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India: Timing the bottom of the investment cycle
India’s investment cycle has slowed
considerably since June 2010, while volatility
has increased sharply. The key question for
Indian markets is when will investment
bottom out and how deep will be that trough?
The slowdown in capex has largely been
driven by a slowdown in government projects
and policy bottlenecks, and to a lesser extent
by higher interest rates and commodity
prices.
Analysis of the past seven historical
investment cycles, sensitivity of investment
to interest rates, and leading indicators
suggests a shallow slowdown and a gradual
recovery in FY13.
Alternative frameworks for analyzing
investment demand based on ‘business
confidence’ and the ‘financial accelerator’
also gives a similar message.
While volatility may remain high, and the
economy has to adjust to higher commodity
prices, our analysis suggests a turn in the
investment cycle in early FY13, which will
be key for a pickup in economic growth.
India: Timing the bottom of the investment cycle
India’s investment cycle has slowed considerably since June 2010, while volatility has increased
sharply. The key question for Indian markets is when will investment bottom out and how deep will be
that trough?
The slowdown in capex has largely been driven by a slowdown in government projects and policy
bottlenecks, and to a lesser extent by higher interest rates and commodity prices.
Analysis of the past seven historical investment cycles, sensitivity of investment to interest rates, and
leading indicators suggests a shallow slowdown and a gradual recovery in FY13.
Alternative frameworks for analyzing investment demand based on ‘business confidence’ and the
‘financial accelerator’ also gives a similar message.
While volatility may remain high, and the economy has to adjust to higher commodity prices, our
analysis suggests a turn in the investment cycle in early FY13, which will be key for a pickup in
economic growth.
I. What is happening to investment—a
slowdown with high volatility
India’s investment cycle has slowed significantly in the
last nine months. Infrastructure investments have fallen
to a trickle, while government investment has nearly
dried up. In the January-March quarter, total Gross Fixed
Capital Formation (GFCF) grew by a mere 0.4% yoy.
The slowdown in the investment cycle has been a key
reason for the deceleration in economic growth. Not only
has investment demand fallen, but volatility has
increased significantly since the financial crisis. The key
question on investors’ minds is when will the cycle
bottom out, and how deep will be the trough?
To answer this question, we look at the investment cycle
through different analytical frameworks. First, we
analyze the shocks that have hit the economy over the
past year. Second, we examine historical cycles to
determine the time from peak-to-trough. Third, we do an
econometric analysis of the impact of interest rates on
investments. Fourth, we consider the information content
in our leading indicators, and alternative investment
frameworks.
The pre-crisis economic cycle was a long one, starting
with a recovery from 2003-2004, a consolidation in
2005-2006, peaking in 2007, and then a decline in 2008-
2009. The post-financial crisis cycle was likely to be
different, given the unprecedented fiscal and monetary
stimulus that was given. The fiscal deficit expanded from
4.8% of GDP in FY08 to 10.1% of GDP in FY09, while
policy rates were cut very aggressively. In response, the
supercharged investment cycle accelerated very sharply
from mid-2009 to mid-2010, with two key
characteristics—it was driven by infrastructure, and by
the government. Expectations were that this could
continue through the next few years, especially as the
private sector moved to take over the mantle of
investment, which did not subsequently materialize.
Further, foreign direct investment actually fell in 2010.
The volatility of investment increased considerably in the
post-crisis period,1 from a period of correspondingly
very low volatility during the ‘Great Moderation’ of
2002-2007.
To understand the factors causing the slowdown in
investment and increase in volatility, we investigate the
shocks that have hit the economy in the past 12 months.
II. Three shocks—higher oil, sluggish policy,
higher interest rates
Since mid-2010, the economy has been buffeted by
three shocks—policy inertia, higher oil prices, and
rising interest rates, with varied impacts on
investment activity. The policy inertia has come as a
consequence of the spate of governance issues affecting
the government starting with Commonwealth Games to
the 2-G telecom licenses. These led to an increase in
regulatory bottlenecks—from land acquisition to
environmental approvals—and a sharp slowdown in
government investments, especially in infrastructure.
The oil shock began impacting the economy from
November 2010, as oil prices climbed from U$84/bbl to
US$125/bbl by end-April.
Since March 2010, the Reserve Bank of India (RBI) has
raised policy rates by 425 bp effectively. Rates were
increased from abnormally low levels, and with real rates
still significantly negative, we would argue it was only in
2011 that rates have begun to affect investment demand.
