By Invitation. Investment cycle revival not imminent

Several formal sectors of the Indian economy displayed contraction or low growth in volumes in Q3 FY2017, partly on account of the temporary disruption caused by the note ban.

However, factors such as the low-base effect, dip in interest costs for a portion of debt, as well as a recovery in commodity prices for metals and oil and gas companies, supported earnings growth in that quarter.

As a result, the Central Statistics Office (CSO) has placed its initial projection of growth of gross value added (GVA) at basic prices at 6.6 per cent in Q3 FY2017, superior to the volume trends in several sectors.

Volume growth is slowly improving in a number of sectors in the ongoing quarter.

The upcoming rabi harvest is likely to be favourable, which would support agricultural growth in Q4 FY2017 and Q1 FY2018.

Agricultural growth and rural demand in subsequent quarters will be influenced by the monsoon dynamics.

Encouragingly, the higher capital spending budgeted by the Centre for FY2018 on sectors such as transport, rural infrastructure and affordable housing will improve the order books of developers and companies in the capital goods sector in the coming months.

However, commodity price trends may not support earnings growth to the extent seen in Q3 FY2017, both on account of lower output prices in some commodity sectors, and the lagged pass-through of earlier increases in raw material costs, including pet coke, other fuels and steel, to the user industries.

The sharp rise in banks’ deposits after the note ban contributed to a decline in bond yields, and to a smaller extent, bank lending rates, during November 2016-January 2017.

However, bond yields have reversed their course after the central bank changed its monetary policy stance from accommodative to neutral, a signal that there may not be any further reduction in the policy repo rate, going forward.

As a result, interest costs for entities in the formal sector are unlikely to ease further in the near term.

The year-on-year (YoY) CPI inflation is expected to print at 4.5 per cent in March 2017, undershooting the Reserve Bank of India’s projection of 5.0 per cent for Q4 FY2017.

However, the Monetary Policy Committee (MPC) of the RBI is likely to keep the repo rate unchanged in the upcoming policy review in April 2017, given the shift in its focus to bringing the CPI inflation to 4.0 per cent in a durable manner.

After the note ban, banks have been flooded with deposits, whereas credit demand has fallen to subdued levels.

This has led to the banking system being flush with liquidity, in contrast to the RBI’s stated stance of maintaining systemic liquidity closer to neutral.

At present, an excess liquidity of over ₹4 lakh crore is being absorbed under the Liquidity Adjustment Facility, with the stock of Cash Management Bills issued under the Market Stabilisation Scheme during December 2016-January 2017 having matured by now.

An alternative method of absorbing the excess liquidity would be through an increase in the cash reserve ratio (CRR) to be maintained by the banks with the RBI.

However, this would constrain banks from reducing the marginal cost of funds based lending rate (MCLR), which adjusts for the prevailing CRR level.

ICRA, therefore, does not expect the central bank to increase the CRR. In contrast, the RBI could conduct open market sales of its holdings of Government securities, to absorb the excess liquidity.

The last private sector investment cycle was primarily fuelled by bank financing, with limited equity committed by the promoters.

Moreover, the prospects of a commodity price super-cycle made many investments appear viable, at home and abroad.

In our view, the private sector is likely to embark upon capacity expansion only after the transition to the Goods and Services Tax has been successfully completed and the capacity utilisation rises to healthier levels.

However, the upcoming capex cycle may not be broad-based or very sharp, as banks are not willing to finance new projects without a significant equity contribution, and commodity prices are not at a level that would encourage a frantic pace of investment.

As a result, ICRA expects growth of GVA at basic prices to rise modestly to 7.0 per cent in FY2018 from 6.7 per cent in FY2017.

The writer is Managing Director and Group CEO, ICRA