India has now entered a virtuous circle where strong economic growth attracts capital. | |
| I had the privilege of attending a keynote address delivered by Dr Vijay Kelkar at one of the investment conferences held in Mumbai last week. Dr Kelkar is a passionate believer in the future of India and delivered an address entitled "India on the Growth Turnpike". In his speech, he gave the rationale of why over the coming decades, India would be able to accelerate its growth trajectory and eventually deliver China-like double-digit growth rates. Dr Kelkar delivered a cogent and well-argued analysis of why this growth acceleration is bound to occur and is irreversible. His credibility (to my mind) is greatly boosted by the fact that I heard him make a similar speech in Singapore over two years ago, wherein he made similar predictions. At that time, the audience was dismissive of India even getting to 8 per cent growth, let alone double-digit. After three years of 8 per cent growth, Dr Kelkar's predictions look much more mainstream today, but one must give the man credit for being very early and spot on in forecasting this growth acceleration. |
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| One of the planks of Dr Kelkar's argument is a coming surge in domestic savings (especially household savings) and India's overall savings rate over the coming decades. This spurt is linked primarily to demographics; India's dependency ratio (the ratio of over 65 and below 15 to population between 15 and 64) will drop over the coming decades and such a demographic transition has invariably boosted savings in every Asian country undergoing this phenomenon. India's savings will be further boosted by the general rise in living standards in our country. Countless studies have clearly demonstrated that the propensity and ability to save is significantly higher as incomes rise. As India grows and millions are delivered from poverty, these people will move from having no savings to becoming providers of capital. |
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| In addition to this expected surge in domestic savings, India has never had easier access to global capital pools. India is now one of the mainstream markets in Asia and flows of capital, be they FII or FDI, are unlikely to reduce from here. In fact, for FDI a strong case can be made for continued strong growth as India is still not attracting its fair share. |
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| India is benefiting from the global realignment of capital flows towards countries that have the ability and need to absorb capital, and can deliver growth and returns on this capital. |
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| All of these trends will only get reinforced as India moves inexorably towards capital account convertibility. |
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| Given the above backdrop, India is now entering a new era where capital has truly become a commodity. Long starved of financial capital and resources, Indian companies have now almost as much choice as their competitors based in more established financial markets. |
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| What are the implications of this commoditisation of capital? The impact has to be looked at from the perspective of investors and companies separately. |
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| For companies, this new environment (of easy access to capital) has to be handled carefully. Indian companies are renowned for their ability to sweat assets and drive down capital costs, especially when compared to their peers in Asia. This focus shows up best in RoCE (return on capital employed) and RoE (return on equity) numbers delivered by Indian companies. A big driver of this focus on returns and capital efficiency is the limited and expensive access to capital for corporate India (till recently at least). Indian companies have naturally valued and used capital more judiciously than their Asian peers as they historically had much less access to it. In today's environment of unlimited and cheap access to capital, they must guard against complacency and maintain their capital allocation discipline. |
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| The easiest way to abuse cheap money is to either put up huge capacities in search of growth or embark on an aggressive merger and acquisition strategy. Previously, unviable capital expenditure plans or acquisition targets could suddenly look reasonable if money was cheap and given on a platter. Signs of both types of behaviour are now visible, and, if not done properly, will be strongly dilutive for corporate returns. |
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| This is an important development to follow, as India's currently high-valuation multiples (highest in Asia) can be justified only by the corporate sector's equally high-return ratios (RoE and RoCE are the best in Asia). If these return ratios were to go into secular decline because of a lack of capital discipline, then markets may be headed for trouble as multiples will de-rate along with returns over time. Investors need to keep pressing their companies to continue focusing on returns; that is what sets India apart from the rest of the region, most notably China. |
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| Another implication for companies is that the role of the CFO becomes even more important, not only to maintain capital budgeting discipline but to proactively use all the new sources of capital in imaginative and value-additive ways. |
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| For the investor, the commoditisation of capital throws up different challenges. The traditional providers of long-term equity capital to corporate India, be they the traditional established FIIs like Capital Guardian or GSIC, or private equity shops, need to understand that they are no longer the only game in town. Companies today have many choices and thus PE (private equity) firms cannot take four months for due diligence, insist on exclusivity, or demand affirmative rights which effectively supersede the board. Companies are far more aggressive in trying to determine the actual value-add (if any) that a PE fund can provide. Unless you can deliver specific value addition from existing portfolio companies, why should my company give you preferential equity/rights and board representation""this is a question CEOs and CFOs commonly ask today. |
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| The large long-term FIIs, having invested in India through most of the 1990s, find it difficult to stomach today's valuations. Having bought everything cheap, they are now mostly underweight and frozen. They cannot understand how companies are able to raise hundreds of millions of dollars overnight in the FCCB markets, and probably pine for the days when no capital raising could get completed with them coming in as an anchor investor. |
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| India has now entered a virtuous circle where strong economic growth attracts capital, which enables even stronger growth. Companies and investors need to get used to a new environment where choice prevails, both in type and instrument of capital as well as the provider. A different and more specialised set of capital providers will dominate the Indian capital markets over the coming decade. The days of a few firms wielding huge financial muscle are numbered. |
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