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Production Cost Curve Rising

Author: Dasari Sreenivasa Rao/Wednesday, November 25, 2020/Categories: Exclusive

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Production Cost Curve Rising

Q2 Clocks Upturn In Factory Output; Modest recovery seen in exports, capacity utilization & availability of workforce; Hiring Yet To Gain Momentum

The production activity across major industry verticals is encouragingly, though in a moderate way, gaining momentum since lockdown imposed on March 22, 2020. However, the production cost is alarmingly rising owing to higher fixed costs and overheads thanks to the safety standards amid coronovirus pandemic. The domestic economic activity started recovering from the devastating impact caused by Covid-19 particularly in the second quarter (July-September, Q2-2020-21). The capacity utilisation in the manufacturing sector rose from 61.5 per cent in the fourth quarter (Q4, Jan-March FY21) to 65 per cent, according to a latest quarterly survey carried out by national industry body Ficci.

Production Cost

The cost of production as a percentage of sales for manufacturers in the survey has risen for 70 per cent respondents. This is higher than that reported in previous year, where 64 per cent respondents recorded increase in their production costs. Industry respondents have attributed the hike in productions costs primarily to high fixed costs, higher overhead costs for ensuring safety protocols, drastic reduction in volumes due to lockdown, lower capacity utilization, high freight charges and other logistic costs, increased cost of raw materials, power cost and high interest rates.

Interest Rate

Average interest rate paid by the manufacturers has been reduced slightly to 9.2 per cent annually as against 9.4 per cent per annum during last quarter and the highest rate is reported to be 12.5 per cent. The recent cuts in repo rate by RBI have not led to a consequential reduction in the lending rate as reported by 55 per cent of the respondents.

Hiring

Hiring outlook for the sector, though bit improving, shows a bleak picture as 80 per cent of the respondents mentioned that they are not likely to hire additional workforce in the next three months. This presents slightly improved situation in the hiring scenario as compared to the previous quarter Q-1 of 2020-21, where 85 per cent of the respondents were not in favor of hiring additional workforce.

Federation of Indian Chambers of Commerce & Industry's (Ficci) quarterly survey on manufacturing points towards recovery of manufacturing sector for the second quarter  as compared to previous quarter. The percentage of respondents reporting higher production in second quarter of 2020-21 has increased vis-à-vis the Q-1 of 2020-21. The proportion of respondents reporting higher output during July-September 2020 rose to 24 per cent, as compared to 10 per cent in the first quarter (Q1) of 2020-21 fiscal. The percentage of respondents expecting low or same production is 74 per cent in Q2 of 2020-21, which was 90 per cent in Q1 of 2020-21 financial year. The survey covered wide areas of relevance for manufacturing like exports, capacity utilization, ongoing restrictions, availability of labour/workforce and others. In many of these areas, there are signs of operations inching towards normal and in coming months could see better performance.

ICCI’s latest quarterly survey assessed the sentiments of manufacturers for Q2 (July-September 2020-21) for twelve major sectors namely automotive, capital goods, cement and ceramics, chemicals, fertilizers and pharmaceuticals, electronics and electricals, leather and footwear, medical devices, metal and metal products, paper products, textiles, textile machinery, and miscellaneous. Responses have been drawn from over 300 manufacturing units from both large and SME segments with a combined annual turnover of around Rs 3 lakh crore.

Capacity Addition & Utilization

The overall capacity utilization in manufacturing has witnessed a rise to 65 per cent as compared to 61.5 per cent in Q4 2019-20. The future investment outlook, however, is subdued as only 18 per cent respondents reported plans for capacity additions for the next six months as compared to 22 per cent in previous quarter. High raw material prices, high cost of finance, shortage of skilled labor and working capital, high logistics cost, low domestic and global demand due to imposition of lockdown across all countries to contain spread of coronavirus, excess capacities due to high volume of cheap imports into India, lack of financial assistance, uncertain demand scenario across globe, complex procedures for obtaining environmental clearances, high power tariff, are some of the major constraints which are affecting expansion plans of the respondents.

It is evident that the average capacity utilization for Q1 2020-21 increased in sectors such as automotive, capital goods, metals & metal products, electronics, paper products and textiles.

Inventories

About 77 per cent of the respondents had either more or same level of inventory in July-September 2020, whereas around 74 per cent of the respondents maintained either more or same level of inventory in April–June quarter of 2020-21.

Exports

The percentage of respondents expecting increase in exports in Q2 2020-21 has increased substantially to 24 per cent when compared to Q1 2020-21, wherein merely eight per cent respondents were expecting a rise in exports. Also, 19 per cent are expecting exports to continue to be on same path as that of same quarter last year.

Dedicated Power Supply

Another major problem that's being faced by the manufacturing industry is power. Addressing this problem, the central government has decided to put in place dedicated power distribution channel for industries in the manufacturing zones in order to provide competitively priced electricity to units giving make in India push.

As part of the new proposal, the government will offer power distribution rights to units in such zones to a private sector entity. This entity will then procure and supply power to industrial units locating manufacturing hubs offering competitive tariff.

Further, Atmanirbhar Bharat initiative has been helping industrial units to gear up to meet the new requirements of the global market. The Union Power Ministry has decided to set up power equipment manufacturing hubs in different states. These hubs are proposed to be set with deemed distribution status. This would allow these zones to get a dedicated power supply independent of state utilities and charges build into the system for such supplies.

Responding to this, a Hyderabad-based CEO welcomed the proposal and said that "such initiative will help the manufacturing industry get competitively priced power. However, I believe that state governments should also help the industry by joining the scheme."

Generally, the electricity supplied to industry by state discoms is loaded with cross subsidy surcharges that makes electricity tariff for industrial tariff expensive as compared to household or other subsidised consumers. Industry also get power supply through open access route directly for their consumption from generators, but such arrangement attracts wheeling and open access charges that adds to the cost.

