By Archana Narayanan and Abhishek Vishnoi
MUMBAI (Reuters) - Sunil Malhotra's expansion plans had a sound logic; they would reduce his company's exposure to imports made more costly by the slump in the rupee this year to a record low. It was an investment to improve profitability.
But banks were unwilling to finance his plan, leaving him instead scrambling to find working capital let alone funds to invest in his firm, Hallmark Steel, a small company supplying the auto industry.
India's prolonged economic slide has affected many companies in India, but small and medium-sized firms have been hit the most because of their more limited access to finance.
Ratings agencies say the debt situation is the worst in a decade, which explains why banks are cautious about lending. That could lead to rising defaults and bankruptcies among small and medium-sized companies, which support a considerable part of the economy - about 45 percent of manufacturing and 40 percent of exports.
"I have gone to not one but three public sector banks for funds and they don't want to lend to any firm in the steel sector," said Malhotra, founder and chief executive of Hallmark Steel in the north India state of Rajasthan.
Malhotra had hoped to raise 500 million rupees $8 million (4.95 million pounds) to fund the purchase of a melting facility in Nagpur in western Maharashtra state, aimed at reducing Hallmark's reliance on imported raw materials.
"We wanted to get out of imports because it was hitting our margins because of dollar fluctuations," he said, adding that banks are asking for collateral equivalent to more than 130 percent of the loan size, from 80 percent previously.
Ratings agency Fitch expects non-performing loans at Indian banks to be as high as 4.5 percent in the fiscal year to March 2014, a nine-year high.
Those that can get credit are forced to pay more as interest rates rise, with the Reserve Bank of India's unexpected rate hike on September 20 making credit even costlier.
Earlier central bank measures to defend the rupee by tightening market liquidity had already pushed up the cost of short-term funds.
The Mumbai interbank offered rate (MIBOR) has risen by almost 300 basis points since mid-July when the central bank announced its measures to bolster the rupee.
"We are arguably looking at the worst credit metrics in 10 years," said Deep Mukherjee, a director at Fitch Ratings. "Midcaps have a smaller scale of operations so they don't have bargaining power," he said.
Smaller companies already have some of the worst debt profiles in India, another factor underlining the banks' caution.
Small listed Indian companies' leverage multiplier, a ratio of assets to equity, is at 6.9 times, compared to 4.9 times for large and mid-cap firms and 5.3 times for all companies, Thomson Reuters data shows. A higher multiple indicates a company has used more debt to finance its business.
The debt-to-equity ratio of small companies is also higher at 1.03 times, compared to 0.87 times for large and mid cap companies, the data shows.
"We are overall cautious in lending these days," said M. Narendra, chairman and managing director of Indian Overseas Bank .
"We are asking for more collateral, personal guarantees from promoters and ensuring the net worth is better," Narendra said, referring to a preference for companies whose assets exceed liabilities.
That caution has spread to investor confidence as well.
While the benchmark Sensex <.BSESN> share index is up 0.5 percent in 2013, the small cap index <.BSESC> is down more than 25 percent and the mid-cap index <.BSEMC> is down nearly 21 percent.
"Debt is exacerbating problems for midcaps as with rupee volatility, short-term rates have increased a lot," said Dipak Acharya, a fund manager at Baroda Pioneer AMC, which has been reducing its holdings in small and mid-sized companies.
"It is a double whammy: higher leverage and higher interest rates without revenue support."
P.K. Ravi, chief financial officer at GEI Industrial Systems Ltd , an engineering and manufacturing firm with a market value of $6 million, said some of its banks had even stopped releasing credit that they had previously approved.
"When banks stopped releasing money I got into trouble because (I) don't have the financial muscle to raise from the market," Ravi told Reuters.
"We are resorting to private borrowing at 14 to 15 percent and managing with customers who are supplying materials and keeping the production going on," he said.
For Fitch's Mukherjee, the prognosis is worrying. The higher funding costs have already resulted in ratings downgrades, debt restructuring and defaults and there will be no let up if the weak economy and elevated funding costs continue, he said.
"We may see bankruptcy cases on the rise," he said.
(Editing by Tony Munroe and Neil Fullick)