We think the evidence suggests that the slowdown
since mid-2010 has been primarily driven by policy
inertia and a slowdown in government spending, and
to a lesser extent by rising interest rates and commodity
prices. In the key sectors of power and roads, there has
been a palpable slowdown in government-led projects.
Government spending as a share of total infrastructure
investment has fallen from an average of 50% to 10% in
1Q2011.
How will the economy respond to these shocks going
forward? Of the three shocks to hit the investment
cycle—two (policy inertia and higher oil prices) are real,
in as much as they need an output response, and a real
adjustment in the economy. The higher interest rate
shock or tighter money supply is a nominal shock which
has a temporary cyclical impact on the economy. The
real versus nominal distinction can be important in
understanding the consequences.
The policy and oil price shocks, however, could
warrant a real adjustment. On the policy side, if the
inertia is temporary, then it will only lead to a temporary
slowdown. However, the oil shock, assuming it is
permanent, needs an adjustment—either energy-saving
technology, or domestic sources of energy, or a
slowdown in demand, or a combination of these.
Therefore, the prognosis for the investment cycle has
a cyclical and structural component. Higher rates will
likely drive investment lower cyclically, but higher oil
prices and policy inertia could lead to structurally lower
investment demand. The upshot is that investments will
likely slow gradually, but not rise sharply thereafter.
III. Lessons from history—the cycle bottoms
out in six quarters
We looked at seven historical cycles, from the 1970s, to
assess the duration of peak-to-trough declines. Our
analysis suggests that on average, peak-to-trough
declines take 1.5 years. Quarterly data, available from
1996 suggests a similar time period.
Although this cycle is clearly different due to the nature
of the global shock and the magnitude of the policy
response, the historical analysis gives us some
benchmarks with which to evaluate the current cycle.
Given the extent and duration of the slowdown, and the
level of interest rates, we appear to be in the late-cycle
stage rather than in a mid-cycle slowdown. Therefore,
investment demand would pick up when the rate cycle
turns, in our view.
IV. Peaking interest rates and investment
activity
To determine the trough in investment activity, we
analyzed the transmission between interest rates and
activity. Our analysis, based on quarterly data from 2000,
suggests that it takes about two quarters on average for
bank lending rates to transmit to investment activity.2
Therefore, assuming our current expectation of bank
lending rates peaking by September 2011 plays out, we
would expect the impact to be felt on activity until
March 2012.
Given the sensitivities from the regression analysis, we
would expect higher rates to continue to negatively
impact investment activity through the remainder of
FY12. The cyclical impact from interest rates is,
however, a bit more deterministic than that from policy
inertia, and therefore we would expect a gradual
slowdown in investments given that real rates are not at
very high levels.
V. Evidence from leading indicators
Leading indicators are suggesting a gradual rather
than a sharp slowdown. Our Goldman Sachs India
Financial Conditions Index (GS India-FCI), the PMI,
business confidence surveys, and employment surveys
do not suggest a further sharp slowdown in investment.
Our GS India-FCI, our preferred leading indicator of
activity, suggests a gradual slowdown ahead. After
loosening by 425 bp during the crisis, the GS India-FCI
has been tightening since October 2009. In 2011, the GS
India-FCI has tightened by 45 bp, a gradual rather than
sharp tightening, suggesting that activity will continue to
slow, but not fall sharply.
The manufacturing PMI has gradually decreased from an
average of 57.5 in 2010 to 55.3 in June 2011, suggesting
a steady, but not a sharp, decline in activity.
Various business confidence surveys have also
moderated in recent months, but only a notch, and
from high bases. The NCAER Business Confidence
Index has decreased a tad since September 2010, while
the RBI’s Overall Business Situation surveys have
peaked a bit later. Although, we would expect them to
continue to decline through the summer, they have not
yet fallen to levels that would indicate a continued sharp
downturn in the investment cycle.
Finally, the employment outlook data, albeit mixed,
does not suggest rising unemployment. While the
RBI’s industrial outlook surveys on employment remain
elevated, the PMI’s manufacturing employment survey
shows a negative employment outlook, with the latest
PMI reading at 48.74, reflective of a volatile
employment situation since the crisis. More importantly,
there appears to be little evidence to suggest any layoffs
or large swathes of corporates refraining from hiring.
VI. What do alternative investment
frameworks suggest?
