Indian
companies bulk up their investment just before the slowdown starts, aggravating
the pressure on their bottom lines, rather than being ready with new capacities
just when an upswing is taking place
INDIA
became a reluctant devotee of open markets ever since its close brush with
bankruptcy. As a result, the country and its policymakers had no choice but to
enroll for continuing lessons on the advantages and perils of open markets as
well as global linkages. Even Indian businesses had to learn some hard lessons.
But, without prejudice to the nature of the economic agency — whether it is the
government or the private sector business organisations — the process has been
like baptism by fire.
However,
the Indian corporate sector has been unable to come to terms with one intrinsic
open market phenomena, which is largely episodic in nature but has a close
bearing on the future growth prospects of almost all companies. It is called a
“business cycle” and impacts bottom lines directly. It is an unavoidable
consequence of open markets and free competition. Most developed markets around
the world have gathered years of experience about it and have geared many parts
of their business activities to forecasting it and then taking action to either
minimise its deleterious impact or to capitalise on its salubrious influence.
But, most companies in India seem to be getting acquainted with this unique
change process only now.
Examples
bear out India Inc’s inability to spot this big trend. The Indian corporate
sector’s genetic architecture still seems to suffer from a passive disposition
to floating along with the tide. Sure, there are some exceptions to this languid
and helpless approach, but these are only a handful. Part of the reason for this
lassitude lies in history and partly it is also due to structural deficiencies
in the market, over which most companies do not have any control.
Here is
one example of how companies miss the timing. If one goes by the chronology of
business cycles drawn up by Pami Dua and Anirvan Banerji (Business Cycles in
India, August 2006), then the period between September 1991 to May 1996 is shown
as an expansion period, indicating increases in output, employment, income and
sales. But, data shows private sector savings quite placid during the
expansionary period (1991-92: 3.1% of GDP, 1992-93: 2.7%, 1993-94: 3.4%,
1994-95: 3.5%), but peaking to 5% only in March 1996, just when the business
cycle is about to contract. The story’s the same for private sector gross
domestic capital formation, averaging around 13.5% of GDP, but suddenly peaking
to 18.4% by April 1996, just as the slowdown begins. Predictably, the savings
and the investment rates fell the next year. This seems to indicate that Indian
companies bulk up their investment just before the slowdown starts, aggravating
the pressure on their bottom lines, rather than being ready with new capacities
just when an upswing is taking place.
Research
shows that most Indian companies rely largely on external financing to finance
expansion (Financial Development & Growth in India: A Growing Tiger in a
Cage, Hiroko Oura, IMF, March 2008). The trend is greatly emphasised in firms
younger in age and smaller in size. The paper provides pointers to another
systemic challenge — dependence on external financing (including equity) is
inversely proportionate to a company’s growth prospects. However, Oura also
concludes that despite all the shortcomings in the economy, India’s
recent growth spurt was largely due to productivity growth.
Typically, most firms have two sources of financing — external and internal.
Again, external can be divided into domestic and “overseas” finance. If one
leaves aside equity, then the sources of financing in the domestic market are
characteristically bank funding, trade credit and capital markets (for issuing
bonds and a host of other short-tenure instruments, such as commercial paper).
According to
studies done over time, it is shown that most Indian companies historically did
not generate enough savings. For example, in the ’80s, private sector savings
hardly amounted to 2% of GDP — it touched 2% in 1988-89 and reached 2.4% in
1989-90. Given this low rate of savings, the corporate sector had to depend
largely on external financing, including equity financing. Over the years, as
markets opened up and tax rates came down (diminishing the incentives of high
leveraging), the corporate sector’s propensity to invest was then directly
related to its ability to generate enough surplus so that a judicious blend of
own funds, borrowed funds (which largely meant bank financing) and equity could
be used as the optimum, lowrisk combination. However, to generate the kind of
internal surplus, most companies had to wait for their savings to touch a
critical mass. Ordinarily, by the time most companies could make use of the good
times and generate enough bulk on their books, the business cycle would turn.
Companies then tended to save their surplus — instead of spending it on capital
expenditure — for seeing them through the tight periods.
One
alternative could be then to use bank credit for the planned investment
expenditure. But, that’s a non-starter given the corporate sector’s inclination
to spend only when the cycle starts heading downwards. The April edition of
IMF’s World Economic Outlook (aptly titled Housing and Business Cycle) mentions:
“Bank credit cycles arise naturally as a result of business cycles.
Specifically, bank lending typically rises during an expansion and declines
during a contraction. In a downturn, firms’ demand for credit normally declines,
reflecting a curtailing of investment plans in response to weaker economic
prospects and greater spare capacity...The price of bank credit also varies with
the business cycle because it incorporates a risk premium. During a growth
slowdown, the risk of insolvency increases in both the corporate and household
sectors. Banks typically respond by charging higher risk premiums and tightening
lending standards, particularly for riskier borrowers. Hence, expansion of bank
credit is typically procyclical, whereas risk premiums and lending standards are
countercyclical.”
The only
alternative left then is either the equity markets or corporate bond markets.
Undoubtedly, the Indian equity markets have reached some degree of global
sophistication and efficiency. However, the same cannot be said of the corporate
bond market. Also, the efficiencies of the equity market are not enough to compensate for the deficiencies in debt financing. In the end, if we give
allowance for the fact that the corporate sector has been maturing over the
years, then the only impediment to an efficient corporate sector is the absence
of a well-functioning bond market.
Published as an Op-Ed in The Economic Times (June 11, 2008).
