D E BATE
India Inc: Will the boom continue?
Corporates have once again recorded a bumper growth but many believe the negative impact of higher interest rates and currency appreciation is yet to play out. Three expert views.
I SS U ES
Will the earnings growth start to slow down due to the higher interest rates?
Will corporates continue to invest at the current pace?
Which sectors do you see doing well in the current fiscal?
SHANKAR NARAYANAN MD, Carlyle Asia Growth Capital Team, India
INDIA, like China, is in the middle of a great economic transformation. Similar to the growth witnessed by the United States in the decades after the Civil War (in spite of hiccups like the crash of 1929 and the depression that followed), India should enjoy a period of sustained growth and prosperity over the next two to three decades.
While the long-term growth potential is wellestablished, the challenge in the short term is clearly inflation. In a country like India where there is a wide disparity in wealth across various sections of the society and where a large part of the populace lives below the poverty line, high inflation is both unfair to the poor and politically lethal to the ruling party’s fortunes. Sustained inflation could be a serious impediment to further reform and liberalisation of the economy and this could force the ruling class to again go down the politically expedient path of the failed socialistic policies of the past.
With the RBI holding its hand by not raising interest rates (and probably being a bit behind in taming inflation), and the rupee strengthening, the export oriented companies are facing the prospect of shrinking margins as they are caught in a vice of wage inflation on one hand and a stronger rupee on the other. Exports of goods and services have been the catalyst of India’s explosive growth and this could be in peril if the rupee continues its advance and there is no respite from wage inflation
Rising interest rates could negatively impact the domestic demand in real estate, cement, building products and a slew of other industries. Further, the double whammy of high inflation and increased cost of credit could adversely impact the retail consumer demand for products like automobiles and other consumer durables as well. Thus we are at a critical point in our history where slowing GDP growth or high inflation could imperil the political will to continue with economic reforms.
Then, what could be the panacea for sustained high GDP growth without the ugly head of inflation rearing its head alarmingly? The short answer is sustained productivity gains in every sphere of economic activity.
Our companies have done a remarkable job of improving productivity since the initiation of economic reforms. Indeed, most auto companies today produce more vehicles per employee than a decade earlier. Almost all sectors have improved their return on capital employed over the past decade or so. Today, corporate India as a whole is more operationally and financially efficient than ever before. But, there still exists scope for productivity gains and this has to come from removal of systemic hurdles in the country.
One of the key prerequisite to achieve significant productivity gains is investment in improving the infrastructure in the country. Improved infrastructure could ease supply side issues and significantly add to GDP growth without stoking inflation. Similarly, other key area of focus should be improvement in government efficiency. While the government has done a commendable job on the fiscal deficit front and tax collections have improved dramatically, overall efficiency of government machinery leaves a lot to be desired. We cannot be a First World country with a Third World bureaucracy and political class. Corruption, inefficiency and insensitivity have to be rooted out from every government department. Reduced corruption and improved government efficiency can create an environment that is conducive for huge productivity gains to the economy as a whole.
The potential for sustained GDP growth at 8-9% without significant inflation does exist, but without proactive tackling of inflation and productivity gains, we could imperil our immediate future.
RITU ANAND Chief Economic Advisor State Bank of India
FOUR years of unprecedented high earnings and profitability, coupled with financial restructuring over the past decade, has strengthened corporate balance sheets immensely. As a result, corporates are in a much stronger position to withstand the upturn in the interest rate cycle than ever before.
The leverage of Indian corporates is quite low (unlike, for example, corporations in East Asia). As a result of lower dependence on borrowing as well as the secular decline in interest rates until 2004-05, their interest burden is relatively low. Indeed, interest payment as a share of gross profits has declined to about 15-17% through the first half of 2006-07 from more than 50% in the 1990s, according to RBI annual studies of over 2,000 firms in the private corporate sector.
Moreover, even though the interest rate cycle has turned upwards since the late 2004, the interest burden has not increased overall for the corporate sector. The reason is their profitability growth has been even higher and has offset the rise in interest costs.
There are, however, some caveats to this seemingly optimistic scenario. The first is the distributional impact of the monetary tightening policy. Smaller firms will be affected much more by higher interest rates. This is because they are more dependent on bank loans than are large firms. SMEs generally also have lower profit margins. Consequently, retained earnings or internal generation of resources account for a smaller part of their investment financing than for large firms.
