Strong consumption and slow industrial growth imply impending capacity crunch.
India’s industrial production numbers for February have predictably been weak. The index for industrial production (IIP) grew 3.6 per cent in February, year-on-year. The figure was lower than the consensus estimate of five per cent, claim economists, due to the base effect as the index grew 15 per cent in February last year. Also, continued weakness in capital goods dragged the index further down. According to Edelweiss Capital, there is a clear trend of weakness in IIP in the second half of financial year 2010-11, due to a slowdown in investments and the base effect, despite consumption being stable.
And, this is where the dichotomy of the Indian economy lies. While the consumer is undeterred by rising oil prices and soaring inflation, companies are cutting capital expenditure. Interestingly, consumption growth has been secular across the consumer durable and non-durable categories, implying high interest rates have not been a deterrent. Despite buoyant consumption, the industry has been cutting investment, as the interest rate cycle has turned upwards sharply in the last one year. Short-term rates have gone up nearly 400 basis points in the last 12 months.
Evidently, a situation of booming consumption and sluggish industrial growth cannot go hand-in-hand for long. Economists believe if investments don’t pick up and consumption remains strong, there may be a problem. It is this school of thought that believes once capacity constraints hit companies, capital expenditure will revive over the next couple of quarters. But prior to this, the current environment of uncertainty surrounding the government policy and interest rates has to ease.
The other school of thought believes consumption will come off in financial year 2011-12, as inflation could spread to the core sector. These economists feel the continued buoyancy in consumption is not likely to continue in financial year 2011-12, as overall growth comes under pressure.
High interest cost has already started affecting profitability. For some capital-intensive sectors, interest as a percentage of Ebitda (earnings before interest, tax, depreciation and amortisation) is in the range of 50-80 per cent. But statistics from the central bank suggest the interest rates do not have a big impact on investment decisions. According to official statistics, data of 4,000 companies show that interest cost as a proportion of sales is in the range of two-four per cent, implying high interest rates don’t impact growth. Policymakers believe investment decisions are driven more by the ‘animal spirit’ than by interest rates. Even if this were true, economists feel the rate move has been sudden and there still isn’t enough certainty on the future to take investment decisions.
Economists believe over the last 12 months, short-term rates have gone up by nearly 400 basis points, from the benign interest rate regime, during the slowdown years. It’s widely believed that corporate India has been caught unawares by this sudden upturn in interest rates and, therefore, investment plans have been deferred, as there is no clarity on how the new financial year will pan out. However, if consumption continues on its growth trajectory and new capacities don’t get created, demand will outpace supply in the second half of this financial year.