While attending meetings at our recent policy and economy conference, I 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 (or its GDP) rapidly when working capital finance (that is, FII inflows into the primary equity market) is abundantly available; and (b) it overreaches itself when finance is available (that is, the economy overheats) and has to then, therefore, go through a purgatory period of slower growth to calm things down.
I explain in this column that we are well past the halfway point in India’s economic downturn and are at the beginning of a meaningful rally in the Indian stock market (since the market rallies before the economy does). Provided the stock market sees some proof of India’s working capital constraint easing, normal service for India should resume in the current year.
India’s working capital constraint
India’s annual savings amount to 34% of its GDP. But that’s not a particularly relevant number because physical savings (gold and housing) consume more than a third of these savings; and the 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% of GDP. Clearly, that is not enough to fund investment in a country where infrastructure investment alone soaks up 6% of GDP and overall investment needs are around 30% of GDP. That then leaves the country dependent on Western capital markets to finance the remaining 10-15% of its investment requirements. This explains why India’s growth rate falls sharply whenever there is a crisis in global financial markets, in spite of the lack of substantial real economy linkages with the West.
In all three of the major global financial crises in the last 20 years — FY97 (the south-east Asian collapse), FY01 (the dotcom bust) and FY09 (the sub-prime crisis) — financial flows into India and, consequently, capital formation and economic growth have fallen precipitously and fallen in an abrupt way that no domestic macro variable can explain.
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 boardrooms largely made up of promoters’ friends and family, many of whom lack 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 is unable to manage risk/ reward trade-offs properly. Therefore, poor investments are made, scarce capital is depleted and a period of slower growth follows soon.
Classic examples of this talent scarcity and management overreach are some of our power, infrastructure and construction companies, which are often run by relatives of politicians, with the board stuffed with friends and family. After a couple of project wins, these companies usually run out of management talent to oversee the subsequent expansion of the company (often into areas where the promoters have no core competence, such as solar power, coal mining, roads). And before you can say “QIP,” investment bankers are trying to help the company ‘strengthen’ its balance sheet and minority shareholders are trying to figure out what went wrong with the Indian infrastructure story.
Thirdly, like a small company, India flourishes using a range of informal processes (including corruption) as opposed to the more formal governance structures in the West. This means 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 of well-established rules, and squabbles begin on the shop floor.
Using our power and infrastructure companies as an example once again, in the first half of the nineties many of these companies had a good run as the original promoter rose from humble beginnings and, with an iron hand and plenty of hard work, established the foundations of a substantial business. As he grew old and wealthy, the promoter became a chairman and the next generation (often schooled abroad) took on the CEO mantle. These privileged “young Turks” look good on TV and on page 3 of newspapers, but often don’t have the steel needed to run an infrastructure business in India.
If you buy my analogy of the Indian economy being similar to a small company, a few things follow:
A relaxation of these constraints has a disproportionately powerful (or non-linear) impact. So, 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 a small company that is once again receiving bank financing. Capital formation should pick up and economic growth should perk up relatively quickly.
India’s economic performance has been and will continue to be volatile — periods of easy financing leading to rapid growth leading to financial and management overreach followed by periods of more muted growth. FY12 was a year of muted growth but FY13 looks to be a year when growth will perk up (to 7.4%, says Ambit’s economist Ritika Mankar), provided the market for raising fresh equity capital opens up in March-April.
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. However, every small company that grows into a titan has at its core a strong and cohesive team of well-drilled professionals. As a country, we are still searching for that cohesive team of well-drilled professionals who can take us to the promised land.
These are writer's personal views