India Transformed

by Rakesh Mohan

  Chart F: Wages and Interest Costs to Net Sales, Manufacturing

  How have manufacturing costs behaved over time, especially in terms of wages and interest? In an environment where firms have had no control over raw material and fuel costs, these companies have been very adroit in keeping wages and interest on a light leash. Chart F plots the data from the consolidated financial statements. Wage and salary costs as a share of net sales have remained remarkably stable, drifting gently upward by just 1 percentage point over thirteen years, from 4.7 per cent in FY 2002 to 5.7 per cent in FY 2015. This has not been just the ‘denominator effect’ or rising net sales keeping a check on the ratio. Instead, while companies have effected annual wage and salary increases, most have compensated by reducing both permanent and temporary employees. This is something that will be discussed later in the chapter.

  Interest costs, now aggregated as ‘financial-service expenses’ under the new Indian Accounting Standards terminology, initially fell quite substantially from 3.9 per cent in FY 2002 to 1.8 per cent in FY 2006. Then came a phase of widespread debt-financed capacity expansion, what with India galloping to a 9 per cent-plus GDP growth. That steadily raised the interest cost, which stood at 4.4 per cent in FY 2015. Though interest cost indubitably increased, it is not at an alarming level for the manufacturing companies. However, it is most certainly so for construction and real-estate firms, to which we now turn.

  Across the globe, corporations engaged in construction and real estate are always more leveraged than either manufacturing or non-financial-service-sector companies. It is the nature of the business. Real-estate and construction companies borrow heavily to buy land banks and execute their projects with the expectation that they will get adequate payment streams from customers and clients to service interest and even raise fresh debt. So, greater leveraging is not a problem per se. It becomes an issue when apartments cannot be sold, or when clients do not pay the construction contractors on time. This is what has happened to the sector during the last decade, more so after FY 2008. Charts G and H clearly show this disquieting trend.

  Chart G: Gearing, Manufacturing vs Construction and Real Estate

  Until FY 2006, the gearing of construction and real-estate companies were under reasonable control—with a debt to equity ratio of 3.88 versus 0.96 for the manufacturing firms. Thereafter, the boom that continued right up to FY 2010, egged on by massive deficit financing in the last two years to combat the deflationary effects of the global financial crisis, led to significantly higher gearing for the construction and real-estate sector based on the expectation that the good days would continue and that India would somehow be immune to any demand compression. Leveraging grew substantially; as did financial costs to net sales.

  Chart H: Financial Cost, Manufacturing vs Construction and Real Estate

  By FY 2011, it was clear that infrastructure spends were drying up and that the supply of apartments and office blocks were significantly higher than the demand. Moreover, state and central-government clients of construction companies started to go slow on their payments. To somehow keep themselves afloat, these construction and real-estate companies borrowed even more and, with it, both gearing and financial-servicing costs escalated to unsustainable levels. By FY 2015, their debt to equity ratio reached an astronomical 7.99; and their financial service costs stood at 12.7 per cent of net sales. Today, barring a handful, these firms are totally in the red and have absolutely no financial wherewithal to successfully execute any major infrastructure project, even when they win the contract. Indeed, the fate of infrastructural growth, which is so central to the sustainability of the Indian economy, is under threat because of the terrible financial health of such companies.

  To summarize then:

  Despite some ups and downs, there is no doubt that the corporate sector in India has flourished in almost unimaginable ways in the last quarter of a century. Gross income has grown eleven times over the period. PAT has increased twenty-five times. And market capitalization has risen an astounding 118 times, giving listed companies more value than ever before.

  With this growth has come significantly greater market concentration. The top 10 per cent of listed companies in 1991 accounted for 69 per cent of total net sales in 1991. By 2015, this share had risen to over 79 per cent. The Herfindahl Index (higher this is, the greater the concentration) has increased from 198 in 1991 to 314 in 2015. Indeed, the Herfindahl indices and the Gini coefficients have increased across almost all industrial and service sectors.

