Delayed trend reversal in private sector capex

True, the worst for private sector capital expenditure (capex) is behind us. But it is too early to rejoice as it may still be a while before there is a firm trend reversal.

The recent Reserve Bank of India survey shows that capacity utilization levels in the private sector are around 70-75%. Some analysts were just beginning to get optimistic about sighting the green shoots of recovery in some manufacturing and industrial sectors. But October’s Index of Industrial Production at 2.2% was again a dampener, with manufacturing growth falling to a low of 2.5% compared to a 10-month high of 3.8% in September.

Even the September quarter’s order flow for most firms in the capital goods universe was weak, in spite of the low base in the year-ago period. Only retail consumption-linked sectors like food processing, automobiles and auto components have displayed capex over the last several quarters.

Nomura’s recent report shows that capex for the BSE 500 (ex-financials) firms has plateaued since fiscal year 2011 (FY11). “Between FY03-11 the annual capex for these companies increased at a CAGR of 35%. Oil and gas, telecom, metals and infrastructure were the key sectors, contributing almost 70% of the capex over the period,” says the report. CAGR stands for compounded annual growth rate.

These sectors barring roads, railways and irrigation that are backed by government spending, are still suffering from overcapacity following the economic downturn and slowdown since FY11. Capital goods firms catering to metals, power generation and mining are yet to see a huge increase in order flows. These sectors actually trigger demand for a host of capital goods through the value chain, from boilers, turbines and furnaces to industrial forgings and heavy machinery.

Unfortunately, analysts foresee capex in these sectors to be another 24 months away, at the least. Incidentally, such forecasts have also consistently been revised in the last couple of years.

Only those companies in power transmission have seen order books expand in the last few quarters.

That said, hope in the economy is kindled by some macroeconomic data. Although capex levels are static, there has been a small pickup in the asset turnover ratio, which implies that asset utilization is slowly improving. This is measured in terms of net sales/net block (of assets).

Meanwhile, the Nomura report says that the doubling of loan sanctions between FY16 and FY17 is a healthy sign, especially since it comes after a decline in the earlier five years. Note that bank loans fund about 70% of the private sector capex in the country.

The Street too has been cautious on the capital goods sector. Although the BSE Capital Goods index has scored higher returns than the broader market indices, it has been range bound in the last couple of quarters, as the initial euphoria from the green shoots of recovery has abated.

In other words, higher demand expansion in core sectors is needed to establish a sure-shot trend reversal in the capex cycle—a healthier indicator of economic growth.