The Ponzi scheme in steel needs to stop - The Daily Reckoning
The Daily Reckoning by Vivek Kaul
On This Day - 21 August 2015
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The Ponzi scheme in steel needs to stop A  A  A

- By Vivek Kaul

Vivek Kaul
In a speech that SS Mundhra, a deputy governor of the Reserve Bank of India, gave earlier this month, he talked about the troubles of the steel sector in India and the impact that it will have on banks.

As Mundra said: "Let me take the example of the steel sector. Bank loan to the steel sector in India has witnessed a 21% CAGR over the past five years and broadly ranges 2 between 4 to 9 % of individual bank's loan book. Banks' total exposure to the steel sector stands at Rs. 3 lakh crore while the net sales for the companies within the sector also stands at around Rs. 3 lakh crore with an EBIDTA of Rs. 37,000 crore."

In the last five years bank loans to steel companies have grown at the rate of 21% per year. The overall lending by banks between March 2010 and March 2015 has grown at around 14.7% per year. This means that the overall lending by banks in the last five years has doubled. In comparison, lending to the steel sector has grown by 2.6 times.

Hence, lending to the steel sector has grown at a much faster pace than overall lending. Further, the banks have lent way too much money to the steel sector. As Mundra pointed out during the course of his speech, the total sales of the steel sector are at Rs 3 lakh crore. The lending by banks is also Rs 3 lakh crore. The operating profit of the sector (i.e. earnings before interest and taxes) is at Rs 37,000 crore.

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What does this tell us? The steel sector is making only around Rs 37,000 crore every year to pay the interest that it needs to pay on a debt of Rs 3 lakh crore. The base rate or the minimum rate of interest they charge to their customers, of most banks is around 10%. Even if we assume that the steel sector is paying an interest of 12% on its loans, the interest on Rs 3 lakh crore, amounts to around Rs 36,000 crore every year. Compare this with a total operating profit of Rs 37,000 crore and you know that the sector has majorly over-borrowed and is struggling to keep paying interest on its debt.

As a recent newsreport in the Mint newspaper points out: "According to Capitaline data, just 41 out of these 129 companies, which have collectively borrowed Rs.2.63 trillion[Rs 2.63 lakh crore, lower than the RBI number of Rs 3 lakh crore], have an interest coverage ratio (ICR) above 1.5 times, considered a safe level while measuring a company's ability to pay interest." Interest coverage ratio is obtained by dividing the earnings before interest and taxes of a company, by the interest that it needs to pay on its debt in a given year.

In fact, if we look at the steel sector as a whole, the aggregate interest coverage ratio comes to 0.79 times, the Mint reports. This means that the operating profit of the sector as a whole is lower than the interest that it needs to pay on its outstanding debt. And this possibly can't be a good sign.

One way of getting around this problem is to get fresh loans from banks and use that money to pay interest as well as repay debt. And that is precisely what a number of steel companies seem to be doing. As Neelkanth Mishra of Credit Suisse wrote in a recent column in The Indian Express: "These companies are borrowing from banks to pay their interest-as underscored by the many "refinancing" deals recently for broke steel companies, where an additional Rs 5,000-8,000 crore were lent by banks."

The fact that many steel companies are broke can be made out that "the level of stressed assets in the sector exceeds 27%," something that Mundra said during the course of his speech.

The stressed advances number is arrived at by adding the gross non-performing assets (or bad loans) and restructured loans divided by the total assets held by the scheduled commercial banks. Hence, the borrower has either stopped repaying the loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan by increasing the tenure of the loan or lowering the interest rate. This entails a loss for the bank.

Hence, of every Rs 100 that banks have given to the steel sector as a loan, more than Rs 27 has either not been repaid or has been restructured. In such a situation banks giving more loans to steel companies so that they can repay their past loans and pay the interest that is due, is outrightly stupid.

