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Summary
The macro challenges reinforce our view of a new normal growth, lower than the much claimed
9% (vs our expectation of 7.6%) for FY12E. A moderation in broader earnings estimates is
camouflaged by steep upgrades in a few companies, leading us to a selective market view.
Overstatement of GDP growth; FY11 probably inflated by 90bp: Over the past two years,
several changes have been made in GDP numbers, including disproportionately large revisions,
change in base year to 2004-05, change in deflator, and expansion in coverage for various
components. While these changes have resulted in an obfuscating flux and increased frequency, of
errors the disconnection with a wide set of leading indicators suggest inconsistencies. Our analysis
indicates widespread up-scaling, but the largest bias to GDP growth comes from financial & trade
services and manufacturing. Working backwards to extend the old series leads us to real GDP
growth for Q1-Q3FY11 of 7.7% vs CSO’s estimate of 8.6%
“Negotiating the new normal” is intact; FY12E GDP at 7.6% with an upside bias: While the
finance minister maintains an optimistic 9% GDP growth forecast in FY12, the RBI’s statements are
sombre. In our view, FY12 will see a transition from the stimulus-driven economic rebound to a new
normal trend around 7.5-8% growth. In our view, the near-term downside risks would dominate the
upside impulses, which would likely emerge gradually and more strongly in FY13. We maintain our
7.6% GDP growth estimate for FY12 with an upside bias. Contraction in real fiscal spending would
potentially create positive supply impulses, its instant impact will be contractionary. Every 100bp
negative shock in real fiscal spending growth translates into a 50bp fall in GDP growth. The factors
weighing on our outlook include subdued investments, lagged negative impact of past fiscal
expansion, downward inelastic interest rates. Amplified inclusion of informal sector in CSOs is an
estimation risk for our projections. Low risk could arise from tightening of global financial
conditions – rate hikes in the US and Europe and decline in savings in Japan.
Declining food inflation and rising cost pressures: Inflation in Feb 2011 rose to 8.3% from 8.2%
in Jan 2011 despite the sharp fall in food inflation. While manufactured product inflation climbed
up, it is relatively small compared to persistent rise in cost of raw materials. Implying intensifying
margin pressure and declining pass-through coefficient. While the risk of further escalation of costs
persists, we believe the onward trend in inflation is likely to decline due to demand moderation. We
expect WPI inflation to decline to 5-6% in FY12 with a reasonable probability of a 100bp upside
from potential increase in fuel prices.
Food surplus beats the facile structural demand-supply shortage thesis: Qfficial position that
food price shocks resulted from structural supply-demand deficit, a thesis we have consistently
refuted, is challenged by recent government decision to lift export ban on rice, sugar and onions to
stabilise declining domestic prices. Wheat export is expected to follow. These imply an oversupply
situation. WPI for most protein based items have declined from their 2010 peaks
Ballooning under-recoveries of oil PSUs: If crude prices remains at US$115 levels (Brent), underrecoveries
would be fairly large (Rs1.75-1.8trn with INR/USD at 46). Our oil analyst believes average
crude price would be US$95 in FY12E, translating into under recovery of around Rs1trn. While this is
manageable, sustenance of crude prices at US$115 would imply intense liquidity pressure.
Rural theme – Rising NPA in agri-lending: We maintain our theme “Fragility of rural growth”. As
per recent reports, PSU banks are reporting sharp rises in farms loan NPAs, between 80%-2,000%
during Q1-Q3FY11. While Budget FY12 enhanced agri credit target to Rs4,750bn, we believe
volatility in farm income arising from supply surpluses, high indebtedness and rising NPAs will force
banks to concentrate on recoveries. While aggressive lending may have fed into consumption
spending, rising indebtedness will result in a bigger default and fiscal problem in the future.
Market strategy: The continued moderation in earning estimates for the boarder markets, though
camouflaged by steep upgrades in a few companies, reflect better expectations for global-oriented
companies and domestic macro stress. While structural changes in the composition of index
earnings make historical comparison less relevant, we believe at 15.32 x FY12E EPS, the market may
still be expensive. Factors that are likely to be critical in the coming quarters are margin pressure,
volume growth moderation, upside risk to lending rates, and the multiplier impact of fiscal
contraction. Hence, we are overweight global/export-dependent themes (tactical positive on IT),
sectors less sensitive to commodity prices (pharma), and consumer non-durables. Rate-sensitive
like infrastructure and real estate sectors would continue to be under stress. While not so positive
on two-wheelers and commercial vehicles, we have a constructive view on LCVs and passenger
vehicles. The steel sector will likely see margin pressure beyond the short-term improvements.
