Managing Business Cycles

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).