Corporate India''s credit fundamentals remain strong after four years of sustained improvement, according to CRISIL''s analysis of the trends in its rating actions. CRISIL''s modified credit ratio (MCR) for 2006-07 (refers to financial year, April 1 to March 31) continues to be above 1 at 1.01; this is marginally below the level of 1.03 recorded in 2005-06.

The trend of improving credit quality in corporate India, which started when an MCR greater than 1 was recorded in 2003-04, continued in 2006-07, but with lesser momentum. Given that CRISIL''s rated portfolio covers key sectors of the Indian economy, and includes most of the top players in each segment. CRISIL says the correlation of its MCR with key economic indicators has been proven over several years (see Box 1).

The significant improvement in Indian companies'' financial position over the last few years has been accompanied by a new-found confidence among corporate managers, resulting in a palpable increase in their risk appetite. With a large number of companies either announcing, or already in the process of implementing, large capacity expansions or aggressive acquisitions, the key to maintaining the current levels of credit quality depends on how well the growth is managed, and in what way it is funded.

MCR continues to decline
CRISIL''s MCR is defined as the ratio of upgrades plus reaffirmations, to downgrades plus reaffirmations over any given period. In 2006-07, CRISIL''s MCR for long-term ratings decreased to 1.01, falling steadily from an all-time high of 1.16 recorded in 2004-05 (see Chart 1). The MCR reflects five upgrades and three downgrades in CRISIL''s long-term ratings portfolio , as against nine upgrades and four downgrades in the previous financial year. (See Annexure for CRISIL''s upgrades and downgrades for long-term ratings in 2006-07.)

The decline in CRISIL''s overall MCR reflects a slowdown in the momentum of improving credit quality. This is in line with CRISIL''s observations, in Ratings Round-Ups published since October 2005, that corporate India will find it increasingly difficult to improve its credit quality.

Downgrade rate remains low
Chart 2 depicts CRISIL''s long-term downgrade rate – defined as the ratio of total downgrades in long-term ratings to outstanding long-term ratings – which continues to be low at 1.74 per cent. No CRISIL-rated instrument has defaulted over the last 27 months, the longest such period since 1995.

Outlook distribution
Rating outlooks, assigned by CRISIL since September 2003, have proven to be reliable leading indicators of the likely direction of rating movements. The proportion of positive and negative outlooks also provides guidance on the likely direction of credit quality.

As on March 31, 2007, more than 96 per cent of CRISIL-rated entities had stable outlooks, reflecting CRISIL''s view that no major changes are expected in the credit profiles of rated entities over the short to medium term (see Chart 3). The remaining outlooks were equally distributed on the positive and negative side.

Rating watch
CRISIL places ratings on watch when an event of significance has occurred which has the potential to impact the rating, but the impact cannot be accurately assessed at that time. As on March 31, 2007, CRISIL had six ratings on watch (see Appendix 1). Five of the ratings were under watch due to acquisitions/projects that are large compared to the current size of operations.

Sectoral view
CRISIL''s rating portfolio consists of entities belonging to all sectors of the Indian economy. CRISIL''s opinion on the prospects for credit quality in the manufacturing, infrastructure, and financial sectors are contained below. On the positive side, the opinion factors in the strong improvement in credit fundamentals across the corporate spectrum; on the other hand, it also takes note of the increasing risk appetite of corporate India, in an economic environment characterised by increasing interest rates.

As in earlier years, the manufacturing sector accounted for the bulk of the rating actions during 2006-07, with four upgrades and three downgrades. One financial sector entity, BoB Housing Finance Ltd, was upgraded to ''AAA'' giving the financial sector an MCR of 1.02. There were no upgrades or downgrades among companies in the infrastructure sector, which resulted in a sectoral MCR of 1.00 for the infrastructure sector during 2006-07. Chart 4 gives the MCR trends in these three sectors.

Manufacturing and infrastructure sectors: Large growth plans in an increasing interest rate environment
The manufacturing sector has witnessed a steady improvement in its financial profile, aided by four years of sustained economic growth. This sustained improvement in financial strength has encouraged a large number of companies to announce very large expansion/acquisition plans. The planned capacity expansions in some industries and estimates of the capital expenditure involved are given in Table 1.

Table 1: CRISIL''s estimates of outlay for planned capacity expansions

Based on the leverage normally used in projects in different sectors, CRISIL estimates that the extent of debt funding would be about Rs.6000 billion — an amount much larger than the total assets of the largest bank in India today.

Apart from these expansion plans, corporate India has also displayed a growing appetite for inorganic growth. The total acquisitions already made or announced during 2006 (refers to calendar year, January 1 to December 31) were Rs.4340 billion (see Table 2). In the first two months of the current year, 80 additional deals valued at over Rs.1000 billion have been announced.

Table 2: Acquisitions announced by corporate India

The implications of these capital expenditure plans and acquisitions are:

A key risk, therefore, would be the funding pattern for the planned growth; debt-funded growth in a regime of high interest rates has the potential to adversely affect the credit quality of corporate India over the medium term. The extent to which this actually happens will depend on the companies'' decisions to press ahead with expansions, or defer them, in the light of macroeconomic conditions. Hence, management attitude towards risk will be a key driver of future credit quality. CRISIL will continue its surveillance on its rated portfolios, and take appropriate rating actions on any signs of weakening in specific credits.

Financial sector: Increasing interest rates herald a slowdown
The increase in interest rates, as well as recent Reserve Bank of India actions to reduce liquidity in the system, will lead to a slowdown in credit growth. Banks will find it difficult to pass on their increased cost of funds as borrowers increasingly look at alternate sources, such as overseas borrowing and convertible bonds. CRISIL believes that the profitability of financial sector entities may be affected, going forward. The increase in interest rates may also lead to an increase in delinquencies, especially in the retail portfolio of financial sector entities; this is, however, unlikely to significantly affect the credit profile of the entities, as a majority of financial sector entity ratings will continue to draw support from their parents. This support is derived from the Government of India for public sector banks, and from foreign parents in case of multinational banks and non-banking finance companies (NBFCs).

Conclusion
Corporate India has built a strong financial position based on four years of sustained good performance. The confidence that comes from such a strong position has increased the risk appetite of company managements. CRISIL believes that this increased risk appetite, combined with higher interest rates, is likely to exert pressure on the credit quality of Indian companies. Going forward, the MCR may fall below one in the short term when the ratings on watch gets resolved. In the medium term, CRISIL believes that the ability to prudently manage large growth plans, and their funding patterns, will be the key rating driver for a large number of companies.

Box 1: CRISIL MCR has strong correlation with IIP and real interest rates

Strong correlation with IIP
CRISIL''s MCR is a sensitive measure of industrial performance and the prospects of the Indian economy, as it covers a wide range of sectors and key players in each sector. This is reflected in the consistently high degree of correlation between CRISIL''s MCR and India''s Index of Industrial Production (IIP) as shown in Chart 5.

Real interest rates and MCR
Real interest rates and CRISIL''s MCR have historically demonstrated a perfect inverse correlation - MCR declines when real interest rates rise and vice-versa as can be observed from Chart 6. The last 24 months have seen an increase in real interest rates mirrored by a declining MCR. High real interest rates, which are not expected to decline in the near term, will add to credit quality pressures.

Appendix - I