Why corporates are not gung ho about investing in India

indian rupeesVivek Kaul  

Several senior functionaries of the UPA government have been confidently talking about the Indian economy returning to high rates of economic growth over the next few years. One of the major factors that needs to be set right for this is to happen is the falling level of corporate investment. 
In 2004-05(i.e the period between April 1, 2004 and March 31, 2005) this was at 10.3% of the gross domestic product (GDP). It rose to 17.3% in 2007-2008(i.e. The period between April 1, 2007 and March 31, 2008). 
Since then the number has been falling and should be currently around 10% of GDP or even lower, for that matter. This is reflected in the sanctions for fresh projects which have been fallen dramatically over the years. As
 an editorial in The Financial Express points out a recent study by Kotak Institutional Equities shows how sanctions for fresh projects have been tapering off from Rs 1,13,900 crore in Q1FY11 to Rs 74,900 crore in Q1FY12, Rs 41,300 crore in Q1FY13 and to just Rs 22,000 crore in Q1FY14.”
When the level of corporate investments fall, it has an immediate impact on the creation of urban jobs. As Chetan Ahya and Upasana Chachra of Morgan Stanley point out in a December 2, 2013 note titled 
India Economics: 2014 Outlook: A Year of Macro Adjustment “The steady decline in the ratio of investment to GDP has had a severe impact on urban job creation.” When enough jobs are not being created this has an impact on consumption and that in turn impacts economic growth. 
Given this, if the Indian economy has to go back to growing at high economic growth rates of 8% and higher, the level of corporate investments as a proportion of GDP need to go up. But that is easier said than done.
aSwanand Kelkar and Amay Hattangadi 
have a very interesting piece in the Mint today where they offer a major reason behind the slowdown in corporate investments. As they write “The Incremental Capital Output Ratio (ICOR)…measures the incremental amount of capital required to generate output or GDP. From FY2004 till FY2011, India’s ICOR hovered around the 4 mark, i.e. it required four units of investment to generate one unit of output. Over the last two years, this number has increased with the latest reading at 6.6 for FY2013.”
What this means in simple English is that the projects that corporates invest in are taking a longer period of time to be completed and start throwing up money. And this in turn is pushing down the return on the money that coprorates invest in fresh projects. In this scenario, any corporate will think twice before committing to a fresh investment. 
This scenario is likely to continue in the time to come. As Neelkanth Mishra and Ravi Shankar of Credit Suisse write in a research note titled 
India: 2014 Outlook dated December 2, 2013, “We expect the investment cycle to stay broken for the next two-three years: most types of large-scale investments with the exception of oil & gas have a depressed medium-term outlook. The order book for BHEL, the bellwether capital goods company, continues to decline, and the fact that new project announcements aren’t seeing any pick-up either would only worsen the situation going forward, in our view…The construction of national highways is unlikely to accelerate with most construction companies having weak balance sheets, and the last one-two years of contracts being so aggressively bid that they are having trouble raising loans.” 
For this cycle to be broken both inflation and interest rates need to come down. Inflation has had a huge impact on private consumption. “Moreover, persistent high consumer price inflation has only eroded the purchasing power of urban consumers, thus adding to the weakness in urban consumption. In addition, rural consumption growth is also moderating as real rural wage growth is decelerating. Slower growth in government spending will also in turn affect rural consumption growth adversely. Hence, we believe even private consumption growth remain slow in the next 6-12 months,” write Ahya and Chachra of Morgan Stanley.

Given this, consumer demand will continue to remain low. And in face of that fact, corporates in a large number of sectors aren’t likely to expand or announce fresh projects. 
High interest rates also discourage corporate investment. Interest rates have risen due to lower savings. “From FY2008 (i.e. the period between April 1, 2007 to March 21, 2008) to FY2013(i.e. the period between April 1, 2012 and March 31, 2013), the savings rate has fallen from 36.8% to 29.6%,” point out Kelkar and Hattangadi. Savings have fallen on account of people paying more for things, due to high inflation. 
What has also not helped is the fact that of the money saved a lot of money has been diverted into physical assets like gold and real estate, in the hope of earning a rate of return that manages to beat the prevailing inflation. “Persistently high consumer price inflation has kept real interest rates negative…encouraging households to reduce financial savings and increase allocation to gold and real estate. This is reflected in deposit growth, which has stayed weak relative to credit growth now for the last three and a half years, elevating the loan-deposit ratio near full capacity levels (76.5%currently),” write Ahya and Chachra.
And due to this the level of financial savings (or the money that people put into fixed deposits, small savings scheme, mutual funds, insurance etc) has come down dramatically. In 2007-2008 the number was at 11.63% of GDP. By 2011-2012 this had fallen to 8.02% of GDP. Currently, the number must be even lower.
If interest rates need to come down the amount of money going into physical savings needs to come down. As Ahya and Chachra point out “the central bank (i.e. the RBI) will also need to manage real rates in a way that incentivises households (savers) to increase their allocation towards financial saving (deposits) and away from gold.” 
The import duty on gold has been raised from 2% to 10% during the course of this year
. Over and above this a gold importer needs to re-export 20% of all the gold that he imports. This has led to gold imports falling dramatically to $3.9 billion during July to September 2013, down nearly 65% from the same period in 2012, when it had stood at $11.1 billion. 
While gold imports are falling, does that mean the demand for gold has been falling as well? News reports suggest that gold smuggling has gone up dramatically. 
A report in the Daily News and Analysis suggests that nearly 500 kgs of gold is being smuggled into India everyday., which means around 15 tonnes a month, and that is clearly a lot of gold. (To read a detailed analysis on this point, click here)
If this is correct, what this means is that Indians are still buying gold. And given that the level of financial savings is unlikely to go up in the near future. This means that interest rates will continue to remain high, making it unattractive for corporates to borrow fresh money to invest. 
What does not help is the fact the Indian corporates are already highly leveraged. In fact, debt to equity ratio of industrial companies was around 0.8 as of March, 2006, point out Mishra and Shankar. This mean that corporates had 80 paisa of debt for every rupee of equity. Since then it has gone up to around 2 i.e. corporates now have 2 rupees of debt for every rupee of equity. 
All these reasons make it difficult for India Inc to be gung ho about making fresh investments in the time to come.

The article originally appeared on www.firstpost.com on December 6, 2013 

(Vivek Kaul is a writer. He tweets @kaul_vivek)