Nikhil Gupta: What's driving the growth of corporate profits? Here's what the data says

How large are India's corporate profits? Whenever this question is raised (or if you Google it), the response would be something like this: 'Corporate profits in India have more than doubled in the post-pandemic period from about 2% of GDP to 5-5.5% now.' This answer is correct, but partial and thus misleading. This response pertains to only listed (or BSE500) companies, not the country's overall corporate sector. A macroeconomic identity, which we call the 'Theory of Everything,' says that total investments in an economy are equal to the sum of gross domestic savings and the current account deficit (CAD). In simple words, every paisa invested must be financed either by domestic savings or foreign borrowings (represented by the CAD). The modification of this identity is the same as the one developed by Michael Kalecki and Jerome Levy (popularly called Kalecki-Levy model). Corporate profits equal net corporate investments plus dividends paid minus household net financial savings plus the core fiscal deficit minus the CAD. Applying this equation to India confirms that India's aggregate corporate profits have been around 9-10% of GDP during the past decade. Past data suggests that India's corporate profits averaged only 3.3% of GDP during the 1990s. As the economy gathered momentum in the mid-2000s, corporate profits reached an all-time peak of 10.1% of GDP in 2007-08, after which they dropped to 7-7.5% immediately after the 2008 financial crisis. They picked up slowly to touch 9% in 2013-14 and have hovered around 9-10% since then. A comparison with other major economies reveals that India's profit is comparable to that in the US, South Korea and the UK, but higher than in China, Japan and the eurozone. In fact, while profits have fallen in China and Japan, they have been stable in India in the post-pandemic period, just like in the US. It is also interesting to note that corporate profits across major economies have either been stable or improved in the post-2008 and post-2020 periods. The only exception being China and Japan. What are the key drivers of profits? The beauty of the abovementioned equation lies in the details it provides. Many a time, it becomes difficult to make sense of rising corporate profits amid falling corporate investments. This analysis, however, helps us solve this puzzle. Corporate profits in an economy are positively correlated with investments, dividends and the fiscal deficit, while they are inversely correlated with household savings and the CAD. The greater the (net) corporate investments/fiscal deficit and lower the household net financial savings/CAD, the higher are the corporate profits. The explanation is straightforward. Whenever any economic participant (i.e., corporate, household or the government) spends, it leads to higher revenue and thus profits for the overall corporate sector. When they save more, it is anti-profit. Similarly, when domestic participants spend on imported goods, it means lower profits for domestic companies, while exports are profit accretive. Thus, a higher CAD is a drag on domestic profits. Three key conclusions from the equation are: One, net corporate investments, the primary driver of profits, have fallen in the past decade, dragging profits down, which is in stark contrast to the previous decade when higher corporate investment was the major force driving profits higher. Two, lower household savings have been the key driver of expansion in corporate profits during the past 15 years. Similarly, a sharp reduction in India's external deficit (CAD) has also supported corporate profits in the past decade. Three, an expansion in the core fiscal deficit has supported corporate profits in the post-pandemic period, while it was narrowing in the 2010s. Thus, investments are not the only driver of corporate-sector profits. They are also linked to the economic behaviour of the household and government sectors, and they also depend on external transactions. With a larger fiscal deficit and lower household savings in evidence, an important policy diagnosis is that lack of consumption demand is not an issue in the economy. What are its implications? There are two key inferences. First, higher corporate savings (now at 13-14% of GDP versus 11-12% in the pre-2009 period) and lower government dis-savings, since capex now accounts for higher portion of their expenditure, have helped offset lower household savings (at 20-21% of GDP now versus 23-24% pre-2009) in the economy. Gross domestic savings (GDS), thus, have remained stable in recent years, which is what matters from an investment funding perspective. Second, with higher savings and weak capex growth, it is apparent that the corporate sector remains highly cautious in India. One way to quantify it is to examine the difference between their savings and investments. As against net borrowings (savings less investments) of 8 percentage points of GDP in the mid-2000s, India's corporate sector has saved more and invested less in the post-2008 period. Indeed, its net borrowings averaged only 1 percentage point of GDP in the past decade. Further details confirm that it's the private corporate sector that is largely responsible for high investments in the mid-2000s and also low corporate capex in the post-pandemic period. What does all this mean? India's economic growth is driven by the household sector, while corporate spending has been weak. This is clearly unsustainable since household income growth has been lagging while corporate profits have been elevated. It is not surprising then that household savings are falling and leverage is rising, with reverse trends in the corporate sector. If India's economic growth must stay on a sustainable high-growth path, then higher corporate capex and a rebuild-up of household savings are non-negotiable. But why isn't corporate capex picking up? We will discuss that in the next piece. The author is an India Economist, executive director at CLSA India, and author of 'The Eight Per Cent Solution'