Waiting for the super capex upcycle – Are expectations justified by the data?

Published On: 29-Aug-2019

Capex cycle is one of the most important economic trends one needs to track in the macro space as it is a critical ingredient in order to achieve a higher trajectory of economic growth in later years. Making capex decisions are usually very complex. These decisions require a fair degree of long-term demand-supply estimation, advanced planning of funding and assumptions galore on the likely trends primarily in the market place for a large part of the decade to come. It requires the animal spirits to come alive driven by the need to time expansion or entry to gain an edge over other entities in the competitive matrix.

Predicting the capex cycle thus is even more complex as it deals with delta of the capex of the government and all private/household entities. It is fraught with capricious factors causing for instance many of the predictions over past 5 years ending up getting revised time and again. 

Given the vagaries of trying to predict the timing of the capex cycle we would prefer to rather test the conventional perception of the capex being weak. We will also attempt to run a reality check on a reasonably healthy expectation of the next upcycle being as strong as the one seen over FY03-08. In the process we touch upon factors which possibly led to this super capex upcycle and the current state of these factors.

Deviation from long term trajectory - Are we that much off the road from the past? 

The Central Statistics Office publishes the gross fixed capital formation (GFCF) which is a summation of the capex in the economy. India’s nominal capex grew by 13.7% in FY19 to Rs. 55.70 trillion. But we prefer to use the real capex growth for our discussion so as to make a comparable study of capex trend over the past six decades. Using the constant currency GFCF, real capex growth for FY19, over the past three years and the past six decades were 10%, 9.1% and 6.8% respectively. 

Exhibit 1: Real capex (at constant prices) in last 3 years is already above 6 decade average capex growth 

Source: CSO, AnandRathi Research, Note – growth rates from FY15 are based on new series

In our analysis, a decisive uptrend in the capex cycle can be marked only if the real capex growth is more than 7% (long term average of 6.8%) for at least 3 out of 5 consecutive years. Based on this threshold, past data suggests, India has witnessed 6 capex uptrends since 1952 (the first uptrend was boosted by the PSU investment-focussed second five-year plan of 1956; the share of private in capex was just 8% in FY54). Out of these, except for first and fifth upcycle, real capex CAGR stood in the range of 8.7-10.3%. The fifth capex upcycle (FY03-08) witnessed real capex CAGR of 16.1% and was driven by the private sector. We therefore call this fifth capex upcycle the super-capex upcycle 2.0 and the only one yet to be driven by animal spirits given the key role played the private sector.

Exhibit 2: India witnessed 6 capex upcycles in past 7 decades

Cycle

Sequence

Period

Duration (yrs)

Construction

Machine

Const. + machine

India's Real capex CAGR

Public

Private

House

hold

Total

Public

Private

House

hold

Total

Public

Private

House

hold

I

FY54-57

3

13.2%

10.2%

10.3%

11.5%

34.2%

43.9%

20.7%

29.9%

18.5%

34.5%

13.2%

17.1%

II

FY59-65

6

11.7%

14.9%

3.5%

8.3%

13.5%

11.7%

9.1%

11.9%

12.3%

12.5%

4.8%

9.6%

III

FY86-91

5

1.9%

5.7%

17.0%

9.1%

5.5%

6.4%

21.4%

8.3%

3.6%

6.3%

18.0%

8.7%

IV

FY94-00

6

4.7%

8.9%

13.3%

9.8%

-0.1%

6.9%

40.1%

8.3%

2.6%

7.2%

17.1%

9.1%

V

FY03-08

5

11.8%

35.1%

7.2%

12.6%

10.8%

31.9%

-2.4%

18.7%

11.5%

32.7%

4.8%

16.1%

VI

FY09-12

3

10.2%

4.5%

18.8%

11.2%

4.3%

13.4%

25.5%

15.5%

4.4%

14.5%

15.9%

10.3%

Source: CSO, AnandRathi research, Note we include PSU capex in public as there is a thin line between PSU capex and government capex over a long period of time; household generally include resident household, non-profit institutions and most of the unregistered micro, small and medium enterprises (MSMEs); we use the same deflators for constituents of GFCF as are built in GFCF. We calculate deflators for GFCF by comparing constant currency data with nominal data.

