Growth debt is an attractive minimally dilutive debt instrument for financing growth companies. These companies have established product market fit and generating stable recurring cash flow. They are entering into an unrelated industry venture, risky turnaround, or gushing to scale up their operations, which requires financing but traditional debt is hard to access, while founders and investors cut back on their stake dilution. Every so often growth debt is sweetened with warrants ensuing lenders get onboard with the company’s growth vision. When NBFCs would lend at 12–13% with collateral, growth debt lenders charge 16–17% at not so stringent terms — subordinate debt, less collateral, with or without modest warrant coverage and convertible clause etc.

The credit market has been on a structural uptrend for more than two decades in India. Growth companies in India have regularly sought growth debt financing from lenders including marquee names such as KKR India. Dalmia Cement, Coffee Day Enterprise, GMR, CG Power, Bharti Infratel, Amtek, and Magma Fincorp to name a few have resorted to growth debt at some point in time.

There have been both hits and misses historically in lending to such growth companies. A high-yield debt portfolio of risky bets has not always paid off well in the Indian scenario. In around 2015, betting on India’s growth KKR India Financial Services (KIFS), the wholesale lending arm of private equity giant KKR was on a book building spree. In 2018, it experienced NPA as high as 50% on a book size of around $800M. It takes great prudence to manage a portfolio with such a risk-return profile.

What makes growth debt attractive?

Growth debt essentially serves two end uses- financing risky ventures and providing runway liquidity to companies till market conditions improve. Growth debt borrowers trade off higher rates of interest for accessible terms and convenience of finance. Convenience often comes in handy with growth debt financing. Private Equity capital and traditional debt can be painstaking as it takes a long time and bulky documentation to get sanctioned and close the deal. Moreover, there is a considerable legal and investment banker’s fee incurred in the process irrespective of whether the deal goes through or not.

Another aspect is the company’s preference for averting steep equity dilution which however is the usual outside means for financing of risky ventures and turnarounds. In undesirable times, when a company is getting a lower-than-desired valuation, the company might prefer to raise by way of debt over equity.

For companies, growth debt doesn’t give the lender the board seats, unlike equity financing. This is great for companies who do not wish to compromise on the company’s control. Companies can top up growth debt with warrants to make it lucrative for lenders as it allows them to enjoy the upside as well. Warrant issuance is covered more in detail later in the post. Lenders can add a convertible clause making debt convertible to equity to cover a credit event.

Debt enhances the return profile but is also accompanied by volatile earnings and agency costs. Moreover, companies with longer working capital should use debt to finance the working capital and shouldn’t be equity financed.

Empirical studies have shown that the optimal addition of debt can enhance the value of a company by 10–17% of the addition to debt. A company that switched from an all-equity capital structure to one that included $10 million of debt would, therefore, see its value rise by $1 million to $1.7 million.

Raise when you can — add cushion

Growth debt can be used to add to the cash buffer for the foreseeable cash burn, extending the cash runway to the next milestone. Therefore, ambitious companies in expansion mode should consider raising debt when they can —having both, considerable creditworthiness and favourable market conditions coinciding because, in times when either condition is not met, it is difficult and costlier to raise. Such cushioning should be done only when the company has a clearly outlined plan and the fund can be sourced at reasonable terms and rates of interest. In uncertain times, companies should carefully evaluate trade off between asset quality and growth. Growth debt taken for rainy days might turn dangerous as well.

Growth debt vs Other forms of capital

Growth debt and venture debt look alike but are quite different in terms of underwriting thesis and risk profile. What private equity is to venture capital, growth debt is to venture debt. Venture capital and venture debt are more suitable for the companies in early-growth stage whereas private equity and growth debt suit mature companies. Venture debt is often indented to enhance the outcomes of the venture capital already invested into the company. Growth debt is normally available to both- VC-backed and standalone growth companies for risky expansions and turnarounds.