  In some industries such as mining, telecommunications, power generation, private ports and airports, and real estate, the rise in industrial concentration and market dominance has been facilitated by crony capitalism, precisely because these sectors depend upon the use of resources that are the properties of the state. But in many others, that is not the case—such as IT, automobiles, engineering, electrical and transport equipment, capital goods, chemicals, pharmaceuticals, health, hospitality and across a wide array of services, all of which remain intensely competitive and relatively unbeholden to the state. As mentioned earlier, crony capitalism increases market concentration, but not necessarily the other way around. And while genuflecting to politicians is a core attribute of almost all Indian entrepreneurs, this must not be automatically equated to crony capitalism.

  The ratio of EBITDA to net sales for manufacturing companies has swayed over the period but, in the main, remained relatively flat at around 12.5 per cent. That of firms in the non-financial-services sector have been higher, averaging at 20 per cent of net sales. As mentioned earlier, much of the higher EBITDA margin in services has been on account of India’s IT industry.

  The RONW of both manufacturing and service-sector firms has oscillated more sharply than the ratio of EBITDA to net sales. After peaking at 47 per cent in FY 2008, manufacturing RONW stood at 16 per cent in FY 2015—a percentage point higher than what it was when the journey was about to begin in FY 1991. Companies engaged in non-financial services have, on average, always earned higher RONW. It peaked at 72 per cent in FY 2008, and stood at a bit below 44 per cent in FY 2015, which still makes it the most profitable service-sector operations in the world. As in the case of EBITDA to net sales, the higher RONW in services is predominantly due to the exceptional performance of IT, BPO and IT-enabled services.

  Manufacturing companies have kept a tight leash on employee costs, which have remained in the region of 5 per cent to 6 per cent of net sales. These firms have also controlled interest costs which, despite a slight upswing, accounted for a bit over 4 per cent of net sales in FY 2015—not fundamentally different from what it was in FY 1991.

  Not so the companies engaged in construction and real estate. Their debt-to-equity ratio has soared to unsustainable levels, especially over the last five years. And with it their interest costs which, at almost 13 per cent of net sales, have made almost all of them unviable corporate entities—desperately in need of radical financial restructuring and debt paring.

  State-owned Behemoths: Winners and Losers

  A noteworthy development over the last twenty-five years has been the spectacular growth of some key SOEs coupled with the increasingly depressing performance of many others. Consider, for FY 2015, the consolidated gross sales of all non-financial-sector companies listed on the BSE. Number one is Indian Oil Corporation. Number three is Hindustan Petroleum Corporation. Number four is Oil and Natural Gas Corporation (ONGC). Number seven is Coal India. Number fourteen is Mangalore Refinery. Number fifteen is Gas Authority of India Limited. Number twenty is Steel Authority of India (SAIL). Number twenty-nine is Bharat Heavy Electricals Limited (BHEL). Number thirty-eight is Metals and Minerals Trading Corporation (MMTC). And number fifty is ONGC Videsh. Together, these ten giants accounted for 23 per cent of the sample’s total gross sales.

  A fact that stares straight in the face is the power of state-sponsored monopolies or oligopolies. Six of these ten SOE giants belong to the oil-and-gas sector, where the firms enj
oy immense and unchallenged monopolistic advantages. So, too, in sizeable measure, does MMTC, which, while no longer the sole importer of minerals and metals as it was in the pre-1991 ‘canalized’ regime, is still a giant among importers and the chief supplying agency to other SOEs. Even SAIL operates in an oligopolistic industry, although arguably, its pricing power has diminished because of greater domestic competition coupled with freer imports of steel. As, to a lesser extent, does BHEL, which, despite Chinese and Korean competition, still gets huge orders for boilers and turbines from SOEs in the power sector—both the NTPC and the National Hydro Power Corporation, as well as state-owned power-generating entities.

