Finance Minister P Chidambaram's advice to companies complaining of a demand slump is based on the healthy profit margins they still continue to enjoy.

MAHESH VYAS
MD & CEO, Centre for Monitoring Indian Economy Pvt Ltd

The finance minister has suggested that industry must cut prices of their goods and services rather than cut production in response to a slower growth in demand. And, industry leaders have responded that a price cut is not a solution. Several news reports and some data suggest that industry is cutting production rather than prices. I do not think that consumption demand will have slowed down suddenly. It grew by nearly eight per cent in the quarter ended June 2008. Incomes have grown robustly — the wage bill of listed companies grew by 24 per cent in the quarter-ended September 2008.

The effect of the Sixth Pay Commission, the direct tax cuts announced in this year’s Union budget, the increase in farm produce prices and output cannot lead to a fall or even a slowing down of consumer spending.

But, if industry leaders know something that we do not and if demand has suddenly slowed down, then, the finance minister’s solution is correct that industry must drop prices to maintain their markets.

Corporate results show clearly that industry is currently enjoying very high profit margins. This provides them with the cushion required to reduce prices and keep growing the size of their market.

Net profit margin of non-refining manufacturing companies was 7.5 per cent in the quarter-ended September 2008. This is high by any standard. Net profit margins usually hover around three to four per cent.

Corporates have enjoyed high margins of over-seven per cent for four consecutive years. This has built their reserves and given them the financial power to whether the current storm. It has also fuelled their capex binge in recent years.

Thanks to this build-up, corporates have been able to withstand the sharp increase in input costs in recent quarters. Margins have fallen over the past one year as a result, but they are still very high. As of the quarter-ended September 2008, the steel industry had a net profit margin of 11.5 per cent and cement had a 12.5 per cent margin.

The real estate sector saw its sales fall by 1.5 per cent in the September 2008 quarter but it had a net profit margin of a whopping 39 per cent. Automobile companies had a lower margin of around 5-6 per cent. Even this provides sufficient cushion for them to reduce prices. Besides, they would gain from the expected fall in commodity prices.

Industry’s apparent resistence to the suggestion of a price cut reflects the existence of strong demand. If demand is strong then, industry would not cut prices. Its cuts in production could either be a means of supporting prices at high levels or an immediate reaction to the unusual uncertainties caused by the financial crisis.

PRABAL BANERJEE
Group President Finance & Group CFO, Hinduja Group India

‘Industry is still stuck with high-priced raw material contracts and the drying of exports as well as the severe shortage of funds means there is little scope to cut prices right now’

Reducing the SLR/CRR and repo rates have been very helpful since this will ensure greater availability of money as well as a reduction in costs. As we know, the earlier steps taken by the finance ministry/RBI were very effective in controlling inflation, but industry suffered as the cost of money went up and demand got affected — for both industry and the market, availability became an issue.

While there is no doubt that latest steps would ease the strain on industry, industry would possibly need to look at the demand for price reduction from various angles before taking a final call.

Firstly, the overall demand for all products has been impacted substantially, reducing the scope of industry to make enough profits — the gap between break even point levels of production and actual production/sales level are narrowing. That being the case, the flexibility of industry to subsidise products from a resource pool of higher volumes is somewhat limited.

Secondly, though the very right step by the finance ministry/RBI will help industry, the most important issue that still plagues the industry is the raw material cost. This is for various reasons — industry still has stocks of raw material and work-in-progress that were bought at old prices and these costs need to be recovered on a first-in-first-out basis. In addition, industry had already entered into medium-to-long-term contracts to save on raw material costs at a time when costs were rising — these contracts are still valid and industry cannot renege on them. Hence, even the drop in prices of various commodities will take some time to reflect in actual prices to be paid by consumers.

Thirdly, the global meltdown has also made it difficult for the Indian industry to take positive steps as it is seriously hurt by the drying up of export opportunities in countries like the US and Europe. With such impact on profitability — or should we say “survival” — Indian industry is really facing serious business issues.

Fourthly, growth capital sourcing is another issue which is haunting Indian companies badly — both the international credit and equity windows are virtually closed for them. With such lack of financial resources, the cost competitiveness of Indian industry is getting more misaligned from global benchmarks, thus making it difficult for it to rationalise the cost and pricing structure at this point of time — the fact that Indian capital is relatively more expensive and is limited in its availability compounds the problem.

In view of this, the call for price reduction will certainly materialise — but with “a time lag” due to the inconsistencies existing at this sudden turn of events. The monetary steps are in the right direction and with demand improving with more liquidity and lower interest costs, the supply side will also improve. In the medium-to-long term, this should bring in price moderation and stability.

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