Growth debt is financed at less strengthened terms than that of bank debt. Debt financing has certain attributes — the company’s unit economics make sense or at least there is a viable business sense i.e. considerable and predictable cashflows and the company has accumulated sizable positive networth and fixed assets which is good for collateral and has a foreseeable low risk of insolvency. Bank debt is usually the cheapest form of capital. But when some of the aforementioned attributes are dubious such as low collateral or unstable cashflow etc. then companies resort to growth debt lenders.

However, you get to see companies financed by both banks/NBFCs and growth debt lenders. Companies going through a hard phase and overburdened with debt often seek risk capital for turnaround either in the form of equity or growth debt. In such a situation, bank debt is often inaccessible and equity comes costly, there, growth capital comes to the rescue and often comes along with warrants and is sometimes issued as convertible debt. In 2011, Avantha Group raised ₹1000 crores of growth debt with a convertible clause for its power venture- CG Group. But when coal block allocations were cancelled, the debt became unserviceable and got converted to equity worth less than 1/10th of the loan amount.

Add on to Venture Capital

Like venture debt, growth debt can be an excellent add-on to venture capital, complementing recent venture capital funding round. By this stage, the lender gets to know the company and its prospects considerably well and has updated corporate information. Lenders can underwrite basis terms of deals in the recent rounds of funding and credibility of the investors.

Venture debt usually comes after the first round of venture capital financing of the early or growth stage companies and it often comes along with 2–10% in warrants which allows them to also participate in the upside of the company and the incentives align such that the lenders root for company’s growth and not just their survival until the debt is repaid.

If the same firm or its sister company has previously participated in any of the previous rounds of equity financing, the lender feels compelled to onboard with the promoters with a long-term view. Whereas, founders and existing investors can avoid further dilution as funding requirements for subsequent milestones are achieved by growth debt.

Warrants topup on growth debt

Borrowers should discreetly make use of warrants as a bargaining chip to lax covenants of the debt. Incorporation of a modest 2–10% warrants to the debt would make the deal look appealing to the lender as they can also enjoy the upside, ensuing lenders' corporation in hard times.

If the company lacks hard assets and doesn’t have holding group comfort or any sufficient financial guarantee, then the lender should seek warrants. Warrant can be issued in two ways, either entitle the lender to exercise a certain number of shares on or before the expiry date at a pre-determined price, or set a fixed percentage of the fully diluted ordinary share capital to be represented by shares on the exercise. The latter entitlement arrangement on a fully diluted basis will protect the lender (investor) from any dilution made between the issuance and exercise dates.

If the interest rate on debt is on the lower side, then no. of warrants can be kept on the higher side in order to balance the risk-return profile. If the warrants get exercised, it typically translates only to 1–2% dilution of the company. This is significantly lower than what it would have been if the company was fully ventured capital funded.

Example: A lender provides a company venture capital funding of Rs 10 crores with 10% warrant coverage. The company issues a warrant to the lender for Rs 1 crore worth of company shares with an expiry of three years, with a strike price valued at the current company’s equity value of Rs 500 crores. In two years, the company’s valuation zooms by 50% to Rs 750 crores and the lender decides to exercise the warrant to buy the company’s shares, now worth Rs 1.5 crores, thereby enjoying a fair upside from the deal.

The lender must look for anti-dilution protections of the warrant issuing company. If the company has already taken on venture capital, there are good chances that the investor has the benefit of anti-dilution protection that provides downside protection which may apply to on exercise of the warrant as well.

Risks to Growth Debt

Debt is cheaper but it has certain hidden costs to it. One of the hidden prices often reins in the form of decreased flexibility. The growth company plans to take on risky ventures but the introduction of debt itself reduces the risk appetite of the company. Therefore, a sensible debt policy must be arrived at to have payoffs of debt capital more than that of equity.

