It’s the Cost of Capital, Stupid!
Cost of capital in India has grown prohibitively expensive in recent years. Both the RBI and Government of India can, and should, do something about it.
Indian policy-makers have limited sway over factors of production. Land and labor are especially difficult to reform given preference of land ownership over financial assets for the rich and strong labor union presence in the industrial sector, respectively. As such, capital remains one area where governments and the RBI have flexed levers to manage business cycles.
Aside from the twin shocks of Demonetisation and GST, Indian Small-Medium Enterprises (SMEs) have had to deal with a significant credit crunch over the last 5–7 years. What began with the previous government’s (crony) stimulus post-GFC, resulting in highly levered companies with poor balance sheets and impossible debt servicing arrangements, has slowed growth across the economy. Non-Performing Assets (NPAs) at the banks began rising just as the global economy was hitting the sweet spot and India was reaching a stable policy-making environment c. 2014. The NPAs at the banks combined with the poor balance sheets at the corporate level created the twin-balance sheet problem, where banks began to realize capital losses on their assets degrading their ability to lend elsewhere in the economy— a long-drawn hangover resulting from the outlandish lending exuberance of the UPA II during 2009–2011.
To add to this, the RBI in 2016 also instituted the Monetary Policy Committee and made inflation targeting its sole mandate. While the MPC has been successful in bringing down inflation (down to 2% in Q1'19 from 5.6% in 2016 when MPC was put in place), it has also made India home to the highest real interest rates of anywhere in the world. Not ideal when raising capital to fund critical capex for long term benefits such as infra.
Raising capital at 8–10% for expected risk-adjusted CAGR of even 15–20% is not a gamble many entrepreneurs might choose to undertake, especially when deposits at banks earn you 6.5–7% for doing nothing. Business investment will slow down, and economic activity will ground to a halt if businesses who would otherwise be building real assets, creating jobs, etc. no longer engage in private investment. The delay in the recovery of the capex cycle attests to businesses reacting to these investment disincentives created by such high rates. A credit crunch will especially hurt a country with a stubborn saving habit, that requires urgent capex growth for creating new infrastructure, investing in new technology, providing jobs to millions, funding basic welfare infra, etc.
As Deepak Shenoy articulated on the CapitalMind podcast recently, the government too must do its part in relieving the credit crunch. By keeping the small savings rate (postal/provident fund) high, the government is offering itself as a substitute to the riskier SMEs. A lender can simply park away funds in highly liquid, stable yields of the Indian government than take on duration and idiosyncratic risk associated with project financing. Still, a private enterprise beholden to its shareholders should continue to look for maximizing shareholder value through opportunistic capital allocation with the highest risk-reward payoffs. Therefore, if the incentives are aligned, financial institutions would be willing to invest in high growth areas. As such, the responsibility for easing the credit crunch does fall on the RBI.
The onus lies with RBI to return to its data-mandated monetary policy and respond to the economy hitting the 2% inflation floor with immediate rate cuts, shedding its fear of inflationary “trends”. RBI must acknowledge that the Modi government’s supply-side reforms of GST and changes to APMC have unclogged previous supply-chain bottlenecks resulting in cheaper food prices that are here to stay. The economics of oil too have changed, making India’s twin inflation headaches, food and fuel, see a fundamental supply-side shift. Finally, the RBI needs the rate cuts to be passed down by the banks. Using levers such as the cash reserve ratio and reverse repo rates, the RBI can force banks to raise lending by transmitting borrowing cuts. The RBI should also remove ad-hoc rules on the entry of foreign institutional investors looking to India as their LPs reach for yield. Competition in lending offerings (currently suffocated due to the NBFC mess) will be a big boost for private investment.
Investors have so far positioned themselves to take advantage of distressed special sits in companies with strong business fundamentals but weak balance sheets. Institutional investors such as BlackRock have setup India distressed funds already and more players are following suit. Especially with record global fundraising in the PE space and LPs in Europe, Japan, and the US reaching for yield, private credit opportunities in India are beginning to blossom. The Insolvency and Bankruptcy Code has given policy certainty to foreign investors trying to avoid past investment experiences in India. By raising capital at 2–3% in places like the US, Japan, and UAE and investing in India given India’s low inflation and relatively stable currency rates has given institutional investors a short window of arbitrage.
Investors can thus take advantage of an anomaly to the uncovered interest parity. An Efficient Market theory of uncovered interest parity will argue that if US treasuries are yielding > the German Bunds, the US$ should depreciate in the future by the amount of difference in the yields to bring things to parity. However, Burns, Enchenbaum, Kleshchelski and Rebelo (2010) shows that instead of US$ depreciating, especially in low inflation countries, US$ will appreciate to make-up for the interest rate differential. Therefore, borrowing in low interest rate currency (in our example German bunds) and lending in high interest rate currency (USTs) will likely be a profitable carry trade strategy.
If India’s inflation has a seen a structural change, and given the recent bout of lumpy FX correction, a similar carry trade between India and a developed market such as the US with low interest rates could be achieved. Watch out for companies like Brookfield raise mega funds to pick up solid businesses with distressed balance sheets on the cheap.
For the retail investors in India companies with strong fundamentals and unchanged business dynamics are likely to remain viable. As Deepak argued in his podcast, companies with decent debt capacity that can use leverage at reasonable rates to take advantage of the exponential growth opportunities of the Indian market are likely to benefit the most.
P.S. If the RBI and the government refuse to act, my personal anecdotes of friends running family-run businesses and entrepreneurs considering moving their business operations abroad to avoid the capital crunch might snowball into something bigger. Companies engaging in export of commodity goods such as textiles that use India primarily as a stop in a global supply chain could look at other business-friendly markets where ease of raising capital can also be combined with tax breaks. When businesses give up on capex due to the high cost associated with investing in real assets, the second-order effects on tech development, employment, and productivity will also come to fore.
