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India Market Outlook
27 JANUARY 2011
What are policymakers thinking?
Our recent interaction with policymakers and corporates has given us some insight on wideranging topics such as the potential direction of monetary and fiscal policy, measures to
curtail inflation, an outlook on key economic variables such as growth, interest rates, fiscal
deficit and others, and the margin outlook for manufacturing companies.
Structurally high inflation
Policymakers believe that the present round of inflation is largely structural, caused by the
past couple of years’ fiscal and monetary profligacy. The increase in global commodity
prices (as investors try to hedge for currency depreciation) has been passed through to end
users as the demand environment remained robust.
Steady growth
Despite high inflation, growth should remain resilient as consumption is now being driven by
rising income growth expectations in an environment of strong job creation in rural and
urban areas. After the reshuffling of ministers, policymakers appear confident of a pick-up in
infrastructure spending, particularly roadways. The resumption of government spending
could ease money-market liquidity.
Fiscal and monetary policy
Despite the consequences of fiscal profligacy being clear to the government, most
policymakers do not believe that the government will stick to its FY12 fiscal deficit target of
4.8% of GDP. The possibility of the government reducing expenditures by lowering fertiliser
or fuel subsidies is remote. Moreover, there is a change of fiscal slippage in FY12 if the
Right to Food Bill (expected to cost 1.0-1.5% of GDP) is implemented.
Policymakers, however, differed on the extent of monetary tightening needed. Some believe
that the RBI need not tighten aggressively as the money markets have done a large part of
the tightening already. Others believe that the RBI needs to tighten aggressively (including
an increase in the cash reserve ratio (CRR)) to counter fiscal profligacy.
Manufacturing companies deeply concerned about input costs
We met up with senior management of Maruti, Hero Honda and Apollo Tyres. These
corporates appear uniformly concerned about raw-material cost pressure, which is adversely
affecting their margins. Even though the demand environment remains robust, it is
increasingly difficult for these companies to pass on the entire raw-material cost increase to
customers. We believe pressure on margins of these companies will become visible in the
upcoming quarterly results
Implications for stock and sector selection
Following these meetings, we are incrementally cautious on our overweight stance on
automotives. We are more positive on construction and engineering companies. Companies
with strong pricing power and sectors with low price elasticity of demand (tobacco, liquor),
regulated utilities (power utilities), and companies geared to global recovery – but immune to
potential tightening and a slowdown in emerging markets (IT Services) – appear relatively
safe in the present scenario
Policymakers’ take on key economic drivers
We met up with Dr Saumitra Chaudhuri (Member – Planning Commission), Dr Rakesh
Mohan (former Deputy Governor – RBI and presently Head of High Level Committee on
infrastructure financing), Dr Ashok Gulati (Director – IFPRI), and with the CEOs and
CFOs of auto and auto-ancillary companies. Feedback from policymakers and
corporates provided insights on wide-ranging topics like the potential direction of
monetary and fiscal policy, measures to curtail inflation, the outlook on key economic
variables like growth, interest rates, fiscal deficit and others, and margin outlook for
manufacturing companies. Another key takeaway from our meetings was the great
divergence of opinion among policymakers, even on some existing policy measures
such as NREGA, that are perceived to be “widely accepted” by equity-market
participants.
The key takeaways from our meetings with policymakers were:
1 The present round of inflation is not entirely cyclical. It is largely structural, and has
been created as a result of the past few years’ fiscal and monetary profligacy.
Consequently, it is imperative that the fiscal and monetary stimuli are rolled back,
though that is easier said than done, particularly for fiscal measures.
2 A second reason for domestic inflation is the transmission of global commodity
inflation, which has been partly caused by exchange rate instability – which means
that fund managers across the world have invested in commodities, in their efforts
to hedge against currency depreciation.
3 Different policymakers have different recommendations for the extent of monetary
tightening going forward. Dr Gulati believes the RBI should be much more hawkish
about inflation than it presently is (and should even consider a CRR hike). Dr
Mohan and Dr Chaudhuri believe the money market has largely done the RBI’s job
and sharp tightening is not needed at this time. Dr Mohan also believes that the
transmission of higher policy rates to higher lending and deposit rates will be much
more efficient now as compared with the past.
4 Despite high inflation, growth could still be resilient, as consumption is now being
driven by income growth and income expectations. In an environment of strong job
creation (artificial or otherwise) in rural and urban areas, it is unlikely that income
expectations will decline significantly in the medium term.
5 The FY12 budget (scheduled for 28
th
February) will likely be a populist affair, with
very few policy changes. Our panel of policymakers by and large perceived a
danger of slippage to the government’s target of 4.8% fiscal deficit (as a proportion
of GDP) in FY12. The Planning Commission member, however, said that the
government could stick to the fiscal deficit target – simply because the debilitating
effect of a large fiscal deficit is now amply clear to the government. Historical
evidence suggests that the government is usually conscious about fiscal deficit as
long as the total deficit (centre and state) remains above 7% of GDP. When it dips
below 7%, the government becomes complacent and profligate.
