A private capex recovery is expected in 2018 for the first time in six years. Here’s why
The challenging macro environment in recent years has weighed on corporate sector balance sheets. But a turnaround in this repair process is in the works.
With the latest GDP data point indicating that India’s economic growth troughed in the June quarter, the debate over the macro outlook is now turning towards the eventual strength of the recovery. In this context, the key area of debate is the outlook for private capital spending. Although discussions with investors suggest that they have a low level of conviction about a private capex recovery, we expect such a recovery in 2018 for the first time in six years. Our confidence is based on three factors:
Wind Beneath the Wings
Corporate return expectations are improving: One of the key drivers of private capex is the return expectations of the corporate sector, which should improve from here. The recovery in India so far has been gradual and unsynchronised, as final demand (consumption and exports) has moved in and out of sync, with multiple headwinds affecting growth at various points in the cycle.'
However, since August 2017, the economy has entered a period of sustained growth momentum in consumption and exports for the first time in four years. This dynamic should remain in place as global growth accelerates further in 2018, supporting global trade and, hence, India’s export growth. Meanwhile, the idiosyncratic headwinds that were constraining consumption growth have dissipated.
So, the economy has a clear runway for growth. The synchronous recovery of consumption and exports should help lift capacity utilisation and corporate revenue growth, and improve corporate return expectations.
Corporate balance-sheet fundamentals are improving: The challenging macro environment in recent years has weighed on corporate sector balance sheets. But a turnaround in this repair process is in the works.
First, at a macro level, the growth and interest-rate dynamics should turn favourable, as real interest rates are expected to drop below real GDP growth for industry by the March 2018 quarter.
Second, listed corporates have delivered their balance sheets over the last two years, and free cash flows are sitting at all-time highs at over 10% of sales.
Third, the credit ratio — the numberof ratings upgrades to downgrades —has improved to 1.9 times in the first half of this fiscal year from 1.2 timesin FY2017, indicating further improvement in corporate balance sheets.
Financial system is strengthening and should be able to meet investment credit demand: To be sure, there are still concentrated debt problems in select sectors such as power and textiles. These sectors have imposed a drag on the banking system in the form of non-performing loans (NPLs).
Consequently, state-owned banks have been facing a related challenge of weak capital positions. A relatively slow pace of resolution so far has led banks to tighten lending standards, resulting in a drag on overall credit growth. However, over the last two years, important steps have been taken to address these issues.
Let Bygones be Bygones
First, an insolvency and bankruptcy code has been instituted, laying down the institutional process for the resolution of NPLs. Second, in May 2017, the government granted the Reserve Bank of India powers to enforce quicker resolution of NPLs.
Finally, in late October, GoI announced a bank recapitalisation plan, which would inject Rs 2.1 trillion ($32.5 billion) of capital into state-owned banks. The cumulative impact of these steps should mark an inflection point in resolving the legacy issue of NPLs. Taken together, these moves should accelerate the resolution process, breaking the more than five-year-long cycle of NPLs and, in turn, strengthening the growth acceleration and spurring a private capex recovery.
The combination of improving corporate return expectations and balance-sheet fundamentals, along with a strengthening financial system, should be able to meet investment credit demand and pave the way for a private capex recovery in 2018 — marking a positive inflection point in the macro cycle as the economic recovers fully. More importantly, a pickup in private capex would lend support to a sustained growth cycle in the coming years. In particular, the recovery in private capex is necessary for a revival of productivity growth.
Total factor productivity contributed 3.6 percentage points to GDP growth in the 2003-07 cycle. This decelerated significantly to 1.5% points in FY2013 and has remained subdued since then. With private capex picking up, the contribution from total factor productivity should improve to 2.7% points in FY2019.
(The writers are economists, Morgan Stanley Research, Hong Kong)