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Inflexion point for private capex upcycle still afar

Share Written By
Mr.Dhananjay Sinha

Head of Research, Economist & Strategist

21 Dec 2017

Recent enthusiasm about a possible turnaround in private corporate capex cycle is pivoted upon improved cash flows from operations (CFO) and some capacity utilization. However, the current excitement is far less intense compared to 2014 when a pro-Gujarat model type nationwide transformation was predicted after the Modi government was voted to power.

Back then, we had debunked the consensus view based on our assessment of the fundamental context. Looking back we find that 3.5 years’ static private capex has sustained over 5 years now and India’s investment rate has continued to decline from 40% in FY08 to 30% in FY17 - the steepest and the longest fall in the last 60 years.

The question is whether there is enough evidence now to confirm a secular turnaround as some have argued. Possibly not, is my short answer. Operating metrics for companies has improved somewhat over the last 3.5 years, but it may not have still reached an inflexion point that would trigger a virtuous cycle of private capex.

 

What are the high frequency data telling us? Industrial production data shows the Capital Goods sector growth averaging at 6.7% during Aug-Oct’17. The IIP data in detail indicates strong traction in Commercial Vehicles, Ferrous Metals and Machinery. But, are these indicators sufficient enough? Historical data during the post-stimulus responses (during 2009-2011 - post Global Financial Crisis) also provided a false start back then. But, notwithstanding a monumental monetary and fiscal stimulus, the investment rate has continued to decline.

 

Therefore, it is premature to extrapolate the preliminary indicators. Q2FY18 commentary from Engineering & Capital Goods (ECG) companies remain muted but positive on government orders. Industrial credit has continued on the downward trajectory and recent IIP data may be capturing the disturbance created by demonetization’s impact last year and re-stocking effect post GST implementation. 

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Also, with emerging fiscal constraints of possible shortfalls in tax & non-tax collections and higher commitment towards revenue spending in the run up to the upcoming state and general elections in 2019, there is a high probability of government capital allocation being compromised.

 

More fundamentally, a study of long-term business cycles suggests that private investments are a function of multiple factors, such as sales growth, return on capital, cost of doing business, balance sheet strength and operating leverage on the one hand and the momentum of domestic savings on the other. While the recent rise in CFO is an indicator of improving operating performance, a host of other indicators are less compelling.

Notably, the earlier investment boom phase (FY04-FY10) was preceded by a sustained rise in CFO without addition to fixed assets. During the slowdown phase of FY98-03, the annual investment in fixed assets by domestic private non-finance companies was stagnant or declined even though the CFO more than doubled over FY99-04. Corporate commitments to investments in fixed assets were significantly lower than the CFO generated during FY99-04 - CFO was nearly twice the level of investments in fixed assets. Clearly, the sustainability of CFO during low investment phase feeds into repayment of long-term debt, contributing towards the deleveraging process. 

What characterized the turning point in private investment?

First, the inflexion point in 2003-04 was preceded by a noticeable turnaround in return on equity (RoE), which bottomed out in FY02 (at ~1%) and continuously increased over the next 5 years. The pick-up in investment cycle gained pace from FY04 onwards after the RoE increased to 18-20%. In the current context, ROE of private domestic non-finance companies is much lower at around 5%.

Second, fixed investments require risk taking and hence there needs to be sufficient spread of ROE over risk-free rate before companies start to invest. At the last inflexion point in 2004, this spread over the 10-Year G-sec yield increased to 1500bps in FY04 (BSE 500 non-finance companies). At 5% ROE of private non-finance domestic companies, this spread over 10-year yield at 7.2% is currently negative and for the BSE 500 companies it is just 300bps. Hence, the current returns are much lower for private capex to be incentivized. 

Third, investment cycle is preceded by sufficient period of robust sales growth, deleveraging and rise in operating profit margins. Data on  domestic non-finance private companies (CMIE database) indicates that while the CFO has improved from a low of 6.7% of sales in FY12 to 8.3% in FY17, it is not feeding into operating profit margin (OPM), which at ~9% is still substantially lower than ~12% in FY03 seen ahead of the previous investment boom cycle. This is because of the rising commitment towards interest cost and depreciation. The balance sheet deleveraging over the recent years is still modest.  Hence, profit after tax (PAT) to net-worth ratio (ROE) has remained low at ~5%, much lower than the steep rise to 15% we saw in FY03-FY04.

Fourth, upcycle in domestic investments in FY04 was preceded by a steep rise in savings rate from 24% in FY01 to 29% in FY04, which superseded the investment rate, thereby translating into 3 years of current account surplus. This situation evolved before the following 10-year rebound in investment rate (gross capital formation/GDP) from FY04 at 27% to 39% in FY12-13. The current situation does not indicate any visible revival in domestic savings as yet. The current account balance remains in deficit despite the sharp decline in global crude oil prices during 2015-16.

The fact that the overall savings rate has continued to decline (29% in FY17 from the peak of 37% in FY08) despite the drop in global commodity prices during FY15-16 is a limiting factor for revival in domestic investments. India’s investment rate has declined from a high of 40% in FY12 to the current level of 30% to align with the declining domestic saving rate. The large influx of foreign direct investments (FDI) and the much touted Make in India campaign have also failed to revive the domestic investment cycle.

