Reviving Private Investment In India, With Clues From EM PeersBloombergQuintOpinion
Why do a few emerging economies enjoy a virtuous cycle of higher investment returns driving increasing global capital allocation; while others like India get stuck in a quagmire of stagnating Return on Capital Employed and increasing external capital dependency? Is it a question of having a ‘scarcity’ versus ‘abundance’ mindset?
When capital is looked at as a scarce commodity, returns would be driven by the availability of capital, opportunity to carve out some productive assets from that capital, pushing for visible sales efficiency out of that capex and finally picking the margin available on those sales. The ability to raise good quality capital in turn depends on getting consistently higher RoCE, effectively making it a Catch-22.
On the other hand, if economies work with a desired level of return in mind, build muscle in the value chain to drive pricing power, strategise their demand-supply positioning within global supply chains to ensure healthy asset turnover, and are helped by disciplined counterparty behavior to ensure minimal loss towards working capital lock-up, good quality capital would likely come calling.
We compare the drivers of RoCE for the top 100 corporates in China, Indonesia, Brazil, and Malaysia to get a perspective of how India’s peers have been navigating through this cycle of investments and returns through the last 15 years.
The tale of India’s investment cycle is a paradox in itself. Vis-à-vis other EMs, through 2005-2019, India reported the highest capex intensity – measured as the total capex divided by the total revenue in a particular period. Yet, India reported the lowest average annual change in per capita GDP or pcGDP in the same period – a meagre $93 (4.84% average annual growth) against an average of $352 (7.04% average annual growth) between India and the four other EMs being studied.
Each of these economies has focused on taking charge of certain aspects of this return generation cycle that has played some role in providing a sustained period of income growth – thereby maximising the ‘growth multiplier’.
Capital Deployment: ‘How’ Is More Critical Than ‘Where’
Despite the constant comparison, India’s case appears to be different from its EM peers. Not only has corporate India’s combined RoCE reduced considerably compared to its peers over these years, but the entire capital raise to RoCE cycle also shows a minimal correlation with year-on-year pcGDP movement. While the difference in India’s basic GDP construct vis-à-vis its EM peers could explain some part of this, the fact remains that without understanding this linkage between RoCE and pcGDP, or lack of it, policy campaigns like “Make in India” or “Self-Reliant” might not prove effectual in meaningfully improving India’s income profile.
For both China and Indonesia, the capex intensity along with the pace of capital raise (i.e., incremental capital raised as a proportion of capital employed) shows a very high correlation with the change in pcGDP. Between 2006-09, India had a comparable RoCE profile to them. However, during this period both these countries undertook a massive capex program, ploughing close to 20% of their respective annual sales into largely equity-funded capex with 15% YoY change in pcGDP.
India, in contrast, spent just 5-6% of sales into capex with 8-9% YoY change in pcGDP.
Brazil, being a natural resource led economy, intuitively shows a greater concurrent correlation with commodity price movements which feed into both fixed asset turnover and profitability ratios. However, even its consumption heavy economy shows a high correlation between capex intensity and pcGDP, lagged by a year. Malaysia, the most developed EM peer with a relatively higher contribution of net exports to its GDP, shows a moderate correlation only with the pace of capital raise.
Does the variance in sectoral GDP construct explain this lack of correlation in India sufficiently, or has it something to do with the way capex planning has happened in India over the last few years?
We compared the relative concentration of capex within a few sectors and few corporates and also the average length of the capex cycle and found some interesting pointers.
Evidently, India seems to have the shortest capex cycle with the second most concentrated spread after Brazil.
Intuitively, a higher concentration would magnify macro-economic vulnerabilities – wherein headwinds faced by a handful of sectors can expose the economy to a deeper economic slowdown and a consequent drop in pcGDP – as in the case of Brazil between 2014 to 2019. A classic example from India is the bunched-up capex in the iron and steel sector in 2008, a fair chunk of which turned up as non-performing assets within five years. Conversely, in countries where investment spending is relatively broad-based, capex cycles tend to be more spread out and sits easier on the lending ecosystem.