  Simply put, these state-owned behemoths are where they are because of non-existent or limited competition. In sectors where there are fewer barriers to entry and more flexible scale economies, the share of such SOEs have fallen quite dramatically. An obvious case in point is telecoms, where both Mahanagar Telephone Nigam Limited (MTNL) and Bharat Sanchar Nigar Limited (BSNL) operate at the fringes compared to private-sector players, only to generate significant losses.

  At the other end of the spectrum are vast numbers of loss-making SOEs that exist because of India’s collective political inability to shut these down. In FY 2015, there were seventy-seven loss-making central-government-owned SOEs (called CPSEs, or central public-sector enterprises, in the official parlance), whose total loss for the year amounted to Rs 27,360 crore.4 These losses, in descending order of magnitude, were: telecommunications (over Rs 11,000 crore in FY 2015), transport services (Rs 2776 crore), consumer goods (Rs 2525 crore), chemicals and pharmaceuticals (Rs 496 crore), textiles (Rs 418 crore), and medium and light engineering (Rs 161 crore). In FY 2015, the two state-owned telecom majors, BSNL and MTNL, incurred losses exceeding Rs 11,125 crore, or 47.6 per cent of the total losses of the loss-making CPSEs. The losses of Air India and its subsidiary, Air India Engineering Services, amounted to Rs 6250 crore, which comprised another 27 per cent of the total losses. The top ten loss-makers accounted for over 85 per cent of the total losses in FY 2015. Among these were firms that have no economic reason for their continued existence such as Hindustan Photo Films, Hindustan Cables, Fertilizers and Chemicals (Travancore) Limited, and Hindustan Fertilizers Corporation Limited.5 Worse still, the accumulated losses of most of these entities have far exceeded their net worth. Consequently, sixty-three loss-making CPSEs are registered with the Board for Industrial Financial Reconstruction, which is still the debt-reorganization body under the Sick Industrial Companies (Special Provisions) Act, 1985 (SICA).6

  The pattern is obvious. CPSEs in industries that are natural or state-sponsored monopolies or are sufficiently oligopolistic, earn profits and bequeath much of these as dividends to the cash-strapped central exchequer; they carry glorious titles such as Maharatnas (seven corporations) and Navaratnas (seventeen more). Many of those that were nationalized during the Emergency (1975–77) and in the early to mid-1980s to suit political objectives and belong to competitive industries where they enjoy neither special advantages nor discriminating fiats, have ended up as loss-making entities, often producing little or nothing, such as the nationalized cotton textile and jute mills, and surviving on budgetary doles and existing only to pay the salaries of unionized non-working employees.

  There is an obvious solution for such severely loss-making enterprises that continue to wither on the vine. It involves a combination of liquidating these entities, paying a fair retirement benefit to the workers, and unlocking the value of land so liberated to increase capital investment and help create newer manufacturing entities. This approach was conceived in the Industrial Policy Resolution of 1991 and executed over the next few years by the generous use of voluntary retirement schemes (VRS) under the National Renewal Fund. The extent of surplus labor was huge. In FY 1993, fifty-five sick CPSEs had an estimated 84,283 surplus staff. Of these, almost half were in the nationalized cotton textile and jute mills.7 Between April 1992 and June 1994, 70,826 workers from these CPSEs took VRS, of whom 38,363, or 54 per cent, were from the cotton textile and jute mills.8 By August 1997, another 1,46,663 workers were voluntarily separated.9

  Unfortunately, since the second half of the 1990s, there has been no political will of any party in power to humanely rationalize the excess labor in unprofitable CPSEs. Consequently, government-funded VRS has died its own death. In FY 2015, for instance, only one CPSE was shut down, and the amount earmarked as VRS was totally insufficient to bring about any structural change.

