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End of the bear market in investments

January 16, 2004

The last large greenfield investment -- the refinery of Reliance Petroleum Ltd -- was financed in 1995-96.

Admittedly, there have been large investments in the infrastructure domains of telecom and roads since that time, but the manufacturing sector has been more muted in its investments.

Surely, we did bite off more than we could chew in the early to mid '90s, and the problems relating to the East Asian crisis and our own government's wavering policies towards private sector investment added to the woes.

However, the snake now seems to have digested the goat, and looks hungry again.

Crisil estimates that most industrial segments will see near 100 per cent capacity utilisation in the coming fiscal year.

Crisil also estimates that by 2006-07 the shortage of supply will be to the extent of over 40 per cent in many industries. Clearly the time to consider investments has arrived.

The sum of all this investment amounts to Rs 200,000 crore (Rs 2,000 billion) -- compared to a total of Rs 80,000 crore (Rs 8,000 billion) in the last five -- and beats the previous bullish investment phase that we witnessed in early to mid nineties.

This talks only about industrial investments and does not account for perhaps a much larger investment bill from the infrastructure segment.

Several issues arise when we talk of such massive investment including viability of such investments, feasibility of financing them, and the effect it will have on the existing markets and the wider economy.

The demand-supply situation will favour fresh investments. Indeed in many industries, we should be witnessing shortages from the second half of this calendar year.

However, the ability of the firm to pull off the investment in a cost efficient manner and position that production in the market, would have to be evaluated individually.

Traditionally, only a few industrial houses have shown the project management skills that are required to build globally competitive facilities.

Cost and time overruns have been the norm rather than the exception.

Some such deviations are also suspected to be due to diversion of funds, in some cases benignly to other productive projects and unfortunately in other cases spirited away unaccounted for.

In the new paradigm of global competition, such profligacy will surely render the projects unviable.

Hopefully there will be more enlightened project sponsors this time around and the check and watch mechanisms all around will be stronger and prevent this phenomenon from recurring.

Finding appropriate finance for the projects is a trickier issue. Despite the fact that the system is extremely liquid and that corporates have built a lordly war chest, the need for raising funds for financing such massive investment is imminent and an imperative.

The current costs of both equity and debt funds are the best that have been seen in living memory. It will be foolhardy not to take advantage of this fortunate confluence of favourable demand-supply regime and low-cost funding opportunities.

Indeed, even if this is not the preferred time, sheer competitive pressures are likely to oblige most project sponsors to access public markets to improve both the scale and economics of their projects.

However, there are likely to be issues with both the equity and debt markets.

Even though this sounds incongruous at a time of easy liquidity, I think we need to be alive to two factors -- one being the competition to lock into these attractive rates and the other being the need to tie up the entire financing before embarking on large projects.

Part of the problem that projects of the nineties faced was that the system ran dry mid-stream and project sponsors scrambled to tie up finances to complete projects. Many ended up with high-cost and shallow maturity funds.

This exacerbated the project's inability to earn decent returns.

To avoid that problem, sponsors of projects this time around will hopefully seek to ensure funds availability before embarking on projects.

Since debt funds are available at extremely competitive rates vis--vis international markets, and equity markets are also showing signs of supporting equity raising efforts, it is expected that the race to lock in resources ahead of embarking on projects will begin now.

It remains to be seen whether the buoyant liquidity that is currently present will be able to support the sudden visitations by a large fund mobilisation effort. Therefore, the sponsors would need to time their foray into the markets carefully.

If they leave it till too late, the rates might harden, and they would have missed the opportunity to lock into attractive rates.

Conversely, decision-makers in the funding industry have to be extremely vigilant at this time.

Bullish sentiments, aggressive sponsors, competitive pressures, and a flood of business after several years of parched throats, are a heady cocktail for a repeat of the disasters of the last decade.

The need to choose wisely, measure and price risks appropriately, and build business with discipline in an era of expansion, are key factors which the funding industry would do well to take into account.

Serious upgradation of skills in project appraisal, devising mechanisms to monitor end-use of funds, evaluating and pricing risks, assiduous monitoring of exposures, and the ability to take swift corrective action, have to be emphasised at express speed by banks and fund managers.

Taking exposures in a manner that allows them to offload quickly, building in covenants that allow the lenders additional comforts should events turn against them, and having a graded credit pricing model to reflect risks at different points of time, are some of the new ways that could be explored for providers of funding to protect themselves.

Fortunately for them, the new disposition in legal framework and policy preference is favourable to their ability to act in a prudential manner this time around.

The impact of resurgence in investment will be salutary to the sustenance of our economic recovery. For an economy that is relatively under-invested, economic growth will continue to be largely driven by investment activity.

It will be some decades before consumption takes the position of being a prime driver of economic growth in India.

Surely it will contribute, as indeed it has begun, but investments in capacity and infrastructure would be required in massive doses to keep the economy buoyant. Therefore the return of the investment climate should be welcome.

Policy cobwebs have been largely cleared. The power sector is the only large segment that needs to be shaped. Efforts to effect the new Electricity Act need to be accelerated to get this crucial sector in shape to support the massive investment programme.

Apart from this, the other worrying factor is the lack of long-term money in the system.

Pension reforms should be aimed at allowing longer term money to flow to infrastructure and industrial investment, of course with all prudential safeguards.

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