The borrower needs to ensure that it is able to comply with all the debt covenants at all times, particularly in adverse times wherein the company sees a plunge in revenue, shrinking operating margins, dry equity funding, debt refinancing risk etc. which in extreme cases might invoke a credit event or make debt unserviceable. Growth debt is usually subordinated debt thus in event of restructuring or liquidation, it gets paid only after the senior debt is paid off.

Empirically, any overuse of debt lowers the payoffs for the investors and its lender. Therefore, CFOs must be clear on the real financing requirements and special characteristics in terms of currency, maturity, etc. and outlay a pragmatic debt policy. Most mistakes are made in buoyant times when the projections look just too good. In order to seize the opportunity, companies get tempted to take on too much debt which gets painful or even fatal in correcting times.

Navigating through inflation times

High inflation periods are often volatile and the interest expense amplifies the bottom line, thereby EPS, and by extension, the share price. Investors do care about volatility in share price. Whereas, lenders worry about the repayment risk in case inflation hits the company adversely.

Inflation allows borrowers to pay lenders back with money worth less than when it was originally borrowed, which benefits borrowers. Further, a higher risk-free interest rate in the economy also results in a higher warrant price and a similar positive correlation also follows with higher implied volatility.

Both the borrower and the lender should keep a close look at certain ratios particularly — liquid assets to short-term debt and interest paid as a per cent of EBIT. The former ratio keeps a check on any heightened default risk while the latter checks on the volatility of earnings. Inflation will reduce the former ratio and adversely increase the latter thereby heightening the risk of credit event.

Who can provide risk capital?

India is a large size credit market with a competitive landscape. When the market leader, HDFC, the largest lending house in India, has been clocking 20 per cent growth for more than 20 years speaks of India’s market size and the latent room for growth. The size of the total lending market in India has grown to Rs 174 lakh crores as of March 2022. The economy expanding into unchartered business activities, and risky turnarounds are part of India’s growth story. This is financed by ‘risk capital’ — either in the form of equity or debt. But not everyone has risk capital. Most importantly, managing a high-yielding portfolio of risky assets is not everyone’s cup of tea. It requires great expertise to manage such skewed risk-return assets.

Traditional banks in India are generally averse to risky financing especially after having gone through a dramatic rough phase of high NPAs in the last decade, and rightfully so as they, on the other hand, have been entrusted with more Rs 140 lakh crores of depositors' money which they deem very-secure. Moreover, many Indian banks, especially the PSBs are not well capitalized, thereby lacking sufficient ‘risk capital.’ However, India has several NBFCs and AIFs which have expertise in this domain. They are often backed by private equity capital, large corporate houses and also gets funded by QIPs, even bank debt (usually lent to the holding company instead of a particular operation), and readily caters to companies seeking growth debt.

The size of the lender has great relevance in India. The ROA (return on assets) starts to fade for large lender groups after reaching a typical book size of Rs 20k- 50k crores. They are therefore compelled to resort to risker products or innovative lending channels. But lenders with weak or without parentage aren’t able to take on much leverage, thus, such companies in order to achieve a high ROA resort to high-yield products such as unsecured microfinance loans, construction loans, etc and growth debt is one of them.

High yields add to the portfolio risk. India has witnessed periods of reckless book building spree such as PNB Housing in around 2013, NBFCs in the period before the IL&FS debacle in 2019. Poor loan book has its ugly results setting in with a lag of a few years. Whereas, a strong book ensues growth over a long-term horizon, such as seen with Kotak Mahindra Bank. The availability of risk capital is sensitive to market sentiments. Post IL&FS and DHFL debacle in 2019–20, Covid times 2020–21, the risk capital disappeared for a good duration as both lenders and investors grappled with fear and uncertainty showed high reluctance to extent risk capital.

Note- views on any entity mentioned above are my personal views and may not be factual.