Summary – Overstatement of GDP growth: FY11 probably inflated by 90bp
Estimation process in a state of flux: All parts moving: Over the past two years several changes
have been made in GDP numbers including disproportionately large revisions, change in base year
to 2004-05, change in deflator and expansion in coverage for various components.
While change in base year should not result in a change in nominal GDP, as it results from a
change in base year for the deflators and hence, also the real GDP, recent modifications have
resulted in all three parts moving simultaneously. Nominal GDP in the new series (base year
2004-05) shows a widening trend over the old series (base year 1999-00) with a projected upside
deviation of 20% in FY11. From our analysis it appears that FY11YTD GDP growth is inflated by
90bp.
While the new GDP deflator and the embedded inflation (a) has been scaled up, it has been
lesser than for the nominal GDP growth (b) there by resulting in an upside bias for the estimated
real GDP growth (b-a) potentially by about 100bp.
The Central Statistical Organisation (CSO) has chosen to make these changes incrementally –
first the annual GDP figure and later adjusting each quarter. Hence, quarterlies do not add up to
annual numbers
The result – Frequent errors
1. Q1FY11 initial release showed real expenditure GDP growth at 3.7% which was corrected to 10%
subsequently citing an error in the deflator used.
2. Over-reporting of capital goods production – over 200% YoY growth for insulated cables for most
of FY10-FY11. The 20.4% QoQ fall in real gross capital formation in Q1FY11, the steepest fall since
Q1FY98, was subsequently revised to -8.4%.
3. Understatement on import data in recent months.
Inconsistencies galore
Disconnect between leading indicators and GDP data (detail list in Exhibit 63, page 23).
1. Investments: While real gross fixed capital formation in GDP grew 20% during Q4FY10 - Q2FY11
(6% in Q3FY11), and also reflected in a huge 34% growth in capital goods production, capital
goods imports grew modestly at 10%. FDI has been contracting consistently since Q2FY10.
2. Agriculture: Food grain production estimated at 232.07MT for FY11 (advance estimate) is 1%
lower than 234.47MT in FY09, but the Real Agri GDP for FY11 is shown to be 5.8% higher.
3. Manufacturing: Bulk of the manufacturing sector (76% weight) grew modestly at 5% YoY during
Q1-Q3FY11 vs 9.2% for overall manufacturing, which is influenced by volatile components. The
manufacturing sector GDP data shows even higher growth of 9.5%YoY.
4. Core sector: Leading indicators such as electricity generation (4.5% YoY during Q1-Q3FY11),
cement (4.4%), coal (0.8%) and mining ex-crude do not support claims of robust recovery.
5. Construction: Recovery in construction GDP (9% YoY CY2010) coincides with rebound in steel
production (8% in CY2010). Cement growth on the contrary declined (5.6% in CY2010). Growths
for seven construction related industries (bars & rods, cranes, construction equipments, pipes &
tubes, steel-railways, structures & telecom cables) have been much softer in FY11 than in 2004-
2008.
6. Trade services: GDP for trade services grew 11.2% in CY10, stronger than 10.3% during FY05-
Q2FY10. Q3FY11 has shown a decline to 9.4%. Leading indicators however suggest slowdown
since Q3FY10. These include aviation (cargo & passengers), foreign tourists, cargo handled (ports,
railways) and outstanding mobile connectivity.
7. Financial services: Notwithstanding recent improvements, average growth in M3, total bank
assets, bank deposits and market cap, are far too modest to generate the 10.6% FY11 real growth
as per CSO’s advance estimates. Gap between the new and old nominal GDP series may have
widened by a huge 40%. It will require 57% YoY in Q4FY11 to match CSO’s advance estimates.
Inflated FY11 real GDP growth
Our analysis indicates widespread up-scaling, but the largest bias to GDP growth comes from
financial & trade services and manufacturing. Working backwards to extend the old series leads us to
real GDP growth for Q1-Q3FY11 of 7.7% vs CSO’s estimate of 8.6%.
1. Industrial GDP: Dependence of manufacturing GDP growth on volatile components has
increased. Balancing out abnormalities would scale down FY11 (Q1-Q3) GDP growth by 270bps
to 6.7% vs. 9.5%.
2. Financial sector GDP: Disproportionate revision in financial sector GDP contributed nearly 70%
of added on services GDP in FY09. Financial services GDP growth is potentially scaled up 3-3.5%
due to wider coverage of informal services. Assuming a lower 38% YoY FY11 growth for the addon
component would imply real GDP of 5.5-6% for Q1-Q3FY11 vs 9.1% as reported by CSO.