Investment demand can be powerfully influenced by the
economy’s growth prospects (accelerator model), and the
stock market (Tobin’s Q). Higher economic growth
prospects leads companies to invest more, as they see
increased sales, rising profits and cash flow. Therefore,
high profit expectations and business confidence actually
leads to higher investments. On the reverse, slowing
GDP growth hurts business profits, sales and cash flows.
The current slowdown in growth does not appear to be
large enough to make the accelerator model work in
reverse in a significant way yet, in our view.
The stock market is also an important determinant of
firm’s investment decisions. If the market value of a
company’s stock is higher than the company’s book
value, then it encourages companies to invest more in
capital because they are ‘worth’ more than the price they
paid for them, and therefore increases investment. With
the slowdown primarily driven by policy bottlenecks, the
movements in the Indian stock market (down 9% yearto-
date), do not, in our view, suggest a major slowdown
in investment demand.
VII. Why a ‘U’, not an ‘L’?
It is one thing to say investment activity will not slow
down significantly, and quite another to expect an
upturn. We think the pickup in investment will be driven
by two factors—government action on de-bottlenecking
investments and an end to the rate hiking cycle.
On the government side, after the virtual paralysis
from January-March, the recent signs are more
encouraging, with more approvals being given for
projects, including environmental and other clearances.
On the rate cycle, we expect the RBI to hike policy rates
by another 50 bp and then stop. The expectation that the
next move in rates will be down will be an important
boost to confidence which will drive investment demand,
in our view. Finally, the economy has to adjust to higher
oil prices, and that process has begun with the
government biting the bullet and raising domestic fuel
prices on June 24 (see Government raises fuel prices—
positive move, higher near-term inflation, India Views,
June 26, 2011).
VIII. Risks
It is inherently difficult to predict the policy environment
in India, with its various pulls and pressures. Further,
movements in commodity prices are likely to add to
investment volatility. A clear risk to our view is if the
interest rate hiking cycle continues for longer then we
expect, given the trenchant inflation. This could cause a
much deeper and prolonged slowdown in the investment
cycle.
On the upside, the risks are if government-led
infrastructure projects start getting speedier approvals,
land acquisition, and other regulatory constraints are
resolved, and this imparts an impulse to investment
demand.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India: Timing the bottom of the investment cycle
India’s investment cycle has slowed
considerably since June 2010, while volatility
has increased sharply. The key question for
Indian markets is when will investment
bottom out and how deep will be that trough?
The slowdown in capex has largely been
driven by a slowdown in government projects
and policy bottlenecks, and to a lesser extent
by higher interest rates and commodity
prices.
Analysis of the past seven historical
investment cycles, sensitivity of investment
to interest rates, and leading indicators
suggests a shallow slowdown and a gradual
recovery in FY13.
Alternative frameworks for analyzing
investment demand based on ‘business
confidence’ and the ‘financial accelerator’
also gives a similar message.
While volatility may remain high, and the
economy has to adjust to higher commodity
prices, our analysis suggests a turn in the
investment cycle in early FY13, which will
be key for a pickup in economic growth.
India: Timing the bottom of the investment cycle
India’s investment cycle has slowed considerably since June 2010, while volatility has increased
sharply. The key question for Indian markets is when will investment bottom out and how deep will be
that trough?
The slowdown in capex has largely been driven by a slowdown in government projects and policy
bottlenecks, and to a lesser extent by higher interest rates and commodity prices.
Analysis of the past seven historical investment cycles, sensitivity of investment to interest rates, and
leading indicators suggests a shallow slowdown and a gradual recovery in FY13.
Alternative frameworks for analyzing investment demand based on ‘business confidence’ and the
‘financial accelerator’ also gives a similar message.
While volatility may remain high, and the economy has to adjust to higher commodity prices, our
analysis suggests a turn in the investment cycle in early FY13, which will be key for a pickup in
economic growth.
I. What is happening to investment—a
slowdown with high volatility
India’s investment cycle has slowed significantly in the
last nine months. Infrastructure investments have fallen
to a trickle, while government investment has nearly
dried up. In the January-March quarter, total Gross Fixed
Capital Formation (GFCF) grew by a mere 0.4% yoy.
The slowdown in the investment cycle has been a key
reason for the deceleration in economic growth. Not only
has investment demand fallen, but volatility has
increased significantly since the financial crisis. The key
question on investors’ minds is when will the cycle
bottom out, and how deep will be the trough?
