Rating Rationale

Strengths:
* Strategic importance to GoI, given REC's key role in financing India's power sector
REC is strategically important to GoI as it plays an important role in the Indian power sector, not only by providing finance but also by implementing GoI's power sector policies. It is the nodal agency for channelling finance towards its rural electrification programme under the Deendayal Upadhyaya Gram Jyoti Yojana (formerly known as Rajiv Gandhi Grameen Vidyutikaran Yojana) and Pradhan Mantri Sahaj Bijli Har Ghar Yojana (translated as the Prime Minister's Programme to provide easy electricity access to all households), or 'Saubhagya'. Furthermore, the company has been nominated as the sole nodal agency to operate the National Electricity Fund Scheme'an interest subsidy scheme introduced by GoI'to promote capital investment in the power distribution sector. REC is the second-largest lender to the sector. The company plays a developmental role in channelling finance to meet the power sector's large funding requirement, particularly of State Power Utilities (SPUs), which constitute 81% of its portfolio.

The government supports the company financially and operationally in various ways, including conferring special status to raise capital gains tax exemption bonds. Even after the proposed stake sale to PFC, GoI will indirectly control REC. CRISIL believes that GoI has strong strategic reasons and a moral obligation to support REC, both on an ongoing basis and in the event of distress, given the latter's role in implementing the government's power sector policies.

* Strong resource profile
REC's credit risk profile is supported by its sound resource profile, with competitive borrowing costs and a diversified, albeit wholesale, resource base. Short-term commercial paper borrowings were Rs.6750 crore as on December 31, 2018, constituting less than of 3.0% of total borrowings. On a steady state, CP borrowings are likely to remain within 5% of the total borrowings. REC's debt instruments have wide market acceptability and the company typically borrows at low spreads over government securities. Its cost of borrowing is lower than that of most of its peers, and stood at 7.14% (annualised) in the first half of fiscal 2019 (7.6% in fiscal 2018).

For fiscal 2019, extra budgetary resources of Rs 8627 crore were raised on behalf of the Ministry of Power, GoI. These bonds will be used to augment infrastructure funding, and be fully serviced by the government through the general budget; hence, a separate government guarantee was not required for issue of these bonds. In its analytical treatment, CRISIL has assumed that REC will ensure the bonds are serviced on time if need be.

* Adequate capitalisation
REC's capital profile provides a cushion against asset-side risks arising from high sectoral and customer concentration. The networth was Rs 35367 crore as on December 31, 2018 (Rs 35491 crore as on March 31, 2018). The reduction in networth was mainly on account of implementation of Indian Accounting Standards (IND-AS). The overall capital adequacy ratio stood at 16.84% as on December 31, 2018 (19.39% as on March 31, 2018), with a Tier I CAR of 14.62%. Gearing stood at 6.42 times as on December 31, 2018. The net worth/net NPA ratio was around 3.3 times as on December 31, 2018. Capitalisation is expected to remain adequate over the medium term, supported by a demonstrated ability to raise external capital. Accruals to networth will be supported by the company's ability to maintain good interest spreads and a low operating expense ratio. The return on assets ratio was 2.29% (annualised) in the first nine months of fiscal 2019 (2.04% in full fiscal 2018). However, profitability will remain susceptible to increase in credit costs because of weakening in asset quality in the private sector exposures.

Weakness:
* Exposure to risks relating to inherent vulnerability of asset quality, and significant customer and sectoral concentration
The company caters only to the power sector and faces inherent asset quality challenges because of the weak financial risk profiles of its main customers, SPUs, comprising around 81% of overall advances as on December 31, 2018. Further, top 10 borrowers constitute 39% of total loans as on December 31, 2018. Effective execution of various reform measures is extremely critical for SPUs to produce the desired positive impact, and broad-based political consensus is necessary to implement the much-needed tariff hikes to ensure sustained improvement in the performance of SPUs. However, REC has been able to manage overall asset quality risks in this segment owing to its criticality to borrowers and through various asset protection mechanisms.

REC also has around 12% exposure to the private sector as on December 31, 2018, which has been vulnerable to asset quality risks owing to issues such as lack of fuel availability, inability to pass on fuel price increases, and absence of long-term power purchase agreements for assured power offtake. In the fourth quarter of fiscal 2018, there was a sharp increase in gross non-performing assets (NPAs) to 7.15% from 2.41% as on March 31, 2018 mainly on account of revised guidelines issued by the Reserve Bank of India for recognition of stressed assets - around Rs 9591 crore or 4.01% was due to this. As on December 31, 2018, the overall gross NPAs increased further to 7.57% - the entire gross NPAs are in the private sector portfolio. Net NPAs have reduced to 3.96% as on December 31, 2018 as provisioning cover has increased following the transition to IND-AS.

Overall, CRISIL believes that the asset quality will remain vulnerable over the medium term primarily because of the increased challenges likely to be faced with private sector borrowers. The ability to resolve stressed accounts will also be a key monitorable going ahead.