A company goes bankrupt when its asset returns fall below the Cost of Capital, i.e. the blended return needed by its debt and equity investors. The value of the business drops when the company can pay interest but is unable to keep equity investors interested. And the company goes bankrupt when it is unable to meet its commitments to its lenders.
Declaimer: This article written was originally in August 2014, and some of the data points may be outdated.
In either case, the first indicator of the slide into bankruptcy is that the supply of incremental capital dries up and the company starts to feel the pinch…..it shows up first in a capital crunch to fund growth projects, then routine ‘maintenance’ capex is not available and finally, the company falls off a cliff when even normal working capital needs are not met. This is the point of the ‘cardiac arrest’ when the blood (i.e. cash) stops flowing.
Any CFO who has seen this stage-by-stage decline will tell you that the final fires break out in the engine room. A CFO like me, who has seen quite a few turnarounds, will also tell you that some very tough decisions are taken at the bottom…..no, they (the decisions) are not taken at the bottom, rather the bottom happens whenever you have the courage to take those decisions…..!!!A country is no different. In the case of India, we first started to misuse our surpluses (i.e. savings), putting them into unproductive (but populist) endeavors like the doles and subsidies that have created all those holes in our national Balance Sheet. In the first phase, we were unable to meet our cost of equity, as a result of which incremental investments for growth came down to near zero.
In the second phase, foreign investors in our debt markets started to take flight. This flight of short-term (foreign) capital hit us disproportionately hard in July-Aug, 2013, creating the “rupee crisis”. I think that point was the nadir at which everyone (even the Congress) woke up. Chidambaram came back with some new initiatives, the most important of which was the appointment of Raghuram Rajan, our white knight in the currency markets. A spate of fire-fighting measures followed, with a near faultless record in stabilizing a chaotic situation, which had the potential to push us into a full-blown economic crisis. I will not dwell on what might have happened, because I have a different agenda…to lay out the milestones of the coming turnaround.
To go back to the company metaphor, the Chidambaram- Rajan combination was like the “turnaround CFO”, whose first job on entering the company is to keep the cash flow running. Any corporate chieftain will tell you that this restoring of confidence can only be done by a ‘new face’, as the old one (i.e. Pranab Mukherjee) would have lost credibility and would not be acceptable to investors taking flight. Remember: when handling a country, the CFO’s role is split into a domestic (investor relations) role which is handled by the FM, while the external (investor relations) is handled by the RBI Governor.
Thankfully for India, both roles saw a new incumbent. In particular, the restoration of international confidence was dramatic, with a ‘rock star’ RBI Governor who knew enough Behavioural Economics to calm markets and control frenzy. Simultaneously, he laid the foundations of a reform program that saw one of the biggest comebacks in recent history, i.e. the credibility of the Rupee has soared well beyond the starting point of the last decline. This was backed up by a serious war against inflation, which convinced local investors to start investing. First, equity investors in international markets, then debt investors in international markets, and later, domestic local equity investors have returned. The visible improvement in the investment climate over the last 12 months has been more as a result of ‘technical factors’ (i.e. the exit and entry of investors)…..but our focus is on the much more structural changes wrought by the slow-moving ‘fundamental factors’.
As any turnaround CEO will tell you, the Cost of Capital for a company is usually a given, and it comes from a confluence of factors, only a few of which are in the control of the company. One of these controllable factors is the way you finance growth, and the other is where you keep the surpluses you generate. If the given Cost of Capital is high, you focus on deleveraging, asset sales, and bringing in equity…..and if the given Cost of Capital is low, you focus on deleveraging, i.e. you invest for growth.
In the case of a company, the Cost of Capital is decided by the interest rate environment, liquidity conditions in the economy (which decide the cost of vendor financing), and the Banks’ appetite for fresh exposures on the company. The cost of equity is decided by the prevailing market conditions. In the case of a country, this is decided by prevailing global monetary conditions, global capital flows, and the cost of energy (especially oil, which provides a cost-push because of geo-political conditions). Global geo-politics decides the prevailing political environment for equity flows. Most of these factors are ‘uncontrollable’ for both a company and a country. What a good CFO can do is take up any opportunities that the environment provides and position his company with the right strategy under the prevailing circumstances.
A good CEO, however, focuses on improving the productivity of his assets to a level that can meet his given Cost of Capital. In the case of a country, there is no real obligation to take special care of the interest of equity holders, whether domestic or foreign. In the case of India just now, there is so much wastage and Govt sloth that for a turnaround CEO to get his teeth into quite a few productivity-enhancing measures is not difficult.
A great place to start is the organization of Govt itself. Get the Govt out of ‘doing things’ and redirect its efforts into ‘regulating’ and ‘catalyzing’ things. The latter is completely alien to India, which sees its private sector as thieves and bandicoots, an attitude that extends to its courts and the CAG. While there is much background to such an attitude, both these independent institutions need to develop a philosophy of catalyzing economic activity…..the Judiciary needs to understand, for example, that iron ore left in the ground is of not much use to anyone….and that time wasted in litigation carries an enormous economic cost for the nation. Justice is a hygiene factor and a public good….its presence does not guarantee progress, but its absence is a huge hindrance to any kind of progress. We need another Raghuram Rajan there to drive up the productivity of the judicial system.
Small steps like pushing up the productivity of the bureaucracy have already been taken, but this has to become a habit. I need to repeat the point about the ‘catalyzing’ role of Govt here, whether it is with the Ganga action plan or the provision of civic services (waste water management, energy conservation, etc.) in urban areas.
To go back to the corporate metaphor, most of the initiatives that turn around an ailing company, actually take no money. It is really about breaking down the web of vested interests (including those of the promoters) that take away more than they provide to the company…. organized labor, theft, and stagnation. In Govt, it is no different……it is engaged in exercising and milking power, rather than providing a service to its people. A Govt that is focused on providing real and measurable services to its populace, will achieve a change of culture that will kickstart an economic turnaround.
Like I am asking in the previous para, it will focus attention on other aspects of Govt, i.e. how much justice do we get from our judicial system and at what cost? How much regulation from SEBI, audit from CAG or policing from our police….and at what cost? Increasing productivity in these institutions requires ‘turnaround CEOs’ in every place, with a sharp focus on the actual utilisation of resources. Like in any company, the cost of these resources can be brought down and the asset productivity can be pushed up through a change of culture, which is brought about by visionary leadership.
……to be continued..2