India caught in two-speed growth

A broad-based economic recovery will be contingent on a sustained pick-up in private investment cycle

Basic macroeconomics tells us that GDP is total value of consumption expenditure, investment expenditure, government spending plus net exports in a given year: (C+I+G+X-M). Here, C+G is the consumption demand of individuals and government. In response to this demand, businesses and government undertake investments (I) to produce goods and services. Net exports (X-M) represent demand for domestically-produced goods and services abroad, minus imports. Then there is the monetary system with the central bank and other commercial banks that supports this economic activity. Simply put, in the domestic scenario, there are three players who drive growth—consumers and households through consumption, industry and corporates through investment, and government through policies. Of course, their economic activities are interlinked.

India’s recent GDP growth has puzzled many economists. The country clocked average GDP growth of 7.4% (as per the new series) in the last two fiscal years (FY15 and FY16). Manufacturing GDP grew 9.6% in the first three quarters of FY16 and 12.6% in quarter ending December 2015, compared to 5.5% in FY15. This seems counter-intuitive as other leading indicators like IIP, PMI, bank credit, exports and auto sales do not reflect a broad-based recovery.

A closer look at monthly indicators points towards a two-speed recovery. While urban economy seems to be looking up, rural demand is languishing. Some sectors like cement, fertiliser and electricity are showing strong growth, while a sustained pick-up in manufacturing growth is yet to happen. Unlisted private companies seem to be faring better than their listed counterparts. However, a broad-based economic recovery will be contingent on a sustained pick-up in private investment cycle. A look at the components of GDP throws some light on the real state of the economy.

Urban consumption growth has benefited from lower inflation and oil prices, but the rural economy is still weak. Two successive years of below normal monsoon and lower minimum support prices have suppressed farm incomes. Rural agricultural wages grew on an average by only 4.5% during April 2015 to February 2016, as opposed to 18.4% during FY15. Rural non-agricultural wages grew by 8.3% over the same period, as compared to 14.5% in FY15. The sector grew at an abysmal pace of 0.9% in first three quarters of FY16. Two-wheeler sales growth—a leading indicator of rural demand—remained subdued in FY16 (3%), compared to 8.3% in FY15. The FY17 Budget’s heavy focus on rural India and forecast of an above normal monsoon may turn the tide in FY17.

On investment side, corporate balance sheets are stressed and fresh investments are not being undertaken. Private investment cycle has failed to pick up despite efforts by the government and rate cuts by RBI. Gross fixed capital formation as a percentage of GDP has been declining since 2011—falling from 34.4% in FY12 to 32% in FY15—which is worrisome.

High corporate debt levels coupled with weak consumption demand are hindering revival of private capex cycle. CMIE data shows that borrowings of private non-financial sector have grown four-fold since FY07, which has resulted in higher interest burden for them. Interest coverage ratio (calculated by dividing EBIT by interest expenses) of private non-financial sector has halved from 6 in 2010 to 3 currently. Lower interest coverage ratio reflects their inability to pay outstanding debt. Low levels of capacity utilisation also hinder fresh capex. As per RBI, capacity utilisation at an aggregate level stood at 72.5% in last quarter of 2015, compared to over 80% seen in 2009.

While corporates are unwilling to borrow, banks are wary of lending. Banking sector, especially PSBs, continue to struggle with rising NPAs. The gross NPA ratio of PSBs increased from 5.43% in March 2015 to 7.3% by December 2015.

On the face of it, bank credit, the main source of funding for the commercial sector, seems to be picking up, clocking double-digit growth since December last year (11.6% in February 2016). It had been hovering in the 9% range since January 2015. But a closer look at the deployment of credit across sectors indicates that most of the growth has come on the personal loan side, while credit to industry has been sluggish. As per RBI, credit growth is on a decline for most sub-sectors including petroleum, coal products, nuclear fuel, beverage, tobacco and food processing.

Balance sheets of banks and corporates are stressed, and there will be no fresh investment even if interest rates are reduced, unless that investment sees a demand it needs to serve. That is where the link between monetary policy/banking system and real economy breaks down. Thus, despite RBI’s efforts to lower interest rates for stimulating investment, private investment cycle hasn’t picked up.

But unlisted private companies seem to be faring better than their listed counterparts/large corporates. In case of private non-financial firms, smaller unlisted companies have outpaced listed ones for the past three years. Latest RBI data on financial performance of 2.3 lakh unlisted private companies shows that their sales grew at a healthy pace of 12% in FY15, while for listed private corporates it was an abysmal 1.4%. This stands true for profit growth as well.

Sector-wise, there are some green shoots. Cement production rose 4% during April 2015-February 2016, compared to 5.9% in FY15. A strong growth of 11.3% y-o-y was seen in the first two months of 2016, which might be driven by infrastructure projects. How this will pan out in the next few quarters will depend on the extent of government spending on infrastructure and demand from housing sector. Sectors like fertilisers and electricity have also been outperformers.

On the external front, exports contracted 16% in March 2015-February 2016. Exports account for 23% of India’s GDP and have been contracting since December 2014. A sharp decline is seen in petroleum and crude, agriculture and allied products, ores and minerals, and electronic goods.

The key players of the economy—C, I and (X-M) component of India’s GDP—seem to be showing mixed signals, with no broad-based recovery in sight. There is weak demand from rural India. Large corporates are unwilling to borrow due to their high debt levels and weak demand. Policy hurdles, low capacity utilisation and existing stalled projects weaken the case for new investment demand. Rising NPAs of banks reduce their inability to support growth.

The Budget focused on rural India and the farm sector saw 94% increase in allocation. This includes 42% rise in irrigation spending, 86% in crop insurance allocation and R150 billion for interest subvention on loans. Fast-tracking of irrigation projects, increase in farm credit, higher allocation to MGNREGA and extension of interest rate subvention to farmers will boost rural income. Total productive spending for capital asset creation under the FY17 Budget shows a mild improvement to 2.75% of GDP from 2.73% in FY16. Allocation for infrastructure-related sectors rose by 42.7% y-o-y for FY17. Public investments on infrastructure can help ease the low capacity utilisation situation in most industries. Infrastructure spending will have a multiplier effect of creating demand for steel, cement, capital goods and commercial vehicles, and spurring fresh investments in manufacturing. Mere capital infusion is not sufficient to improve the health of PSBs, so bank consolidation can improve capital efficiency and their ability to recover loans. Geographical synergies, technology platforms, cultural synergies and cost rationalisation would be the criterion for bank consolidation.

The government has to play its part before all key components of GDP pick up pace and a broad-based recovery happens. This will take time. The cheers will have to wait.

Authors are corporate economists. Views are personal

(The article is based on GDP data till Q3FY16)

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