In my previous column, I noted that high inflation in India impedes the translation of revenues growth into earnings growth and hence, prevents shareholders from reaping the benefits of the strong economic growth that the country enjoys.
Then I went on to say that the supply-side constraints, currently prevailing in India, are so powerful that the benefits of economic growth – rather than accruing to shareholders – are being transferred almost entirely to the suppliers of labour, debt capital and raw materials.
In this column, I will focus on the key supply side constraint facing the Indian corporates – namely, the excessively high cost of capital.
High Capital Cost: How It Plagues India
The cost of borrowing in India is one of the highest globally. Based on the IMF data, my colleague Ritika Mankar estimates the average nominal cost of borrowing in India to be 12 per cent over the last five years. Among the major emerging markets, only Indonesia has a higher cost of borrowing at 14 per cent. In contrast, the corresponding figure for China is 6 per cent and that for the developed nations, such as the UK, is sub-5 per cent.
Even if we adjust for inflation, India’s cost of capital is among the highest. India’s real (i.e. inflation-adjusted) cost of capital over the last five years is 5 per cent. Again, we find that among the major emerging markets, only Indonesia, at 5.5 per cent, has had a higher real cost of capital than ours. China’s real cost of capital over the same period has been 3 per cent.
The profligacy of the government is the main driver of the high risk free rate of borrowing in India. I find a clear relationship between the Indian sovereign’s borrowings over the past decade and the 10-year government bond yield. In effect, the more the government borrows, the higher the government bond yields rise and that pushes up the cost of borrowing for the rest of us.
The second driver has been the authorities’ unwillingness to let Indian corporate houses access the capital freely from global capital markets. Over the past couple of years, the cost of borrowing in London for an Indian corporate has been at least 2 percentage points below the Indian banking system’s PLR (even after adjusting for currency hedging costs). And yet, such is the restrictive nature of the RBI’s External Commercial Borrowing (ECB) rules that this obvious arbitrage opportunity cannot usually be utilised.
Among the many restrictions that the ECB rules impose, I find one particularly egregious. The ECB rules impose interest rate ceilings, so that foreign debt with a maturity of 3-5 years cannot be raised if the interest cost is any higher than 3 percentage points over LIBOR. Even the Indian sovereign found it hard to borrow abroad at such rates. That, in effect, means, due to this arbitrary RBI restriction, few Indian companies are able to borrow overseas in spite of international banks’ willingness to lend to Indian corporate houses.
To make matters worse, in the coming months, India’s cost of capital constraint will become even more binding as the RBI is likely to continue raising rates, probably by 50-100 bps over the next 12 months.
Reforms That May Lower Capital Cost
The good news, however, is that the government can initiate three types of reform measures which can actually lower the cost of capital:
Fiscal consolidation: By bringing its spending under control, the government can lower the upward pressure its own borrowing exerts on system-wide interest rates.
Developing alternative sources of domestic funding: Quite a few sources of domestic funding (for example pensions funds) have not been tapped at all in India.
Capital account liberalisation: Allowing greater FII participation in corporate and government bond markets, as well as easing restrictions on ECBs, are steps that can lower the cost of capital domestically.
Given that the RBI does not seem to like capital account liberalisation, reform is more likely to take place in the first two areas highlighted above. With the general elections two years away, the government now has a window of 9-12 months to make a difference to our economy by easing the most binding of India’s supply side constraints – punitively high cost of capital.
A reform-induced lowering of the cost of capital in India is likely to benefit debt-heavy and cash-starved sectors such as construction, capital goods, telecom and realty. However, once alternative sources of funding mature in India, banks’ net interest margins and hence, profitability can come under pressure.