3. Trade services: The key issue here is the lack of supporting evidence from leading indicators.
Trends in leading indicators and normalised IIP growth (adjusted for aberrations) prompt us to a
trade services GDP growth of 9.7% in Q1-Q3FY, 110bp lower than the reported 10.8%.
Outlook: “Negotiating the new normal” is intact; FY12E at 7.6%
Mixed official views – RBI sounding less optimistic than the finance minister: While the finance
minster maintains 9% GDP growth in FY12, recent RBI statements have been more sombre. With
concerns on global crude prices and non-food inflation rising, the RBI is now finding it difficult to put
into context its anti-inflationary stance given its recent acknowledgement that investments are
declining. Misjudgements on both growth, engendered by inflated GDP numbers and inflation
profile can result in RBI overacting on the tightening side, thereby hampering growth.
Outlook – Upside risk will emerge; but downside to dominate the near-term: We believe FY12
will see a transition from the stimulus-driven rebound during Q2FY10- Q2FY11 to a new normal
trend around 7.5-8% (Exhibit 2). In our view, the near-term downside risks will dominate the upside
impulses. Positive impulses would likely emerge gradually and more strongly in FY13. We maintain
our 7.6% GDP growth projection for FY12 with an upside bias, which will be roughly similar to our
estimate of effective growth of 7.7% in FY11 (lower compared to 8.6% projected by CSO’s advance
estimates).
Downside risks arising from:
Initial negative shock from contraction in fiscal spending – 3.4% expansion in expenditure
budget for FY12 will imply contraction in real term after 20% average growth during FY08-FY11.
Our estimates show that for every 100bp negative shock in real government consumption
spending translates into a 50bp cumulative four quarter fall in GDP growth (Exhibit 4).
Subdued investments in the past three years would constrain future growth. Gross fixed capital
formation/GDP fell to 27.3% in Q3FY11 after a rebound to 33% in the previous three quarters.
Lagged negative impact of huge fiscal expansion during FY08-FY11 reflecting in elevated cost of
production & living, downward inelastic interest rates and higher taxes. Risk of further
tightening in policy rates and lagged impact of earlier tightening on lending rates.
Lingering impact of high inflation for raw material inflation averaged 25% in FY11 and possibility
of further increase in fuel prices due to elevated crude prices.
Low risk arising from tightening of global financial conditions: potential rate hikes in US and
Europe. Decline in savings in Japan in response to post-quake reconstruction activities.
Upside risks arising from:
Fiscal moderation should create positive supply responses - Lower the pace of inflation, ending
of rate tightening cycle after a quarter. Reversing the crowding out effect will result in positive
investment impulses, translating into a firming up of the investment cycle. Estimated impulse
response function indicates a lag of 4 quarters for the positive multiplier to emerge (Exhibit 4).
Risks to our view of 7.6% in FY12E with upside bias:
The biggest risk arises from potential changes in GDP estimation. CSO can potentially post a 9%
GDP growth due to amplified inclusion of intractable informal sector.
Early correction in commodity prices can be a big fundamental positive, in our view.
Summary of our recent macro thoughts
Declining food inflation and rising cost pressures: Inflation in Feb 2011 rose to 8.3% from 8.2% in Jan
2011 despite the sharp fall in food inflation. The rise is attributed to the sharp increase in global cotton
and oil seed prices. While manufactured product inflation climbed to 4.9%, it is relatively small compared
to persistent rise in cost of raw materials – 11.5% and 25%, respectively, for fuels and primary ex-food,
implying intensifying margin pressure and declining pass-through coefficient. While the risk of further
escalation of costs persists, we believe the onward trend in inflation is likely to decline due to demand
moderation. Recent decline in food inflation and moderation of prices of some raw material components
are indicative trends. While we expect WPI inflation to decline to 5-6% in FY12 there is a reasonable
probability of a 100bp upside from potential increase in administered fuel prices.
Food surplus beats the facile structural demand-supply shortage thesis: While the official position
has been that food price shocks resulted from structural supply-demand deficit, a thesis we have
consistently refuted , recent developments substantiate our view. Government has decided to lift export
ban on rice, sugar and onions to stabilise declining domestic prices. Wheat export is expected to follow.
