View: Capex cycle has likely bottomed out

Projects coming to a halt

The stock of under-implementation projects (defined as CMIE as those where some progress has happened beyond just its announcement) currently stands at just lower than 80 percent of GDP, down from the peak of ~90 percent of GDP in FY11. 

In contrast, during the last capex downturn, at the trough in FY01-03, under-implementation projects averaged ~40 percent of GDP. 

This leads to the question that what explains such a sharp decline in the capex levels if there is such a large pipeline of outstanding capex projects. The answer, not surprisingly, is that the capex cycle has deteriorated due to a precipitous fall in execution or project completion rates.

At an aggregate level, project completion rate (defined as value of projects getting completed in a year as proportion of total under-implementation projects), which had averaged ~8-12 percent between 2004 and 2008, declined to ~4 percent as of September 2013.

In the trough of last capex downturn during 2002-03, project completion rate was just more than 6 percent or almost 50 percent higher than the rate today. 

If project completion rates were comparable to that during the last downturn, it would have resulted in additional productive capacity addition of ~1.5 percent of GDP pa in the last couple of years. This gives a sense of how much damage the slowdown in project execution rate has done to the economy.

Macro environment not weaker than in 2002-03

A logical follow-up question then is whether there is sufficient deterioration in the macro environment that can explain this sharp decline in the execution rate. 

Clearly, some macro variables like inflation and current account deficit are much weaker than during the last downturn. However, some macro variables are actually better than the ones during the last downturn.

Take corporate leverage, probably the most important variable that affects corporate capex. While corporate leverage has increased in recent years, it remains significantly lower than during FY01-03 period.

Aggregate non-financial leverage had averaged ~1.5x during the last downturn (FY01-03 period). In contrast, in FY12 (the latest period for which we have aggregate data) non-financial sector leverage was just under 1x. Leverage would have increased further to ~1.1x in FY13, but it still remains significantly lower than during the last downturn.

Similarly, like corporate leverage, banking sector NPAs are also lower than during the last downturn. While total stressed assets in the banking system currently are just above 9 percent (as of FY13, includes GNPLs plus total restructured assets) during FY01-03, they averaged 11 percent.

While this looks like a modest difference, two points should be noted: Firstly, during FY01-03 the NPAs were recognised using 180-day rule as against the 90-day currently. Secondly, in the current scenario we are treating 100 percent of restructured assets as being NPAs.

Similarly, fiscal deficit, both for central government and in particular, for state governments is currently much lower than during the FY01-03. State governments in aggregate are currently running (modest) revenue surpluses as against a revenue deficit of ~2 percentage points of GDP during FY01-03 period.

The current backdrop

The capex cycle has seen a sharp deceleration. The slowdown has been more severe than the last downturn and the investment rate is close to the trough of the last down cycle. 

Almost no new projects have been announced and execution of already announced projects is much lower than the last downturn. This is despite the macro environment not being worse than during the last downturn. Clearly, a large part of this is due to sentiment (animal spirits) being much weaker than during the last downturn. 

Given that outlook for investments in some sectors in manufacturing has improved due to currency depreciation and the large pipeline of under-implementation projects, an improvement in sentiment can result in acceleration in capex activity in a relatively short period without any large new projects being announced. 

This, coupled with the already low capex-to-sales ratio for the corporate sector, suggests that it is unlikely that businesses can cut capex any further, unless growth itself takes another leg down, which is not our base case.

Therefore, our base case is that the capex cycle is likely to stabilize around the current levels and is unlikely to turn worse. If this is complemented by a favourable political/regulatory environment, a recovery in the capex cycle can start to unfold in FY15 itself.