The pick-up in capacity utilisation is dodgy

Also published in Hindu BusinessLine...here

The uptick in RBI’s capacity utilisation indicator to 75.2% in Q4FY18 is seen by many analysts and investors as an indicator of an impending turnaround in India’s private capex cycle, which has been on a downward trajectory since the 2008 peak. Indeed, RBI in its Aug’18 monetary policy statement noted that investment activities remain firm. These have resuscitated investors’ interest in fixed investments related stocks.

According to us, the reason to be sceptical about a possible structural turnaround in private capex is that such hopes have emerged 3 times in the past decade. First, during 2010-11, i.e. soon after the stimulus-led recovery post the Global Financial Crisis (GFC). Second, when Mr Modi was elected to power in 2014; on expectations of a transition from social welfare model to an investment-led model and good governance. Lastly, expectations have been built up over the past 6-8 months about a decisive turnaround in private capex.

But across these episodes, India’s investment rate (29% of GDP in FY18) has been declining from its 2008 peak (39% of GDP). It improved temporarily for a few quarters in 2010-12, but it has been trending down in the past 10 years. 

So, does the RBI’s utilisation index provide an accurate indication of traction in private capex? Our short answer is: no.

The Q4FY18 reading of 75.2% capacity utilisation is indeed the highest in the past 2 years. But, similar levels have been witnessed several times in the past 3 years: 74.6% in Q4FY17, 75.5% in Q4FY16 and 75% in Q4FY14. In fact, it is a seasonal phenomenon and on a seasonally-adjusted basis, it declined in the Jan-Mar’18 quarter.

The contrast is starker when one sees this indicator over a longer term. The most important inference is that there has been a structural decline in average capacity utilisation in the Indian manufacturing sector since 2014, which is alarming.

Importantly, the average for the 5 years after the 2008 GFC was better than the past 4 years’ average. Between Q4FY09 and Q4FY13, it averaged at 77.3%. At the height of the 2008 GFC, it was 75% (in Q4FY09) and the peak level during this period was 83.2% in Q4FY11.

The average during Q1FY14-Q4FY18 is much lower at 73%, only slightly lower than 75.2% in Q4FY18, but substantially weaker than the pre-2014 average of 77.3%. 

Other important indicators from RBI’s capacity utilisation data suggest improvement in the order book of Indian manufacturers. But, the average inventory level of Indian manufacturing companies is also quite low.

The recent recovery in the order backlog is more attributable to recovery from the post-demonetization contraction of 56% from the level seen prior to demonetization. Similarly, the recovery in average sales per company during FY18 is only a partial recovery from the post demonetization contraction seen during Q4FY16-Q3FY17; it contracted by 54% from the level seen prior to demonetization.

Average inventory level (finished goods, raw material and work in progress) as a percentage of sales, remains low even after the recovery post the demonetisation disturbance. At 44%, it is much lower than 51.5% during FY09-Q2FY17.

So, while the capacity utilization as per RBI data has improved to 75.2%, the trends in sales and inventory levels indicate that companies are still less confident about a meaningful recovery in sales growth compared to the period prior to demonetisation, and especially compared to FY10-FY13 when the average inventory level was 52.3% of sales.

Our analysis of Capital Goods index (within IIP, released by CSO) reveals that strong growth recovery in it during 2HFY18 has emanated from much distorted estimates of underlying deflators (estimated at -23.4% in 2HFY18), which is at odds with any inflation indicator.  

CMIE data on investment projects suggests that investment activities remained slack even in Q1FY19. New investment projects announced contracted by 13% yoy. The 4-quarter average (Sep’17-Jun’18) was 55% lower than the average 2 years back. Similarly, projects dropped, including those abandoned and shelved, continue to rise (20% on average basis). Projects under implementation have been growing by a measly 2% over the past 6 quarters - much lower than the CSO’s estimate of nominal GDP growth of ~11%. Hence, the investment rate has continued to decline well into FY19.

Overall, the exuberance about a decisive revival in private capex appears premature. Recent recovery in utilization levels indicated by RBI’s survey is still way below the 2011-2014 averages. The revival in sales growth in the quarters following the demonetization shock and GST-related dislocations may have improved asset utilization for Indian companies, but it will still take some more time before a sustainable investment cycle is established.

Fiscal reflation ahead of the elections, including spending on Railways and Roads, are near-term positives for the investment cycle. But, that is unlikely to be big enough to move the needle much - at best it may help prevent further decline.

Sustainability of the recent traction in economic growth will depend on resuscitation of a sustainable private investment cycle, which has remained muted till now. It will depend on a whole host of factors, such as corporate profitability, capacity utilization, leveraging capability, bank lending capability, level of risk-free rate and revival in domestic savings.

Corporate deleveraging process is underway, but with banks credit-deposit ratio rising back to 75.3% (little lower than its earlier peak of 78% in 2013) after a transient decline to 69% post demonetization, the ability of the banking sector to fund fresh investments will need to be strengthened materially. 

Also, the risk-free rate has been rising quicker than the improvement seen in profitability of Indian corporates. Corporate results for Q1FY19 thus far show that while sales growth has been robust, aggregate profit has grown at a modest pace of 5-6%, as companies face margin pressure from the rising cost of raw materials. This is much lower than the consensus expectation of 20% profit growth. Clearly, the return ratios of India Inc are still quite feeble. Productivity gains from GST reforms and the much-touted demonetization reforms are still not visible.

Additionally, as RBI has highlighted, scope of fiscal slippage arising from populism amid a decline in private and household savings can worsen financial market conditions, thereby crowding out private investments. Deteriorating trend in global trade protectionism is also another source of uncertainty for an upswing in private capex cycle.