India Inc. has no excuse to underinvest anymore. It is time to take the plunge

Structural reforms since 2014 led to a dip in expected cash flows for promoters. The tax break will offset that

The Indian economy has shown signs of a significant slowdown. Consumer spending is, over the longterm, driven by the investment appetite of companies in the economy. As companies make new investments, they signal to the market that new jobs will be created, leading to greater confidence, which leads to consumption. Indian investment has dropped from 39% to 32% of GDP over the past decade.

We should, therefore, not be surprised that investment appetite is so closely aligned with consumer spending.

The recent tax breaks announced by finance minister Nirmala Sitharaman, seeks to reignite investment. To understand whether this will succeed, we first need to question why Indian business appeared to go into an investment funk in the recent past. Were Indian promoters always this diffident? After all, Indian corporate history has been replete with examples of animal spirits. The expansion of the mobile telecom industry in the early 90s, and the airport industry from 2000 onwards, reflected how individuals with limited experience in an area demonstrated the chutzpah to bid for circles and airports. However, something had changed in the last few years, which appeared to dampen these aggressive instincts.

When deciding on an investment, company owners make assumptions of different profit outcomes. An unintended consequence of the institutional reforms from 2014 was to cause a dramatic downward shifting of the anticipated cash flows from projects, especially during periods of stress. If we understand what caused this change in corporate mojo, we can assess how the transmission of tax cuts could possibly help reignite animal spirits. The hope is that these tax deductions work to effectively offset the impact of lower cash flows

Starting from 2012-13, the Reserve Bank of India (RBI) insisted on the SMA 1/2 identification of accounts. This made it necessary for lenders to publicise delayed payments to the entire lending community, thereby discouraging the ability of lenders to keep rolling over loans. Moreover, in the so called June 7, 2019 circular of the RBI, there are strict timelines to resolve its non-performing status, which, if not done, requires materially higher provisioning by banks, roughly accelerating Non-performing Assets (NPA) recognition by about 15-18 months. These steps have made bankers far less liable to accept weak business plans. From an investment perspective, all those scenarios of being funded by the system to live to fight another day have ceased to exist. This is a material change in expected returns from investing.

The new insolvency code has also resulted in unintended consequences. Usually, a new insolvency code allows the promoter to retain some control over his company and recover some of his investment. In India, because the recovery dispensation was so lax anyway, the new bankruptcy process forces concessions which a business would have avoided. The expected residual value of the asset that the promoter would have expected is likely to be lower than in the past. Furthermore, the enforcement mechanisms of the state were often unable to bring offenders to book. The present government has demonstrated a preparedness to make wilful defaulters forfeit personal assets. In making an investment case, the promoter may now believe that he will lose more than his equity as well.

That the system is more effective now is proven. In contrast to the performance of the Sarfaesi Act and the debt recovery tribunals, which typically generated lower absolute recoveries, the insolvency code enabled recovery of ~4.9 lakh crores (RBI’S report on trends in Banking, 2018). Much of the recovery has been from large corporate borrowers, who typically tend to be large investors in the economy.

The likelihood of negative outcomes is, thus, higher now than before. Promoters now have less time to recover (impacted by stricter RBI provisioning norms). If his company makes persistent losses, he is likely to need to infuse more capital (thanks to stronger RBI norms). He may need to give us more of his stake (impacted by a strong and effective insolvency code) and perhaps liquidate other assets to make good this one (stricter enforcement mechanisms). These steps all pointed to lower expected cash flows, from the same project, than before.

The finance minister, by the announcement of reduced taxes, has, in one sweep, increased cash flows in any investment calculation, nullifying the negative effects one has described before. In effect, the government is saying we have tightened the institutional rules for the better — reducing shortterm cash flows that you might otherwise have been used to — but we are also giving you a sufficient tax break on regular business incomes to offset that.

Given that new manufacturing units have one more attractive tax dispensation of between 15-18%, there is little more the government could have done by way of a stimulus. At ~1.45 trillion, this is a generous fiscal step taken by the state and most excuses for underinvestment have been taken away.

It is now incumbent on India Inc. take the plunge and invest for a new wave of growth.

THE FM, BY THE ANNOUNCEMENT OF REDUCED TAXES, HAS, IN

ONE SWEEP, INCREASED CASH FLOWS IN ANY INVESTMENT CALCULATION. THERE IS LITTLE MORE THE GOVERNMENT

COULD HAVE DONE