A monopolistic business with strong tailwinds in India, India’s most prominent 86 years gymnasium brand ran by a family business with seemingly strong management with decades of experience, marquee investors and individual investors including Jennifer Lopez, subsequent strong set numbers in the results, a fine-looking balance sheet numbers with rising profitability, and a company on an expansion spree with new offerings enhancing high growth prospective. The IPO came in 2010. This is how the Talwalkars looked till 2015–16. As promising as it sounds, it wasn’t a buy-and-forgot stock for the long term.

The demerger didn’t create synergy

Talwalkar Healthclubs Ltd (THL) was demerged into Talwalkar Lifestyle Ltd (TLL), the core gym business and Talwalkars Better Value Fitness Ltd (TBVFL) which got the wellness business, effective from FY 2017–18. There was also a lot of ambiguity in the naming of the demerged businesses as a result of which TBVFL was widely mispriced at its listing as many investors thought it has the core gym business and were locked in lower circuit for several days.

The management was selling the vision of future cash flows by subsequently announcing new (cash-intensive) ventures, partnerships and expansions. Some of these ventures being too modern and largely untested in India, essentially it sounded like a long shot success on Indian soil.

The wellness business was incubated with the core gym business and over 3–4 years it had to acquire scale and character. One of the prominent thesis for the demerger given by the management was greater respective valuation realization of the independent entities. Did it make you think of the infamous Sintex’s demerger attempt to create value that end up destroying wealth?

Even though the wellness business was accounting only~25% of the revenues in FY16, but it scaled largely within the company’s existing infrastructure. Independent studios for wellness businesses further only enhanced the costs. The company had several major wellness projects such as Zobra, Nuform and Reduce. By 2017–18, Zobra expanded to 78 centres and Nuform to 76 standalone centres. The most cash-intensive venture in wellness was the David Llyod, a 50:50 JV with Europe’s David Llyod Leisures.

The spree of expansions and joint ventures were undergoing pretty much in the same time frame. But the demerger had separated the cash-cow gym business from the wellness. To fund these, the company was aggressively raising new capital every year both from debt and equity. In fact, more money was raised for the gym business expansion. Money was raised from QIPs and other outside investors. The larger portion was debt funded — term loans and non-convertible debentures on a regular basis over years. Interestingly, the debt-equity ratio and interest coverage ratios were good looking during that period. The company keep selling newer and newer visions, raised more money, but cash flows didn’t follow, profits were dubious and one day the music finally stopped.

How real were the profits?

The company had a consistent dividend payout ratio of 8–13% from 2011 till 2016, post that payout increased further until the default. That’s a good sign, a dividend paying company is some basic assurance that the profits are real. Let's dig a little deeper and see the taxes as no company wants to pay taxes on fake profits.

For the eight years of period FY 2011–18, the have combined the PBT and the taxes paid and the effective tax rate comes out to be around 33%, which looks great, seems the profit are legit. Had it been low at below 22%, I would have objected to the legitimacy of profits.

The company was posting decent CFO over years, the CFO/PAT ratio was seemingly in a healthy range for most of FY11 to FY18 (refer to the table below). No problem till here.

However, a better way would be to see core-CFO (cash flow from core operations adjusted to exceptional items) to PAT ratio, above 70% would be fine. Despite good CFO, FCF was consistently negative over the years which was funded by aggressive borrowing and equity capital.

Now, let's put a more revealing test- comparing operating profits with CFO over the long term shows the indisputable reality of profits. I calculated operating profits as a percentage of CFO for FY2011–16 (till before the merger) and another for FY2011–18. The company posted an operating profit of Rs 601 crores against a CFO of Rs 368 crores. That’s a clear manipulation of profits.

Dubious Gym Fundamentals

Well, I have seen a couple of gyms, to what appears to me is that gym business requires regular new memberships, so it should be a high turnover business, that should guide the business ROCE. However, the turnover for the company was dismal, hovering at around 0.5 for most of the years.

Moreover, gyms and even wellness centres charge you upfront as a norm in India. I have paid 9 months upfront for gym membership. But here, the debtor days averages to over two months.

