Posted in Finance Articles, Total Reads: 1096
, Published on 27 August 2015
Volatility in the commodity market of late has occupied significant mind share of pundits in various financial circles of the world as well as front-page space across various newspapers. Prices for various commodities be it gold, oil or steel has been highly fluid and responsive to various global events- data fed and political. Falling commodity prices generally augurs well for India, which is a net energy importer and helps meet its Current account deficit targets, maintain healthy foreign reserves and keep the much sought after figure of inflation in check. However, there is a definitive victim in the form of Steel Industry in India, which is teetering on the brink of a major breakdown owing to sluggish demand, direct competition from duty-free imported hot-rolled coil steel from China, and escalating financial burden due to gigantic levels of debt coupled with lower productivity compared to peers.
Prices of iron ore have nose dived during the course of past one year and is being currently traded at $ 51 per metric ton (dry) as compared to $ 130 odd levels one year back in July-2014. The Baltic Dry Index (BDI) which measures the rates in USD per day per metric ton for chartering the giant ships that transport iron-ore, coal and grain has hit a 30 year low and is currently trading at 1055 levels (BDI scale) from highs of 3000 points in 2011. Though BDI is most widely followed index that predicates the global demand scenario, it is rather difficult to read much into the number given the highly dynamic demand-supply and the inelastic nature of supply of the vessels as it takes more than 2-3 years between ordering a new vessel and its launch.
Steel prices have seen a precipitous fall from the highs of $ 210 per ton in 2008 to current levels of $ 140 per ton. As a result, the behemoths of the industry including US Steel, POSCO, and Nippon Steel have reported exorbitant fall in the profits in quarters gone by. India, which is also the fourth largest steel producer with production at 86.5 mt (million tonnes) in FY 2015 and also world’s largest sponge iron producer is no exception to this story and is also dangerously keeping its feet off the claws of bankruptcy and downgrade unless clear roadmap for the revival of the industry is given. In this article, we discuss some of the issues faced by the local steel producers- both intrinsic and external factors and the steps taken by the regulators and the government to counter this serious issue.
It is important to have a minimal and basic understanding of terminologies of Steel Industry to correlate better to global happenings. In 2014, global steel production increased by a modest 1 % over 2013 to 1663 mt with China atop at (823 mt) followed by Japan (110.7 mt), the USA (88.2 mt) and India (86.5 mt) at the 4 th position. However, per capita steel consumption for India is still paltry at 52 kg compared to global average 217 kg and China’s whopping 510 kg. This is however a fair reflection of the surge in infrastructure in China over the past 20 years. China’s rail network alone could loop around Earth twice.
The Indian steel demand is slated to grow by 6.2% in 2015 and by 7.3% in 2016 as per the report by World Steel Association-WSA. Global steel consumption is expected to grow by 0.5% and 1.4% respectively for the same time period. Chinese steel use is projected to decline in both these years by 0.5%. Iron ore is an integral and basic building block of any form of infrastructure that we see and depending upon varying proportions of carbon, type of heat treatment, production process that it is subject to, the end product has been graded internationally. Generally speaking, we can classify iron ore end use as either of Crude steel, Pig iron or Sponge iron. Crude steel is the first solid state upon solidification of liquid steel. BFI (Blast furnace iron or Pig iron) and DRI (Direct reduced iron or Sponge iron) as the names indicate are differentiated based on production process. Pig Iron is high on carbon content and is further refined to obtain steel and wrought iron. Whereas, for Sponge iron, blast furnace is not required and is rich in iron content making it suitable for use in electric furnace. Production of Pig iron stands at 9.7 mt in FY 2015 whereas, for DRI or sponge iron, India is world’s largest producer and capacity stands at 46.23 mt in FY 2015-90 % of it being from the coal-based route.
India’s net exports stand at 5.59 mt in 2015 as against import of 9.32 mt thus making it a net importer. Japan and South Korea have been long partners and have been exporting high-grade automotive class steel that India anyways does not produce in substantial terms. However, it’s China, which is a cause for concern as it exports hot-rolled coils, which finds use in majority applications such as white-goods, automotive panels etc. Chinese imports have increased by 70 % in past one year due to competitive price advantage as well as exemption of import duty if the Indian importer intends to import steel products from China with the end-use of eventual exports. This holds true for any country India has signed FTA agreement with. As a result, Indian steel makers are bearing the brunt with declining sales and higher costs due to underutilization of installed capacities.
Banks especially the PSU’s with large exposure to steel companies have all the more reason to worry as facts exposed by the RBI’s financial stability report dawns on harbinger of bad news. The report stays that 5 out of top 10 private steel producing firms are under severe stress on account of delayed implementation of new projects, further capex investment for augmenting capacities along with land acquisition and environmental clearances. According to a Credit Suisse report, $ 50 bn of debt in the books of major steel companies in India is around 15 times their collective operating profit in FY 2015. It goes on to say that compared to its Chinese counterparts, Indian steel companies would make losses even if they have no interest costs to pay as the cash costs of Indian steel companies were higher than steel prices in China.
The Indian steel sector is highly leveraged (net debt/EBIDTA) basis. Balance sheets of many steel companies including names such as SAIL, Tata Steel, JSW etc. reveal Interest Coverage ratio of less than 1 which in any ways must be greater than 1.33. In such a scenario, debt financing to reach capacity expansion targets may prove detrimental to the credit ratings given by rating agencies such as Crisil, ICRA, CARE etc. Credit rating degrading will further increase cost of capital for these companies. Already, cost of capital in India is amongst the highest compared to peers and western countries that have taken significant steps to revamp the manufacturing sector and are providing practically zero rates of interest for the sector. The debt levels of the companies might turn chronic- IC ratio of less than 1 for four quarters is classified as chronic which will necessitate severe debt restructuring and haircuts.
