Greater energy efficiency and lower borrowings keep India Inc’s profits healthy, but rising wages, especially for services, could cause trouble.
Over the last few years, the Indian economy has seen an unprecedented growth based on productivity and innovative capacity of the corporate sector. This newfound dynamism of the corporate sector has undoubtedly contributed to the medium-term sustainability of the Indian growth story. However, with a downturn in the business cycle unfolding at present, macroeconomic developments such as cost pressures including wage costs, interest rate increases and a slowdown in demand can affect the health of the corporate sector.
We do a reality check of the Indian corporate sector to absorb macroeconomic shocks. We are able to identify a number of trends in corporate performance, which help us draw significant conclusions about how the macro environment is likely to impact corporate performance in the coming months.
The current macroeconomic developments can affect the health of the corporate sector via:
Let us first lay out the recent trends in profit margin of the corporate sector
To begin with, how have companies managed the gross margin in current business cycle? One reason behind this appears to be a significant increase in energy efficiency of the industry, in the face of mounting cost pressures. While consumers are largely protected by government subsidies on the retail price of oil, companies are not. Nevertheless, it is apparent that the energy cost per unit of sales as well as its share in material cost is coming down over time, with a slight upturn in last two quarters. Although the share of total material costs in sales has been increasing over this time, reflecting a rise in other input prices, the energy intensity has come down.
How the corporate sector has managed to reduce the energy cost per unit of sales in spite of rising energy prices requires a detailed micro-level study. However, at the macro level, the contribution of the recent acceleration in investment is likely to be significant. High investment is associated with rapid technological upgradation, including energy efficiency. Whatever the case, this illustration makes clear the way firms have partially insulated their bottom-line in face of rising energy prices.
Coming now to the net profit margins, one factor that could have a significant impact on net margins is domestic and world interest rates. Again, it appears that a mix of relatively low interest rates and increased dependence on equity capital has reduced the interest burden in recent years. Further, in recent years, companies have sourced debt from outside India at lower interest rates than at home. Along with a lower interest rate regime, the stock market taking off has led to a change in the financing structure of firms in the current decade. As a result of these developments, while in 2001-02, 60 per cent of gross profits were consumed by interest payments alone, the figure now stand at at less than 20 per cent.
It should however, be noted that the interest payout ratio (interest cost to sales) shows an inverse relationship with firm size as expected. While large firms have lower interest burden, small firms bear disproportionately higher interest cost. The average interest payout ratio in 2000-01 was around 38 per cent for small firms (based on the median sales of the sample) while for large firms the ratio was only 7 per cent. On a positive side, by the first quarter of 2008-09, this ratio had come down sharply for both categories of firms. While the ratio for small firms stood at around 10 per cent, it is only 3.4 per cent for large firms.
Before oil prices and interest rates began to increase, average corporate salaries were increasing like never before. This represented the first serious supply shock to hit the corporate sector, especially the services industry. In spite of this shock, the service sector continues to outperform the manufacturing in terms of the profit margins, notwithstanding the fact that it has seen a relatively larger decline in recent quarters.
A higher profit margin in services is the result of higher productivity. When we break-up of the profits-to-sales ratio into the profit-to-value added (the share component) and the value added/sales (the productivity component) ratio, it is clear that productivity of the services sector has been higher than the manufacturing in the entire period. Higher share of value added in sales also implies lower non-factor input costs for the services sector which reduced its vulnerability to commodity price shocks.
Given the higher share of value added in sales for the service sector, a follow-up question that arises is: What is the entrepreneur share within the value added? In fact, the share of profits in value added has been declining for the services sector during the period under consideration. It is clear that the shortage of skilled-labour force in recent years has pushed up significantly the wage costs in the services sector such as IT and ITeS. As a result, the claim of human capital in the value added has gone up. In contrast, excess supply of low skilled and unskilled labour has kept manufacturing wage cost under control, leaving a much larger share of the pie for owners of the firms. The above analysis reveals the medium threat posed by the skill-mismatch in the labour market to corporate and overall economic growth.
In sum, it is clear that the corporate sector, both manufacturing and services sectors, has reduced its vulnerability to shocks by continuously improving efficiency. Overall, this exercise suggests that the stability of the Indian corporate sector is unlikely to be threatened by a range of plausible adverse shocks, especially given that the corporate sector at present is relatively less leveraged. Nonetheless, this exercise emphasises the importance for the policymakers of continuous reforms, specifically to reduce the labour skills mis-match facing the corporate sector.
The authors are Senior Economist and Economist, Crisil
