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Economic survey: Quick turnaround in investments unlikely, underplays the role of savings

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Mr.Dhananjay Sinha

Head of Research, Economist & Strategist

12 Feb 2018

Economic Survey chapter on the investment slowdown has been rather candid in highlighting that the current slowdown in the investment rate has been both unprecedented and the longest, declining for 11 successive years from its peak in 2007 and the fall has still not abated. There is no evidence to suggest that the turnaround in private capex is just around the corner, as some have claimed.

The analysis on the investment slowdown by the Survey has devoted considerable work to disentangle the causal relation between the investment rate (gross fixed capital formation/GDP), the domestic saving rate (household, private & public sector savings/GDP) and economic growth. The cumulative 900bps decline in the investment rate from 35.6% in FY07 to 26.4% in FY17 has been the steepest in the past 60 years and has been accompanied by a similar decline in the savings rate (from 38.3% to 29%).  Such a steep decline in the investment rates did not occur even during the economic crisis of 1991 or in the aftermath of the Asian financial crisis of 1997-98.

The key conclusion that the Survey attempts to derive is that the revival in private investments does not have to depend on the revival in domestic savings. Therefore, the policy response need to be geared more towards reviving investments rather than savings, which is essential for a sustainable high GDP growth rate.

The other substantive point the Survey has articulated is that the deceleration in private investments is due to significant malaise in corporate balance sheets. Companies had to curtail investments due to financial stress emanating from past heavy investments and indebtedness; past investments did not generate enough revenues to service debt. 

An analysis of empirical data from similar global episodes of corporate balance sheet led difficulties reveals that investments remain highly depressed even 17 years after the peak, having recovered only 25% from the bottom of the initial 14 years of decline. Conversely, non-balance sheet slowdowns are shorter and tend to reverse more quickly.

But, having faced the balance sheet drag, India is 11 years past the peak investment rate. So, conforming to the global median trend, there is a possibly that it will take another 3 years to reach the bottom of the investment cycle. And even following that, the recovery will be just 2.5% (or 25% of the decline during FY07-FY18).

The conclusion drawn by the Survey that the drag on India’s investments is more protracted mimics our theme that the inflexion point for private capex upcycle is still afar and counters the consensus view that the turnaround is around the corner.

Where we differ is that while the Survey has relied primarily on average duration of cycles, the extent of decline in the investment, savings rates and statistical causality, its analysis has failed to capture the underlying dynamic relationships. Below are a few examples:

First, the claims that revival in investments precedes economic growth and savings defies business cycle dynamics, which is characterized by lagged and extrapolative behavior of private investment cycle. One reason why balance sheet stress has sustained in India is because private capex continued to remain elevated even past the peak of the business cycle. India’s investment rate remained robust till FY12 despite the business cycle reaching a peak in FY08.

Second, the claims that the investment rate is unrelated to or precedes saving rate revival also misses the point that private investments respond to prior incentives of improving return ratios and profitability, which are essential components of cyclical upswing in private corporate savings. For instance, the pick-up in private investments in FY04 onwards was preceded by 2-3 years of revival in return on equity (RoE) for private domestic non-finance companies from close to 0% to 15%. At the current juncture, there is little evidence that RoE has moved beyond 5-6%, which is a decline from the peak of 22% in FY08. Over the past 4 years, earnings for these companies have hardly grown (+4-5%), much lower than the nominal GDP growth rate of 10.5%.

Separately, the Survey has highlighted that India’s current corporate earnings/GDP ratio has been sliding since the Global Financial Crisis, falling to just 3.5%, while profits in the US have remained at a healthy 9% of GDP. Hence, while India has been touted as the fastest growing economy in the world, strangely, it doesn’t reflect in the corporate performance.

Third, it is not the first time that Indian corporates have faced balance sheet problems; it always happens during the economic booms when overzealous investment commitments far exceed business cycle peaks. Earlier upcycle in private investments during FY91-97 also saw considerable rise in leverage ratios of companies, which was followed by a deleveraging process till FY05, mostly contributed by balance sheet restructuring till FY03.

The difference this time is that the intensity of rise in the investment rate during FY04-FY12 was the steepest since 1950s and hence requires much longer time to regenerate productivity of capital and emergence of returns incentive. Also, unlike the pervious boom periods, which were funded by large development financial institutions (eventually merged into their promoter banks), in the current cycle, the project funding banks do not have the liberty to transform into any other entity. The eventual option is turning out to be conversion of private bad debt into public debt via the government recapitalization bonds.

Unlike the earlier inflexion point of private capex revival, the concern now is that the further decline in savings rate (due to rise in current account deficit in the face of reflationary fiscal policies and rise in global crude prices) is causing the risk free G-sec yields (10 year at 7.5%) to rise faster than the profitability of Indian corporates. This is not helping to generate return arbitrage for the much-awaited private capex revival.

In a possible scenario of bad debt resolution of banks and recapitalization of public sector banks (PSB), the adjustment process can get expedited and stimulate consolidation across vulnerable industries. Also, one can hope that pick-up in sales growth will improve asset turn ratios of companies over time. But, in this milieu, it is difficult to surmise a quick turnaround in private capex, something which the Survey is also agreeing to.