Date: 20/09/2022

Relevance: GS-3: Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment.

Key Phrases: Unicorns, Soonicorns, Market capitalization and revenue, Easy monetary policy, negative real interest rates.

Context:

• India has emerged as the third largest startup ecosystem in the world, with 107 unicorns with a total valuation of $340.79 billion.
• Let us explore the prospects of unicorns and startups in India.

Background

• In business, a unicorn is a privately held startup company valued at over US$1 billion.
• The year 2021 witnessed a record set of 44 entries to the coveted unicorn club, even as many ‘soonicorns’ (soon to be unicorns) waited in line.
• The promising Indian startup ecosystem is, however, facing serious challenges partly due to current global macroeconomic conditions.
• An indicator of this challenge is the steep decline in funding available for Indian startups in 2022.

Data and statistics

• Funding data from Inc. 42 and Traxcn reveal that as opposed to $4.6 billion worth of funding received in January 2022, Indian startups seem to be facing an early winter, with only $885 million in funding received in August 2022.
• Similarly, the quarterly funding of Indian startups peaked in the third quarter of 2021 at $14.8 billion, and has been steadily declining since then.
• The figures for startup funding in the first and second quarters of 2022 have been $10.3 billion and $6.84 billion respectively.

What accounts for such volatility in funding?

• The reason for such a ‘funding winter’ is to be traced to global macroeconomic developments, especially changing interest rate regimes between 2020 and 2022.
• As the pandemic struck, several central banks and especially the US Federal Reserve followed easy monetary policies to ensure the flow of credit in the economy.
• These policies involved the use of both conventional and unconventional monetary-policy instruments.

Actions of US Federal Bank

• The US Fed lowered the benchmark Fed Funds rate to historic lows in the range of 0-0.25%.
• This action was meant to act as a signal for other short-term rates to be lowered, with such low interest rates expected to boost spending by lowering the cost of borrowing for households and businesses.
• The Fed also provided forward guidance on the future path of interest rates in successive Federal Open Market Committee (FOMC) statements throughout 2020, indicating that it would keep interest rates at near zero.
• The stated goal was to achieve maximum employment and inflation at the rate of 2% over the longer run.
• The FOMC stated that it would maintain an accommodative monetary policy stance until the stated outcomes were achieved. It began to make large purchases of US government and mortgage-backed securities.
• The Fed would purchase Treasuries and residential and commercial mortgage-backed securities to support households, employers, financial market participants, and state and local governments through massive lending.
• The result of this unprecedented accommodation and low interest rates was negative real interest rates in global bond markets.
• Investors, who sought real returns and growth, diverted their attention to holding public and private stocks, from the earlier bonds held. As a result, despite a severe contraction of global GDP, share valuations rose the world over, including India.

In case of India

• India received net equity portfolio flows of over $4.4 billion, even as debt portfolio flows fell to more than -$3.3 billion.
• With the US Fed having raised interest rates four times already in 2022 and also tapering its quantitative easing and other measures taken to cope with the pandemic, and the resultant squeeze on liquidity, one can expect a reversal from stocks back to bonds.
• This has meant a pulling out from domestic markets especially equity by foreign investors and the rupee consequently depreciating.
• The Reserve Bank of India (RBI) too has hiked interest rates thrice this year to cope with spiraling inflation, while also changing its monetary policy stance from ‘accommodative’ to a relatively hawkish policy stance.

What do these macro developments mean for Indian startups?

• As interest rates rise, these hikes would lower the valuations of startups, even if they had no debt exposure and have used equity capital to finance their operations.
• Rupee depreciation too would impact both startups that are trying to raise funding in dollar terms and those which have already borrowed in dollars.
• In the case of the former, depreciation of the rupee affects their funding and also their valuations in the process.
• For those which have already taken dollar loans, their debts would become more expensive on account of rupee depreciation. Such startups may not be in a position to use the complex hedging strategies used by large corporations.
• The Indian currency’s depreciation is also likely to increase the operational costs of several startups, affecting their margins negatively.

Way Forward

• This year’s change in the global macroeconomic scenario spells a change in the investment climate for Indian startups.
• The reversal of liquidity in the system and rupee depreciation will lead to venture capital investors prioritizing profitability and unit economics overgrowth.
• Companies whose valuations are lower and for which raising funds at lower valuations is less attractive will need to find sources other than equity funding.
• Cash preservation rather than cash burn may thus be the mantra to follow amid such financial uncertainty.

Source: Live-Mint 

Mains Question:

Q. Cash preservation rather than cash burn may be the best mantra for our startups to follow amid high financial uncertainty. Comment. [150 Words].