I tried looking at sales per gym and the corresponding capex during the good years. Talwalkars was clocking over 1 crore of annual sales per gym. I found that Talwalkars Gym used to charge around Rs 30,000 pa for gym membership back in 2015. So, to achieve sales of 1 crore, there should be at least 335 annual members. I leave that on you to judge if that’s achievable.

There was some serious abnormality while looking at the newer gyms and clubs added per year against the capex happening — illogical and dubious. In FY2014, for incremental addition of five clubs, the company did a capex of Rs 117 crores and in FY2015, Rs 110 crores capex for a single new club. Then, I found many answers in related party transactions (below).

Related Party Transactions

The company had sizeable related party loans (RPT) as given in the latest available AFS of both the demerged entities.

It would be inquisitive to see the combined RPT as a percentage of combined sales.

That’s a really very high outflow, totalling 20–60% of yearly sales on account of related party transactions. The company had also given corporate guarantees to four of its subsidiaries to the tune of Rs 260 crores (outstanding as on FY16). When the company went into financial distress mode, there were dismal gains from its subsidiaries and other JVs, except for some fees and other small incomes, I couldn’t find these loans paid properly or called back till the latest available AFS 2017–18 even though Talwalkars had a controlling stake in them. The worst aftermath is explained below.

Between 2016–18, Rs 209 crores went to Denovo Enterprise Pvt Ltd, 50:50 JV started in 2011. Prior to 2016, the franchise fee to Talwalkars from Denovo was dismal and a large part of the fee (80–90%) was lying into the receivables. The rationale for this another Rs 209 crores wasn’t stated but we can assume it could be a JV obligation.

Another large transfer of Rs 450 crores was made to PWG (Sri Lanka) between 2016 and 2018. Further, PWG was an associate entity (lower status than a subsidiary or a JV). Any lender should have objected to such a large related party transaction, especially when the company is itself posting high negative free cash flows amidst the rising cost of capital.

🚩Expanding when cash-strapped

As an investor, I love to hear expansion stories as it’s all about growth but it should be sustainable. Let’s have a look at the reinvestment rate over a long period — over 150% reinvestment rate for straight six years! Too good to sound sustainable.

The negative FCF was mostly funded by debt and equity, and lesser by the internal accruals. That wasn’t a frugal expansion but a totally reckless one. The David Llyod JV was the final coffin for Talwalkars, one week after the inaugural of the luxury club, Talwalkars missed its first interest payments to the banks.

🚩Promoters Selling

In 2015–16, the key promoters reduced their holding by more than 5%, bringing promoter holding down to 38% in FY16 from 43.3% in FY15. This time around the company’s stock price also made a peak. The red flags were visible and the market was more vigilant. Perhaps, the management was cognizant of the downward trajectory that was to be followed for the next four years till the default.

The Music Stops

Talwalkars accounts with the major lenders (Axis Bank, The South Indian Bank, Andhra Bank and others) slipped into SMA0 category (SMA0 means meaning principle/interest is overdue for 0 to 30 days) on 31st July 2019.
Just one week before this credit event, the luxury David Llyod club in Pune was inaugurated as one of the most promising ventures. The overdue was due to non-payment of interest on term-loans and not on the principle amount (which is usually far lower than the interest component). This was an indication that this wasn’t just a small asset-liability mismatch (ALM). Then a chain of helpless events followed-

Aug 10, 2019: Prashant Talwalkar, Managing Director and CEO resigned. Followed by two full-time directors and an independent director resignation.

Aug 26, 2019: Independent director, Raman Maroo resigned.

Aug 28, 2019: M K Dandeker & Co. resign as auditors, stock hits lower circuit.

Axis Bank, the lead bank in the consortium dragged TBVFL to NCLT. A forensic investigation was called in. Another lesson for the market.

**********

Thank you for reading. I hope, it was insightful for you.