Let us focus on the super-capex upcycle 2.0 as real capex CAGR in it was nearly twice of almost all the earlier capex upcycles. As discussed, private participation was a significant contributor with private real capex growing at a CAGR of 32.7% over FY03-08, an unprecedented high (yet to be surpassed to date). Capex upcycle I was public sector led. Capex Upcycle II was led by private and public at similar but moderate pace. III, IV and VI were led by household capex; both private and public participation were weak.

Exhibit 3: Last three year’s real capex growth qualifies for capex cycle uptrend definition

Period

Construction

Machine

Const. + machine

India's Real capex CAGR

Public

Private

Household

Total

Public

Private

Household

Total

Public

Private

Household

FY12-15

6.8%

9.8%

-2.1%

1.6%

1.9%

4.8%

8.3%

4.6%

4.5%

6.1%

-0.5%

3.0%

FY16

21.7%

21.0%

-20.4%

-3.2%

4.1%

13.0%

28.1%

13.2%

13.9%

15.2%

-12.0%

6.5%

FY17

4.5%

-3.9%

11.5%

6.1%

7.4%

-6.7%

61.2%

8.5%

5.7%

-5.9%

24.1%

8.3%

FY18

18.5%

12.3%

1.0%

8.4%

0.1%

13.4%

23.8%

13.2%

11.0%

13.1%

8.5%

9.3%

FY19

BREAK-UP NOT AVAILABLE

10.0%

Source: CSO, AnandRathi research

Recent capex trend has been healthy. India’s real capex growth accelerated from 8.3% in FY17 to 9.3% in FY18 to 10.0% in FY19. This growth trajectory is similar to the average of previous upcycles. It also meets the threshold of our capex upcycle definition. Consequently, we believe we are already in capex upcycle VII. However, the important question is whether the animal spirits exist to convert it into a super-capex upcycle 3.0 as equity markets await a further uptick. Before we answer this question, let us analyse the peculiar features of super-capex upcycle 2.0.

What sparked super-capex upcycle 2.0?

Often capex has a multiplier effect. Capex in one sector translates into higher demand for its vendors triggering capex for another sector. Intuitively, if the first level capex is in heavy industry with multiple capex vendors, then the multiplier effect is understandably likely to be stronger. 

If we look at FY03-08 upcycle, the first level round of capex was triggered in the core industries such as metals, oil and gas, telecom, power and road due to following factors:

  1. Global commodity cycle boom: Super capex upcycle 2.0 coincided with the global commodity boom. LME Copper Spot which is a key indicator of the global commodity cycle witnessed 4.4x increase in price over FY03-08. Indian metal companies with fortunes linked to global commodity cycle, spent heavily on expansion. Gross capex of India’s top 8 private sector metal companies increased 280% over FY04-08 vs FY99-03. Jump in crude price from 28$/barrel in March’03 to 146$/barrel in July’08 also triggered capex amongst upstream oil and gas companies. Consequently, gross capex of India’s top 2 upstream oil and gas companies increased by 457% over FY04-08 vs FY99-03. 

  2. Surge in export demand led by global factors: India witnessed a surge in export demand starting from FY02 led by global demand robustness; constant currency exports grew by 21% CAGR over FY02-07. Export to GDP expanded from 8.9% in FY02 to 13.3% in FY07.

  3. Expansion of the cellular networks: Capex of largest private telecom player multiplied 4.6x over FY03-08 led by the expansion of the cellular network coverage in India. Industry capex growth would be higher as this period marked the entry of new players. 

  4. Opening up of heavy weight sectors to private sector Investment:

  1. Power sector: Electricity Act, 2003 declassified power generation from license requirement, thereby boosting private investments in the sector. Installed private coal based capacity increased from 4.7GW in FY03 to 5.0GW in FY08 and 23.5GW in FY12; work on plants which got installed over FY08-12 would have started in FY08 given 4-5 years construction period.

  2. Road development: Over FY03-08, 4,684kms were awarded under PPP vs 811kms over FY99-03. Traction in road PPP was led by viability gap fund, tax benefits under section 80IA and robust capital markets.

Global liquidity and aggressive credit stance by public as well as private financial institutions in India supported the capex aspirations of private entrepreneurs. 

What can spark super capex upcycle 3.0?