To answer this question, we look at the investment cycle
through different analytical frameworks. First, we
analyze the shocks that have hit the economy over the
past year. Second, we examine historical cycles to
determine the time from peak-to-trough. Third, we do an
econometric analysis of the impact of interest rates on
investments. Fourth, we consider the information content
in our leading indicators, and alternative investment
frameworks.
The pre-crisis economic cycle was a long one, starting
with a recovery from 2003-2004, a consolidation in
2005-2006, peaking in 2007, and then a decline in 2008-
2009. The post-financial crisis cycle was likely to be
different, given the unprecedented fiscal and monetary
stimulus that was given. The fiscal deficit expanded from
4.8% of GDP in FY08 to 10.1% of GDP in FY09, while
policy rates were cut very aggressively. In response, the
supercharged investment cycle accelerated very sharply
from mid-2009 to mid-2010, with two key
characteristics—it was driven by infrastructure, and by
the government. Expectations were that this could
continue through the next few years, especially as the
private sector moved to take over the mantle of
investment, which did not subsequently materialize.
Further, foreign direct investment actually fell in 2010.
The volatility of investment increased considerably in the
post-crisis period,1 from a period of correspondingly
very low volatility during the ‘Great Moderation’ of
2002-2007.
To understand the factors causing the slowdown in
investment and increase in volatility, we investigate the
shocks that have hit the economy in the past 12 months.
II. Three shocks—higher oil, sluggish policy,
higher interest rates
Since mid-2010, the economy has been buffeted by
three shocks—policy inertia, higher oil prices, and
rising interest rates, with varied impacts on
investment activity. The policy inertia has come as a
consequence of the spate of governance issues affecting
the government starting with Commonwealth Games to
the 2-G telecom licenses. These led to an increase in
regulatory bottlenecks—from land acquisition to
environmental approvals—and a sharp slowdown in
government investments, especially in infrastructure.
The oil shock began impacting the economy from
November 2010, as oil prices climbed from U$84/bbl to
US$125/bbl by end-April.
Since March 2010, the Reserve Bank of India (RBI) has
raised policy rates by 425 bp effectively. Rates were
increased from abnormally low levels, and with real rates
still significantly negative, we would argue it was only in
2011 that rates have begun to affect investment demand.
We think the evidence suggests that the slowdown
since mid-2010 has been primarily driven by policy
inertia and a slowdown in government spending, and
to a lesser extent by rising interest rates and commodity
prices. In the key sectors of power and roads, there has
been a palpable slowdown in government-led projects.
Government spending as a share of total infrastructure
investment has fallen from an average of 50% to 10% in
1Q2011.
How will the economy respond to these shocks going
forward? Of the three shocks to hit the investment
cycle—two (policy inertia and higher oil prices) are real,
in as much as they need an output response, and a real
adjustment in the economy. The higher interest rate
shock or tighter money supply is a nominal shock which
has a temporary cyclical impact on the economy. The
real versus nominal distinction can be important in
understanding the consequences.
The policy and oil price shocks, however, could
warrant a real adjustment. On the policy side, if the
inertia is temporary, then it will only lead to a temporary
slowdown. However, the oil shock, assuming it is
permanent, needs an adjustment—either energy-saving
technology, or domestic sources of energy, or a
slowdown in demand, or a combination of these.
Therefore, the prognosis for the investment cycle has
a cyclical and structural component. Higher rates will
likely drive investment lower cyclically, but higher oil
prices and policy inertia could lead to structurally lower
investment demand. The upshot is that investments will
likely slow gradually, but not rise sharply thereafter.
III. Lessons from history—the cycle bottoms
out in six quarters
We looked at seven historical cycles, from the 1970s, to
assess the duration of peak-to-trough declines. Our
analysis suggests that on average, peak-to-trough
declines take 1.5 years. Quarterly data, available from
1996 suggests a similar time period.
Although this cycle is clearly different due to the nature
of the global shock and the magnitude of the policy
response, the historical analysis gives us some
benchmarks with which to evaluate the current cycle.
Given the extent and duration of the slowdown, and the
level of interest rates, we appear to be in the late-cycle
stage rather than in a mid-cycle slowdown. Therefore,
investment demand would pick up when the rate cycle
turns, in our view.