Moreover, larger, well-established firms have greater access to alternative sources of funding. They can access credit markets directly through stock and bond as well as borrow abroad, which they have been increasingly relying upon. Although bond financing is still insignificant, due to the undeveloped Indian bond market, equity issuance more than doubled in 2006-07. And resources raised through markets abroad also rose substantially last year. External commercial borrowing (ECB) provided an attractive option as the interest differential between Indian interest rates and foreign rates rose.
Smaller firms may not be able to borrow abroad directly because of the high transaction costs involved for small amounts. In this case, banks could intermediate by sourcing lower cost funding based on their credit rating (if permitted within the ECB ceiling), cover the exchange risk by hedging, and on-lend to SMEs. But this should be done on a purely commercial basis without any subsidy to SMEs and taking into account the prevailing forward premia.
Going forward, there is likely to be a greater impact on the corporate sector due to the rise in interest rates. The last few months witnessed stronger monetary tightening, the ripple effects of which are still making their way through the system. Future profitability may not grow as fast — not just because of higher interest cost, but also because of the rise in commodity and other input costs as well as other factors. Firms will also have to be prepared for greater volatility in the exchange rate and hedge their currency risks.
The cumulative impact of the monetary tightening is now beginning to tell, with real interest rates starting to rise, growing appreciation of the real effective exchange rate, and asset price inflation slowing down. Together, these factors will rein in demand — as is the intention, after all — until capacity constraints are eased and potential supply increases. Slowing consumer demand would lead to a slowdown in investment in those sectors to avoid excess capacity. Growth prospects remain bright over the medium to long-term, though. There is no need to be alarmist. We are headed for a soft landing and robust growth over the long haul.
P K CHOUDHURY Vice Chairman & Group CEO, ICRA
THE prevailing macro-economic conditions and the overall performance of the Indian economy over the recent years have resulted in a justified confidence about continued economic growth. India Inc is being taken very seriously as an integral part of the global economy and the brand India is well respected. While the main growth driver has been the service sector led by IT & ITES, the manufacturing sector has also not lagged behind and has been demonstrating its ability to stand up to the global standards of performance.
This has been achieved despite infrastructural bottlenecks, competitive pressures arising out of opening up of the economy and the occasional uncertainties in the process of disinvestment. However, there have always been certain anxieties and some valid apprehensions about sustainability of this pace of growth. This has now become a little stronger due to some recent developments in the Indian economy.
The most important of them is the gradual hardening of interest rates. The anxiety is that, at this rate, we may go back to the interest structure prevailing in early/mid ’90s and consequently the manufacturing sector, in particular, may become globally uncompetitive. The other apprehensions are in terms of steep rise in the manpower cost and space cost eroding the competitive advantages of India as a low cost economy and reducing the advantages of cost arbitrage. The infrastructural bottlenecks, of course, continue to be a major cause of concern. The exporters, including IT & ITES service exporters, are also worried about the exchange rate movement vis-à-vis the dollar, the United States being the major importer of these services.
These are valid apprehensions and genuine causes of concern. However, it is very unlikely that these would have a serious adverse impact on the economic growth. There are mitigating factors and systemic strengths to offset the adverse impact to a significant extent. The Indian economy, during its recent growth phase, has demonstrated considerable resilience to adverse conditions. Almost all the major economic entities and sectors in the country have restructured and realigned themselves to become globally competitive in terms of skills, technology, productivity and quality standards. The acceptability of Indian goods and services is at all times high. The consumption pattern within the country, backed up by adequate purchasing power, has significantly increased the domestic demand.
The most vulnerable to the interest rate movements are the SMEs and exporters. The large organised players are not highly leveraged and, in any case they would be in a position to access the global capital market, if the need arise and may even be benefited due to hardening of the rupee. The viability of infrastructure sector would be somewhat affected due to the upward movement in the interest rates. However, the initiatives taken in infrastructure development through private sector participation, though may become a bit slow, would continue to have considerable investment through innovative funding structures in the years to come and would have consequential positive economic impact.
The buoyancy in investment climate and the level of confidence of the investors have not dampened despite the hardening of interest rates or the rising manpower cost. Even the interest rates would be dependent on demand-supply interactions and the water would find its own level. There could be some marginal movements in the rate of GDP growth, either way, but within a narrow band in the next few years. There could be minor adjustments but not economic slowdown; definitely not in the medium term.
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