India capex: The revival begins: Credit Suisse,

Mythbusting
Recovery underway and set to continue: Contrary to conventional wisdom
we note evidence that an investment recovery is underway, while the
fundamentals suggest the pick-up will be both reasonably robust and
sustainable. We are looking for real gross fixed capital formation to expand by
around 8% in 2013/14 and 12% in 2014/15. Both projections are significantly
above the consensus. It seems to us that the market’s bearish view of Indian
capex is conditioned by a number of factors, most of which appear to be myths.
 Myth 1 – There is no recovery in investment: The national accounts data
actually showed capital spending rising 6% in the year to the December
quarter, while growth in the production of capital goods bottomed in mid-2012.
 Myth 2 – Investment won’t pick up before capacity utilisation rises:
While this appears logical, the data suggest capex growth actually leads
CapU. This is also true of other countries.
 Myth 3 – Bank lending growth lead capital investment: This is another
popular argument but, again, the causality runs the other way round probably
because companies initially finance higher capex from retained earnings.
 Myth 4 – Interest rates have little impact on investment spending: Our
statistical analysis clearly suggests that interest rates have a significant role to
play in driving capex.
 Myth 5 – Upcoming elections will lead firms to postpone investment:
History again suggests this is unlikely to be the case.
Reasons to be positive: In modelling real investment growth, we find various
interest rate variables, the oil price, export growth and the equity market
(designed to pick up profit expectations) to be the key macro drivers, all of
which are becoming more supportive. Meanwhile, the government’s Cabinet
Committee on Investment may succeed in unlocking some stalled projects. The
obvious riposte is that companies are not telling us that a recovery is underway,
but there are a number of factors that could explain this.

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Five great myths
One of the strongest consensus views concerning the Indian economy is that capital
expenditure is flat on its back and highly likely to remain so for the foreseeable future. We
disagree. Not only have the fundamentals for a pick-up in capital spending improved but
we note some evidence to suggest that a recovery is already underway. In this report, we
aim to de-bunk a few popular notions with regard to investment spending in India before
discussing the outlook for capex in the country.
Myth 1 – There is no recovery in investment ?
It may have gone largely unnoticed, but India’s October-December GDP release showed
real gross fixed capital formation (GFCF) growing 6.0% year-on-year – up from -4.6% in
the June quarter of 2012 and the strongest since April-June of 2011. While history
suggests that these numbers can be revised considerably over time, it is of some comfort
that the growth in the production of capital goods has been trending higher from mid-2012
as well. In Exhibit 1 we have smoothed this volatile series by taking a three-month moving
average of the year-on-year rate
We also note that in providing its estimate for 2012/13 GDP growth, the statistics office
suggested that real GFCF rose 2.5% in the fiscal year as a whole. This in turn is
consistent with a further improvement in year-on-year capital spending growth to 9% in the
March quarter just ended. The final numbers are typically different from these advanced
estimates but, in most cases, not massively so.
Myth 2 – Investment won’t pick up before capacity utilisation rises
While logic would certainly dictate that investment spending will not strengthen until
capacity utilisation rises and bottlenecks begin to be hit, this is not supported by the data
(see Exhibit 2). This could say more about the quality of India’s CapU statistics, but we
have also found this to be true of other economies in the region and elsewhere. It
probably reflects the more volatile nature of demand relative to supply – in other words in
cyclical upswings the growth in demand outpaces the growth in investment, leading
capacity utilisation to rise in tandem with stronger capex growth and vice versa during
downturns. Firms will also be aware that it takes time for investment spending to create
additional capacity.

Myth 3 – Bank lending growth leads capital investment
Another popular argument is that any improvement in investment spending will be
heralded by stronger bank lending growth, meaning that the current weakness of the latter
bodes badly for a near-term recovery in the former. The hard data again suggest
otherwise, however. In fact, as Exhibit 3 shows, the causality appears to run the other
way with capex growth typically leading commercial bank lending, which we have deflated
by wholesale price inflation in the chart (the results are unchanged if we use the nominal
bank lending series instead). This is probably because companies initially finance higher
investment spending from retained earnings, before tapping more expensive credit lines
as they become increasingly confident of a demand recovery.

Myth 4 – Interest rates have little impact on investment spending
The Reserve Bank of India has often argued that the sharp downturn in investment
through 2010 and 2011 was not the result of monetary tightening, while other analysts
have come to same conclusion, suggesting that interest rates matter little for capital
spending in India.

Nevertheless, without wishing to suggest that interest rates are the be all and end all for
investment spending, our statistical analysis very clearly suggests that when controlling for
other drivers, both short- and long-term interest rates have a significant role to play in
explaining capex developments. This is supported by Exhibit 4 which tracks the level of
nominal three-month inter-bank rates on an inverted scale against the growth in gross
fixed capital formation. Statistically, the strongest effect from this interest rate variable is
felt after two quarters.