6 The government is focused on expenditure reduction, but the chances of subsidy
reduction in the near term appear slim. Among the three main subsidies – food,
fertiliser, and oil – fertiliser is the most intractable, while oil subsidies are relatively
easy to reduce. However, significant attempts at oil-subsidy reductions may only
occur in the second half of 2011; we do not expect them earlier.
7 Potential implementation of the Right to Food Bill (or the “National Food Security
Bill”) could increase the fiscal deficit further by 1.0-1.5% of GDP. Though a panel of
the PM’s Economic Advisory Council (PMEAC) has rejected the recommendations
of the National Advisory Council with regard to the NFSB, the ruling party
leadership may be keen to introduce the NFSB in some form.
8 Infrastructure orders: After a recent reshuffling of ministerial portfolios,
policymakers appear more confident of infrastructure orders, particularly with
roadways being kick-started. This could be incrementally positive for the
construction sector and also for the liquidity situation in the banking sector, as
resumption of infrastructure order awards could ensure new government spending
9 India's reliance on public-private partnership in infrastructure financing is perceived
to be too high. The 11th Plan proposed 43% funding from PPP and the 12th Plan
may propose an even higher proportion from PPP. But when the private sector
assumes all risks pertaining to a project (e.g. environmental clearance risk,
execution risk, land acquisition risk etc.) the prices of these risks get built into the
project cost, and hence into user charges for the project. But such inflation in user
charges is not desirable for developing countries like India. Going forward,
policymakers may focus on increasing central budgetary support for infrastructure
and on channelling long-term money (e.g. insurance, pension funds) into
infrastructure.
Feedback from IFPRI on food inflation and how to tackle it
The International Food Policy Research Institute (IFPRI) conducts extensive research
on food policy in several countries in support of food security and nutrition. Dr Ashok
Gulati of IFPRI discussed at length the reasons behind recent food inflation and
measures needed to tackle it. The key takeaways are:
a Fiscal and monetary stimulus packages need to be wound down: Food
inflation is now a global phenomenon – as seen in the FAO’s food price index,
which has crossed the previous peak of June 2008, as money supply growth has
outstripped agricultural production.
b Augment supply: The government can smooth price fluctuations by releasing
some of its excess stock (over warranted buffer) of food grain into the market.
Similarly, for vegetables and fruits, which are not stored by the government,
reducing import duties to less than 10% could bring down prices in the near term.
c Eliminate multi-layered agricultural supply chain: The present agricultural
supply chain is long and riddled with layers of middle-men, which increases cost to
consumers. Reforming the APMC Act, and allowing the private sector (including
modern retailers) to source directly from producers, would immediately lower food
prices. Large-scale sourcing of agricultural produce will reduce wastage by making
efficient transportation and storage infrastructure economically viable (the ‘farm-tofork’ model).
d Set up a commercial intelligence unit for sensitive commodities: Dedicated
infrastructure to track local and global production status and stocks will provide
government intelligence on potential price fluctuations of sensitive crops. Such
early-warning systems can help government frame policy responses to reduce
supply shocks.
e The agriculture reform programme: Sustainable agricultural growth requires
more investment in R&D, water and soil management, logistics, processing and
packaging and organised retailing. The IFPRI believes that harnessing the private
sector’s strength to invest in efficient food supply chains, among other things, is
essential.
Manufacturing companies severely concerned about input cost
We met up with the senior management of Maruti (MSIL IN; HOLD; CP: INR1,288; TP:
INR1,400), Hero Honda (HH IN; HOLD; CP: INR1,774; TP: INR1,875) and Apollo Tyres
(APTY IN; BUY; CP: INR56; TP: INR82). These corporates appear uniformly concerned
about raw-material cost pressure adversely affecting their margins. Apollo Tyres talked
about natural rubber prices being 30% higher than the peak of the previous cycle.
Maruti’s procurement cell expects steel HRC prices to increase about 25% (from
INR33/kg to INR40-41/kg) in the near term. Hero Honda is likely to suffer from a
combination of raw-material price increases and the additional cost of catalytic
converters (INR915/bike) following the recent emission norm changes. Even though the
demand environment remains robust, it is increasingly difficult for these companies to
pass on the entire raw-material cost increases to customers. We believe pressure on
margins of these companies will be visible in the upcoming quarterly results.
India Equity Research Reports, IPO and Stock News Visit http://indiaer.blogspot.com/ for complete details �� ��
India Market Outlook
27 JANUARY 2011
What are policymakers thinking?