IV. Peaking interest rates and investment
activity
To determine the trough in investment activity, we
analyzed the transmission between interest rates and
activity. Our analysis, based on quarterly data from 2000,
suggests that it takes about two quarters on average for
bank lending rates to transmit to investment activity.2
Therefore, assuming our current expectation of bank
lending rates peaking by September 2011 plays out, we
would expect the impact to be felt on activity until
March 2012.
Given the sensitivities from the regression analysis, we
would expect higher rates to continue to negatively
impact investment activity through the remainder of
FY12. The cyclical impact from interest rates is,
however, a bit more deterministic than that from policy
inertia, and therefore we would expect a gradual
slowdown in investments given that real rates are not at
very high levels.
V. Evidence from leading indicators
Leading indicators are suggesting a gradual rather
than a sharp slowdown. Our Goldman Sachs India
Financial Conditions Index (GS India-FCI), the PMI,
business confidence surveys, and employment surveys
do not suggest a further sharp slowdown in investment.
Our GS India-FCI, our preferred leading indicator of
activity, suggests a gradual slowdown ahead. After
loosening by 425 bp during the crisis, the GS India-FCI
has been tightening since October 2009. In 2011, the GS
India-FCI has tightened by 45 bp, a gradual rather than
sharp tightening, suggesting that activity will continue to
slow, but not fall sharply.
The manufacturing PMI has gradually decreased from an
average of 57.5 in 2010 to 55.3 in June 2011, suggesting
a steady, but not a sharp, decline in activity.
Various business confidence surveys have also
moderated in recent months, but only a notch, and
from high bases. The NCAER Business Confidence
Index has decreased a tad since September 2010, while
the RBI’s Overall Business Situation surveys have
peaked a bit later. Although, we would expect them to
continue to decline through the summer, they have not
yet fallen to levels that would indicate a continued sharp
downturn in the investment cycle.
Finally, the employment outlook data, albeit mixed,
does not suggest rising unemployment. While the
RBI’s industrial outlook surveys on employment remain
elevated, the PMI’s manufacturing employment survey
shows a negative employment outlook, with the latest
PMI reading at 48.74, reflective of a volatile
employment situation since the crisis. More importantly,
there appears to be little evidence to suggest any layoffs
or large swathes of corporates refraining from hiring.
VI. What do alternative investment
frameworks suggest?
Investment demand can be powerfully influenced by the
economy’s growth prospects (accelerator model), and the
stock market (Tobin’s Q). Higher economic growth
prospects leads companies to invest more, as they see
increased sales, rising profits and cash flow. Therefore,
high profit expectations and business confidence actually
leads to higher investments. On the reverse, slowing
GDP growth hurts business profits, sales and cash flows.
The current slowdown in growth does not appear to be
large enough to make the accelerator model work in
reverse in a significant way yet, in our view.
The stock market is also an important determinant of
firm’s investment decisions. If the market value of a
company’s stock is higher than the company’s book
value, then it encourages companies to invest more in
capital because they are ‘worth’ more than the price they
paid for them, and therefore increases investment. With
the slowdown primarily driven by policy bottlenecks, the
movements in the Indian stock market (down 9% yearto-
date), do not, in our view, suggest a major slowdown
in investment demand.
VII. Why a ‘U’, not an ‘L’?
It is one thing to say investment activity will not slow
down significantly, and quite another to expect an
upturn. We think the pickup in investment will be driven
by two factors—government action on de-bottlenecking
investments and an end to the rate hiking cycle.
On the government side, after the virtual paralysis
from January-March, the recent signs are more
encouraging, with more approvals being given for
projects, including environmental and other clearances.
On the rate cycle, we expect the RBI to hike policy rates
by another 50 bp and then stop. The expectation that the
next move in rates will be down will be an important
boost to confidence which will drive investment demand,
in our view. Finally, the economy has to adjust to higher
oil prices, and that process has begun with the
government biting the bullet and raising domestic fuel
prices on June 24 (see Government raises fuel prices—
positive move, higher near-term inflation, India Views,
June 26, 2011).
VIII. Risks
It is inherently difficult to predict the policy environment
in India, with its various pulls and pressures. Further,
movements in commodity prices are likely to add to
investment volatility. A clear risk to our view is if the
interest rate hiking cycle continues for longer then we
expect, given the trenchant inflation. This could cause a
much deeper and prolonged slowdown in the investment
cycle.
On the upside, the risks are if government-led
infrastructure projects start getting speedier approvals,
land acquisition, and other regulatory constraints are
resolved, and this imparts an impulse to investment
demand.
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