Why Ratan Tata is right about Indian economy

Ratan Tata’s year-end message to employees probably sums it up best. The cost and availability of money in the system is the single most important factor holding back an economic recovery which many now seem as possible even in an environment of all-round pessimism.

In his year-end message, Tata admitted that while 2012 would be a tough year, it would also present opportunities. He advised his companies to moderate projections in line with current realities, but there is also a clear message that if policies are in the right direction, and credit and money supply re-infused into the system, a dramatic recovery could well be round the corner.

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Let’s take the bad news floating all around first. Headlines say corporate bottomlines are under intense pressure as rising fund costs force companies to cut back sharply on their growth and expansion plans.

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Essentially, companies are cutting costs drastically, and taking some tough decisions all over again, in a throwback to 2008. Investment plans are either on hold or being scaled down, and mergers and acquisitions have seriously dried up.

Broking firms are laying off employees as margins are under severe strain and turnover falls, and private equity firms are weighing their options carefully as exit options dry up in a depressed and uncertain market.

Tata’s caveat of inflation remaining in check and money being made available at cheaper rates assumes critical significance in this scenario.

Consider some facts: in sectors like infrastructure, investment bankers and fund managers now say that even for the top 20 engineering and project (EPC) companies, the incremental order book is under pressure, debtor days (the time lag for collecting payments) are on the rise and the cost of working capital is pinching as many of these firms are significantly leveraged.

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“If, for about 75 percent of the project, the cost has gone up by 4-5 percent, then the internal rate of return (IRR - a measure of profitability) on equity will be significantly lower as a result. This is a serious disincentive and is hitting the appetite for growth and new projects,” says Sudhir Dash, managing director of specialist investment bank and asset management firm Investec.

“If you ask me, the cost of funds and the availability of money is the single most important factor hitting sentiment now.”

According to Dash, the payment cycles of several firms are being impacted with debtor periods going up. As a result, the cost of funding rises, as bank money is expensive. “Debtor days, which typically used to be between 90-105 days around three years ago, has now gone up to as much as five months,” he points out.

Privately, investment bankers say the policy confusion in the power and energy sectors and the high costs of putting up projects is leading even large firms planning big investments in these sectors to shelve their plans for the moment. “I know of at least two or three companies which have decided to wait and watch on their power plans,” says a leading investment banker.

“In the medium term, there will be stress, particularly for small and medium enterprises, as the cost of funds remains high and there is ambiguity in policy,” says Viren Mehta, partner, SR Batliboi & Co, underscoring the fact that a cut in the cash reserve ratio and a reduction in interest rates is now overdue to make more money available at cheaper rates to kick start investment and growth.

Mehta is among those who feel the time is right for the government to announce a blockbuster budget this year and ensure that the growth momentum is back on track. And despite the gloom all around, he is optimistic that the recovery Tata is talking about is a distinct possibility given a strong policy push.

“There is some control on inflation, domestic consumption is surely not dead. It’s just that the sentiment is very weak and some sections are projecting a seriously gloomy scenario. If there is a policy push now, India has every chance of becoming a standout economy in this global environment,” reasons Mehta.

“Signals like the rollback on retail FDI surely do not help the cause.”

Investment bankers and analysts point out that a big policy push in infrastructure, like in power and roads, would be a major booster dose for kickstarting public spending and getting the growth momentum going once again. Together with this, the Reserve Bank of India’s monetary policy would need to make easier funding available.

“Take the textiles sector, for instance. It is a highly competitive sector now, and a 5 percent increase in the cost of funds is enough to give a serious hit to EBITDA (earnings before interest, taxation, depreciation and amortisation) and bring it down from 15-16 percent to 3-4 percent now,” explains Dash.