Food Delivery Service Market Behaviour and Risks

1. Trusted brand, best value, and great experience largely define user sentiment for a platform. As historically seen, a small negative PR event can often cost the platforms dearly, wiping out years of growth.
2. The food delivery business is a moderately defensible business. The barriers to entry are moderate as companies rely on high turnover and very low operating margins.
3. A constant flush of funds is required to cover for negative margins and frequent acquisitions and that the music mustn’t stop.
4. Much of success depends on the ability to raise funds, continuously over time. A solid reputation amongst the VCs, PEs, and public market (IPO) with a Godfather is as important.
5. One shouldn’t be in the food delivery business alone for a very long time- it’s fatal. Companies often plan to venture into similar delivery segments such as grocery, pharmacy delivery. This not only increases their turnover but also certain segments improve their average profit margins.
6. Growth in food delivery revenue usually remains higher than growth in food delivery app users in most of the countries.
7. The dumbest player often sets the prices. It’s partially true for food delivery services but it has a wide ranging impact. Much like the online services competing for airline ticket booking, the cheapest ticket gets sold. It’s a double edge sword, restaurant commissions on one side and price sensitive Indian people on the other.
8. Companies have to constantly spend on advertising and discounts.
9. Proactive management and strong funding backup (godfather) are key to survival.

Moderate Network Effect

This is an insightful concept to understand the defensibility of platform business. Network effect is key to the thriving of a platform business. Airbnb has by far the strongest network effect. The network effect in food delivery businesses is quite similar to that of ride-hailing services such as Ola-Uber.

A traveller on Airbnb would care about the hosts all around the world except for her locality. Whereas in the case of a food delivery service, say Doordash, she would only care about the food delivering restaurants in her locality available within the platform.

Platforms on global networks are much less vulnerable to challenges because it’s difficult for new rivals to enter a market on a global scale.

Much of the comfort lies in the reliability of the platform to make good food options available wherever the user goes without having to switch to other services. Therefore, food delivery and ride-hailing companies should constantly and aggressively expand their presence across geographies so as to look omnipresent to the users. This also means frequent acquisition of local or emerging players which is capital intensive.

There are some local threats as well in the food delivery business. Some local restaurants provide their own delivery service in their proximity, which intensifies as restaurant commissions increases. Some have their own delivery fleet, eg. Dominos. Restaurant commission is core to the profitability and also a moat which is often attacked first by the new entrances. Read this recent development — Amazon Food’s reduced commission rate may hurt Swiggy, Zomato’s growth.

Profitability is nowhere near and difficult to achieve

As we have already discussed how network effect moderately plays out in favour of such platforms and how increasing profitability through restaurant commissions faces resistance and threat. The margins in food delivery shall continue to be low for a very long time. Meituan, China’s largest food delivery service with around 60% market share, has an operating margin of -5%. Doordash, in the US, has an operating margin of -10%. The key to profitability is ramping up the turnover.

The food delivery business is a launchpad and a good one

Once you have a wide user base and logistics in place, food delivery companies should venture into other segments such as grocery or pharmacy delivery. The profitability margins are expected to remain shallow forever and therefore companies must focus to ramp up their turnover via new offerings so as to improve their operating margins. With a little incremental capex, a company can easily expand its offerings that would disproportionately reflect on their ROIC.

Recently, Meituan announced that it would be entering groceries and ride-hailing businesses. Zomato’s competition is not only with Swiggy but any company with deep pockets or at least a godfather investor with deep pockets. In the Indian context, Zomato’s key rivals are Amazon, Reliance, Tata, and Swiggy. All of them are aggressively entering into one or another platform business and moving into each other’s territory. In the indispensable quest for expansion via new offerings, Zomato will face them head to head while venturing into their segments and also when these companies venture into the food delivery business.

Market leadership is not a strong moat- always under threat

In the US, Grubhub was a market leader with a market share of 70% in 2016 and other players were relatively very small, it fell down to 20% in 2020.

Grubhub couldn’t stand the onslaught of Uber and DoorDash, both have been funded by Softbank.

