India has long been waiting for a revival of its investment cycle. Investment rate (gross capital formation to GDP) has fallen by almost eight percentage points from around 40% in FY08 to 32% in FY15. Economists have time and again reiterated that for growth to be sustainable, India needs a revival of its capex cycle. As per conventional neoclassical economics, lower interest rates should spur investment and hence growth. But what if the private sector does not borrow despite access to cheaper credit? In other words, what if the transmission mechanism between the banking system and real economy breaks down?
Before we delve into this, let’s look at how the investment cycle has behaved over the past few years.
Data from the Central Statistics Office shows that share of industry in gross capital formation declined from a peak of 47% in FY08 to 38% in FY14, and share of services increased from 48% to 54% in the same period. Within industry, manufacturing was the worst hit, with its share falling from 27% to 19%. Clearly, within the investment pool, more money was going into the services sector than into manufacturing. This would seem intuitive, given the high growth in the services sector. However, manufacturing sector growth has a multiplier effect on all other sectors of the economy.
Hence, in the absence of additional capacity creation in the manufacturing sector, some benefit to growth will be shaved off. This, of course, has implications for the economy—faltering growth and high inflation.
During FY15—a recent RBI study shows—830 companies intended to invest in projects with an aggregate cost of Rs 1,459 billion, in comparison with an investment intention of Rs 2,081 billion (revised) by 1,056 companies during FY14. Based on investment plans, capital expenditure for FY16 stands at R819 billion, which is Rs 1,114 billion short of last year. In FY15, investment in ‘new projects’ accounted for 39.7% of the total cost of projects, as against 65.2% in the previous year. Also, the number of big-ticket projects with long gestation periods has gone down significantly.
Even CMIE’s quarterly data on investments shows that new investment (in rupee terms) announced by private Indian corporates during 1HFY16 is around 5.2% lower compared to the same period last year. Overall, there is a downward trend in the investment cycle.
Given this backdrop of faltering growth and capex, the government along with the industry pitched for rate cuts to revive private corporate investment. While RBI reduced its policy repo rate by 125 bps over the last one year, the average prime lending rate of six leading banks in the country has fallen by around 50 bps over the same period. Therefore, if banks do not cut their lending rates, the impact of an accommodative monetary policy on the real economy will be limited.
This brings us back to the question, whether corporates are willing to undertake new investment when interest rates are reduced? A logical proposition is that corporates will borrow and invest more when they have access to cheaper credit. However, corporate balance sheets don’t look very good. Japanese economist Richard Koo’s analysis shows that the private sector behaves outside the conventional framework of neoclassical economics when their balance sheets are stressed. In other words, they do not increase borrowings even at lower interest rates. This happened in Japan where record low interest rates did not spur investment demand. Thus, monetary policy renders itself ineffective in a situation where debt levels are high. In such a scenario, corporates try to minimise debt instead of maximising profits, hence the transmission mechanism between the banking system and real economy breaks down.
Japan’s corporate sector shifted from being a traditional borrower of funds to a massive re-payer of debt. New cheaper debt is taken essentially to pay off the earlier costlier debt and not for investment. Therefore, the corporate sector is only restructuring its debt. While this will have an impact on the cash flows and profitability of businesses, it will not impact their debt levels and investment.
Is a similar situation playing out in India? May be. Consider these numbers.
CMIE data shows that borrowings of private non-financial sector have grown almost four-fold since FY07, which has resulted in higher interest burden for them. Weak demand and rising input costs have resulted in reduced profit margins. As a result, interest coverage ratio of non-financial private corporates has been declining since the Lehman crisis. Interest coverage ratio (calculated by dividing a company’s EBIT by the company’s interest expenses for the same period) is a measure used to determine how easily a company can pay interest on outstanding debt. For example, a ratio of 1.5 indicates that for every R1 of interest, the company makes R1.5 profit. The ratio has almost halved from 6 in 1Q2010 and is hovering around 3 currently. This includes large corporates as well.
Low levels of capacity utilisation also hinder fresh capex. As per RBI’s Quarterly Order Books, Inventories and Capacity Utilisation survey, capacity utilisation at an aggregate level stood at 71.5% in 1QFY16. This is down from over 80% seen in 2009. According to CRISIL, capacity utilisation levels are currently at a five-year low in 10 out of 12 large industrial sectors, due to which new project announcements have dried up. Steel, aluminium and petrochemicals are the worst hit. CRISIL, in fact, predicts fresh investments to account for only 20% of total investment for the next couple of years.
Corporate balance sheets are therefore stressed and fresh investments are not being undertaken. If the private sector is unlikely to lead the revival in investment cycle, then the only option is for the government to take lead and increase its capex expenditure. In such a situation, however, government borrowing and spending does not ‘crowd out’ but crowds in private investment. Moreover, government spending on infrastructure projects can help increase capacity utilisation rates, while lower interest rates can help corporates restructure their debt. Once this happens, corporates will be willing to undertake fresh investments.
So, when exactly will the corporate capex cycle pick up? Economists will keep guessing.
The authors are corporate economists based in Mumbai. Views are personal