 15.8% in the previous quarter.

Finally, Insight also discusses the trends in the sugar industry. Sugar production, expected at a record 29.5 million MT in sugar year 2018 (SY2018), will outstrip consumption by around 4.0-4.5 million MT. As a result, sugar mills are likely to face pressure on sugar prices and profitability in the near term. This will possibly lead to pressure on their debt coverage metrics and also liquidity indicators, including cane payments. Under these circumstances, Government support will remain critical for the sugar industry.

The issue concludes with the regular features: monthly rating updates, upcoming ICRA events, and news features related to the company.

I hope you will find this newsletter useful and informative.

Best Regards

Anjan Ghosh
Chief Rating Officer, ICRA Ltd

 
 
 
 
     
  Recovery in Indian economic growth under way  
 

The pace of GVA growth printed at a four-quarter high 6.7% in Q3 FY2018, a sizeable uptick from the revised 6.2% expansion in Q2 FY2018, confirming that a recovery in Indian economic growth is under way. However, GVA growth in Q3 FY2018 modestly trailed the 6.9% revised estimate for Q3 FY2017, a trend which we expect to see reversed in Q4 FY2018. Based on the initial estimate for Q3 FY2018, ICRA continues to expect a GVA growth of 6.5% in FY2018.

The pick-up in service sector growth to 7.7% in Q3 FY2018 from 7.1% in Q2 FY2018 reflected a favourable base effect, as well as the improvement in expansion recorded by bank credit, cargo handled at major ports, passengers carried by domestic airlines, foreign tourist arrivals and the Government of India’s (GoI’s) non-interest revenue expenditure.

Moreover, industrial growth rose to 6.8% in Q3 FY2018 from 5.9% in Q2 FY2018. As anticipated, manufacturing GVA growth recorded a substantial improvement to 8.1% in Q3 FY2018 from 6.9% in the previous quarter, supported by restocking of inventories after the festive season, a catch-up effect after the muted volume growth in H1 FY2018 and the healthy expansion of corporate earnings in that quarter. Furthermore, construction growth rose considerably to 6.8% in Q3 FY2018 from 2.8% in the previous quarter, reflecting the trend in its inputs, such as cement and steel, even though sentiment in the real estate sector remained weak after the introduction of the RER(A)D Act and the Goods and Services Tax (GST). Mining and quarrying was the clear outlier in Q3 FY2018, recording a mild 0.1% YoY contraction, reflecting weak volume growth in that quarter.

Despite an unfavourable base effect, agricultural growth rose to 4.1% in Q3 FY2018 from 2.7% each in the previous two quarters. This reflects the year-on-year (YoY) rise in the output of sugarcane, cotton, coarse cereals and rice, revealed by the Second Advance Estimates of crop production.

Moreover, the GDP growth improved to a five-quarter high of 7.2% in Q3 FY2018 from 6.5% in Q2 FY2018, driven by the Government final consumption expenditure (to 6.1% from 2.9%) and gross fixed capital formation (to 12.0% from 6.9%), even as the pace of growth of the private final consumption expenditure moderated to a 10-quarter low of 5.6% from 6.6%, respectively. In our view, the record high crop production in FY2018 may translate into a pick-up in private consumption growth, with a lag.

The double-digit growth of capital goods, the sharp rise in the capital spending of the GoI and the modest pick-up in the capital spending of the state governments in Q3 FY2018, are likely to have contributed to the six-quarter high expansion in gross fixed capital formation in Q3 FY2018. However, since the value of the new investment projects and the value of projects completed recorded a contraction in Q3 FY2018, it may be premature to conclude that a broad-based revival in investment activity has commenced.

