It's a long way to go before the next super capex upcycle

The last time the super capex cycle played out was in FY2003 when capex to GDP ratio was 23.7%. Now, we are already at 29.3% and with higher capex to GDP, the probability of growing capex at a higher pace is difficult, say Vetri Subramaniam, Head- Equity Funds and Deepesh Agarwal, Associate V-P, UTI AMC. Excerpts from an interview with ETNOW.

When can we see the next big super capex cycle play out in India?
Deepesh Agarwal: When we compare with the last cycle, the key difference is the starting point. Last time in FY2003, capex to GDP was 23.7%. Now, we are already at a 29.3%. Certainly with higher capex to GDP, the probability of a growing capex at a higher pace becomes difficult.

In terms of key sectors, last time, it was global commodity and global demand cycle. Our exports doubles, the profitability of Indian metals and oil and gas companies improved substantially. Even on the domestic front, last time, there was an expansion of the telecom coverage network and the government opened up the key sectors like road and power generation for the private sector.

In the current situation, none of these sectors are anywhere close to where they were in FY2003. It seems like we need to wait a bit for the next super capex cycle.

One of the key things in the previous super cycle was the real estate prices were continuously going up. The construction activity is nowhere near recovery now and that was one of the important factors?
Vetri Subramaniam: If you look at the super capex cycle in 2003-2008, that was driven more by private capex and not necessarily by real estate. Looking ahead, could real estate be one of the drivers of the next super capex cycle? It is possible though currently it is a sector which is plagued with multiple issues stemming from credit related problems and the transition to RERA. But you have to presume that given that most data indicates that there is an aggregate deficit though micro market situations might look different. That is an area which could help drive the next capex cycle.

Also just to be careful about the use of that term super capex cycle, the big point we made with this wide paper which Deepesh authored was really to say that even in the last three years, we have seen well above-the-trend growth rate in capex. The problem which most participants are experiencing is that they are trying to benchmark the growth in capex to what may well have been a once in a lifetime trend of 2003-2008. When real capex growth averaged almost 16.5% real CAGR and in the last three years, it has been about 9.2% CAGR, well above the historical range but obviously not comparable to that super capex cycle. The disappointing factor with the investment cycle is that we are comparing it to the wrong benchmark.

When we look at the interest rate, how big a differentiator is that because interest rates are quite low and IRR projects maybe workable. How important do you think this low interest rate is if the cycle had to start once again?
Deepesh Agarwal: If there is no demand for your product, even the benefits of lower interest rates or even lower tax rate will be passed on and you will be back to the old IRR assumption. The key is demand. Which businessman will set up a factory if the demand-supply is not in his favour?

In your report you have talked about opening up some of the heavyweight sectors like power, road development, etc. to private investment. What potential does this hold in the overall cycle of capex picking up?
Vetri Subramaniam: Power is one of the pain points from the previous cycle. While we have allowed the private sector to come into power generation, the reform agenda is still unfinished and it is not clear to me that you can really make power the driver of the next capex cycle.

In fact, if you can resolve some of the issues in the power sector, that might actually bring relief, strengthen entrepreneur balance sheets, give the banks a little bit more risk appetite again. It is more repair work as far as power is concerned. Roads are continuing to do reasonably well over the last five years but it is not something which can really give you a step up. Just to go back to the areas where there is potential -- real estate, railways and transportation infrastructure -- could be areas which could be opened up further to the private sector and that could drive investment.

Third, we are trying to implement some policies and I would say the headline tax rate cut which was made just about 10 days ago to attract more FDI into India and to make it a manufacturing destination for the things that we are still importing.

When you look at our import bill, what gains a lot of disproportionate attention is oil prices. While the Indian income levels have gone up, the biggest pain point in our trade deficit is increasingly electronics and you can actually kill two birds with one stone, if you get a large amount of FDI coming into India for electronics manufacturing. It would not only bring in FDI but also help address a critical issue as far as the trade deficit is concerned.

So these are three areas where certainly the government can do a lot more in terms of enabling.

Are market participants’ earnings on the street overall consensus earning factoring in a recovery in capex?
Vetri Subramaniam: No, I do not think at this point of time, anybody is budgeting for a significant improvement in capex. There is obviously some increase in earnings estimates because of the cut in corporate tax rates but it is more a building block because it leaves money in the hands of businesses and it is the businesses which take the decision on where to invest, who and how many to hire and what kind of products and services do they want to manufacture and sell to customers, and also put in place, a branding and distribution system.

By leaving more money with the producers, you are giving them the option to determine how they want to use these additional resources. This is an important part of the equation for us to drive capex in the economy. Capital in the hands of businesses and entrepreneurs is likely to be far more productive than capital in the hands of businesses. So it is an enabling mechanism.

Again to repeat, the health of capex trends is actually quite good. If you look at our capex to GDP, it is significantly higher than where we were in 2003. So we are doing reasonably well, but we would like to do better. Leaving more money with the entrepreneurs hopefully would help this cycle go up further in the days ahead.

How important are the tax cuts in terms of savings for companies and how important is that for capital of banks and capex of a lot of large companies?
Vetri Subramaniam: Certainly important. The government has put out an estimate of about $20 billion, but there is some debate about whether that was the actual benefit or if it was smaller. But it is a significant benefit. The key issue is that the government’s takeaway of pre-tax profit comes down. As you are leaving money with the entrepreneurs, they get to determine whether they want to invest in new facilities and if they want to hire more people, create new products and services which might involve R&D, innovation, branding and distribution.

Therefore, it is a very strong enabling factor but it is not sufficient by itself to turn things around for two reasons; one, what the economy is currently experiencing is actually a problem on the demand side. The economy is also facing stresses as far as credit is concerned which has clogged up the markets. There is a trust deficit in the markets and to that extent, credit is not reaching the people who actually need it.

I do not think these issues are actually addressed by the tax rate cut and therefore they will need to be some continued tinkering around with the policies vis-a-vis credit and freeing up of markets.

There has been discussion about RBI doing an AQR for some of the entities. There has been talk of needing to put in place a much speedier system for resolution of distressed NBFCs. It has been more than a year since we have had one or two entities get into trouble and I honestly think it is taking too long for us to resolve some of these problems, resulting in cholesterol building up within the system.