- ƒ Fiscal and monetary profligacy led to structurally high inflation
- ƒ Despite high inflation, growth should be robust on resilient consumption
- ƒ FY12 fiscal slippage: Lack of subsidy reduction and food security bill
- ƒ Higher interest rates, input cost pressure are key risks to corporates
Our recent interaction with policymakers and corporates has given us some insight on wideranging topics such as the potential direction of monetary and fiscal policy, measures to
curtail inflation, an outlook on key economic variables such as growth, interest rates, fiscal
deficit and others, and the margin outlook for manufacturing companies.
Structurally high inflation
Policymakers believe that the present round of inflation is largely structural, caused by the
past couple of years’ fiscal and monetary profligacy. The increase in global commodity
prices (as investors try to hedge for currency depreciation) has been passed through to end
users as the demand environment remained robust.
Steady growth
Despite high inflation, growth should remain resilient as consumption is now being driven by
rising income growth expectations in an environment of strong job creation in rural and
urban areas. After the reshuffling of ministers, policymakers appear confident of a pick-up in
infrastructure spending, particularly roadways. The resumption of government spending
could ease money-market liquidity.
Fiscal and monetary policy
Despite the consequences of fiscal profligacy being clear to the government, most
policymakers do not believe that the government will stick to its FY12 fiscal deficit target of
4.8% of GDP. The possibility of the government reducing expenditures by lowering fertiliser
or fuel subsidies is remote. Moreover, there is a change of fiscal slippage in FY12 if the
Right to Food Bill (expected to cost 1.0-1.5% of GDP) is implemented.
Policymakers, however, differed on the extent of monetary tightening needed. Some believe
that the RBI need not tighten aggressively as the money markets have done a large part of
the tightening already. Others believe that the RBI needs to tighten aggressively (including
an increase in the cash reserve ratio (CRR)) to counter fiscal profligacy.
Manufacturing companies deeply concerned about input costs
We met up with senior management of Maruti, Hero Honda and Apollo Tyres. These
corporates appear uniformly concerned about raw-material cost pressure, which is adversely
affecting their margins. Even though the demand environment remains robust, it is
increasingly difficult for these companies to pass on the entire raw-material cost increase to
customers. We believe pressure on margins of these companies will become visible in the
upcoming quarterly results
Implications for stock and sector selection
Following these meetings, we are incrementally cautious on our overweight stance on
automotives. We are more positive on construction and engineering companies. Companies
with strong pricing power and sectors with low price elasticity of demand (tobacco, liquor),
regulated utilities (power utilities), and companies geared to global recovery – but immune to
potential tightening and a slowdown in emerging markets (IT Services) – appear relatively
safe in the present scenario
Policymakers’ take on key economic drivers
We met up with Dr Saumitra Chaudhuri (Member – Planning Commission), Dr Rakesh
Mohan (former Deputy Governor – RBI and presently Head of High Level Committee on
infrastructure financing), Dr Ashok Gulati (Director – IFPRI), and with the CEOs and
CFOs of auto and auto-ancillary companies. Feedback from policymakers and
corporates provided insights on wide-ranging topics like the potential direction of
monetary and fiscal policy, measures to curtail inflation, the outlook on key economic
variables like growth, interest rates, fiscal deficit and others, and margin outlook for
manufacturing companies. Another key takeaway from our meetings was the great
divergence of opinion among policymakers, even on some existing policy measures
such as NREGA, that are perceived to be “widely accepted” by equity-market
participants.
The key takeaways from our meetings with policymakers were:
1 The present round of inflation is not entirely cyclical. It is largely structural, and has
been created as a result of the past few years’ fiscal and monetary profligacy.
Consequently, it is imperative that the fiscal and monetary stimuli are rolled back,
though that is easier said than done, particularly for fiscal measures.
2 A second reason for domestic inflation is the transmission of global commodity
inflation, which has been partly caused by exchange rate instability – which means
that fund managers across the world have invested in commodities, in their efforts
to hedge against currency depreciation.
3 Different policymakers have different recommendations for the extent of monetary
tightening going forward. Dr Gulati believes the RBI should be much more hawkish
about inflation than it presently is (and should even consider a CRR hike). Dr
Mohan and Dr Chaudhuri believe the money market has largely done the RBI’s job
and sharp tightening is not needed at this time. Dr Mohan also believes that the
transmission of higher policy rates to higher lending and deposit rates will be much
more efficient now as compared with the past.
4 Despite high inflation, growth could still be resilient, as consumption is now being
driven by income growth and income expectations. In an environment of strong job
creation (artificial or otherwise) in rural and urban areas, it is unlikely that income
expectations will decline significantly in the medium term.