From the earlier discussion it is clear that public capex is relatively steady (growth range has been 2.6%-12.3% over past upcycles) vs private. Hence, public capex on its own cannot lead to a super-capex upcycle. Consequently, the onus of super capex 3.0 will have to fall on private and household capex

In the private, we first look at heavy weight sectors which triggered first level capex over FY03-08. At the current juncture, it seems certain that India may need to look at new heavy weight sectors to trigger super capex upcycle 3.0. Though metals and oil and gas sectors have witnessed fresh capex announcements in past years, the global cycle is still out of favour. The capex phase in the domestic telecom sector seems well behind us with heavy consolidation and stretched balance sheets. The multiplier effect of the power sector is declining as we move away from thermal to renewable (number of Indian vendors going down) power. Road is the only sector from above discussion which is in a bright spot given the government thrust on the Bharatmala project. On the export front, global demand continues to be weak. Though there may be potential for India to gain out of the US-China trade war, we will have to leave the debate, on whether can India step into China’s shoes, to some other discussion.

Let us look at other large sectors which can potentially trigger first level of capex:

  • Revival of real estate demand: Household construction accounted for 24% of the national capex in FY18. Though it includes factory construction by SMEs, a large pie of household construction is believed to be in residential real estate. A revival here could possibly trigger the next round of super-capex upcycle 3.0.

  • Import-substitution of electronics: India’s import of electrical equipment (includes mobile phones, computers, etc) stood at US$35.6bn in CY17. If India manufactures these electronics, it may require a capex of ~US$12bn (assuming 3x gross block turnover, in-line with global cell manufacturers). Though this will account for just 1.6% of national capex, export potential and capex multiplier impact may trigger a large private sector capex.

  • PPP in railways + metro rail expansion and building of high speed rail: Railway is the only large sector which is still not fully opened for the private sector. Railway capex (excluding metro) at Rs1.32tn in FY19 accounted for 2.4% of national capex. If railway opens up to private participation and its capex multiplies then it could emerge as a driver for super-capex upcycle 3.0. Further, investment in metro rail and high speed rail corridor can also add legs to ongoing rail capex. Metro and high speed rail are not purely public capex as majority of funding is done through off-balance sheet external debt.

Can this capex upcycle VI convert into super capex upcycle 3.0?

India’s capex to GDP (also known as GFCF to GDP) increased from 9.3% in FY51 to 23.7% in FY03 (i.e. 28bps increase annually). Super-capex upcycle 2.0 witnessed a massive increase in capex to GDP from 23.7% in FY03 to 35.8% in FY08. In hindsight, this step-up jump was long due as India’s capex to GDP was near world average till CY00 despite being a prominent developing country. 

Exhibit 4: India’s capex/GDP saw a sharp 121% jump in Super-capex upcycle 2.0…

Source: CSO, AnandRathi Research

Exhibit 5: ...perhaps long overdue as it was the world average till CY00

Source: World Bank

Super capex upcycle 3.0 thus requires a “stepfunction” rise in capex to GDP. However, the luxury of a low base of capex to GDP is not available at this time. We ran a scenario-analysis to see the capex to GDP outcomes at various magnitudes of capex growth till FY25.

Exhibit 6: At a CAGR of 7% real GDP & 12% real capex, capex/GDP could touch last upcycle’s peak in early-FY24*

Source: CSO, AnandRathi Research, *for 8% and 6% GDP assumptions - refer annexure

Interestingly, if India’s real GDP grows at 7% CAGR over FY19-25 and real capex CAGR outcome is similar to super-capex upcycle 2.0 at 16% then exit capex/GDP in FY25 should be 47.6%. Achieving such capex to GDP will be challenging as no large country has ever achieved such capex/GDP in the past 5 decades. (We will compare India’s capex cycle with global capex cycle in another discussion at a later date.)

If we assume a more modest pathway with real capex target of 12%, outcomes seems more reasonable. At 7% real GDP CAGR, exit capex/GDP would be 38.5% in FY25 i.e. it will touch super-capex upcycle 2.0’s peak (35.8%) in early-FY24. 

From the current base therefore, a full-fledged super capex up cycle seems to be a stretch; a toned-down super capex upcycle or normal capex upcycle is possible if positive indicators continue for another 2-3 years.

Long story short – Mismatch between market expectation and reality

  • India has witnessed 6 capex upcycles; of which Vth capex upcycle (FY03-08) was a super capex upcycle as real capex growth CAGR at 16.1% was nearly twice of 4 other capex upcycles. 

  • Growth trend from FY17 has been encouraging with real capex growth in the range of 8.3-10.0% over past three years. Consequently, we are already in capex upcycle VI. 

