Exchequer to the rescue

All hopes of a possible economic turnaround are fast ebbing away with anaemic corporate earnings growth, leaving equity investors both shocked and confused. The current earnings woe of India Inc, however, could be better explained if one refers to a macro-economic equation discovered way back in the early 1900s.

Popular macroeconomic textbooks as well as discussions around financial earnings often neglect this equation, which goes by the name of Kalecki-Levy Profit Equation (KLPE). This equation is what connects macroeconomic variables directly to aggregate corporate profit of the entire corporate sector. The strength of this equation lies in its high success rate in predicting the profitability of corporates in various economies and across business cycles. 

The beauty of this equation also lies in explaining what type of government action may be required to support corporate earnings. This is particularly relevant in the current scenario, where everyone expects the government to turn around the economy, including the corporate sector. They are, however, often unable to pinpoint exactly what action the government should take and why this particular action will be beneficial. In addition, the equation may also get lobby groups — which constantly demand lesser corporate taxes — to rethink their demands from the government.

What is KLPE?

KLPE is expressed as follows: Aggregate corporate profits = Investment – foreign savings – household savings – government savings + dividends + corporate profit taxes. Before we go into details, let’s take a look at the history behind the equation. The relationship was first observed by Jerome Levy in the 1920s. As the legend goes, Levy, using this analysis, sold his stocks in 1929, much before the US stock market crash!

In the 1930s, Michal Kalecki, a Polish economist, rediscovered the relationship between aggregate corporate profitability and macro variables. To his credit, his explanation and derivation of the identity contributed significantly to broaden the appeal and usage of the equation. Interested readers may refer to selected essays on dynamics of the capitalist economy by Kalecki. Of course, the most comprehensive guide in this context remains the macroeconomic ‘cult classic’ Stabilising an Unstable Economy by Hyman Minsky.

For the business sector, the aggregate profit net of corporate profit tax and dividend of all corporates is a measure of corporate savings. Given that savings are the accumulation of wealth, corporate savings represent the corporate sector’s ownership on incremental wealth created in the economy during that period.

Here, it may be worthwhile to point out that corporate actions that may be driving short-term profitability of one firm, if adopted by all firms in the economy, may be detrimental to the overall profitability of the corporate sector. For example, if a firm decides to increase its profitability by reducing wages or reducing consumption of raw materials, then in the immediate short term, profitability will increase. But if all firms in the economy undertake the same cost-cutting measures, then overall wages in the economy will fall, in turn, consumption will fall and, thus, aggregate corporate revenue will come down. 

Similarly, raw material suppliers are themselves firms. So, if all other firms reduce raw material purchase, then the revenue of raw material suppliers will fall. Thus, a downward spiral of reduced profitability and shrinking aggregate corporate revenue will start just because all firms in the economy simultaneously decided  to take a ‘reasonable corporate decision’ of improving profitability by reducing cost. In this case, the  end result will actually be different from what the firms expected.

With specific reference to KLPE, the directional impact of some of the aggregate firm variables, such as dividend and corporate taxes, on aggregate corporate profitability may appear to be counterintuitive in comparison with the drivers of profit/wealth creation of a single firm. At an individual level, distributing dividend or paying taxes tends to reduce the wealth of the firm. But if one broadens the argument to an economy-wide level, then the aggregate dividend paid by firms across the economy will enable shareholders to spend more on goods and services, which will add to the revenue of the business segment within the economy. 

Similarly, higher corporate tax outflow may be detrimental to a specific firm in that time period, but it will enable the government to spend more on capital expenditure and other consumption-related spending. If the government does spend, then this would benefit the overall revenue and profitability of the business sector. 

Making sense of macro drivers 

Let’s take a look at the intuitive reasons behind the relationships listed above. First, household dis-savings as a profitability driver: Let’s visualise an economy with just two sectors, businesses and households. Businesses supply goods and services which are purchased by households and other businesses. Households provide labour to business and earn wages. Households are also consumers and help businesses generate revenues and earn profit. In this hypothetical closed economy, the total income of the business (profit) and the household (wage) is equal to the total expense of the business (investment) and the household (consumption). So, business profit + household wage = Business investment + household consumption.

Acknowledging that for the household sector, wage net of consumption is household savings, the above equation becomes: Business profit = Business investment + household consumption – household wage. And profit = investment – household savings.

Certain aspects of this hypothetical two-sector economy are applicable to the real economy. If the businesses do not invest in physical asset creation, then the investment’s contribution to business profit is zero. In such a situation, even if households spend their entire wages on consumption, there is zero household saving and, thus, incremental profit still remains zero. In a scenario of zero investment, what may add to business profit is if households borrow to consume or spend their past savings in current consumption. No doubt, corporates love it when a consumer’s purchasing power is increased, albeit unsustainably, by extending cheap credit systematically.

