Cost of Capital

Before I start off writing about what I intend to, let me issue a caveat. This isn’t about Capitalism and its implications on the society or a technical treatise on the economic/financial theory of Cost of Capital. Having told you this, I continue.

Let’s be honest, why is capital coming to India? With our headline economic indicators showing a continuous downward trend( at-least for last 3 quarters), why are we still seeing big money flow into India, albeit hot money flowing into the stock market?

I have been speaking to a lot of businessmen and businesswomen and I get this sense that it is not a good time to put money in India, or to clarify long term money in India. By long term, I mean capital investment in form of FDI or capex by existing companies. But every other week I hear a lot about how markets are scaling new heights! So, what gives?

Reading a few articles and trying to make sense of it, I realised that more than the sentiments driving this bull run, it’s plain economics. We have seen a surge in FPI investments in India post May 2019. Well this is simply because we have been generating returns far in excess with what is the cost of capital for these investors. Let’s say I am a European institutional investor. I am able to borrow at close to 0-0.5% and I bring this money to India to invest in stock market to generate some returns. Even adjusting for risk, I would still be making a better return than I could have made back in Europe. So, why wouldn’t I bring money into India for short term?

And this is where Indian businesses are stopping dead in their tracks. They are able to get money only at 10% and above. To generate any significant returns on capex (post tax), their IRR should be above 17 %. The debt by banks comes at either this high cost, or doesn’t come at all. Fearing any NPAs and subsequent investigations by central agencies, Public sector bankers have stopped taking calls on lending to MSMEs. Private Sector bankers are, on the other hand, very selective about the exposure they are willing to take. This means source of funds drying up for a small businessman. Not every company is a Reliance which can borrow from the market at costs lower than the government risk free rate.

With some of my clients, I have been discussing the same. I have always felt that 450 billions in FX reserves is basically India subsidising businesses in USA or Europe. As a start, let’s keep 10% of these reserves as collateral and borrow money at next to 0 cost from Europe. Put this money in infrastructure and industry, and within a year or two, there would be a significant uptick in overall economic activity. However, politicians believe that this is bad optics and their idea of nationalism would be at odds with this step. This is where we falter again. Conflating nationalism and economics has never worked for any body.

With all these automation technologies coming in, our so called demographic dividend can turn into demographic disaster if we are saddled with huge unemployment numbers, as there might be less and less job creation by the large corporates. MSMEs are the biggest employment generators and they should be encouraged to do so by allowing them to access cheap credit.

Banks on the other hand, both private and public have been offering cheap credit for personal loans and home loans and other consumption loans. No doubt,it’s a profitable deal and the number of such loans has kept on increasing but in the end, it’s the same universe that almost every bank is lending to. How much more leverage can a salaried individual or a small time self employed person sustain? At one point of time, in the near future, this cycle is going to stop.

Not trying to sound like a doomsayer, but hey, we need to look into the future ahead and not drive by looking at the rear view mirror. What has worked in the past, will not work anymore.

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