 

Net household savings rate has been declining due to outpacing of incremental household liability compared to incremental financial assets and deceleration of household income growth. Consumption spending growth of 10-11% in the recent years has far outpaced the 5-8% growth in compensation to employees by Indian companies and retail lending is growing at 15-20%.

Despite the impact of demonetization, which temporarily converted currency holdings into bank deposits, and inflow of transitory idle money (caused by demonetization and GST disruption shocks) towards mutual funds, the household financial saving has improved only marginally to 8.2% of GDP in FY17 from 7.9% in FY16 - but it is much lower than the 11.5% average seen during FY08-FY11 and 10-11% seen in FY03-FY04. Hence, the household saving rate, including physical saving, is estimated to have declined to a low of 18-19% in FY17 from a high of 26% in FY09.

Fifth, despite the Rs 2.11tn package announced in Oct’17 to resurrect the public sector banks (PSBs), who currently hold impaired loans worth Rs 10tn, government’s contribution towards their recapitalization is still to fructify. While positive market reactions to the package has encouraged PSBs to raise funds, it is still going to be a long drawn process before banks regenerate the appetite to support private capex. 

Clearly, the current indicators do not appear to conform to the impulses that prevailed during the previous investment cycle inflexion points.

Surveys of companies across core industries indicate that some capex outlays are expected in Oil & Gas, Cement and Ferrous Metals. No major capacity additions are expected in Thermal Power, while capacity additions in Renewable Power are getting delayed. While major announcements have been made in the Road sector, it is yet to translate into firm orders. The Oil & Gas sector has recently completed major capex (averaging ~Rs1.3tn p.a.).

A lot of recent positive impulses are driven by improvement in global trade, reflecting in a rebound in EXIM data and high pace of government spending. While the sales growth of companies has improved over the past few quarters, utilization of existing capacities remains low. In the current context, crucial indicators such as return ratios, spread of ROE over risk-free rate, balance sheet leverage, asset turns, OPM and banking sector impairments suggest that cyclical recovery in demand has to become more deeply entrenched before a sustainable private investments is established.

The risk is that the crowding in impact of government capital outlay can take a backseat if political imperatives of upcoming elections drive governments to shift focus back to higher revenue spending. Our assessment of the revenue nature of spending incorporated in Supplementary Grants this year, outlook on hardening of G-sec yields and higher of raw material costs due to rising commodity prices suggest that the cyclical upturn in corporate performance will be gradual. It will still take some time before the animal spirits towards a sustainable private investment cycle emerge. 

Recent enthusiasm about a possible turnaround in private corporate capex cycle is pivoted upon improved cash flows from operations (CFO) and some capacity utilization. However, the current excitement is far less intense compared to 2014 when a pro-Gujarat model type nationwide transformation was predicted after the Modi government was voted to power.

Back then, we had debunked the consensus view based on our assessment of the fundamental context. Looking back we find that 3.5 years’ static private capex has sustained over 5 years now and India’s investment rate has continued to decline from 40% in FY08 to 30% in FY17 - the steepest and the longest fall in the last 60 years.

The question is whether there is enough evidence now to confirm a secular turnaround as some have argued. Possibly not, is my short answer. Operating metrics for companies has improved somewhat over the last 3.5 years, but it may not have still reached an inflexion point that would trigger a virtuous cycle of private capex.

 

What are the high frequency data telling us? Industrial production data shows the Capital Goods sector growth averaging at 6.7% during Aug-Oct’17. The IIP data in detail indicates strong traction in Commercial Vehicles, Ferrous Metals and Machinery. But, are these indicators sufficient enough? Historical data during the post-stimulus responses (during 2009-2011 - post Global Financial Crisis) also provided a false start back then. But, notwithstanding a monumental monetary and fiscal stimulus, the investment rate has continued to decline.

 

Therefore, it is premature to extrapolate the preliminary indicators. Q2FY18 commentary from Engineering & Capital Goods (ECG) companies remain muted but positive on government orders. Industrial credit has continued on the downward trajectory and recent IIP data may be capturing the disturbance created by demonetization’s impact last year and re-stocking effect post GST implementation. 

 

Also, with emerging fiscal constraints of possible shortfalls in tax & non-tax collections and higher commitment towards revenue spending in the run up to the upcoming state and general elections in 2019, there is a high probability of government capital allocation being compromised.

 

More fundamentally, a study of long-term business cycles suggests that private investments are a function of multiple factors, such as sales growth, return on capital, cost of doing business, balance sheet strength and operating leverage on the one hand and the momentum of domestic savings on the other. While the recent rise in CFO is an indicator of improving operating performance, a host of other indicators are less compelling.

Notably, the earlier investment boom phase (FY04-FY10) was preceded by a sustained rise in CFO without addition to fixed assets. During the slowdown phase of FY98-03, the annual investment in fixed assets by domestic private non-finance companies was stagnant or declined even though the CFO more than doubled over FY99-04. Corporate commitments to investments in fixed assets were significantly lower than the CFO generated during FY99-04 - CFO was nearly twice the level of investments in fixed assets. Clearly, the sustainability of CFO during low investment phase feeds into repayment of long-term debt, contributing towards the deleveraging process. 

