India’s Economic Future

Harsh recently wrote an excellent piece on how India’s economy will grow from the current $2.5 trillion GDP to $12 trillion by 2030. His prediction rests on on two planks: increasing participation of women in the workforce, and technological change.

The Solow growth model – one of the few economics topics I actually remember something about from business school – takes three inputs, namely capital, labour and productivity growth, to project what the future output of an economy might be. Harsh has made a persuasive case from first principles, on how an increase in women’s participation in the workforce combined with the mobile internet revolution will propel India’s GDP to $12 trillion by 2030.

These media reports add a lot of colour to what can sound like a routine development – it is anything but that:

Rural Indian Girls Chase Big-City Dreams

Latest HRD survey shows girls going to college out number boys in seven states

Their Postcards For 2018: From 18 places, girls who turned 18 this year speak out

Harsh’s point on technology too is visible and obvious – Reliance Jio’s entry into telecom is making 4G mobile connectivity ubiquitous. Over the next 3-4 years, we should see 5G (with speeds on the order of hundreds of MB per second) rolled out across India. Consider what this will do for education, health care, media and entertainment. The possibilities are enormous.

Last year, I had co-authored two op-eds with investor Navroz Udwadia on how India can achieve sustained double-digit growth, by fixing the banking sector and building infrastructure for agriculture. The former addresses the capital piece of the Solow model, the latter helps increase productivity for agriculture through “technological” interventions. The introduction of GST too is a technological step change, the longer-term benefits of which monthly or quarterly economic data cannot capture.

There are real changes underway in how India allocates capital, in the composition of our labour force, and in technology. These will all mutually reinforce each other and the gains will compound. It can be difficult to see the bigger picture when we ourselves are inside the frame. I feel very positive about India’s economic future. It’s a great time to invest in India and to be an entrepreneur here.

Financing A Business

The accounting equation, a fundamental identity of accounting, states that:

Assets = Liabilities + Owner’s Equity

A business converts debt (liabilities) and equity (owner’s equity) into assets that generate cash flows. Those on the right side of the equation make claims on this cash flow depending on the security they hold. Debt capital providers receive a coupon on their investment, while equity capital providers participate in the upside (and downside) as the owners of the business.

With that 20-second crash course in accounting and corporate finance out of the way, the question, both practical and philosophical, every entrepreneur has to answer is how the business should be funded.

Selecting the capital source for a business is one of the most important strategic choices an entrepreneur makes. Founders may not necessarily think through it in the way I have described above, but as Prime Minister PV Narasimha Rao said once, not taking a decision is also a decision.

Venture capital investors are equity participants, and expect higher returns compared to public equity investors. In recent years, the terms attached to equity investment by venture investors have turned equity into a quasi-debt instrument.

Debt financing is suitable for relatively predictable and regulated sectors, such as infrastructure and power, and it is unsuitable for riskier and innately unpredictable endeavours such as creative projects or technical innovation. Debt funding has an added advantage because interest payments are tax deductible, a provision introduced in the First World War.

Let’s examine what’s been happening in some sectors through the financing lens:

India e-commerce – Several e-commerce players raised very large sums of money at, it is now obvious with the benefit of hindsight, unjustifiably high valuations. These companies thought they were raising equity, but it was actually debt disguised as equity. This was not unique to Indian startups, and happened in other markets too. Venture capitalist Bill Gurley eloquently described the phenomenon as the “calcification of the cap table”. Onerous covenants on equity and the fund-raising arms race made the capital structure of many startups fragile, and the fragility has broken many companies. The calcification happened because founders chased higher and higher paper valuations. The price equity investors extracted for the high valuation was to take debt-like protections in case things went sideways. The transformation of equity into debt-like instruments was necessitated partly by the drive for higher headline valuation numbers. This is always irresponsible. Instead of fund-raising being a means to the end of building a business, fund-raising at ever-increasing valuations became an end in itself. While e-commerce startups have to do a capital raise to continue investing in the business, Amazon simply parks a chunk of the cash flows from its thriving marketplace and cloud businesses into India. Amazon is more conservatively financed than its Indian competitors and that is making a very big difference.

India telecom – Telecom spectrum is the essential “raw material” to run a telecom business. The corruption-mired allocation of this scarce and valuable resource by the Congress-led UPA government is one of the biggest scandals in India’s history. After the scandal, it became politically difficult to not maximize revenues on auctions of telecom spectrum. The legacy players borrowed huge sums of money from government-owned banks to license spectrum. Then Reliance Industries entered the business with Jio, funding spectrum acquisition and network buildout through very large equity-funded investments. Reliance can afford to invest on this scale because of its oil refining business. That business generates huge cash flows, and Reliance is investing some of this cash into its new telecom business. In a sense, Reliance Industries is doing to legacy telecom companies what Amazon is doing to e-commerce startups. Both Amazon and Reliance are investing equity, while the others are investing debt.

