While attending the meetings at our recently held Policy & Economy conference, I have realised that India is the world’s biggest small company. Like a small company, it is working capital-constrained, has low management bandwidth and is reliant on a strong CEO. Hence, (a) it grows its P&L (i.e., GDP) rapidly when working capital finance (i.e., FII inflows into the primary equity market) is abundantly available and (b) it overreaches itself when finance is available (i.e., the economy overheats) and, therefore, has to go through a purgatory period (or a period of slower growth) to calm things down.
I will explain in the paragraphs below that we are at the halfway point in India’s economic downturn and (since the stock market rallies before the economy does) at the fag end of the stock market downturn. Provided the stock market sees a bit of proof of India’s working capital constraint easing, normal service for India should resume in CY12.
India’s Working Capital Constraint
India’s annual savings amount to 34 per cent of its GDP. While that is true, it is not a particularly relevant number as:
• Physical savings (gold and housing) consume more than a third of these savings.
• Government expropriates around a third of the financial savings (via banks and insurance companies) to finance its deficit.
Hence what is left for the corporate sector’s debt and equity requirements is only 10-15 per cent of the GDP. Clearly, that is not enough to fund investments in a country where infrastructure investment alone soaks up 6 per cent of the GDP and the overall investment needs are around 30 per cent of the GDP. That leaves the country dependent on Western capital markets to finance the remaining 10-15 per cent of its investment requirements. This explains why (in spite of the lack of real economy linkages with the West) India’s growth rate falls sharply whenever there is a crisis in global financial markets. India’s precipitous drop in capex, investment and economic growth in the wake of each of the major financial crises during the last 20 years – FY97, FY01 and FY09 – is testimony to the country’s need for foreign capital to fuel its investment requirements.
Secondly, India is a manpower-abundant but talent-scarce country. This talent scarcity becomes increasingly acute, the closer we get towards the boardroom (so much so that in many cases, we have the boardrooms largely made up of promoters’ friends & family, many of whom have little or no relevant skills for the company in question). As a result, management bandwidth is scarce and as soon as a company kicks off more than two or three projects, it stops being able to manage the risk/reward trade-offs properly. Therefore, poor investments are made, scarce capital is depleted and a period of slower growth has to follow.
Thirdly, like a small company, India flourishes using a range of informal processes (including corruption) as opposed to the more formal structures of governance used in the West. This means that things get done when there is a strong CEO to crack the whip and oversee the production process. In the absence of a strong CEO, the informal processes break down due to the lack well-established rules and squabbles begin on the shop floor.
If you buy my analogy of the Indian economy being similar to a small (working capital constrained, management talent constrained, CEO-driven) company, a few things follow:
• A relaxation of these constraints has a disproportionately powerful (or non-linear) impact. For example, if the current burst of QE, unleashed by the ECB, does result in risk capital flowing into India, the impact on India’s growth will be similar to that of a small company, which is, once again, receiving bank financing.
• India’s economic performance has been and will continue to be volatile – periods of easy financing leading to rapid growth and then leading to financial and management overreach, followed by periods of more muted growth. FY12 was and FY13 looks to be such a period of muted growth.
• The notion that policy paralysis in Delhi has triggered this downturn looks less defensible. I reckon even if New Delhi had functioned properly over the past year, our economic position would not be materially different to what it is today (the financing and management constraints would have throttled growth anyway). I also believe that we do NOT need New Delhi to perform spectacular policy stunts to retrieve the situation. A sensible budget in March would be enough to stabilise nerves on the shop floor.
• Finally, to state the obvious, small companies can become big provided they have access to financing. And IF they do become big, they tend to have fewer constraints to suffocate them.
(Saurabh Mukherjea is the Head of Equities at Ambit Capital. The views expressed here are his own and not Ambit Capital’s.)