4 min read.Updated: 07 Feb 2019, 12:54 AM ISTNipun Sahni,Rajnish Gupta
The entire economy might be paying higher cost of capital due to outdated weightage assignments
As the weather changes so does our clothing style. In peak summer, it is T-shirts and, in winters, we get our sweaters out. We keep doing this every year so that we remain in our comfort zones. While this is not an exact corollary, but interest rates, inflation and economic growth, too, follow a cyclical and reflexive behaviour. High interest rates drive down economic growth and inflation. Low economic growth pushes the central bank to reduce interest rates and this cycle continues forever. There is always a debate about “ahead of the curve" or “behind the curve", and striking balance between inflation and growth.
As the Indian economy has grown at over 7% compounded annual growth rate (CAGR) for the last 15 years, credit formation has deepened across both industrial and consumer sectors. While India is the fastest growing large economy in the world, it has had high interest rates—both real and nominal. The real interest rates in India are at over 4% as against 1% or even negative rates in other large economies, such as the US, China, Germany, Japan and the UK. Prevailing interest rates impact the cost of capital and return expectations.
Our analysis suggests that the return on total capital employed (ROCE) by leading Indian companies in capital intensive sectors is similar to that earned by leading global companies. For example, leading Indian and global steel companies have an ROCE of approximately 7.5%. Global rivals are earning higher returns in sectors such as airlines and telecommunications.
However, when we take the impact of leverage and look at the return on equity (ROE), in most capital-intensive sectors, the returns to Indian companies are less than their cost of capital (they are comparable with the yields on government securities).
In India, the equity returns in capital-intensive sectors financed with high debt-equity ratio suggest that it might not be economically prudent to invest in these businesses. It is no coincidence that these sectors are also witnessing high levels of non-performing assets.
Returns in the industrial, manufacturing and infrastructure segment are driven by competitive forces and the cost of capital. High cost of debt increases the risk premium, and is one of the reasons capital-intensive manufacturing and infrastructure projects are not as attractive to invest into.
Anecdotally speaking, entrepreneurs are investing their equity in low capital expenditure (capex) sectors with shorter working capital cycles such as information technology, consumer goods and services sectors. These sectors need small doses of debt capital, as they have low capex needs and a short working capital cycle of 60 to 90 days. Whereas, hard asset sectors are long-cycle businesses, and require 7 to 15 years’ capital. It is no surprise that almost all infrastructure companies and real estate developers operate at 0-10% ROE.
For setting interest rates, the Reserve Bank of India, in 2015, had decided to use inflation data derived from the consumer price index (CPI) instead of the wholesale price index (WPI).
CPI is more representative of inflation, which is calculated based on a basket of goods that are assumed to be consumed by the people in their daily lives. A major divergence between the two indices is the weightage given to the basket of goods considered. In particular, the food articles have a weightage of 15.26% in WPI, and 45.86% in the case of CPI.
In CPI, there is no weightage to housing in rural areas, or for electronic goods such as TVs, fridges, mobile phones and computers, but there is weightage of 2.38% to tobacco and intoxicants.
Between 2012 and 2017, the annualized CPI was 6.12%, and WPI was 1.7%, which shows that there is a large variation between the two. In other countries, difference between WPI and CPI tends to be less than 2%. This means that the choice between using CPI and WPI for setting interest rates becomes particularly important for India. Further, the question is whether the current construct of CPI reflects the price changes being experienced.
Maybe it is time for the ministry of statistics, the central government and the RBI to review the inflation metric more carefully. There is a strong case to revisit the same so that the inflation reflects the true consumption pattern. The entire economy might be paying higher cost of capital due to outdated weightage assignments.
Should this review result in lower interest rates, capital formation, which has slid from 35% in 2007 to 26% in 2017, may catapult to the mid-30s level. Lower interest rates will go a long way in making our companies globally competitive, create jobs and take us closer to 10% gross domestic product (GDP) growth.
Then, there are some other questions: Can the interest rates be sustained by the sectors where the bulk of bank lending goes? What would be the impact on savings rate? Will government and state finances improve if the old debt stack gets refinanced with lower interest rates? Will infrastructure finance become easy? And, what will be the impact on corporate earnings?
Maybe, there is a case to reduce interest rates by 200 to 300 basis points. Ultimately, change is always difficult to bring about.
As John Maynard Keynes said: “The difficulty lies not so much in creating new ideas, as in escaping from old ones."
Nipun Sahni & Rajnish Gupta are, respectively, partner at Apollo Global Management and associate partner at EY
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