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• Indian economy and the equity market have stepped into 2011
facing some powerful headwinds. Government policy will have to
deal with these decisively early in the year. In this report, we
highlight a few key macro risks for Indian equity investors.
• Rising Global Crude Oil Prices. Given the dependence on imports
and a complex subsidy mechanism, high oil prices have always been a
problem for the Indian economy. The impact on inflation and the fiscal
and current account deficits and hence on interest rates and currency
has been meaningful in past cycles.
• High Inflation. Inflation has remained stubbornly high and not
moderated in line with policy makers’ expectations. While there could
be some relief over 1QCY11 owing to base effect reasons, the issue
could come back to the fore, as all the major drivers are looking up.
Core inflation remains elevated. Global commodity prices are rising on
forecasts of a broad based economic recovery. Also, food inflation is
again beginning to rise, both due to a pick up in global prices and
unseasonal rains.
• Tight Liquidity and Higher Interest Rates. Over CY2010, the RBI
has been normalizing monetary policy to tame inflation. Tightening is
expected to continue into 2011 as well given inflation concerns.
Additionally, system liquidity remains tight and the banking system
currently borrows more than ~US$20 bn everyday from the RBI.
Borrowing rates have been rising sharply as a result, more so at the
short-end. Banks are currently borrowing one year money at 9.5% in
the wholesale deposit market, an increase of more than 300 bps yoy. A
pick up in the investment cycle and rising global crude oil prices will
likely add to the pressure.
• A related concern going into FY2012 pertains to the fiscal deficit.
The enthusiastic response to the telecom auctions enabled the
Government to raise nearly US$20 bn and reduce the deficit
meaningfully over FY2011 (to 5.5%). But this was a one off initiative.
And with expenditure levels likely to remain elevated (and higher
global crude oil prices could add to this), the Government’s ability to
raise resources and reduce the deficit in line with the 13th Finance
Commission’s recommendations (to 4.8%) will be tested. Relying on
high growth rates alone may not work.
India 2011 – What do we worry about?
The economy and the equity market have stepped into 2011 facing some
powerful headwinds. Government policy will have to deal with these decisively
early in the year.
Political Turmoil and a Distracted Government. Exposes on various corruption
scandals, across the political spectrum, over the last 4-5 months have vitiated the
political atmosphere and eroded business confidence significantly.
The winter session of Parliament was stalled by the Opposition, to protest procedural
differences (with the Government) pertaining to the investigation of the Telecom
allegations. And there are fears in some quarters that the Budget session scheduled
for February could also be impacted.
Policy making is beginning to suffer as a result and there is no clarity on the
timeframe for the implementation of crucial reforms. For eg: the Goods and Services
Tax.
Lack of business confidence and a slowdown in decision making within the
Government could imply further delays to the revival of the investment cycle with an
adverse impact on both growth and inflation.
Rising Global Crude Oil prices. Given the dependence on imports and a complex
subsidy mechanism, high oil prices have always been a problem for the Indian
economy.
The impact on inflation and the fiscal and current account deficits and hence on
interest rates and currency has been meaningful in past cycles.
The adverse impact could get accentuated in the current environment. Sticky
inflation and a pick up in the political calendar – 5 states are going to the polls over
1H CY2011, imply the Government has limited political room to pass on price hikes
to consumers (at least early in the year). Crude oil at US$90 / bbl implies a subsidy
bill of US$20 bn and at US$100/bbl implies a subsidy bill of UD$26 bn.
High Inflation. Inflation has remained stubbornly high and not moderated in line
with policy makers’ expectations. While there could be some relief over 1Q owing to
base effect reasons, the issue could come back to the fore, as all the major drivers are
looking up.
Core inflation remains elevated. And even if the investment cycle were to revive
meaningfully now it would take 12-18 months for capacities to be commissioned and
ease supply side pressures. Global commodity prices are rising on forecasts of a
broad based economic recovery. Also, food inflation is beginning to rise again, both
due to a pick up in global prices and unseasonal rains.
Tight Liquidity and Higher Interest Rates. Over CY2010, the RBI has been
normalizing monetary policy to tame inflation. Tightening is expected to continue
into 2011 as well given inflation concerns.
Also, system liquidity remains tight and the banking system currently borrows more
than US$20 bn everyday from the RBI.
Borrowing rates have been rising sharply as a result, more so at the short-end. Banks
are currently borrowing one year money at 9.5% in the wholesale deposit market, an
increase of more than 300 bps yoy. A pick up in the investment cycle and rising
global crude oil prices will likely add to the pressure.
Large companies have access to global financial markets, where rates remain
attractive. But the same cannot be said for small and medium enterprises and retail
consumers. Consequently Ancillaries along the supply chain could become a
bottleneck for increasing capacity. Separately the consumption cycle could suffer as
interest rates head north.
A related concern going into FY2012 pertains to the fiscal deficit. The
enthusiastic response to the telecom auctions enabled the Government to raise nearly
US$20 bn and reduce the deficit meaningfully over FY2011 (to 5.5%). But this was a
one off initiative.
And with expenditure levels likely to remain elevated (and higher global crude oil
prices could add to this), the Government’s ability to raise resources and reduce the
deficit in line with the 13th Finance Commission’s recommendations (to 4.8%) will
be tested. Relying on high growth rates alone may not work.
The policy response to these issues will determine if the economy grows at the
aspirational 9% or in the range of 7-8%. Top line growth will be very important for
the corporate sector to meet earnings growth expectations of 18-20%. Margins will
likely be dented by higher input costs and interest expenses.
It is comforting to note however that valuation at about 16x forward earnings are in
line with historic comparatives and not in bubble territory.
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