What characterized the turning point in private investment?

First, the inflexion point in 2003-04 was preceded by a noticeable turnaround in return on equity (RoE), which bottomed out in FY02 (at ~1%) and continuously increased over the next 5 years. The pick-up in investment cycle gained pace from FY04 onwards after the RoE increased to 18-20%. In the current context, ROE of private domestic non-finance companies is much lower at around 5%.

Second, fixed investments require risk taking and hence there needs to be sufficient spread of ROE over risk-free rate before companies start to invest. At the last inflexion point in 2004, this spread over the 10-Year G-sec yield increased to 1500bps in FY04 (BSE 500 non-finance companies). At 5% ROE of private non-finance domestic companies, this spread over 10-year yield at 7.2% is currently negative and for the BSE 500 companies it is just 300bps. Hence, the current returns are much lower for private capex to be incentivized. 

Third, investment cycle is preceded by sufficient period of robust sales growth, deleveraging and rise in operating profit margins. Data on  domestic non-finance private companies (CMIE database) indicates that while the CFO has improved from a low of 6.7% of sales in FY12 to 8.3% in FY17, it is not feeding into operating profit margin (OPM), which at ~9% is still substantially lower than ~12% in FY03 seen ahead of the previous investment boom cycle. This is because of the rising commitment towards interest cost and depreciation. The balance sheet deleveraging over the recent years is still modest.  Hence, profit after tax (PAT) to net-worth ratio (ROE) has remained low at ~5%, much lower than the steep rise to 15% we saw in FY03-FY04.

Fourth, upcycle in domestic investments in FY04 was preceded by a steep rise in savings rate from 24% in FY01 to 29% in FY04, which superseded the investment rate, thereby translating into 3 years of current account surplus. This situation evolved before the following 10-year rebound in investment rate (gross capital formation/GDP) from FY04 at 27% to 39% in FY12-13. The current situation does not indicate any visible revival in domestic savings as yet. The current account balance remains in deficit despite the sharp decline in global crude oil prices during 2015-16.

The fact that the overall savings rate has continued to decline (29% in FY17 from the peak of 37% in FY08) despite the drop in global commodity prices during FY15-16 is a limiting factor for revival in domestic investments. India’s investment rate has declined from a high of 40% in FY12 to the current level of 30% to align with the declining domestic saving rate. The large influx of foreign direct investments (FDI) and the much touted Make in India campaign have also failed to revive the domestic investment cycle.

 

Net household savings rate has been declining due to outpacing of incremental household liability compared to incremental financial assets and deceleration of household income growth. Consumption spending growth of 10-11% in the recent years has far outpaced the 5-8% growth in compensation to employees by Indian companies and retail lending is growing at 15-20%.

Despite the impact of demonetization, which temporarily converted currency holdings into bank deposits, and inflow of transitory idle money (caused by demonetization and GST disruption shocks) towards mutual funds, the household financial saving has improved only marginally to 8.2% of GDP in FY17 from 7.9% in FY16 - but it is much lower than the 11.5% average seen during FY08-FY11 and 10-11% seen in FY03-FY04. Hence, the household saving rate, including physical saving, is estimated to have declined to a low of 18-19% in FY17 from a high of 26% in FY09.

Fifth, despite the Rs 2.11tn package announced in Oct’17 to resurrect the public sector banks (PSBs), who currently hold impaired loans worth Rs 10tn, government’s contribution towards their recapitalization is still to fructify. While positive market reactions to the package has encouraged PSBs to raise funds, it is still going to be a long drawn process before banks regenerate the appetite to support private capex. 

Clearly, the current indicators do not appear to conform to the impulses that prevailed during the previous investment cycle inflexion points.

Surveys of companies across core industries indicate that some capex outlays are expected in Oil & Gas, Cement and Ferrous Metals. No major capacity additions are expected in Thermal Power, while capacity additions in Renewable Power are getting delayed. While major announcements have been made in the Road sector, it is yet to translate into firm orders. The Oil & Gas sector has recently completed major capex (averaging ~Rs1.3tn p.a.).

A lot of recent positive impulses are driven by improvement in global trade, reflecting in a rebound in EXIM data and high pace of government spending. While the sales growth of companies has improved over the past few quarters, utilization of existing capacities remains low. In the current context, crucial indicators such as return ratios, spread of ROE over risk-free rate, balance sheet leverage, asset turns, OPM and banking sector impairments suggest that cyclical recovery in demand has to become more deeply entrenched before a sustainable private investments is established.

The risk is that the crowding in impact of government capital outlay can take a backseat if political imperatives of upcoming elections drive governments to shift focus back to higher revenue spending. Our assessment of the revenue nature of spending incorporated in Supplementary Grants this year, outlook on hardening of G-sec yields and higher of raw material costs due to rising commodity prices suggest that the cyclical upturn in corporate performance will be gradual. It will still take some time before the animal spirits towards a sustainable private investment cycle emerge.