How far is India from witnessing a turnaround in its capital expenditure (capex) cycle? No, the answer to this question is not "just one general election away". Uncertainty around the general election is often cited as a hurdle for fresh investments, especially by companies. INFRASTRUCTURE TODAY digs deep into past data, which indicated that even after the polls, overall capex does not necessarily revive, and even when it does, the improvement isn't sharp.
Macro indicators - such as the bottoming out of gross fixed capital formation (GFCF), increased capacity utilisation, and robust capital goods production and imports - have been indicating that a nascent capex recovery is underway. However, Teresa John, Economist, Nirmal Bang, believes that capex recovery is going to be a slow and a long drawn-out process, with stops and starts.
She explains, "Election cycles typically act as a drag on capex cycle recovery, with the government prioritising revenue expenditure over capital expenditure. Moreover, private sector investment also slows with political uncertainty, although it tends to rebound quickly."
While the nascent capex recovery has been largely spearheaded by the government sector, economists believe the fundamentals are in place for a revival in private sector investment recovery. In particular, manageable inflation, stable interest rates and a contained fiscal deficit bode well. Nevertheless, inordinately high real interest rates and excessive fiscal profligacy could stifle the recovery.
Economists, INFRASTRUCTURE TODAY, interacted with, see scope for acceleration in the private capex cycle in India by late FY20 to early FY21, barring a global economic slump or an unstable government which may cause further delay. Sectors such as railways have been leading the capex recovery supported by government spending, while relatively resilient consumption-linked sectors such as food have also witnessed a recovery. In economisyts view, consumption-related sectors such as household and personal care and building materials may form a part of the next leg of capex recovery.
Overall, sectors that have witnessed a sharp reduction in leverage are likely to participate in the next leg of capex recovery, while sectors with a very high gearing level may be laggards in the capex cycle. Finally, in terms of sources of funding, while previous capex cycles were funded by banks, this cycle is likely to be more reliant on market funding, particularly the bond market.
Foreign funding will also play a role mainly through the external commercial borrowing or ECB route. Foreign direct investment (FDI) into India, including through the private equity route, continues to be focused on the services sector, although this is slowly changing with foreign investment in stressed assets slowly picking-up. (Refer graph on page no 22)
Are there signs of a capex recovery?
GFCF, after peaking at 34.3 per cent of GDP in FY12, has been on a declining trend. However, since FY18 there have been signs of bottoming out in GFCF. GFCF stood at 31.4 per cent of GDP in FY18, up from 30.8 per cent in the previous year, while the Central Statistical Office (CSO) estimates it to touch 32.9 per cent of GDP in FY19. The bottoming out of GFCF clearly indicates that a nascent capex recovery is underway. (Refer graph on page no 22)
Similarly, capacity utilisation has also witnessed an improvement. This suggests that the time for capex revival may be approaching. Currently, capacity utilisation is close to 75 per cent. Typically, capacity utilisation between 75-80 per cent signals significant pricing power, providing an incentive to invest. Over the past 17 months (August 2017- December 2018) capital goods production averaged 7.6 per cent year-on-year (YoY). In the same period, import of capital goods averaged 20.8 per cent YoY. Obviously this suggests that some incremental capex has been underway.
In the recent interim budget, the Union government announced direct income support of Rs 6,000 per year in three equal installments for around 120 million farmer households. For Samata Dhawade, Lead Economist (Vice President), Aditya Birla Management Corporation, farm loan waiver, waiver of power bills, unemployment allowances, etc. are a few "populist policies that have short-term objectives. Says Dhawade, "They do not focus on any long-term structural reforms agenda. So, it is no surprise that they are more of a drain on the government's budget and will have an impact on the government's capex plan."
Mostly, loan waivers have been the prerogative of the respective State governments (which has largely been discouraged by the centre), impacting the State's deficit scenario. Recently, post-State elections, Madhya Pradesh (MP), Rajasthan, and Chhattisgarh have announced farm loan waiver. Rajasthan's state finance has estimated that complete waiver of short-term crop loan will cost around Rs 2 trillion, which will cost the exchequer Rs 180 billion. Even earlier, the then BJP Government in Rajasthan had waived farm loans up to Rs 500 billion, which had cost the State's exchequer of Rs 84 billion. Similarly, the farm loan waiver in MP is estimated to cost almost 20 per cent of the total State expenditure. Consequently, to limit the deficit, the State governments will have no choice but to reduce capex. Another alarming fact to be noted is that State governments' capex has been the major driver for investment growth and been higher than the capex of the central government. So, any curtailment in the State's capex will impact the investment scenario of the economy, in general.