  There has been another major failure regarding the SOEs, which relates to divestment—called ‘disinvestment’ in India. Barring some enthusiasm shown in the NDA regime under Atal Bihari Vajpayee, this has essentially been about selling bits and bobs of the shares of listed, profit-making SOEs, including some of the state-owned banks, to garner non-tax revenue for the central government. Even this has been unsuccessful. As an example, consider the data for the last five years, which is given in Table 4. As is evident, over the period, there has been an average 45 per cent shortfall in achieving the targets. Thus, neither have we as a nation been successful in having efficient insolvency procedures for those that are fit to be shut down; nor have we been able to divest anywhere close to the annual budgetary targets.

  Table 4: The Failure of Disinvestment (Rs crore)

  Budget Estimate

  Actuals

  % Success

  FY 2012

  40,000

  18,850

  47%

  FY 2013

  30,000

  25,899

  86%

  FY 2014

  54,000

  19,027

  35%

  FY 2015

  58,425

  32,620

  56%

  FY 2016

  41,000

  25,913

  63%

  Total

  2,23,425

  1,22,309

  55%

  Source: Union Budget, successive years, Capital Receipts.

  The Services–Manufacturing Conundrum

  In a regime where ‘Make in India’ is being paraded as a major thrust area in the nation’s manufacturing policy, it is useful to examine where India stands in manufacturing vis-à-vis other comparable nations in Asia and Latin America. Chart I plots data used from the World Bank’s World Development Indicators, 2015 for the year 2014. The vertical axis plots services as a share of GDP and the horizontal does the same for industry (essentially the secondary sector, of which manufacturing is a subset).

  Chart I: The Share of Industry and Services, 2014

  Source: World Development Indicators, 2015, World Bank.

  On the right of Chart I is the cluster of five East and South East Asian nations, which built significant manufacturing capabilities across a large number of sectors and used these to generate export- and investment-driven growth. In all these countries, the share of industry to GDP is significantly higher than India’s: South Korea has higher share of services as well, and Thailand has approximately the same share. In fact, there are four more nations that have higher share of both industry and services vis-à-vis India: the Philippines, Russia, Mexico and Chile. Only four countries have a lower share of industry, though higher of services. These are Brazil, Turkey, Argentina and Bangladesh.

  This raises two fundamental policy questions. First, over the next decade and a half, should India continue on a path where it takes relatively small strides in manufacturing and larger ones in services—to have a composition somewhat akin to the Philippines in Chart I? Second, if we want to predicate higher growth and competitiveness through greater manufacturing as ‘Make in India’ exhorts, and lift the share of industry to around 35 per cent of GDP, what reforms should we earnestly engage in?

  As it stands, it would seem that services will continue to hold the upper hand, primarily because there are far fewer barriers to setting up or expanding myriad service activities throughout India compared to starting new factories. The
refore, in a more laissez-faire state of play, one would expect India (30 per cent industry and 53 per cent services) to drift upwards to where the Philippines is today—that is, about 33 per cent of GDP comprising industry, and 58 per cent services. It is not necessarily a bad thing in a world of increasingly integrated global trade with steadily falling tariffs. For one, services today tend to be more employment-intensive than mining, manufacturing and other industrial activities. For another, there is a vast continuum of scales in services depending upon what these are, and can thus accommodate enterprises ranging from the small to the very large. Besides, these are generally immune to the pressures of lower pricing via global trade and can thus generate decent profits for the service entrepreneurs. However, if increasing the share of manufacturing is to be our credo, then much needs to be done. The next section focuses on some of these issues.

  Failure of Physical Infrastructure: Difficulties in Doing Business

  Barring the period of the NDA-led government under Atal Bihari Vajpayee (1998–2004) and the first three years of the UPA-I regime under Manmohan Singh (2004–09), India has suffered from an acute failure in jump-starting work on the much-needed physical infrastructure. Things seem to have improved under Narendra Modi, but we have a very long way to go. To understand how poorly off we are, it is useful to compare ourselves with other East and South East Asian nations. Table 5 gives some data.