Global media and entertainment – A few months ago, Netflix issued corporate debt to fund new content. This is quite risky. Netflix’s low-rated and high-interest bonds were lapped up by investors starved of yield in the current low interest rate environment. It says something about the present environment that even though Netflix has told investors it will turn to bond markets to raise money frequently and invest the proceeds into a speculative assets like films and television shows, investors are handing over billions of dollars to the company knowing Netflix will keep burning cash. At the same time, digital music streaming startups in the US and India have raised enormous amounts of capital from private investors, probably with onerous terms attached – so these instruments may be labeled equity, but work more like debt. The problem the streaming services face is that the more money they make, the more content owners (typically large music labels and media companies) extract from them. As the intermediary, streaming services have limited bargaining power with the content owners. They are running the classic Red Queen race. The bet investors in such companies are taking is that the subscriber base can grow fast enough to a large enough scale so that eventually the economics of the model tilts in the favour of the licensee (i.e., the streaming service).

India agriculture – Indian agriculture is woefully over-regulated. Farmers have little control over both the price they can get for produce and where they are allowed to sell their output. For decades, India has simultaneously romanticized and infantilized the farmer. Farming is simply not viewed as a business, even though it is one. As if it wasn’t enough, farmers are left to the mercy of the weather too because India has a dearth of irrigation infrastructure. About 45% of employment is in the agriculture sector. Most people (we are talking tens of millions of people) just default to agricultural employment as there are limited opportunities to do anything else in rural India. There isn’t much equity capital entering farming, as farming tends to be largely subsistence-based. Deprived of equity funding sources, farmers turn to loans from formal and informal sources. They don’t have much of an incentive to invest in productivity tools for their farms either, because of pricing and other regulatory distortions. Given the high dependence of India’s population on farming and the inefficiencies built into Indian agriculture, every now and then there is a political clamour for farm loan waivers. This is a vicious cycle, and can only be broken by structural policy reforms for the sector.

When evaluating an investment, I find it very useful to think both backwards and forwards about how the business has been financed and how it will be financed. It reveals a lot about both the economics of the business and the management behind it.

Hindi Medium

English medium types like me read an Oscar Wilde short story called The Model Millionaire in school. The story is about how Hughie Erskine, despite being poor, gives away whatever little he has to somebody who he thinks is an old beggar.

Irrfan Khan-starrer Hindi Medium has elements of that story. The film portrays in stark contrast the nobility of a poor family against the pettiness of a rich couple. It conveys many truths about sections of India’s new (and old) urban elite.

The title of the film refers to the Hindi-language education of the two main characters in the story. One of them has an inferiority complex because of an inability to speak in “proper” English. Though they are wealthy, their educational and particularly non-English language background marks them as misfits in Delhi’s high society circles. Hindi Medium is about the social dynamics of being newly rich in a still-clubby urban India, and on the social challenges faced by the urban poor.

The film also shows how elite schools have become less about learning, and operate more like social clubs that have signaling value. It’s almost as if becoming a part of that club gives confidence – and connections – to an individual. Obviously, this is not what an educational institution should be about.

But the confidence factor matters. Believing it’s possible to succeed is the first step to actually being able to succeed. Developing that confidence, especially when you are an “outsider”, is not easy. The insanity of school admissions shown in the film is not exaggerated. It is particularly bad in cities like Delhi, and this is a problem created by bad regulations. The shortages are manufactured, as government clamps down on supply.

Government schools in a India are bad because teachers and administrators have no incentives to do any better. There is practically no accountability in the government school system. Consumers are choosing private schools because those schools deliver better learning outcomes for students. If they don’t deliver a good product, private schools will lose their customers. Unlike government schools, private schools go out of business, so they have a strong incentive to keep doing better.

The Union and state governments are doing the opposite of what they should do – rather than reducing entry barriers and making it easier for new schools to enter the marketplace, large numbers of existing private schools are being shut down across India. This hurts the poor the most, as they are forced to go back to the ineffective government schooling system they finally had the chance to escape.

The policy issues here are complex and multi-faceted, and this is where the film’s solution to the problem is wrong. Everybody sending their children to government schools will not improve those schools – for government schools to change, the incentives for those schools have to change. There needs to be accountability. There are very good reasons why the rich and poor alike wish to send their children to private schools. But I’m delighted somebody made a film like this, and that it is being watched and appreciated widely in India.

It is a movie with a great message, delivered in an entertaining way. These lines from a song in the film capture the spirit of India’s new generation and why the new India has achieved escape velocity:

इक जिन्दड़ी मेरी, सौ ख्वाहिशाँ

इक इक मैं पूरी कराँ

मुिश्कल हुमें रोकना !

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