The expected 82mt wheat production in 2010-11 is in excess of annual consumption of 76mt. Total food
grain production of 232mt and large buffer imply an oversupply situation. RBI till recently argued that
rising incomes and consequent increase in protein diet resulted in increase in prices of milk and nonvegetarian
items. But we do not hear that argument any more. The reason: WPI for most protein based
items have declined from their 2010 peaks: pulses (-14%), milk (-2%), poultry (-17%), eggs (-8.2%) and
mutton (-4%). Overall, misplaced assessment is bound to lead to misplaced policy responses. Along with
the declining trend in manufactured food prices, food inflation declined to 6.5% in Feb 2011 (10% in Dec
2010). Going forward, it will be cost factors that will be more important for food economy than demand
pressures.
Monetary policy – RBI’s stance could be a reaction to cost pressures: In our view, given the cost
pressures and recent moderation in manufacturing sector and investments growth, the RBI’s antiinflationary
stance can result in the central bank erring on the tightening side, which could adversely
impact growth. The RBI increased the inflation target to 8% in its March 2011 statement. Rise in crude
prices continues to pose serious risk to inflation and fiscal management. We believe beyond maintaining
the current level of monetary tightening, the RBI can do little to control it. In our view, rising cost pressures
can itself contract demand. RBI will find it difficult to increase rates beyond mid-2011. Liquidity conditions
may not ease substantially due to increased borrowing by PSU oil companies to fund their under
recoveries which will balance out moderation in government gross borrowing in H1FY12 atRs2,500bn.
Fiscal – Pro-stability FY12 budget, but managing subsidies will be tricky: The moderation in spending
in budget FY12 to a modest 3.4% and lower fiscal deficit comes from lower budget for both non-plan
revenue and capital expenditure, despite higher commitment for plan spending. Lower fiscal deficit of
Rs4,128bn vs our expectation of Rs4,500bn is arrived at based on an optimistic disinvestment target of
Rs400bn and conservative spending. This translates into an optimistic fiscal deficit/GDP number of 4.6%.
Lower net market borrowing of Rs3,580bn also assumes an optimistic 36% growth in mobilization through
small-savings schemes. We believe a realistic net market borrowing number could be around Rs4,200bn.
Overall, we expect significant compromises on social and capital spending in the consolidation process.
Ballooning under-recoveries of oil PSUs: If crude prices remains at US$115 levels (Brent), the under
recovery would be fairly large (Rs1.75-1.8trn with INR/USD at 46). Our oil analyst believes average crude
price would be US$95 in FY12E, translating into under recovery of around Rs1trn. Out of this, about 40-
45% would be borne by upstream companies and oil marketing companies (OMCs), and the balance by
the government. Given the budget provision of Rs236bn, the government needs to provide for another
Rs300-400bn. Overall, this means higher fiscal borrowing or credit demand by OMCs, thereby putting
pressure on liquidity. While this is manageable, sustenance of crude at US$115 would imply intense
liquidity pressure.
Rural growth theme – Rising NPA in agri-lending: We continue hold our macro theme view “Fragility of
rural growth” (May 2010 and update in Nov 2010). As per recent media reports , PSU banks are reporting
sharp rises in farms loan NPAs - between 80%-2,000% during Q1-Q3FY11 (Exhibit 5). SBI reported bad
loans of around Rs372mn (80%YoY). While Budget FY12 enhanced agri credit target to Rs4,750bn, we
believe volatility in farm income arising from supply surpluses, high indebtedness and rising NPAs will
force banks to concentrate on recoveries rather than lending. We maintain that while aggressive lending
may have fed into consumption spending, rising level of indebtedness and rising risk of default will result
in a bigger default and fiscal problem in the future.
Market strategy: Macro stress still significant
Wider earnings downgrades overwhelmed by sharp upgrades in few companies: While the
BSE Sensex EPS estimates for FY12 and FY12 has undergone only a moderate corrections (2.4% for
FY11E at Rs1,067 and 3% for FY12E at Rs1,269), the underlying components show a fairly
divergent trend. 18 companies have seen an average downgrade of 10.4% (FY11E) while the
remaining 12 have seen an upgrade of 13.6%, dominated by 187% for Tata Motors and 20% for
Hindalco Industries. Similar pattern holds true for FY12E. Overall, better expectations for global
oriented companies have helped keep index EPS stable reflecting domestic macro stress. Hence
overweight global / exports dependent companies will be a good theme to play. While structural
change in the composition of index makes historical comparison less relevant we believe at 15.32
x FY12E EPS, the market may still be somewhat expensive. The key risk would arise if developed
markets undergo renewed slowdown.