 
     
  Weak PSBs initiate early recall of their AT-I bonds, risk of coupon skip subsides  
 

Given the recent recapitalisation by the Government of India (GoI), if banks currently under the prompt corrective action (PCA) framework were to recall their AT-I bonds, then some of them may not be able to meet the Tier I regulatory requirements (including capital conservation buffers) as on March 31, 2018. In this regard, five public sector banks (PSBs) have already issued notices to their additional tier I (AT-I) bondholders, intimating them about an exercise of early call option on their AT-I bonds.

As on December 31, 2017, the PSBs had AT-1 bonds outstanding of Rs 60,385 crore. Out of the banks that are currently under the PCA or are likely to come under PCA, ~60% of AT-I bonds totalling Rs 37,600 crore can be prematurely recalled. With a capital infusion of Rs 80,562 crore during Q4 FY2018, the effective recapitalisation will stand reduced for many PSBs. Accordingly, despite recapitalisation some banks can potentially be lower than the regulatory Tier I capital requirements level (including capital conservation buffer) for March 31, 2018.

As per stock exchange filings by five PSBs (Bank of Maharashtra, Oriental Bank of Commerce, Dena Bank, IDBI Bank and Corporation Bank) and notice to the bondholders of these banks, the Reserve Bank of India (RBI) has confirmed the inclusion of a bank under the PCA framework as a ‘Regulatory Event’. Further, as per the terms of the AT-I bonds, banks have a right to exercise an early call option on their AT-I bonds upon occurrence of a regulatory event, among others, provided these are replaced with similar or better quality capital. This, coupled with the confirmation by RBI that capital infused under the recent recapitalisation programme can be utilised to replace the existing AT-I bonds and subsequent instructions from the GoI to recall their AT-I bonds, have triggered early calls by banks. The RBI has already invoked the PCA on 11 out of 21 PSBs (of which 10 banks have issued AT-I), and based on the PCA framework, as per ICRA’s estimates, five more PSBs can be included under the PCA framework. Earlier, in January 2018, the GoI had instructed PSBs not to issue AT-I bonds without prior approval. Accordingly, the weak banks would be required to raise equity capital to meet their overall Tier I requirements, which otherwise could have been met through the AT-I bonds.

With continued losses and significant erosion in accumulated profits, the serviceability of these bonds while adhering to regulatory features of these bonds was becoming a challenge for the PSBs. This had also created an ambiguity among the investors on likely skip of the coupon by weaker PSBs on their AT-I bonds. Cumulatively, the PSBs have reported losses before tax of over Rs 92,000 crore during Q3 FY2016-Q3 FY2018 (Rs 49,379 crore in FY2016, Rs 7,041 crore in FY2017 and Rs 35,600 crore during 9M FY2018). The recent revision in guidelines for resolution of stressed assets is likely to see a further deterioration in reported NPAs and an increase the credit provisioning requirements for banks, further pressurising their profitability.

During FY2018, some PSBs also paid coupon for their AT-I bonds, despite breaching the regulatory criterion for coupon servicing on these bonds. Further the risk related to these AT-I bonds’ likely inability to absorb losses, and the risk of allotting Tier I capital status to these bonds – in other words, creating an illusion of comfortable capitalisation, would be misleading, if these bonds are not allowed to absorb losses.

 
     
  Good tidings likely to continue for domestic steel industry  
 

Good tidings, including consolidation for the domestic steel sector to continue, supported by sustained buoyancy in the automobile sector and recovery in growth rates in the construction and capital goods sectors. Domestic steel demand growth too has improved to 5.2% in 9M FY2018 as against 4.5% in 7M FY2018, aided by a healthy growth rate of 6.2% reported in December 2017. The industry is upbeat on the back of the Government’s thrust on infrastructure - particularly towards affordable housing, power transmission and the Railways in the Union Budget 2018-19. A combination of favourable domestic demand, remunerative prices in both international and domestic markets, and lower growth in imports are likely to support domestic steel production growth in the near term.