Overall capex never witnessed acceleration immediately after elections. According to an analysis by a broking firm Nirmal Bang, which spans nearly four decades by Nirmal Bang, gross fixed capital formation as a share of GDP has never really witnessed a major acceleration immediately after elections. In FY99 and FY05, there was an increase in GFCF as a share of GDP, but it was marginal at best.
Says, Madan Sabnavis, Chief Economist, Care Ratings, "Government capital expenditure tends to slacken before elections, as revenue expenditure takes precedence. Nevertheless, this is not always the case."
To add more, GST collection has been lower than its target. The budget estimate of GST collections for FY19 is Rs 13.48 trillion, with a monthly target of Rs 1.12 trillion. However, the actual collection has been on an average of Rs 900 billion per month. The collection crossed Rs 1 trillion only thrice since its implementation. Lower GST collection will exert pressure on the fiscal scenario, and hence restrain the spending on infrastructure. That apart, the Central Board of Direct Taxes (CBDT) has collected Rs 11 trillion in total direct taxes in FY19, a shortfall of around Rs 830 billion of the Rs 12 trillion collection target.
Analysis of the past four general elections in India suggests that in FY'00 and FY'09 capital expenditure witnessed sharp cuts, thereby acting as a drag on overall capex. However, in FY04, capital expenditure far outpaced revenue expenditure, while in FY14 capital expenditure grew a tad faster than revenue expenditure. The slackness in government capital expenditure ahead of elections tend to have a lagged impact, affecting growth in the following quarters.
That said, in FY19, capital expenditure is estimated to grow 20 per cent YoY, while revenue expenditure is expected to grow 13.9 per cent YoY, according to the revised budgetary estimates. However, Sabnavis anticipate some cut-back in capital expenditure to meet the fiscal deficit target of 3.4 per cent of GDP. As a case in point, capital expenditure is already witnessing a cut-back (refer Government capex under pressure in FY19 on page no 24). Consequently, Dhawade believes that the slowdown in government capital expenditure may dent overall capex recovery over the next few quarters.
Brokerage firm UBS Securities India estimates that overall capex in the fiscal year 2020 may grow 6 per cent, trailing the 20 per cent increase in FY19. "This reflects deteriorating spending quality and a skew towards social welfare spending. In our base case, we expect gradual capex recovery from late FY20 onwards (March 2020 quarter onwards)," said an economist on the basis of anonymity.
Apart from the Government, private sector capex also slows on political uncertainty, but usually witnesses a quick rebound immediately after elections unless global economic conditions turn extremely unfavourable. "In six out of eight election cycles, private corporate investment as a share of GDP witnessed a pick-up, and in most cases meaningful acceleration," said Teresa John.
It was only in FY97 and FY99 that private corporate investment slowed after the elections. In FY97, Indian witnessed political instability after the elections resulted in a hung parliament. In FY99, global growth slowed sharply on account of the Asian financial crisis.
Meanwhile, on the basis of interactions with stakeholders, an economist from Bank of America Merrill Lynch suggests that infrastructure order flows would take a breather for next two to three quarters as large and fast growing verticals accounting larger than 40 per cent of sector orders are prioritising execution over project award in the near term. However, despite muted near-term orders and likely disruption on-ground for 2-36 months around election, most stakeholders do not expect execution to slow-down.
Where will the fund come from?
Commercial bank financing has been the pillar of support for infrastructure growth for much of the last decade (Refer graph on page no 24). PM Modi Government's sustained push in the infrastructure sector has led to rise in bank credit growth, reversing the fall seen in the last two years. The total credit outstanding to the sector surged by more than Rs 950 billion or 10.8 per cent between April 2018 and January 2019 to Rs 9.86 trillion, the data from the Reserve Bank of India (RBI) showed. While the credit stood at Rs 9.64 trillion as of March 2016, it fell to Rs 9.06 trillion by March 2017 and further plunged to Rs 8.90 trillion by March 2018. Of credit surge of over Rs 956 billion within the infrastructure sector, 36 per cent came to the power sector, while 22.6 per cent and 8.6 per cent came to roads and telecom, respectively. Other infrastructure sector, gained 33 per cent of the bank credit.
The overall bank credit to infrastructure rose from (-) 1.3 per cent in April to 12.6 per cent in January 2019, even as the number of overall credit has risen from 10.4 per cent in April 2018 to 13.1 per cent. RBI data shows that the given pick-up in credit growth for the industry is largely on led by rise in bank credit. During April 2018 to January 2019, credit to overall industry including infrastructure surged from 1 per cent in April 2018 to 5.2 per cent in January 2019, mainly on account of rise in the infra sector, the data noted.
