In the past one year, some analysts and market experts have highlighted the sharp decline in the corporate profit-to-GDP ratio in the last decade. As per some reports published earlier this year, India’s corporate profit-to-GDP ratio has more than halved from about 8 percent to 3 percent over 2008-18. The sharp decline in productivity, especially the public sector productivity, is highlighted as one of the key reasons for the decline in this ratio. The trend is contrary to the one seen in the US where the corporate profit-to-GDP ratio has improved over the same period.
Some analysts see the decline in the corporate profit-to-GDP ratio as a big opportunity. In their view, as the virtuous cycle of growth begins to unfold, the ratio may normalise to its pre-global crisis level yielding super normal profit in the next one decade or so.
I though disagree with this hypothesis. In my view, in India the fall in corporate profitability is a structural, and not a cyclical phenomenon.
The investing community in India must admit that to achieve the higher growth target of 8 percent plus, it is imperative that the policy of protectionism and localisation is abandoned forthwith. In fact large amounts of foreign capital -- monetary, intellectual as well as technological -- is needed even to sustain the present rate of growth.
We also need to assimilate that the cost of doing business shall increase in direct proportion to the ease of doing business. Global competition, higher cost of capital, better and stricter compliance standards, enhanced social responsibility standards and transparent and accountable administration will inevitably result in higher cost of doing business, forcing a whole lot of businesses, out of business.
In my view:
1. The businesses in India shall continue to face multiple disruptions from compliance rules, taxation, technology, changing consumption patterns and global competitive landscape, resulting in lower aggregate profitability.
2. The policy environment in India is still in a state of flux. Ideally, the direction will be towards further opening of the economy to global capital, technology and competition. If the present trend continues, we shall see more and more global players dominating the Indian industrial space in near future, especially in the manufacturing and financial sector. This may make many Indian corporate, including some large ones, operationally uncompetitive, financially unviable and technologically redundant. Though, some smaller niche businesses that can potentially play a supporting role to the global players may see substantial growth in their businesses.
3. Historically, Indian businesses have enjoyed state patronage in terms of lower cost of compliance, natural resources, land, capital and wages. This may no longer be the case going forward. The legal and regulatory changes made in the recent past make sure that the businesses pay market price (or even higher in some cases) for land, natural resources, capital and wages. The standards for corporate governance, social responsibilities and sustainability have also been raised materially. This all shall have a material bearing on the corporate profitability.
The rising competitive intensity for businesses, may also materially impact the margins of domestic businesses, for example due to (a) erosion of pricing power; (b) higher investment in technology and therefore lower ROCE; and (c) higher compliance cost due to adoption of best global business practices.
4 A large proportion of new investment may be happening in the new age businesses. While these businesses may be generating substantial revenue and a large number of employment opportunities, on profitability matrix these may take years or may be decades to match the conventional businesses.
Comparing corporate profitability in the US and India may therefore be totally irrelevant. Mega US businesses like Amazon, Google, Apple, et al are already in harvesting stage, whereas in India most of the new age businesses are still in sowing stage. Moreover, the prevailing turbulent weather conditions in India and global markets have actually reduced the survival rate for the new crop.
The worst part is that Indian new age businesses score very poorly on innovation scale. Most of the top Indian new age companies are poor clones of the global leaders. These may not be adding to gross corporate profitability anytime soon. Many of these may actually never contribute to profitability, but only add to the overall financial stress.
To conclude, in my view, Indian economy and businesses are passing through a challenging period. A large number of businesses are in fact facing existential threat. Under these circumstances, forecasting the future performance using the conventional matrices may not be entirely appropriate. The investors may not accord undue weightage to the macro indicators like overall corporate profitability-to-GDP ratio in their investment strategy.
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Vijay Kumar Gaba explores the treasure you know as India, and shares his experiences and observations about social, economic and cultural events and conditions. He contributes his pennies to the society as Director, Equal India Foundation.