5 The FY12 budget (scheduled for 28
th
February) will likely be a populist affair, with
very few policy changes. Our panel of policymakers by and large perceived a
danger of slippage to the government’s target of 4.8% fiscal deficit (as a proportion
of GDP) in FY12. The Planning Commission member, however, said that the
government could stick to the fiscal deficit target – simply because the debilitating
effect of a large fiscal deficit is now amply clear to the government. Historical
evidence suggests that the government is usually conscious about fiscal deficit as
long as the total deficit (centre and state) remains above 7% of GDP. When it dips
below 7%, the government becomes complacent and profligate.
6 The government is focused on expenditure reduction, but the chances of subsidy
reduction in the near term appear slim. Among the three main subsidies – food,
fertiliser, and oil – fertiliser is the most intractable, while oil subsidies are relatively
easy to reduce. However, significant attempts at oil-subsidy reductions may only
occur in the second half of 2011; we do not expect them earlier.
7 Potential implementation of the Right to Food Bill (or the “National Food Security
Bill”) could increase the fiscal deficit further by 1.0-1.5% of GDP. Though a panel of
the PM’s Economic Advisory Council (PMEAC) has rejected the recommendations
of the National Advisory Council with regard to the NFSB, the ruling party
leadership may be keen to introduce the NFSB in some form.
8 Infrastructure orders: After a recent reshuffling of ministerial portfolios,
policymakers appear more confident of infrastructure orders, particularly with
roadways being kick-started. This could be incrementally positive for the
construction sector and also for the liquidity situation in the banking sector, as
resumption of infrastructure order awards could ensure new government spending
9 India's reliance on public-private partnership in infrastructure financing is perceived
to be too high. The 11th Plan proposed 43% funding from PPP and the 12th Plan
may propose an even higher proportion from PPP. But when the private sector
assumes all risks pertaining to a project (e.g. environmental clearance risk,
execution risk, land acquisition risk etc.) the prices of these risks get built into the
project cost, and hence into user charges for the project. But such inflation in user
charges is not desirable for developing countries like India. Going forward,
policymakers may focus on increasing central budgetary support for infrastructure
and on channelling long-term money (e.g. insurance, pension funds) into
infrastructure.
Feedback from IFPRI on food inflation and how to tackle it
The International Food Policy Research Institute (IFPRI) conducts extensive research
on food policy in several countries in support of food security and nutrition. Dr Ashok
Gulati of IFPRI discussed at length the reasons behind recent food inflation and
measures needed to tackle it. The key takeaways are:
a Fiscal and monetary stimulus packages need to be wound down: Food
inflation is now a global phenomenon – as seen in the FAO’s food price index,
which has crossed the previous peak of June 2008, as money supply growth has
outstripped agricultural production.
b Augment supply: The government can smooth price fluctuations by releasing
some of its excess stock (over warranted buffer) of food grain into the market.
Similarly, for vegetables and fruits, which are not stored by the government,
reducing import duties to less than 10% could bring down prices in the near term.
c Eliminate multi-layered agricultural supply chain: The present agricultural
supply chain is long and riddled with layers of middle-men, which increases cost to
consumers. Reforming the APMC Act, and allowing the private sector (including
modern retailers) to source directly from producers, would immediately lower food
prices. Large-scale sourcing of agricultural produce will reduce wastage by making
efficient transportation and storage infrastructure economically viable (the ‘farm-tofork’ model).
d Set up a commercial intelligence unit for sensitive commodities: Dedicated
infrastructure to track local and global production status and stocks will provide
government intelligence on potential price fluctuations of sensitive crops. Such
early-warning systems can help government frame policy responses to reduce
supply shocks.
e The agriculture reform programme: Sustainable agricultural growth requires
more investment in R&D, water and soil management, logistics, processing and
packaging and organised retailing. The IFPRI believes that harnessing the private
sector’s strength to invest in efficient food supply chains, among other things, is
essential.
Manufacturing companies severely concerned about input cost
We met up with the senior management of Maruti (MSIL IN; HOLD; CP: INR1,288; TP:
INR1,400), Hero Honda (HH IN; HOLD; CP: INR1,774; TP: INR1,875) and Apollo Tyres
(APTY IN; BUY; CP: INR56; TP: INR82). These corporates appear uniformly concerned
about raw-material cost pressure adversely affecting their margins. Apollo Tyres talked
about natural rubber prices being 30% higher than the peak of the previous cycle.
Maruti’s procurement cell expects steel HRC prices to increase about 25% (from
INR33/kg to INR40-41/kg) in the near term. Hero Honda is likely to suffer from a
combination of raw-material price increases and the additional cost of catalytic
converters (INR915/bike) following the recent emission norm changes. Even though the
demand environment remains robust, it is increasingly difficult for these companies to
pass on the entire raw-material cost increases to customers. We believe pressure on
margins of these companies will be visible in the upcoming quarterly results.
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