Traversing across the hope and fear

Business Standard, 2 May 2022

Large Indian firms today see a combination of internal strength and external difficulties. There is a new level of supply chain disarray. The spectre of macroeconomic instability is back with high and variable inflation, and DM responses to this inflation will roil the global financial system. There are stubborn economic problems in the Indian household, which hampers the demand side. While the large firms have improved revenue growth and profitability, with buoyant exports growth, the optimism within successful firms is tempered by a strategic sense of the difficult landscape. The recent gains in private investment reflect cautious strategic thinking when faced with a strong internal MIS.

The supply chain problem

Over the decades, just-in-time production systems were built, by harnessing modern IT. These were disrupted when Covid-19 came along. The hope that this disruption would be limited to 2020 have been dashed, with a combination of extreme lockdowns by the authoritarian government of China, and Russia's invasion of Ukraine.

As India has come of age, producing in India is more internationalised; it is more interlinked into global value chains. China is India's biggest source of imports (with a 14% pre-pandemic share) and the second largest destination for exports (with a 5% pre-pandemic share). Therefore, the extreme lockdowns in China affect the Indian economy also.

Global firms are watching the damage caused by one nationalistic state, and envisioning what others like it might do. Such strategic thinking has led to demands for improving supply chain resilience. This results in the desire for more diversification and more inventory. The desire for more diversification by global firms has worked very well for us in India, with increased activities being placed in India. The desire for increased inventories worldwide is temporarily boosting demand. It also has an adverse impact upon the ROE: there is a certain rethinking of the risk/reward tradeoffs involved in the old ways of production.

The macroeconomic instability problem

For many decades, low and stable inflation had created a stable environment for financial planning by individuals and by firms. We are now back to wrestling inflation back to the ground. The latest data for India shows 7% headline inflation in March 2022. This is beyond the 2-to-6 range required in the legal mandate of RBI. In April and May, it may worsen somewhat. Globally, inflation is at unprecedented deviations from the 2% inflation target. This high inflation environment is a more risky environment for households and firms to plan in, and acts as a drag that impedes long-range plans.

DM central banks are seized of the problem and rates are going to go up. There is clarity that the loss of stable and predictable 2% inflation was a mistake. The short rate will go up a lot; the present debates are only about the magnitude and speed of the hikes. This tightening will cause a rearrangement of the global asset allocation: capital that had gone into dark corners of global finance in the search for yield will retreat from those places. This will adversely impact upon EMs in general, and illiquid/risky assets in particular. In India, we saw how the retreat of global capital in 2007-2008 and 2012-2013 was followed by the collapse of many a house of cards.

Problems of the Indian household

Income, employment and consumer confidence in India are facing difficulties. While consumer sentiment has improved greatly compared with the depths of the lockdown of April 2020, the economic life of most households remains stressed. This hampers household demand.

The questions of firm strategy

But the firms are doing well. When we look at the revenues and profits of the listed non-financial firms, these have gains in the recent period of a kind which had not been obtained since 2010. For example, from Q2/2010 to Q2/2021, there was stagnation in the real sales of listed non-financial firms, but in the last two quarters we have got growth of 20%. There is a dichotomy between the world as seen inside many large Indian firms versus this external environment characterised by the three problems of supply chains, macroeconomic instability and weak household income.

The puzzle lies in reconciling the two divergent perspectives. Many a manager is excited about what the internal MIS is showing, with strong demand, pricing power, top line growth and profit growth. This performance, and an execution perspective, would suggest renewed opportunities for investment.

Alongside this is the strategic view, one that understands the external landscape, and calls for more caution. The precise ways in which the external landscape, as depicted above, impinges upon each firm will of course differ. Each board is engaged in a strategy discussion on these questions.

Private investment in the economic outlook

This tension, between the view inside and the view outside, has come together to give the first signs of revival in private investment in a long time. From 2011 onwards, the stock of private projects in the CMIE Capex database, was declining (year-on-year, real) in each quarter. For the two most recent quarters (Oct-Nov-Dec 2021 and Jan-Feb-Mar 2022), we have the first positive values for this year-on-year (real) growth.

Increased private investment is tonic for the economy. While projects are afoot, the demand side of the economy is bolstered through project spending, and once they are commissioned, the demand side of the economy is bolstered through jobs and contracts. The transition from a declining-investment environment to a rising-investment environment is a good thing to have and will fuel improved economic performance.

The picture in India -- a moment where private firms are showing the best numbers in a while for output, profit and investment -- is strong, while facing an adverse macroeconomic environment. This diverges from the difficulties seen elsewhere in the world, particularly in China (where health policy is holding back the economy) and Europe (where the war is holding back the economy).

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