Private Capex: An inside story

With Gross Fixed Capital Formation (GFCF) as a proportion of GDP around 31 per cent during 2017-18, Private sector investment has been and will continue to be one of the important pillars of GDP growth, and why wouldn’t it be so, given its multiplier effect on the economy in the form of creating job opportunities, boosting employment, increasing consumption demand and so on.
But sadly, over the last one year or so, this component of GDP growth has taken a heavy beating and private investment by companies have been falling to multi-year lows.

The Modi Government was well-aware of this fact and in September 2019, it took the entire country by surprise when it announced a sharp cut in corporate tax rate. The move was aimed to boost manufacturing and encourage businesses to expand production capacities, thereby hoping for a revival in private sector capex. Additionally, the RBI also did its part by slashing interest rates by as much as 250 bps between February 2019 and May 2020 and coordinating with the banks to improve rate-cut transmission.
The move, to an extent paid off, with the MCLR coming down by 104 bps over the last 12 months when the rate cut was to the extent of 150 bps.

Prima facie, it seems that not only the nominal rates would have come down, but real rates as well. So, a lower real interest rate should have invigorated businesses to borrow more and make new investments. But is something like that happening?
Private capex has been on a southward journey in FY20; from 4.6 per cent in Q1 to (3.9) per cent in Q2 to (5.2) per cent in Q3 to (6.5) per cent in Q4.
But why is it so?
Yes. We know your answer: it’s because of COVID-2019 pandemic. But the pandemic started spreading in our country only after March.
There’s something which we are missing!!!
It is because of the way we treat inflation rate in our calculation of real rates. Theres’s a common perception that “inflation rate” means retail inflation (CPI) in the economy. This is 100% true for consumers but not for businessess. For example, a steel manufacturing company would have little to do with what the inflation in fruits and vegetables are. It will be more concerned with the wholesale inflation in steel.
Looking at the wholesale prices gives a sense of the “pricing power” that a firm or industry enjoys. The pricing power varies between businesses – steel, consumer durables, hotel, aviation depending on their industry scenario and product demand.

So, to gauge inflation for businesses, one should look at Wholesale Price Index(WPI) and within WPI – the non-food manufacturing inflation, also called the Core-WPI.

Source: Bank of America Securities
WALR: Weighted average lending rate

Charts 1 and 2 show what happens to the real interest rate for businesses when we calculate it by using core-WPI as the inflation rate. It can be clearly seen that the real rates have moved north since Dec-2018 (Also the month in which Shaktikanta Das took over as the RBI Governor). This has been a significant factor in deterring businesses from making investments.

Now, with the Covid pandemic the situation has become even worse for the businesses, with an uncertain and bleak future outlook. In about a week’s time, the Monetary Policy Committee will reconvene to take decision on interest rates. It would be interesting to see how the RBI deals with the above dilemma and help the corporate sector come out from the double whammy impact of high real rates and Corona virus.

Source: The Indian Express

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