One bad PR can cost the company dearly. Either you love it or hate it, India is one of those extreme nations.

Such businesses are definitely not buy-and-forget stocks. The key is to have proactive management that can oversee such threats. Zomato seems to have great management (discussed later). Zomato has Infoedge as godfather which is big but not that big. Its closest competitor, Swiggy in India has been funded by Meituan (backed by Tencent/Naspers). There is no dearth of PEs firms willing to throw new money in this game of increasing valuations so long there is growth. In such games, consolidation means death.

The Indian market has strong tailwinds in food delivery services.

Backed by increasing smartphone users and digitization.

Growth in food delivery revenue usually remains higher than growth in food delivery app users in most of the countries.

The “Next Billion” are flowing into Aspirer and above categories

Aspirer, affluent, and elite Indians are apparently the users of food delivery services, growing rapidly at 6%, 9%, and 13% respectively (10 yr compounded growth).

Reasons for lower valuation multiple to Zomato below global peers

1. GDP per capita in India at $2000 is much below the global average of $18000. Lower disposable income makes India a price sensitive market, thereby less loyalty as customer succumbs to greater discounts.
2. Only 34% of India’s population resides in urban (2019) and is projected to increase to 37% by 2025. In China, 64% population lives in urban areas. It’s important because food delivery businesses are only feasible in high density urban areas.
3. Food delivery businesses plan for profitability once they have reached high user stickiness and a wide user base with a defensible network effect. It has not even happened in mature food delivery markets. Meituan and Doordash haven’t made any profit so far and profitability nowhere near. Given, India’s food delivery market is still at an early stage, it’s a very long call and it’s difficult to expect profitability in years to come.

Reasons for higher valuation multiple to Zomato over global peers

1. There are strong tailwinds in the food delivery segment in India.
2. The Management and work culture is one thing you absolutely cannot miss while evaluating Zomato. Zomato has seemingly a high demanding work culture and employees have also risen up the hierarchy. The company has handsomely rewarded those who have done added a significant value to the extent of elevating some of its employees to co-founder level, a practice seldom heard of. The women's representation is also significant at the top levels. Further, the board of directors and KMP looks pretty competent comprising people with diverse backgrounds and rich experiences.

A business with several cons but a few strong pros can sometimes create great value for investors. The food delivery market is marred with several shortcomings for all the reasons we just discussed. Good management and strong tailwinds in India could be the prominent points for an investor to count on.

A raw role of a central bank is to lubricate the economy by controlling the money supply in such a way best understood by Fisher equation, MV = PY, where M = Money Supply, V= Velocity of money in circulation, P= Price Level and Y =national output. This equation is central to monetarism school of thought, formulated by Milton Friedman. Monetary tool has evolved a long way in last half a century and has taken the prime position globally in driving market sentiments, spurring demand and controlling inflation. While most other major tools- fiscal stimulus, consumption demand, etc. have shown their limits in several economies, central banks globally have seemingly taken the charge to spur growth and market sentiments. This is an inorganic way of growing an economy. The problem worsens further if the capital expenditure returns a low economic multiplier in the economy, then the debt becomes more of unsustainable debt. It continues until one fine day when it can no longer hold.

Monetary Delivery: GDP growth to M2 growth

M2 which is a narrow money metric comprising of highly liquid assets, is the best indicator of money supply in an economy and is often targeted by central banks. We shall compare the how major economies have fared in GDP growth vis-a-vis growth in M2 supply over last decade. Here, in my discussion, I will use the word “Monetary Delivery” defined as a ratio of GDP growth to M2 growth during a certain period, as a measure of GDP growth compared to monetary injection by the central bank.

In China, during the period from 2009 to 2019, the M2 money supply has roughly grown by $20 trillion, while the GDP grew by just $8.4 trillion during the same period. That means China’s GDP grew only by 42% of M2 supply growth.

