The pickup in India’s economic growth rate since 2003 has been a source of easy money for investors. Sure, there have been brief episodes of volatility, related to a change in government in May 2004 and fleeting reversions in global risk appetite in May 2006 and February 2007. Yet, corporate profitability in India has grown strongly for 18 quarters as companies, responding to a revival in consumer demand, worked off excess capacity acquired during a mid-1990s boom that then went bust.
Monday’s decline in the shares of ICICI Bank Ltd, the country’s largest lender by market value, was a gentle reminder that the cycle may now be turning.
Financial investors must realize that further growth in corporate profitability in India may not be possible without a big increase in investments. That means shareholders must brace for equity dilution, especially by banks that are going to channel savings in the economy to satiate a growing hunger for roads, ports, airports, electricity and other infrastructure.
That reality is yet to sink in fully. ICICI’s announcement of a Rs20,000 crore share sale, the biggest yet for an Indian company, came as a shock to investors. The stock fell as much as 9.6% on the Bombay Stock Exchange.
Chief executive K.V. Kamath sees an investment pipeline of $500 billion of bankable projects in infrastructure and manufacturing.
While Kamath is working on a three-year plan, investors aren’t willing to look beyond the next quarter. They are concerned about the impact of the equity dilution on the bank’s per-share earnings. Yet, such a short-term fixation with profitability may be unwarranted.
“ICICI Bank is not a play on valuations but on its ability to ride the wave of India’s long-term growth story,” Batlivala & Karani, a securities firm in Mumbai, said in a note to clients on Monday, maintaining a “buy” recommendation on the stock. ICICI’s loan book is at present dominated by retail loans, especially mortgages. However, the consumer boom may have already run its course.
Led by leveraged purchases of new homes and automobiles, consumer debt in India has tripled from four years earlier to Rs6 lakh crore, or about 15% of annual gross domestic product, according to Chetan Ahya, a Morgan Stanley economist in Mumbai.
For Indian lenders, now is the time to retool the loan book and increase exposure to corporate borrowers for whom the currently high interest rates aren’t a big deterrent because most of them are looking beyond the present business cycle.
The Indian economy is rapidly modernizing. In the next few years, some industries—like organized, big-box retail—will be created in the country virtually from scratch. To tide over energy shortages, the government will invite bids this year for nine power projects, each of 4,000MW.
Airports will be upgraded; new ports and townships will be built. These industries are already demanding—and will eventually get—a lot of capital.
“Infrastructural bottlenecks are emerging as the single most important constraint on the Indian economy,” Y.V. Reddy, governor of the Reserve Bank of India, said in his monetary policy statement last week. “Rapid growth in demand for infrastructure with a less-than-proportionate supply response in the prevailing investment climate has resulted in stretching capacity utilization in electricity generation, roads, ports and major airports to overheating.”
Amenities of all kinds will see higher investments; that doesn’t mean all of them will be immediately profitable.
Wal-Mart Stores Inc., Reliance Industries Ltd and other investors will pour the equivalent of $20 billion (Rs82,000 crore) between now and early 2011 into hypermarkets, groceries and departmental stores, according to brokerage First Global Securities Ltd.
Assuming that half of this investment is funded by debt, the return on equity will, in a realistic scenario, be no more than 8%, First Global said in a recent study.
That’s far short of the 14% rate that Pantaloon Retail India Ltd, India’s biggest publicly-traded retailer, earned last year.
Changing growth pattern
As long as they had slack capacity, it was easy enough for Indian companies to meet investor expectations of scorching profitability growth.
Capacity utilization, which had fallen to a little more than 60% after the boom-bust cycle of the mid-1990s, recovered to more than 96% by 2006. Naturally, this contributed to strong corporate profits: Savings by India’s non-state-owned companies doubled, as a ratio of GDP, from 2003 to 2006.
This will now end. Some companies will be bolder than others in fundraising; others will be wiser than the rest in investing their resources. A small subset of companies will be both audacious in spotting growth opportunities and judicious in using shareholders’ money. Discovering them will require skill, patience and luck.