The Hindu Business Line : Capital, the key to recovery

The capital formation mechanism, as it has evolved over three to four generations, has evaporated; till such time as a new and more reliable framework evolves, growth will be slow definitely, and possibly steady, but not spectacular, says V. RAMAKRISHNAN.

How long, how deep and how wide will the ongoing global economic crisis be, what will be its impact on the global economic order and how will it impact India and Indians? Expert opinion is that this is going to be the longest, deepest and widest slowdown seen by any generation of business and political managers.

At the heart of the problem is that the capital formation mechanism, as it has evolved over three to four generations has evaporated; till such time as a new and more reliable framework evolves, growth will be slow definitely and possibly steady, but not spectacular. The developed world will make changes slowly in its approach to capital formation; India has to learn and, given its conservative approach to banking, high savings rate, firm internal demand and low dependence on exports, has the potential to recover faster.

Capital productivity

Capital productivity or intensity is the revenue or GDP a unit of capital generates; ideally, for every dollar or rupee in the business, the revenue should be greater than 1.5.

The working logic is simple. Capital is a fundamental need to start a business. If assets are used productively, the surplus generated requires less capital. Turned on its head, a country or a business that uses less capital to generate a larger surplus has a greater chance of coming out this crisis faster and stronger.

General Motors averages around 0.6; for every dollar in capital GM produces 60 cents in revenue! Ford does around 40 per cent better, but is still below 1. GE, stripped of GE Capital, fares only slightly better at 0.80. Most public sector firms in India and elsewhere have similar capital intensities. Infosys has dropped steadily, over the past five years, from slightly above 1.5 to around 1.25 It would help to understand how freely available capital generated the sort of growth witnessed in the last few years. Investment banks such as Lehman leveraged 35 times (it borrowed $35 for every dollar it owned) could lend to high-risk ventures, only a handful of which succeeded.

But the few that succeeded such as the ebays, the amazons and the googles generated huge employment, helped improve business productivity and generated large surpluses in the economy and for their stakeholders. These, in turn, generated a host of smaller and successful businesses; it is a matter of wonder that downloading ring tones from the net is a $5 billion-plus business – and it did not exist a decade ago! The point then is capital is vital to growth; it can come from equity from internal generation, or as a mix of debt and equity from external sources.

Crisis: Primary driver

The primary source of capital, especially risk capital — investment banks — are out of business. Revenues for almost all firms driven by falling consumption — commercial, industrial and retail — is compressing, if not falling off the cliff; hence, internal generation will be low if existent. This leaves only commercial banks, private equity, venture funds and the stock market as a source of growth capital.

Venture funds and private equity are either dehydrated of funds or are risk-averse. With disposable incomes falling and equity investors fleeing, the stock market is no longer a source of funds. This leaves commercial banks but they are unwilling to lend to each other let alone to businesses, even when tasked to do by their governments. Given that some reports still indicate huge unresolved sub-prime issues in the US, it is going to take these banks a while to start low-risk lending; forget about high-risk funds for a couple of years. As and when they resume lending they can be expected to be conservative.

And these factors are working in each and every country of the developed world, the mid-East and BRIC.

This is a situation the world has never faced. The old order has fallen.

A new order, with greater transparency and discipline has to rise, phoenix like, from these hot ashes. It will take time to flesh out a new system, establish the rules of the game and start priming the capital pump; it requires concerted effort and it appears no one really knows what the scope and extent of the effort has to be. As and when capital flows start — and let us hope that happens sooner than later — there is going to be a lag before supply catches up with consumption or demand. Hence, the argument that the uptick will be slow and take a while in the coming.

IMPLICATIONS FOR INDIA

India has slowed, despite the strenuous commentary from Delhi. It is visible in airport lounges, in malls, in restaurants and every where the typical Indian communes.

Capital has, thankfully, not entirely dried up; but has become costlier.

With the compression of internal demand and export demand, salaries, bonuses and, in many cases, jobs have reduced. Much of this hurts discretionary spending but given the steep rises in take home pays in the last few years and falling commodity prices, disposable income is safe. Hence, India will see a slow down but not a steep fall in demand. This is the better part. On the down side, Indian industry has made substantial investments in increasing capacity based on straight line growth projections; much of it has happened in the last two-three years. Hence, there is a gap between the capacity utilisation and actual demand leading to falling revenues and higher break-even points, making it difficult for businesses to generate surpluses for growth; most would be hard put to make ends meet in the short-term. Good times have masked poor all round productivity in India. India is weak on capital and asset productivity and her people productivity lags all but the most disadvantaged nations.

Poor infrastructure causes huge productivity losses, much of it unseen. Forget about roads – just see the call drop rates from the modern cell phone players – it is abysmal and way short of world-class. Infrastructure is important, but attitude to customer service is more important.

In Tamil Nadu, energy is supplied for people to watch political programmes costing thousands of industries, which could use the hundreds of mega watts more gainfully, dear. Industries with low-entry barriers like textiles, where everybody and his brother has rushed in, will take more time to recover. Indian industry has to understand need for scale; for profitability led by more internal productivity than top line growth; and by management that has less hubris and a greater understanding of globalisation.

It is a long road ahead, pot-holed, which we Indians are used to, and up a steep slope, which we Indians, poor in physical fitness, we are unused to.

(The author is Managing Director, Organisation Development Pte Ltd., a consultancy firm based in Singapore. blfeedback@thehindu.co.in)