Companies such as Tata Steel, JSW etc. are relatively well positioned as they have managed to access capital from debt and equity markets. Their levels of debt are at $250-$400 levels per tonne of steel compared to $1200-1500 levels per tonne for Bhushan Steel, Usha Martin etc. These companies have seen their debt levels increase almost 5 fold in past five years. The capacity utilization of the sector is close to 73 pc and even less for companies such as Bhushan Steel bringing it on the verge of bankruptcy. Average per capita labor productivity in India is very low at around 90-100 tonnes compared to 700-800 T in US and South Korea coupled with labor union issues. The cash flows for 15 largest steel companies in India have still not turned positive due to aggressive capital expenditure.
Keeping in line with the recent happenings, the GOI and RBI have taken few steps. Moreover, these steps seem to be more of symptomatic in nature than systemic. As a response to Chinese Yuan devaluation, the directorate general of anti-dumping duty slapped anti-dumping duty of up to $ 309 per tonne on certain variants of HR steel from China for a period of five years.
However, as a major relief for the infrastructure sector and Steel industry; RBI came up with a flexible refinancing and repayment option for long-term infrastructure projects with exposure of greater than Rs 500 cr. Loans that have been classified as bad-loans are also eligible to get their loans restructured but will continue to be termed as NPL. This scheme is also popularly known as 5 by 25 scheme. Large infrastructure projects that have an economic life of say 25-30 years usually take 7-8 years to even start generating positive cash-flows from the day of commencement of the project and till the construction is complete and capacity production is reached. However, banks used to only extend credit for 12-15 years for such loans resulting in higher loan installments, which not only strains the balance sheet and solvency, but also limits the ability of promoters to generate fresh equity. Under the new scheme, banks are allowed to evaluate the proposal based on fundamental viability on the basis of all requisite financial and non-financial parameters especially funding within suitable IC (Interest Coverage) and DSCR (Debt Service Coverage ratio). Banks will now be able to fix higher amortization schedule for a loan with the option of refinancing after a fixed tenor of 5 years.
India has the luxury of not repeating the same mistakes that China committed and tread a more reasonable way to achieve double-digit growth. The AQI-Air Quality Index measured in a yardstick of 0-500 indicates the air quality and the levels of health concern. The airpocalypse in Beijing is best described by the scene of the locals wearing a heavy-duty facemasks equipped with canister filters. It is not uncommon for the AQI levels to keep on revisiting the 800 mark. 500 levels are termed as hazardous and 800 is just a glimpse of the possible future era if these biggest polluters continue to turn a blind eye to this serious issue. The hollow promises earlier made by the government in 2013 were exposed when a staged’ Operation Sunday’ at Hebei- a province just outside Beijing came to light. Hebei alone churns steel output that is twice that of the U.S. worsening the air quality in Beijing. The officials had sent the demolition squads in Nov-2013 to destroy blast furnaces, imploding mills that made a national headline only to turn out that the destroyed mills had long been out of production. In fact, China’s steel output increased to 700 million metric tones in 2014 as opposed to 650 million metric tones in 2013.
Much more needs to be done to wake up the sleeping giant. According to Frost and Sullivan mining report, India is slated to be the second largest crude steel producer in FY 2016 with expected installed capacity of around 113 mt. India will need another $ 60- $ 70 bn of fresh capital to create an additional capacity of 100 mt in coming 10 years. The adjoining graph shows the steel consumption pattern in India and the underlying opportunities with the government committed with initiatives such as: Allowing 100 pc FDI in railways, Smart City initiative and Make in India initiative, aggressive power capacity augmentation and infrastructure such as DMIC. Following facility that is a pre-requisite need to be put in order to start with:
1. Government incentivizing: E.g. South Korean government subsidized POSCO’s transportation and allowed a 40-50 pc rebate on rail-road and port use during initial stages of growth. This also includes creation of SPV (Special Purpose Vehicle)- for better co-ordination in terms of land acquisition, regulatory and environmental clearances and timely completion of projects.
2. Logistics: Indian railways meet more than 70% of the steel industry’s transportation needs and needs to gear up for targeted growth in the sector, dedicated freight corridors, port capacity and operating efficiency, modernization.
3. Skill India: Average per capita labor productivity in India is very low at around 90-100 tonnes compared to 700-800 T in advances economies coupled with labor union issues. This may turn out to be a major deterrent to outclass our neighbor.
Moreover, if countries such as South Korea and Japan which do not have any reserves of Iron Ore are able to master the technology and export high-grade steel through their initiatives and infrastructure, India with vast reserves of Coal and Iron ore definitely can match and perhaps beat the competition!
The article has been authored by C. Nitesh from Kotak Mahindra Bank
References: 1. Figures regarding India’s current steel production etc. taken from official website of ‘Ministry of Steel’ http://steel.gov.in/overview.htm 2. Facts relating to the debt scenario of Indian companies taken from EY report on ‘Indian Steel – Strategy to Ambition’ 3. News regarding RBI’s financial stability report etc. taken from secondary sources such as news articles from The Economic Times etc. 4. RBI’s 5 by 25 scheme details directly taken from the RBI circular 5. For other perspective and details, various articles on The Economist, CNN Money, WSJ, Sector reports by leading houses such as Credit Suisse, BCG etc. taken
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