Capital shortfall of Rs9.8 trillion could slow India’s growth

Capital shortfall of Rs9.8 trillion could slow India’s growth

New Delhi: An India fallout of a global financial crisis could be a potential capital shortfall of about $200 billion (about Rs9.8 trillion) over the next three years, as savings of companies fall and foreign investments flow out, McKinsey and Co. told Planning Commission officials in an internal presentation this week.

A copy of the consultant’s presentation, which clearly notes that it is a discussion document, was reviewed by Mint.

It says that despite the Indian economy’s strong fundamentals, growth could lose steam on account of a shortage of capital. McKinsey’s assessment covers a three-year period, which began on 1 April through 31 March 2011.

A McKinsey spokesperson said the presentation was only a draft “discussion" document for the Planning Commission and didn’t represent the firm’s crystallized view.

McKinsey’s presentation also prescribed a possible antidote to the capital shortage.

Echoing the government’s mid-year review, the presentation says the government should persist with economic reforms and make itself an attractive destination for foreign investment, particularly sovereign wealth funds. Banks, which would have to emerge as the primary source of credit to offset the vacuum in other credit markets, would need to be recapitalized.

The potential shortage of capital largely stems from a decline in companies’ internal accruals, or retained profits, and foreign investors pulling out of India, both on account of the global financial turmoil, the presentation said.

Indeed, a part of McKinsey’s observations are echoed in the Indian finance ministry’s mid-year review 2008-09, which was presented in Parliament on Tuesday. That review identified a “moderation" in companies’ savings and also that of the public sector as a challenge confronting the economy.

“There could be a shortage of funds if avenues of funding other than banks remain weak," says D.K. Joshi, principal economist and director at the credit rating agency Crisil Ltd.

India’s credit crisis in the last 10 weeks has been largely due to funds in non-banking channels drying up. In a speech on 10 December, Reserve Bank of India governor, D. Subbarao, identified bearish capital markets, a freeze in overseas credit markets and a dip in internal accruals as the main sources of pressure in the country.

Bear markets have also coincided with a $13 billion outflow of foreign portfolio investment, a development McKinsey’s discussion paper indicates might continue for a while longer. The firm’s presentation indicated net foreign inflows—including direct investment—could be $30 billion over three years.

Taking a bird’s eye view of the capital the economy requires in three years, McKinsey has estimated the need would be around $1.2 trillion. Driven largely by household savings, the economy would collect a shade over $1 trillion, the presentation said.

Companies’ retained earnings, which totalled about $215 billion in the last three years, would shrink by 21% to $170 billion over the next three years, the discussion paper noted.

Some of the sectors identified by McKinsey in its presentation as the worst-hit are automobiles, media, real estate, cement and iron and steel. These sectors are currently grappling with falling demand and pressure on prices, and need working capital and longer-term funds for projects that are already underway, the presentation noted.

“Banks are not easily increasing their portfolios in the current situation. Corporate India, which largely depends on banks for capital, may suffer due to dual effect of low savings and less money from the banks," says Robin Roy, associate director at consultancy firm PricewaterhouseCoopers.

McKinsey’s draft forecast is based on a few critical assumptions, the most important being a 7% economic growth rate over the next three years. Among the other important assumptions are a moderation in inflation to about 5.5% over the next two fiscal years and capital productivity of the last fiscal year to be held over the next three years.

The Indian government’s mid-year review has forecast a 7% growth rate for the current year. However, growth rates for the world economy have been revised downwards in the space of a few weeks during the course of the current year by multilateral agencies as negative news has come in.

As 70% of Indian banking is controlled by public sector banks, McKinsey’s presentation suggested the government inject up to $35 billion over the next three years to maintain its current holding as banks step in to fill the credit vacuum.