  • Question is whether this can translate into a super capex upcycle 3.0 as equity markets are very divided on the advent of the same

  • Super-capex upcycle 2.0 was led by sharp jump in private capex in heavy industries such as metals, oil and gas, power, road and telecom led by global commodity cycle and cellular network expansion. At the current juncture, these heavy-weight sectors do not seem to have a large private sector capex plan.

  • Export growth which supported super capex cycle 2.0 is currently low due to indifferent global demand.

  • Further, FY03-08 super capex upcycle was long overdue as India’s capex to GDP was at world average till CY00 despite India being a prominent developing economy. (In that upcycle, India’s capex to GDP jumped from 23.7% in FY03 to 35.8% in FY08.)

  • Based on the current capex trends, a super capex up cycle 3.0 appears to be a huge ask, as the step function jump in capex to GDP is unlikely given the absence of a low base; FY19 capex to GDP was at 29.3%. 

  • Consequently, the probability of current capex up cycle translating into super-capex up cycle is low and hence faith in a significant acceleration in capex growth from current levels may be misplaced.

Annexure: 

Exhibit 7: Household construction accounted for 24% of India’s capex

FY18 fig. In Rsbn

Govt.

PSU

Private

Household

Financial Corp

Total

Construction

5,441

2,810

4,998

11,831

133

25,213

Machine

1,058

2,138

7,962

5,583

194

16,935

Intellectual property

205

439

5,929

1

103

6,677

Others

5

6

8

124

0

143

Total

6,708

5,393

18,898

17,540

430

48,968

Share in national capex

           

- Construction

11%

6%

10%

24%

0%

51%

- Machine

2%

4%

16%

11%

0%

35%

- Intellectual property

0%

1%

12%

0%

0%

14%

- Others

0%

0%

0%

0%

0%

0%

Spender's share in capex

14%

11%

39%

36%

1%

100%

Source: CSO, AnandRathi research

Exhibit 8: Sector-wise split of capex of BSE 1000 companies

Sector

FY03

FY08

FY18

Oil & Gas

28%

17%

19%

Telecom

12%

19%

15%

Metals & Mining

10%

12%

10%

Utilities

12%

8%

13%

E&C and Infra

3%

6%

4%

Auto

5%

6%

13%

IT + Pharma

7%

5%

6%

Conglomerate

3%

5%

3%

Other

21%

24%

18%

Source: AceEquity, Ambit Capital, Note – we have split the capex of the largest oil and gas company for FY18 into the end sectors; we have reduced spectrum payment and international capex from telecom capex

Exhibit 9: At 8% real GDP CAGR + real capex CAGR of 12%, capex to GDP will touch last upcycle’s peak in mid-FY25

Source: CSO, AnandRathiresearch

Exhibit 10: At 6% real GDP CAGR + real capex CAGR of 12%, capex to GDP will touch last upcycle’s peak in mid-FY23

Source: CSO, AnandRathi Research

Exhibit 11: Correlation between real GDP growth has been strong with real capex growth on 5 year rolling basis

Source: AnandRathi research

Exhibit 12: Private capex sentiment index turned positive in FY18 at 1.59x (above 1 – positive, below 1 – negative)

Source: AnandRathi research, Note – we define Private capex sentiment index (PCSI) as Private capex growth divided by GDP growth, Higher PCSI implies positive animal spirit as growth in private capex is higher than output growth i.e. GDP 

Exhibit 13: Limiting factors to the analysis - Data which we would have loved to analyse

Data

Reason for not analysing

Utilisation level

Unfortunately RBI has started publishing this data only from 2008

Machine capex/manufacturing GDP

Nominal manufacturing GDP in 2011-12 series has changed materially from 2004-05 series

Disclaimer

Disclaimer for Market Review/Research Report

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

Author Bio

Deepesh Agarwal
Mr. Deepesh Agarwal is an Associate Vice President and research analyst in the domestic Equity Division of UTI Asset Management Company Ltd. He tracks the Capital Goods, Infrastructure and Textile sectors. Deepesh joined UTI AMC in its equity team in 2017, prior to that he worked with Ambit Capital as equity research analyst for 4 years. He has also worked with Hexaware Technologies in Corporate Finance for 2 years. He is a Chartered Accountant from the Institute of Chartered Accountant of India and has cleared the Level 3 exam of the CFA program conducted by the CFA Institute, USA.