Next, incremental investment adds to corporate profit: Investment leads to creating of physical assets which did not exist previously. When a firm buys an asset using cash, from an accounting perspective, one form of asset (cash) gets converted to another (plant and machinery). During the period of purchase, there is no expense for the buyer. The expense arises in subsequent years when the asset’s value erosion, owing to wear and tear, gives rise to depreciation both from an economic and accounting perspective. But for the other firm, selling the asset to the buyer at the price at which it was sold included the profit for the seller firm.

The investment transaction between the buyer firm and the seller firm not only created investment but also ‘gave birth to’ profit in the economy, which otherwise would not have been there during that period. The bumper profits enjoyed by the Indian corporate sector during the period FY05 to H1FY09 were driven mostly by investments created in the economy.

Third, increasing fiscal deficit increases corporate profitability: Government spending in the economy — be it for the creation of public utilities or even direct transfers to the households — ultimately creates revenues and aids profitability. However, if the government tries to rein in the fiscal deficit at a time when other drivers of corporate profitability — private investment or household spending — are struggling, then profitability may be severely impacted.

The boost in aggregate corporate profitability during FY10-FY11 owes a lot to the spike in government spending in H2FY09 in response to the global financial crisis (see: Speeding the cycle).

Fourth, high current account deficit (CAD) drags profitability: CAD is technically equivalent to foreign savings. When payments to foreign participants in a domestic economy exceed the receipts from them, then there is a net outward transfer of wealth which is created in the domestic economy. Understandably, the aggregate domestic savings is reduced and all sectors suffer including business.

To summarise the key aspects of KLPE, if savings of sectors such as household, government, foreign investors/trade partners are not circulated back to the economy for consumption or asset creation, then aggregate corporate profitability is dragged down. If everyone puts their savings ‘prudently’ into banks and banks ‘conservatively’ do not lend further for asset creation, then, too, corporate profitability shrinks along with economic activity.

Similarly, if savings are invested in pure financial securities such as stocks and no profit from the stock market is monetised for the purpose of consumption or creation of assets, then per se, the stock market surge does not benefit the real economy. In addition, hoarding of wealth or savings, where the savings move away from the formal economy into the bespoke ‘black economy’, creates a severe drag on corporate profitability. An observation being that as wealth flows across the economy, corporate profitability along with the overall economic activity improves. 

Where is profitability headed?

The overall profitability of the corporate sector is driven by the cumulative impact of the factors discussed thus far. In the past decade, the critical driver of aggregate profitability of India Inc was investment as well as fiscal deficit.

As per an analysis by India Ratings and Research, the aggregate profitability of India Inc (represented by 1,000 large corporates) empirically shows a strong predictability of corporate earnings in the following period based on macro drivers discussed here. 

The only meaningful support that may stem the fall of earnings may come from government spending. As per the FY16 budget, government is planning an incremental investment of ₹70,000 crore on infrastructure and ₹79,500 crore on rural development. If this spending actually occurs, then corporate earnings will improve after a lag of two to three quarters,. 

 As such, if crude oil stays below $65 a barrel and the rupee stays around ₹63 to a dollar, the government gains a booty of an estimated ₹110,000 crore to ₹120,000 crore, driven by lower subsidy bill and higher excise revenue from petroleum products. However, if the crude and currency triggers are breached, then the government’s ability to spend will reduce. But given that the government has committed itself to reduce fiscal deficit, reduction in spending may push down corporate spending.

Besides, household spending is unlikely to grow substantially. Given the moderation in consumer price inflation and positive real interest rate (after a long time), households may be tempted to save. Thus their contribution to aggregate corporate profitability over the next few quarters may be muted at best. An increase in service tax to 14% from 12.36% in the current budget, is a demotivator, particularly for urban spending.

Also given the decade high corporate leverage and capacity utilisation at around 70%, corporate investment is unlikely to be significant over the next 12-18 months. Hence, corporate earnings growth is likely to remain muted in FY16 and FY17.

Possible way out 

The critical question is: would the government increase fiscal deficit to revive the overall economy including corporate profitability? Clearly, this move will be both pro-households as well as pro-businesses. However, challenges remain in increasing fiscal deficit. But the economy may be moving towards the point where the government may be left with limited options but to take a hard look at the option of increasing fiscal deficit along with its pros and cons.

Till then, the government can take incremental steps to revive the economy such as temporary withdrawal of dividend tax. While corporate leverage is at a decade-high, some corporates (with miniscule leverage) are sitting on historically high amounts of cash. As of FY14, the top 500 Indian corporates were sitting on a cash pile of a whopping ₹360,000 crore. Of this, the 10 largest cash hoarders account for ₹170,000 crore. If even half of this is distributed as dividend it could provide a boost to the economy. If conditions are created to enable them to distribute super dividends, the economy may get a modicum of support. Aggregate corporate earnings will benefit to the extent that cash-rich corporates let go of cash by paying exceptional dividends or by investing in domestic assets.

While corporate taxes are likely to moderate over the next four years, those payable in FY16 could inch up further. Also, interest expense is not expected to reduce given the weak monetary transmission mechanism or, in other words, the act of passing on lower rates to borrowers. The market, despite the recent correction, continues to hover around record high levels. Is there a Jerome Levy around?