Myth 5 – General election will lead companies to postpone investment
Many have argued that uncertainty regarding the timing and outcome of the next general
election (which must be held by May next year) will persuade companies to postpone
some investment plans. There is, however, little evidence to suggest that past elections,
where the outcome has been similarly uncertain, has had noticeable effects. Exhibit 5, for
example, illustrates the apparent lack of relationship between the past four general
elections and investment spending in the country. In some ways this shouldn’t be
particularly surprising, after all it is not as though India is unused to political instability – it
had three elections in three years in the late-1990s, for example.

Capex outlook – reasons to be positive
When considering the outlook for investment spending it would be helpful to be able to point to
a series of good lead indicators, but this simply isn’t possible. Having checked a wide range of
measures, including capital goods imports as well as the production of basic and fabricated
metals, steel and cement we couldn’t find anything that works – in fact, rather strangely,
investment growth often leads growth in these various series rather than vice versa.
This leaves us with little choice but to build a model of capital investment growth based on
likely fundamental drivers. The results of so doing are shown in Exhibit 6, with our
favoured equation incorporating the following explanatory factors: changes in short- and
long-term interest rates (with lags up to five quarters), the rupee-denominated oil price
(also lagged up to five quarters), export growth (lagged four quarters) and equity market
moves (with lags up to six quarters). The last of these is designed to pick up confidence
effects as well as proxying profit expectations. Clearly the fit is good (it has an R-squared
of 0.88) and the equation passes all the standard statistical tests.
It suggests that after a potentially disappointing number for January-March (data for which
is due to be released on 31 May), the recovery will resume in the current quarter,
registering close to double-digit year-on-year growth by the final three months of the
2013/14 fiscal year. On the basis of the model, the pick-up from here will be driven largely
by the lagged effects of lower interest rates, slightly stronger exports and the improved
equity market performance. For the record, we have assumed that three-month interbank
rates fall gradually from 8.3% currently to 7.8% by the end of the period, while the ten-year
yield drops to 7.6% from the June quarter and remains there. The oil price is unchanged
at USD100/bbl and the INR-USD exchange rate at 54.0 throughout the forecast period,
with the Sensex registering 10% year-on-year gains.

But why aren’t companies telling us there’s an investment recovery?
The obvious riposte to this relatively positive view, is that the relevant companies are not
signalling any appetite to increase their capital investment. It seems to us, however, that
there are number of possible reasons for this.
 In the US at least household investment (mainly property purchases) typically leads nonresidential
business fixed investment (the reasons for this are explored by Jonas Fisher in
the Journal of Political Economy). The equivalent data are not available to check whether
this is the case in India, but, if it is then this would obviously help square the circle.

 It may be the case that an investment recovery normally begins with small and mediumsized
companies, rather than the large, quoted companies with which most analysts
normally communicate. According to our equity strategist this is likely to be happening
in India right now, with investment in small food processing units, for example, growing
strongly at present.
 Companies often think more in terms of nominal as opposed to real investment, while
we are focused on the latter here. This could be important as, at the bottom of
economic cycles, price pressures tend to be weaker and even negative in some cases,
depressing nominal capex spend relative to real investment growth.
 We also wonder whether companies don’t declare that an investment upturn is
underway until they are actually expanding capacity, as opposed to just spending more
on replacing/upgrading existing machinery and equipment. The latter will still count
towards total capital spending, however.
Upside risks?
No doubt many will still suggest that the risks to our model based projections are on the
downside. But it seems to us that there are upside risks as well. First, as we mentioned
earlier, the statistics office estimate of investment growth in the March quarter is
significantly above that suggested by the equation. Second, the Cabinet Committee on
Investment (CCI), that was constituted in December 2012, could prove successful in
unlocking many stalled projects worth billions of US dollars.
The CCI is designed to “monitor and review the implementation of major projects to ensure
accelerated and time bound grant of various licences, permissions and approvals. The
CCI would also prescribe different time limits, in consultation with the concerned Ministries,
for taking decisions […] In case the decision is not taken within the stipulated time period
the Cabinet Committee would look into the reasons for delays and facilitate decisionmaking
on critical issues to de-bottleneck key impediments by fast-tracking the required
approvals/clearances”.
So far, the CCI has cleared roughly 30 oil and gas blocks for new exploration (worth
USD2.7bn) and 13 power projects (USD6.1bn) as well as allowing the Steel Authority of
India to clear an area of forest in order to build a facility to significantly expand production
of iron ore. It has also introduced a fast track dispute mechanism for highway contracts.
Not surprisingly, there remains considerable uncertainty regarding the magnitude and
timing of these and potential future measures but it seems unwise to ignore their effect
altogether.
Forecasts – remaining optimistic
Bringing all this together, we are not inclined to change our top-of-the-range projections for
the growth in real gross fixed capital formation. In our view, investment will register fiscal
year average growth in the order of 8% in 2013/14 (compared with a median consensus
forecast of 5.6% according to the April edition of Consensus Forecasts), and 12% (7.5%
consensus) in 2014/15, up from 1.5% in 2012/13.