Mapping India’s Post-Covid Capex Recovery

A meaningful recovery in private sector investments is still at least half a decade away, finds this India Ratings analysis.

Labourers work at a construction site in Gandhinagar, Gujarat. (Photographer: Adeel Halim/Bloomberg)
Labourers work at a construction site in Gandhinagar, Gujarat. (Photographer: Adeel Halim/Bloomberg)

With lessons from China’s growth story.

One of the biggest impediments to India’s economic growth in the last decade has been the muted level of investment activity. Annual growth in gross fixed capital formation averaged at around 8% in FY10-FY20 as against over 15% in the previous decade. Even before the Covid-19 pandemic struck India, the country’s economy was losing momentum with real GDP growth plummeting over the previous nine consecutive quarters. As a result, the country entered into this pandemic on a weak economic footing and these legacy issues could significantly dampen any prospects of quick economic recovery.

In India, Who Invests?

Between FY12-FY19 households accounted for 39% of the gross fixed capital formation, corporates contributed 37% while only 24% was investment activity by the government sector and public sector enterprises. Nearly 75% of the total investment by the households has been limited to real estate assets – where the income effect has had an overbearing impact on the investment appetite.

Between FY07-FY13, GFCF growth was supported by a robust growth in both manufacturing and the real estate sector –driven by a rise in employment and wage growth in the services sector. The rising income levels provided a fillip to the capacity utilisation of various industrial units as demand remained strong. This provided the much-needed confidence to Indian corporates to undertake a massive round of capex between FY13-FY15 – increasing financial leverage to nearly an all-time high.

However, sluggish external demand and domestic supply-side factors hampered risk appetite creation. Services as well as manufacturing growth fell off a cliff, pushing nominal growth to the sub-13% levels for the rest of the decade. This phase of sub-optimal return on capital spawned a fresh round of NPA-cycle and also indefinitely pushed corporates’ investment plans. As a result, employment growth suffered, wage increases fell off compared to nominal growth, and household demand plateaued – setting into motion a vicious cycle.

When Will Corporates Invest Again?

Our analysis indicates that meaningful recovery in private sector investments is still at least half a decade away. Our framework weighs the demand-supply equation against the credit strength of corporates to understand the emerging patterns.

Two intuitive but distinct trends are evident – for companies with strong balance sheets, capex decisions will be driven by the level of capacity utilisation; while for those with highly levered balance sheets, the investment decisions will be contingent on their deleveraging plans.

Since FY14, the capacity utilisation of even those entities with relatively strong balance sheets has persistently remained below 80%. However, as these corporates have continued to spend on upgrading existing facilities in a bid to enhance their profitability, their capex outlay has increased, albeit at a slower pace than the previous decade.

Till their capacity utilisation peaks, these corporates will explore diversification opportunities along with vertical integration plans to enhance their muscle in respective value chains.

This trend will continue to offer a strong case for consolidation across industries in the coming years.

On the other hand, for stressed corporates (i.e., those with weak balance sheets), working capital pressures, subdued return on investments, and corporate governance missteps have inhibited their ability to de-lever their balance sheets. As a result, their capex growth has been significantly lower at around 2-4% in the last decade. Even after their capacity utilisation peaks, their leverage levels will continue to dampen their animal spirits for green-field capex for at least another five to six years. Till then, these corporates will report a fall in their revenue growth rates.

Three Improvement Areas

Three factors are affecting the recovery of the investment cycle in India.

First, the slow pace of resolution of stressed assets. These assets in-limbo have kept the idle capacity of the system at a fairly elevated level. Ironically, these corporates were the heavy spenders in the previous capex cycle and accounted for up to 30% of the total investment outlay between FY07-FY14. Since the inception of Insolvency and Bankruptcy Code, of the top 500 debt-heavy private sector corporates, 113 cases have been admitted by the NCLT – 93 driven by financial creditors and 20 by operational creditors. As of March 31, 2020, only 32 of the admitted cases had been resolved while resolution on 81 cases is still pending. The timely resolution of these stressed assets remains critical for the revival of animal spirits in the lending ecosystem.

Second, there is a need to develop a market for long-dated liabilities and a very dynamic refinancing ecosystem including instruments like mezzanine funding. It is imperative that borrowers’ liability structures mirror the payback period of the underlying asset – the lack of which has driven, at least in part, Indian corporates’ refinancing challenges in the last 5 years.

The study in the chart below compares this aspect of the asset-liability mismatch for India and China. It illustrates the role played by a diverse liability mix in China’s growth story.

Despite a relatively smaller difference in their asset payback period, Chinese corporates have been able to do a better job at matching their liability profiles with their investments’ payback periods.

A large part of this divergence could possibly be explained by the ownership pattern of these corporates. With nearly 45% of the aggregate debt of these top 100 corporates coming from state-owned players, their ability to tap-long tenor funds from both domestic and external sources is clearly superior to their Indian counterparts.

Third, the factors of productivity – both labour and capital – again compare weaker for India. In a previous commentary, India Ratings & Research had estimated that in order to reach a sustained nominal GDP growth rate of 8%, labour productivity in India will need to increase by at least 21%. The gap in productivity for both capital and labour is almost glaring when compared to that of China’s, as seen in the charts below.

Among other prescriptions, enhancing productivity requires focused investments, a coordinated approach towards the development of information, communication, and technology or ICT capital throughout the value chains including the small and medium enterprises, strengthening corporate governance standards, and ensuring predictability of public policy.

A bulk of India’s GDP growth in the last three decades has come from a rise in labour output—both size and productivity of labour—and non-ICT capital deepening.

However, in comparison to the trends in China, only a minuscule portion of growth has come from the growth in ICT capital.

Non-physical capital creation has a large multiplier effect. It not only enhances the productivity of physical and financial capital but also complements growth in labor productivity and has been a key driver of growth in several large economies over the last three decades.

Another very interesting comparison to drive home the above point is how the quantum of investment in non-physical assets like research and development, patents, trademarks, and software differ between the two countries.