For a sample of 22 large and mid-sized steel companies, accounting for about 60% of the current domestic capacity (referred as ‘the industry’), the operating margins improved to 18.8% in Q3 FY2018 from 15.8% in Q2 FY2018 and 16% in Q3 FY2017 supported by better realisations in both the domestic and the export markets. In line with the operating margins, the interest coverage of the industry also improved to 2.1 times in Q3 FY2018 from 1.7 times in the previous quarter. The margin also improved from 1.5 times in Q3 FY2017 and is likely to improve further in Q4 FY2018. Even though the cost of blended coking coal has increased and the availability of iron ore from Odisha may be curtailed, the gross contribution of a domestic blast furnace player is expected to see a marginal increase in Q4 FY2018 over Q3 FY2018, supported by the increase in hot rolled coil prices.

Cost pressures from elevated coking coal prices are also expected to continue in Q1 FY2019, given that premium hard coking coal spot prices have trended higher, averaging at around US$234/MT in January-February of 2018 as against US$198/MT in Q3 FY2018. However, domestic iron ore prices are expected to weaken in Q1 FY2019 following the easing of mining restrictions in Odisha from the middle of February 2018.

The resolution process, under the Insolvency and Bankruptcy Code (IBC) regime for five steel companies, comprising around 17% of the current domestic installed capacity, has seen good participation, not only from domestic entities engaged in the ferrous and base metals sectors, but also from overseas steel majors and financial institutions. At present, top three domestic steel producers account for around 40% of India’s annual crude steel production, and given the initial readings in the resolution process thus far, the domestic steel industry is heading towards a further consolidation in the near to medium term. This augurs well for the industry, given that these capacities have been operating at sub-optimal utilisation levels thus far.

 
     
  Sugar oversupply to affect mills’ profitability  
 

Sugar production is likely to be a record 29.5 million MT in sugar year 2018 (SY2018) and will outstrip consumption by around 4.0-4.5 million MT. Given the oversupply, sugar mills may face pressure on sugar prices and profitability in the near term. This might result in a pressure on their debt coverage metrics and also liquidity indicators, including cane payments. Under these circumstances, Government support will remain critical for the sugar industry.

The revised domestic sugar production for SY2018 is likely to be around 29.5 million MT (as against its earlier estimate of at least 27.0 million MT) - driven by the higher output in Maharashtra, Uttar Pradesh (UP) and Karnataka. Hence, as against the consumption of 25.0 million MT, the production would be higher by around 4.5 million MT than the estimated consumption. The resultant closing stocks are expected to significantly increase to around 8.5 – 9.0 million MT in SY2018. The reverse stock limits imposed by the Government are valid up to March 31, 2018. Hence this upward revision in the sugar production estimate, along with the liquidation of sugar stocks, especially by several cash-strapped sugar mills, post March 2018, is likely to result in pressure on sugar prices from the coming quarter.

After hitting a low of Rs. 31,500/MT in February 2018 (first week), sugar prices stabilised at around Rs 34,500 to 35,000/MT on the back of Government support like doubling of import duty to 100% and the imposition of limits on sugar sales by sugar mills. Currently, the prices are hovering at around Rs. 32,500/MT.

As for profitability, mills are likely to come under stress on account of the higher cane cost of production (higher SAP and FRP for the current season) along with the likely pressure on sugar realisations during Q1 FY2019. However, most major UP-based mills have by and large seen significant deleveraging over the last couple of years, which will help them withstand cyclical downturns better. Given the increase in production levels, the fall in prices could lead to an increase in the cane arrears.

Government support, therefore, will be critical for the sugar industry in the near term.

 
     
 
           
 
   
m Rating Updates for the month of February 2018
   
Upcoming Events
   
March 2018: Trends and Sector Outlook for the Indian Tyre Industry
March 2018: Trends and Sector Outlook on the Indian Steel Sector
 
ICRA in News
 
Business Standard : March 13, 2018: BIZ-ICRA-SUGAR
Livemint : March 13, 2018: A TOT on the Road
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