And you thought low interest rates can help revive capex? Or does it work the other way

By Pankaj Sharma

It may sound like a convoluted logic, but in an interesting 2013 paper, titled “Long-term investment, the cost of capital and the dividend and buyback puzzle” in the OECD Journal on Financial Markets Trend, Adrian Bundell-Wignall and Caroline Roulet have argued that low interest rates are bad for capex.

They argued that interest rates are so low today that they are not even enough to support banks. Hence, we are seeing a liquidity-driven speculative bubble in almost all possible asset classes. They also said since there is a disconnect between bond yields, equity risk premium and nominal GDP trend, it would be extremely difficult and volatile to raise interest rates in this environment.

The authors looked at 4,000 global companies and highlighted that a) capex decisions are influenced by cost of equity; b) buybacks are driven by the gap between cost of equity and debt, c) low interest rate works against long-term investment because debt finance is cheap and cost of equity for making long-term investment (risky) may not come down that much, d) when sales growth is low and uncertainty is high, companies would not incur capex, but would look for inorganic growth as a preferred option, and, e) until we return to normal interest rates and reduce the incentive for low capex, it won’t really help recovery.

Coming back to today’s scenario, interest rates have declined almost everywhere across the globe and though low global capex may be linked to weakness in commodities, the issues are interlinked and it is difficult to establish which one is the cause and which one is the effect.

So, though it may sound counter-intuitive, cheaper capital may have actually increased the incentive to postpone capex for companies.

In the Indian context, we certainly have issues like, a) excess capacity and low end-user demand, b) poor credit availability because of troubles in the banking system, and c) numerous issues with many private companies and promoters. But, it is something to be pondered over “why even the rate cuts so far have not led to any capex revival.”
Another important point that needs a mention is that you don’t only need to do a buyback. Anything that is an inorganic option for growth and where you can use the excess cash; it would be equally good for Indian companies.

When so many good quality assets are available and at such cheap (or at least reasonable) valuations and banks and financial institutions would be offering so much of concession and flexibility to good companies with balance sheets, why should companies even bother to set up new plants.

Hence, this is what it means. You may try rate cuts but it could make capex even more unattractive vs. acquiring assets for most companies in today's environment.

Also, as discussed (or rather proven in the paper mentioned in the first two paragraphs with sufficiently large sample size) earlier, low interest rates may not be always very helpful in reviving end-user demand and recovery.

On the other hand, it is possible that low interest rates may harm capex plans and, in turn, economic recovery. In a weak demand and poor sales growth scenario over the past few years, this is how it has been playing out.

Let us hope a good monsoon and the seventh Pay Commission award would revive the demand environment and only then the desired effects of ‘low interest rates’ would start to kick in.

(Pankaj Sharma is Head of Equities at Equirus Securities. Views expressed in this writeup are his own and do not represent those of ETMarkets.com)