The situation is akin to a Ponzi scheme, where outstanding debt as well as interest due on outstanding debt is being paid by taking on more debt. The banks are doing this in order to keep their bad loans under control. By giving new loans to companies, banks are postponing the recognition of bad loans.

They are essentially kicking the can down the road. And this possibly can't be a good thing because by doing what they are, they will increase the losses in the days to come. As Mishra of Credit Suisse writes: "It would be in the banks' best interest to call an end to this charade, but the unwillingness to book losses on their current loans is preventing that. Even if it means that losses eventually could be much larger."

What does not help Indian steel companies is a slowdown of growth in China. The country was growing at greater than 10% in the past. The growth has now fallen to around 7%. This means that it does not need all the steel that it is producing. As William Vanderpump of UBS writes in a recent research report titled Indian Steel: Turning Point Approaching : "Steel overcapacity driven by China is a global problem from which India is not exempt. Prices are under pressure and there are yet no signs of a material government response."

China has increased domestic steel production at a really fast pace. "In the last 10 years China has added some 770 million tonnes of capacity (almost 80% of global growth in this period) and now accounts for 50% of global capacity...Excess Chinese supply has found its way into Global markets via higher exports and lower prices. Chinese exports continue to rise year to date (YTD) in 2015 (up 38% YTD in May; after being up 47% in 2014)," writes Vanderpump.

And this possibly can't be good news for Indian steel companies.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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5 Responses to "The Ponzi scheme in steel needs to stop"

Prasad

Aug 26, 2015

Promoters of these companies give themselves huge dividends. When the going is good, they make big profits. Now promoters should make some contribution. Government should not bail them out with tax payers' money.

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Girish Patkar

Aug 21, 2015

Bank Lending is happening more on relationship basis and less on project and risk evaluation. There is no equity invested in the project. In such situations Banks can only pray and hope for miracles to save write offs. Bank Managements have no option but to restructure loans and hope that the bomb does blow till they retire.

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R Tayal

Aug 21, 2015

A disclaimer at the outset : I have great regard for Vivek for the lucidity and simple language explanation of complex economic phenomena, that makes it easy to understand for the average reader like me. Yet there are times when he tends to get carried away like calling lending to steel sector as a Ponzi scheme. This is more like hindsight wisdom. All of us know steel is a commodity and can therefore experience significant variations in price sometimes cyclical and at other times due to various other reasons. Steel prices have been terribly depressed for the last couple of years. In fact current prices are way below those prevailing a couple of years ago. That also explains (to an extent) the depressed EBITA & Sales figures. At the time the loans were granted many years ago, this situation would certainly not have been taken as the basis. If & when (and given current Chinese scenario, its a big IF) the situation improves the loans wouldn't appear Ponzi. The important thing to realize is the period of time when the loans were granted. Of course corrective action needs to be taken now by both steel Cos. & banks, but to attribute motives in sanctioning the loans would be stretching it too far.

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R K NAGPAL

Aug 21, 2015

As usual very good analysis by Vivek . I am now addicted to read his articles/analysis.

It seems that Banks still fear to take harsh decision for there BS purposes .Not probabaly heeding to RBI Governor regular advise on the subject of NPA. Banks should stop further fundig case which are not worth restructuring and putting good money into existing account which have gone bad and turning worse day by day .

If this is the analysis of one sector that steel the capitilisation of PSU Banks by 70th cr by the Government ( Public Money ) in the coming 4-5 years may not bring the desired results at the end of the days . thanks rk nagpal CA & Ex Banker

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Niraj

Aug 21, 2015

Couple of things that need to be factored in the analysis.

1. Out of the total sale of 3 Lakh Crore and total profit of around 36,000 Crore a part must be of some of the large players (Tata Steel) / Govt. Entities (SAIL) which may not be stressed at this point of time. If we exclude them, the total lending to total sales/profit will look much more bleak.

2. While the total sales and profits may be for Indian Entities, some of them may have invested abroad. We need to include those also before reaching this far reaching conclusion.

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