An independent power supply arrangement could reduce all these charges where tariff would be determined based on cost of procurement by distributors.

Q2FY21 GDP contraction at 10.7%

On the other hand, the GDP contraction during Q2FY21 is expected to come in at (-)10.7 per cent, as per the report by SBI Ecowrap. An earlier Ecowrap report had estimated GDP for Q2FY21 at (-)12.5 per cent. Considering this, there's an improvement in forecast on India's GDP growth.

"Our estimate of Q2FY21 (or Q32020) is aligned with the economic growth seen by various economies in Q32020. The GDP contraction halved in Q32020 compared to Q22020 for select 18 economies. We are also revising our Q2 GDP growth to (-)10.7 per cent (from the earlier (-) 12.5 per cent) with positive bias, based on our nowcasting model with 41 high frequency indicators, associated with industry activity, service activity and global economy," says the SBI Ecowrap report.

According to the report, the upward revisions reflect faster recovery and these estimates would have been even better had July and August shown even a little bit of traction. The SBI business activity index shows that there is continuous improvement and Q3 numbers could be even better. However, the extent of recovery in the subsequent quarters can only be gauged after the actual Q2 numbers are published. There is no doubt that the economy has suffered.

The report further added that "the MSME sector has borne the brunt of the Covid pandemic and the ECLGS scheme was a shot in the arm. Future prognosis will depend on two things - the shape of the recovery from Covid infections and how fast the vaccine is rolled out." In addition, the report said the current trends of Covid-19 infection shows that cases in India peaked in September. "With Unlock 5.0 and festival season till December end, the chances of a possible second wave will increase. The fortnight post Diwali will be crucial and we need to carefully monitor the situation," the report said.

"With domestic vaccine entering Phase III and one more phase to go, Covid-19 recovery will be contingent on how fast the vaccine is rolled out and consumer confidence is restored. The best estimate of full recovery in consumer confidence can be placed in Q3 FY22," it added.

Concerns Over New Bank Licences

Industry experts and economists voice concerns over the latest decision by RBI on licences for setting up new banks. They said that as bank failures mount, RBI decision on new bank licenses could be controversial. At a time when bank failures are increasing in India, the decision to distribute licenses could be controversial, says Macquarie Research.

RBI has released an internal working group (IWG) report to review ownership guidelines and corporate structure for private sector banks. "While the arguably bold recommendations suggest NBFCs as well as corporate houses could apply for a banking license, we believe the possibility of them being granted is very remote," Macquarie said in its latest report.

The timing of this report is quite surprising, coming amidst a spate of bank failures. "At a time when bank failures are increasing in India, the decision to distribute licenses could be controversial, in our view. We expect RBI to exercise caution in this regard and hence some recommendations may not come to fruition", the report added. Nayak Committee in May 2014 recommended that a class of investors called Authorised Bank Investors (ABI) be allowed to hold a 20 per cent stake in private sector banks without any regulatory approval. The recommendations of that committee were never implemented.

Macquarie said: "By the same token, we don't believe industrial houses, even if they own NBFCs, will be allowed to open a bank or convert into a bank. The experience of allowing corporate houses to run banks has been pretty bad for RBI (eg: Times Bank, Bank of Rajasthan, etc) and thus, we do not believe RBI will grant licences to corporate houses. Note, on-tap licensing is currently available, but RBI has not issued any licences." The ultimate power of fit and proper criteria and due diligence rests with RBI. Irrespective of these guidelines, RBI is the final deciding authority.

RBI didn't give licence to a corporate house like Larsen & Toubro (L&T). Uday Kotak has been allowed to hold a 26 per cent stake in KMB. RBI has not yet decided on play of the promoter Hinduja for raising its stake in IndusInd Bank (applied in March 2020). While RBI has reservations about a single entity owning more than a 10 per cent stake in a private sector bank, Prem Watsa's Fairfax was allowed to hold more than a 50 per cent stake in Catholic Syrian Bank. The cap on promoters' stake in the long run (15 years) may be raised from the current level of 15% to 26 per cent of the paid-up voting equity share capital of the bank.

RBI is the sole deciding authority, regardless of the IWG recommendations. "While rules can be black and white, fit and proper criteria and due diligence will remain a grey area, in our view," said the report. Edelweiss said in a report that the recommendations promote more open access to the country's deposit base, while charting a future course for asset specialists too. Business models that stand on a single solid leg (asset or liability) will see future in partnership or merger. "Asset specialists with CASA possibilities (like Bajaj) may even go it alone in a new bank avatar. With new claimants to the CASA pie, shallow-moat businesses will suffer," it added.

"Large corporations with working NBFC platforms (Bajaj, L&T, Birla, Tata, etc.) can stake a substantial claim on this pie if they convert into banks, thanks to public trust and widespread branding (in some cases century plus vintage)," the report said. Mid-sized banks with limited asset side differentiation will bear the brunt of this squeeze as their small (in some cases niche) CASA pools are targeted. Majority of new generation NBFC/HFCs, that have faced thorough market interrogation on asset moats since 2018, will see the pitch rise even higher, it added.

"There will be blood," the report added. There has been the likely increase in concentration of the economic profit pool in the hands of top few banks. "These recommendations potentially introduce new competition in the ecosystem in terms of large corporate brand names, some with meaningful NBFC presence, competing for the CASA pool. This cumulative competition increase will disproportionately impact the marginalised. For larger franchises, a weakened and disrupted field often could at least mean an acquisition/partnership on favourable terms. Those weak on business models, don't get a ‘silver lining' to this cloud," it said.

The writer is a business journalist with 27 years of experience

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