However, as the uncertainty over new government still looming around, the big question is where will the finances come from? Here economists open the Pandora box to IT readers. The first one is budgetary provision and the second one is off-budget domestic institutions like provident funds, NBFCs, banks, external commercial borrowings (ECBs), mutual funds, insurance funds, capital/corporate bond markets, etc., which can be leveraged to their fullest. Due to the long-term funding requirement of infrastructure sector, it is best suited to be financed by institutional investors with matching long-term liabilities as well as risk appetite.
Among NBFCs, infrastructure finance companies (IFCs) also play a major role in providing credit to infrastructure entities. They are dedicated to lending majorly to the infrastructure sector with a stipulated minimum of 75 per cent of total assets to be deployed in infrastructure loans. Apart from these sources, funding of some infrastructure projects is also from multilateral agencies like World Bank (WB), International Finance Corporation (IFC), Asian Development Bank (ADB), Japan International Cooperation Agency (JICA), etc. Road cess, coal cess and cess on petroleum products are also collected to invest in large infrastructure projects. What's more!Since the Government is the owner of high-valued public sector enterprises and large stretches of land, the options are all open. Adding to the bucket, long-term institutional funders from abroad such as Brookfield, the Canadian Pension Fund as well as National Investment and Infrastructure Fund (NIIF).
That said, Ashutosh Datar, an economist, who was associated with IIFL a few months ago, believes that the non-banking sources of credit will play an important role in funding the infrastructure sector. In the previous capex cycle, bank credit to GDP ratio increased from 33 per cent of GDP in FY05 to close to 50 per cent in FY09 and has been hovering around those levels since. In the emerging capex cycle, he believes that market sources of funding - particularly bond market - is likely to play a bigger role.
Regulatory intervention will also play a role in encouraging funding from the bond market. According to new regulations put in place by the Securities and Exchange Board of India (SEBI), large corporates having outstanding long-term borrowing of at least Rs 1 billion and credit rating of "AA" and above are required to meet 25 per cent of their borrowing requirement through the bond market, beginning FY20. Foreign funding will also play a role mainly through the external commercial borrowing or ECB route. Recent relaxation in regulations of ECBs should help. FDI into India, including through the private equity route, continues to be focused on the services sector, although this is slowly changing with foreign investment in stressed assets slowly picking up.
Who will lead the capex cycle?
The share of capital expenditure in total government expenditure increased from 14.7 per cent to around 23 per cent in FY04 and FY05 before falling to 13.11 per cent in FY06. This suggests that the initial impetus to capex recovery comes from the Government before the private sector takes over the baton. Even this time around the initial push has come from the Government, with the share of capital expenditure increasing from 11.83 per cent in FY13 to 14.70 per cent in FY17 before falling to 12.3 per cent of total expenditure in FY18. Nevertheless, the improvement in this cycle has been far less than the previous cycle.
The data shows that the Government leading capex, particularly PSUs and states. According to Larsen & Toubro (L&T), the largest infrastructure company in India, the higher share of domestic order book is clearly an outcome of the continued focus by various public sector entities on infrastructure capex. L&T's order book distribution broadly consists of the private sector contributing around 20 per cent, central government around 10 per cent, state governments around 32 per cent while the balance is accounted for by public sector undertakings or PSUs at close to 40 per cent. However, according to Sabnavis, there have been some green shoots as far as private sector capex is concerned, but it is still not very wholesome. With non-performing assets or NPAs and NCLT processes running, most of the money is getting diverted to consolidate the sector by acquiring the assets which are stressed.
Sanjeev Sanyal, Principal Economic Adviser, Ministry of Finance, Government of India, is of the view that although the country has done reasonably well over the last two decades in the infrastructure space, there are many areas that we do need to invest in. However, Sanyal strongly advocates developing a robust legal infrastructure. The enforcement of contracts is now possibly the single biggest constraint to long-term economic development. This shows in other areas as well. The sanctity of those contracts and their enforceability has tremendous impact on other infrastructure projects. The future government has to begin work on smoothening this process in partnership with the judiciary. "So, if you gave me Rs 100 billion and allowed me to spend it on anything that I desired for, I would spend it on upgrading our legal system!"
That said, elections are expected to provide a trigger for growth in secondary distribution and last-mile connectivity with every State wanting to live up to their promises. Large-ticket capital expenditure and greenfield projects are not expected in the near future. There has been deferment of orders and delay in awarding bids. Election cycles typically result in delay in award of projects that are not urgent.
- RAHUL KAMAT