During the same period in US, the M2 money supply growth and GDP growth remained roughly the same at $6.1 trillion. So, the GDP grew 100% of M2 supply growth during the period which, despite, includes years of quantitative easing by US Fed and years of near zero interest rates. Historically, the ratio has hovered between 160 to 250 % for the US. Euro area which also had long years of ultra monetary easing, witnessed a decent 93% GDP growth of M2 money supply growth during the same period.

Now, let’s have a look at another Asian country, India which has similar demography to that of China. Post 2008 GFC, India’s central bank sharply lowered its policy rate, but within a span of two years 2010–12, RBI worked on absorbing excessive liquidity. During the period of 2009 to 2019, India’s monetary policy mostly remained tilted to the tighter side. Hence, it posted an excellent monetary delivery- GDP growth of $1379 billion against $280 billion growth in M2 money supply growth which is almost 5x.

Fiscal Stimulus Push and the Big World Class Chinese Infra Narrative

Post 2008 GFC, China responded heavily via fiscal stimulus (see fig 1), which pushed monetary trajectory- Broad money as a % of GDP, further towards the monetary trajectory of Japan, which has experienced lost decades (chronic deflation and low growth).

But the bigger inquisitive question remains where and how did this money get channeled? Why has the monetary delivery remained elusive despite revival of exports and domestic demand after 2010 in China? In case of Euro area and USA, which have full current account convertibility, there was a sizable spill over to the rest of the world from both the avenues. But that hasn’t been the prime case for China, although it has lent several billion dollar lines of credit to several nations worldwide- China’s debt diplomacy. A big chunk of this money was channeled to finance large infrastructure projects, a good part of which are un-sound projects. The severity of situation remains vague due to lack of transparency in Chinese data and policies.

Low Growth Multiplier?

The M2 growth of $20 trillion against a stunted GDP growth of $8.7 trillion between 2009–2019 still remains unexplained. Living in Mumbai, I have been reading about stress in commercial real estate projects lately- a large Rs 47k crores of unsold inventory lacking demand in Mumbai, and the entities who have financed it. Therefore, the current outlook of lenders is to reduce exposure to such projects. In contrast, I get to think how those ghost cities in China get financed along with several big infra projects- typical Chinese narrative in social media!

Rather than build incrementally, adding infrastructure if and when it becomes necessary. China has herd-like, embraced the if-you-build-it-they-will-come model of urban planning. As a corporate banker, the economic feasibility of such projects from lender’s perspective is beyond my understanding. However, this has been possible because of financing by State owned banks at the will of the State. Now, I have start seeing where and how did a chunk of this $20 trillion get channeled.

Someone has to bear the economic brunt for all those uneconomic activity. Notably, in last decade, several Chinese banks have made to the top ten global banks with fat balance sheets. Chinese banks weren’t under pressure from CBRC to adopt the then introduced Basel I and II capital adequacy norms. Then there came a sudden push from CBRC starting a few years back to adopt Basel III norms which asks for 8% capital adequacy ratio which many regional banks, according to a post in South China Morning Post, has found it difficult.

Last month, we have start getting news like - “Another Month, Another Chinese Bank Bailout”- WSJ. After the takeover rescue of failing Baoshang Bank, another big bank, Bank of Jinzhou is facing severe liquidity problems and has got State intervention last month. I found a list of banks who have delayed annual reports here- Bailout #3: Chinese Bank With $200 Billion In Assets Is Nationalized. This is a red flag and might be an indication of the bigger problem.

It is difficult to gauge the actual size of the brewing banking problem in China as the state controlled information is slow to come out to the world. I am still not able to justify the $20 trillion monetary injection which produced only $8.7 trillion GDP growth over the period. It should get reflected somewhere- in exchange rate, inflation rate, GDP growth (includes consumption and exports), debt diplomacy or somewhere. The question of economic feasibility and sustainability of use of money in terms of returns and responsibility is also very important as otherwise it poses a domino-solvency and credibility risk to the whole system.