Capex Retrenchment – A Lot More to Go

Investment Cycle on the Slowdown Path

Official investment (as measured by gross capital formation) data tend to be released with a lag, but corporate sector fundraising activity tends to be a good proxy for this trend. Aggregate capex fundraising by the corporate sector rose to a new high of 14.5% of GDP (US$170 billion) in F2008 (12 months ended March 2008) but is estimated to slow to 8.6% of GDP (US$101 billion) in F2009 and 7.4% of GDP (US$82 billion) in F2010. We arrive at the aggregate figure by adding fundraising by the corporate sector through various sources, including bank credit, external commercial borrowing/foreign currency convertible bonds, domestic bond issuance, equity issuance and FDI inflows. If we include internal accruals generated by the corporate sector for this exercise, the total funding available for investment slowed to 14.9% of GDP (US$175 billion) in F2009 and should slow further to 12.5% of GDP (US$138 billion) in F2010 compared with 21.2% of GDP (US$249 billion) in F2008.

Based on the trend in fundraising activity and other capex indicators, we estimate that official industrial/infrastructure investment (including private corporate plus government capex) has declined to 23.6% of GDP in F2009 and should decline further to 20% in F2010 from the peak of 25% in F2008. Private corporate sector capex is estimated to have declined to 14.3% of GDP in F2009 and should decline further to 11% in F2010 from the peak of 15.9% in F2008. We estimate that public sector investment has increased to 9.3% of GDP in F2009 from 9.1% in F2008, but believe that it will slow to 9% in F2010. Similarly, household investment is expected to slow to 11.5% of GDP in F2010 from 12.8% in F2009 and 12.6% in F2008. Aggregate investment (including household, corporate and government) to GDP declined to 37.9% in F2009 and should decline further to 33% in F2010 from 39.1% in F2008.

Bottom of the Capex Cycle Is Ahead of Us

A number of indicators show that investment growth has decelerated sharply over the last 12 months. Capital goods output growth slowed to 10.2%Y during the three months ending February 2009 from the peak of 24.2%Y during the three months ending October 2007. Similarly, the trend for aggregate fundraising has suffered in the last 12 months.

Bank credit, equity issuance and foreign debt borrowing have trended down. Bank credit, which has been the largest source of fundraising for the corporate sector, is likely to slow further. Annual incremental bank credit funding had accelerated to an average of 6.7% of GDP in the four years ended March 2008, compared with 2.5% in the preceding three years. Bank credit accounted for about 40% of the total funds raised by the corporate sector in the past four years. We expect incremental bank credit to decline to just 4.5% of GDP in F2010.

Excess Capacity Burden Remains High

The corporate sector is suffering on account of large operating leverage. The gap between corporate capacity for growth and realized growth is expected to be much larger in the current cycle than in the mid-1990s; the capex binge was much larger in the current cycle. With the growth trend remaining higher for longer and continued easy access to risk capital from the international market, the corporate sector was far more aggressive in building capacity. Private corporate capex to GDP increased to 15.9% as of F2008 from 6.8% in F2004. In the 1990s cycle, it increased to 10.4% of GDP in F1996 from 6.1% in F1994. However, industrial production, which is some proxy for utilization of that capacity created, contracted by 1.2%Y in February 2009 from the peak of 13.6%Y during the quarter ended January 2007. In the 1990s, industrial production had decelerated to 1.5%Y by January 1997 from the peak of 13.7%Y during the quarter ended September 1995. Even with the recovery in industrial production to an estimated 6-7% by March 2010, capacity utilization for the corporate sector should stay relatively low, dissuading them from initiating any major new capex plans.

Global Credit Market Environment Should Also Be an Important Factor Affecting the Outlook

The weak global financial markets have resulted in a slowdown in capital inflows into India. While there has been some improvement over the last three months, the average CDS rate for Asia ex-Japan has remained significantly higher than levels recorded in early 2008. The average CDS for Investment grade 5-year bonds is currently at 278bp, compared with 106bp in early 2008. The Indian paper has seen a similar trend, with CDS rates at 245-425bp currently compared with 75-285bp in early 2008. While we expect a significant improvement in capital inflows to US$19.1 billion in F2010 compared with outflows of US$3.7 billion during the quarter ended December 2008, it will still be about one-fifth of the amount received during the 12 months ending March 2008.

Reminiscent of Mid-1990s Cycle

We believe that the current macroeconomic trend has similarities with the 1993-96 cycle. In the 1990s, private corporate capex to GDP increased to a peak of 10.4% in F1996 from a low of 6.1% in F1994. During that period, the capex cycle recovered sharply with the support of positive sentiment for emerging markets and due to investment sector deregulation implemented by the government. However, it was soon constrained by a tightening monetary policy triggered by signs of overheating.

A simultaneous reversal in risk appetite for emerging markets and reduced capital inflows caused further tightening in interest rates and affected the corporate sector’s ability to raise funds from international investors. Moreover, a slowdown in domestic consumption meant that the corporate sector suffered on account of high operating leverage. This adversely weighed on their profitability and investment confidence. Private corporate capex to GDP declined gradually to 7.1% in F1999.

As in the mid-1990s, we believe that the combined impact of slowing domestic consumption, higher domestic cost of capital and reduced capital access from international capital markets will result in a further major slowdown in the investment cycle over the next 12 months. We expect private corporate capex to fall to 14.3% in F2009 and further to 11% in F2010 from the peak of 15.9% in F2008. Similarly, we expect total investment to GDP to decline to 33% in F2010 from 39.1% in F2008.

How Could We Be Wrong?

The upside risk to our estimates could be from a potentially faster recovery in global growth than currently implied in our team’s forecasts. Our economics team currently estimates global growth of -1.6% in 2009 and +2.6% in 2010. Stronger global growth would help India by way of increased financial risk appetite, implying higher capital inflows and stronger export growth. This in turn would mean lower real interest rates, a quicker improvement in capacity utilization and increased corporate confidence for investment. The second upside risk could be a positive surprise in the general election outcome. If we get a clearer verdict with either the Congress or the BJP getting about 170-180 seats out of a total of 543 seats in the parliament that allows them to form a coalition that will be narrow compared with the current ruling coalition, then this would likely increase the pace of reforms, boosting business confidence.