Also, barring a few large conglomerates, in India, we have seen corporates often focusing on specific parts of the value chain without having full visibility or sufficient bargaining power to turn around the investment if the sector fundamentals were to deteriorate. The current struggle of many auto ancillary players during a capex cycle is a case in point. In contrast, some of the Chinese corporates, which raised a vast amount of capital for capex in 2007-08, like China Rail or China Unicom, had a fair mix of domestic and overseas projects lined up while courting retail and strategic investors.
The sustained asset turnover profile of Chinese corporates is testament to their strategic planning horizons along with their ability to boost competitive advantage on a global scale.
We do have a few success stories in India as well, like the specialty chemical sector. From being a mere subcontractor in generic products, these players have gradually become technology partners, signing long-term deals and technology sharing agreements. Along with the export opportunity arising from the de-risking of global supply chains, many of them are also working to bridge the large trade deficit domestically. These companies have expanded their portfolio through backward and forward integration with a focus on value-added products and have employed agile go-to-market strategies to target new geographies. In this case, sustained policy push and benefits from a healthy ecosystem like PCPIRs have helped. But these need to become more pervasive across other sectors as well.
Talking of the ecosystem, counterparty behavior has been another key determinant of how the capital gets deployed into productive assets. The comparison above illustrates the loss in translation from capital raise to capex deployment for India and how it has accentuated in the recent years. One of the major culprits here is bulging receivables from public sector counterparties. In a previous article, we have argued how getting the distressed asset resolution process on fast track would go a long way in accelerating our recovery. The point becomes even more pertinent given that only about 50% of incremental capital employed is going towards return accretive assets in India.
Just to wind up the RoCE comparison, a quick look at EBIDTA margins reveals India’s relative disadvantage to its more resource-heavy peers, although the gap with China has been coming off. However, as we opined in our previous article, China has been consistently investing in enhancing labor productivity, increasing its global reach and growing intangible assets including intellectual property, research, and innovation, to ensure the sustainability of future margins. We need to start thinking on those lines today.
Finally, What Is Good Quality Capital?
Corporates have four essential sources of capital to fund their investment needs – internal accruals, unutilised cash and liquid investments, fresh equity infusion, and fresh debt raise.
Equity flows—both direct and portfolio—have been inadequate to cover for its net imports – contrary to other EMs. Although most of these other EMs are structurally current account surplus (while India is not), yet these EMs have been able to offset their fall in net exports by attracting additional equity flows. As a result, the build-up of financial leverage in India has been significantly higher.
The same story repeats at the corporate level. In comparison with other EMs, around 40% of the total capex in India was funded via debt, against an average of 22%.
Again, the key question to ask here is that are we really attracting symbiotic capital – one that doesn’t feed on inefficiencies or impose suboptimal return cycles? Or has it been mostly fueled by relatively higher real interest rates?
India’s recovery since the global financial crisis was fueled by excess credit. Consequently, while high real rates continued to attract capital from across the world, the high real cost of capital weighed in on equity returns. Equity investors have often been collateral damage while the debt markets continue to be crowded out by the huge quantum of government borrowings. In other words, have the debt investors been dictating the quantum and nature of capex which has often led to myopic investment plans?
So, as we restart our recovery planning in the aftermath of the Covid-19 pandemic, what would it take to change the mindset? A strong sovereign underwriting large part of the capex planning cycle through its lending institutions, or a vibrant ecosystem with consistent policy roadmap, easy dispute resolution processes, and coordinated long term capacity planning? However, the right prescription could differ from sector to sector.
Abhishek Bhattacharya is Head - Large Corporates, and Arindam Som is Senior Analyst, at India Ratings & Research – A Fitch Group Company. With contribution from Jinesh Rajpara, Senior Analyst.
The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.