In search of risk capital
Did a shortage of equity capital in India contribute to banking stress? What happens in the next investment upturn?
Were the banking problems that India is in the middle of inevitable? Is there more to this situation than just corrupt promoters, ownership of banks, and regulatory sloth? As we seek closure to the lending excesses of the previous economic cycle, and set the base for the next investment upturn, answers to these questions are necessary.
There are basically two sources of capital for investment: Debt and equity. The more common definitions are from the perspective of the supplier of capital. Debt is the ‘safer’ option: The return on capital is capped but return of capital is much more certain, as the firm that gets the capital promises to pay back all of it. For suppliers of equity capital, there is no promise of return of capital, but the return on capital can be potentially very high.
Seen from the perspective of the business owner, debt is riskier: In an economic downturn, businesses with high debt are less likely to survive than those with low debt. This is due to the rigidity of debt — interest payments must be made on time, and the capital must be returned in full irrespective of the success of the venture. Equity capital on the other hand has the ability to absorb losses: Only when profits are made does the supplier of capital need to be paid her share. In long gestation projects where the set-up process is risky and uncertain, the patience of equity capital helps.
And to close this primer on finance, no project should be fully debt-funded — it would be just too risky for the lender, as the owner(s) of the enterprise, which provide the equity, would have no skin in the game. It would also make the business riskier, given the rigidity of debt capital.
Now let us do some arithmetic. Over the last 10 years India’s thermal power capacity has increased by 130 gigawatts and steel-making capacity by about 75 million tonnes. The combined capital requirement for these expansions was more than $200 billion. Even at relatively aggressive debt to equity ratios, these would have required nearly $60 billion of equity capital. Given that most firms in these two sectors were much smaller a decade back, accumulated savings would not have sufficed, forcing companies to use a range of stratagems to tide over the gap in equity. Some used gold-plating, that is, they marked the capex at say 30 per cent higher than it really was, and that 30 per cent became their equity investment. Some others used multiple layers of subsidiaries: They borrowed at the parent level, and used that as equity in a subsidiary.
It is not surprising that many of these projects ended up in bankruptcy: Even if promoters did not siphon out funds from their companies, the capital structure was too risky.
Would a better capital structure have helped: One that had more equity capital? Definitely, but the challenge in developing economies like India, which are starting from a very low level of per capita income, is a deficit of equity capital: There are not too many business groups that have the ability to undertake billion dollar projects. This is clear in the limited demand for assets coming up for bids under bankruptcy proceedings. Bringing in foreign capital may help, but that, too, has its limitations: For example, foreign capital may be more risk averse than local capital.
That so many banks chose to lend to such risky projects is of course a matter of concern, particularly if a quid pro quo existed. But at the same time, it is quite obvious that these capacities are needed: Steel capacity utilisation is already quite high in India, and given India's very low per capita power consumption, once distribution issues are addressed, most of this power generation capacity would be needed too.
One can say, in a convoluted way, that taxpayers paid for the failed, but necessary, projects where public sector banks (PSBs) unwittingly provided the risk capital. Recapitalisation of PSBs by the government, to pay for losses on writing down loans to these projects, is nothing but a circuitous route of doing that. However, this is an undesirable process, both from the perspective of fairness, as well as in the time it takes for resolution.
Among other large emerging economies that have gone through this stage of their development, Russia and China did so under communism, where command-and-control policymaking ensured that there was very little difference between debt and equity when it came to risk or return. Others like Brazil and Mexico were at India’s current per capita prosperity three to four decades ago: They have had long periods under authoritarian governments, and still have a serious ‘crony-capitalism’ problem.
Looking forward, it is reasonable to assume that the average annual growth rate of the Indian economy should be similar to the 7 per cent growth of the last 25 years. The loopholes exploited in the last economic upturn by unscrupulous promoters and banks may not be available — who then will provide the equity (that is, risk capital)? We have seen the transformative impact of a large investment of risk capital in the telecom industry: If such investments do not happen in other industries, where will growth come from?
For now, the government seems to be stepping in wherever it can: Most of the new road projects for example, though constructed by private firms, are being funded by taxpayer money. While this may work for roads or railways, even if only temporarily, going back to the public sector owning all assets that require heavy capital investment seems far from optimal.
Traditionally, most of India’s financial savings ended up in bank deposits or in LIC premiums: Savers were happy supplying debt, which they find safer. The last few years have seen some diversification, with inflows into equity mutual funds. The proposal to increase equity market allocations of pension funds should also help create more equity capital. The challenge though remains in aggregating these into larger projects. Elevated stock prices have revived the primary equity markets, but much of the fundraising so far has been in financial firms (which only issue loans), or in exits by private equity firms.
Given that they appear to be the only sizeable source of equity capital, are vibrant stock markets more critical to India than to other economies?