Margin pressure – Overweight sectors less sensitive to commodity prices: Commodity prices
have been rising since mid 2009 and have sustained longer than our expectation. Inline with our
long standing view, earnings expectations are moderating and would possibly intensify due to
contraction in fiscal spending against the backdrop of modest pricing power pricing power and
rising cost. In our view, there is a strong likelihood for this scenario sustaining in the coming
quarters. To summaries our earlier findings (Feb 2010), while sectors like automobiles, FMCG, oil &
gas, power and metals are more susceptible to rise in commodity prices, pharma and real estate
are less impacted. Auto and auto ancillary being the most vulnerable. Consumer durables seem to
have a low correlation and the cement sector has no meaningful correlation. For most sectors, rise
in commodity prices impacts the raw material/sales ratio with a lag of two quarters. Hence,
overweight sectors enjoying strong pricing power or low sensitivity.
Moderation in government spend to result in lower cash for rural India: Moderation in
government spending support on social, correction in food prices and focus on recoveries of farm
loans will imply lower cash flow for the rural story. We believe the agri-driven story would sober
down. Consumption-led demand recovery would be oriented towards non-durables, but the
volatility in food grain procurement-related flows would slow growth for durables and autos.
Concerns on credit risk would have implications for PSU banks.
Interest rate sensitive — End of the tightening cycle still some time away: Notwithstanding
the positive signals from the budget, we believe the lending rates would continue to harden
given the RBI’s hawkish stance. Liquidity scenario will likely ease in the initial quarters due to
lower government gross borrowing of Rs2,500bn in H1FY12 (60% of total annual of Rs4,171bn).
Gsec yield curve will likely undergo bull flattening implying short-term positive for banks. Overall,
the rate scenario will continue to impact infrastructure and real estate sectors adversely. Our
stand can potentially change if crude price corrects below USD 100/bl in a sustainable fashion.
Overweight sectors benefiting from rising commodity prices: We would overweight selective
energy stocks (which benefit from higher crude price, GRMs, pet chem margins).
Consumer space: Overweight non-durables, underweight durables and pharma (non-correlated
with interest rates). Decline in prices of primary food articles will benefit FMCG companies
dependent on cereal inputs.
IT services sector: We are tactically positive on the sector due to our cautious stance on interest
rate sensitives. The sector is also likely to benefit from upgrades in economic growth estimates of
US and Europe. Structurally, intensifying competition with MNCs would lead to slower growth
and pressure on margins. We are expecting 18-22% volume growth for Tier I IT companies in FY12
with an upward bias.
Automotives: Overall we see moderation in volume growth, particularly for 2Ws and CVs.
However, we are somewhat positively disposed towards LCVs and passenger vehicles. Broadly we
expect moderation in demand, weakening pricing power and margin pressures. The backdrop for
M&HCVs is not favourable, in our view, given the challenge arising from subdued cargo
movement data for both railways and major ports, notwithstanding the stronger performance of
the container segment. Port volume grew just 1.1% in the 11mFY11..
Metals: We are not very favourably inclined towards domestic steel industry though recent hikes
in product prices in Jan 2011 and stable to marginal increase in quarterly contract raw material
prices in Q4FY11 are expected to improve margins in Q4FY11. However, we expect this to be short
lived as product prices have corrected by 10-12% globally in last 6 weeks and contract prices of
raw materials are expected to show a significant jump from Q1FY12E (20-45% hikes expected in
iron ore and coking coal), we expect margins to get squeezed in H1FY12E.
Financial services: Estimated real GDP growth potentially scaled up 3-4%
Perhaps the biggest deviation in the GDP data (vs 1999-2000 series) comes from financial
services GDP. While the base year nominal GDP for the sector for FY05 was revised up by 7.6%
over the earlier series, it may have widened to nearly 40% in FY11 assuming CSO’s advance
estimate of Rs1,2990bn. Taking into account the released data for Q1-Q3FY11, CSO’s advance
estimate for FY11 implies nominal GDP growth for the sector at a huge 56.5% YoY in Q4FY11E
and 13.7% YoY in real terms, something we have not seen even during the most robust 2004-
2008 phase.
As per the CSO, the 2004-05 series covers a wider sample of informal financial services (non
bank and informal finance) and informal services relating to real estate, renting of machinery,
computers, legal, accounting, ownership of dwelling and research. Though forming a smaller
portion (about 24%) of the sectoral GDP, in the case of the latter, upward revisions have been in
the region of 120% for the base year.
We find these numbers inconsistent, and on assessment of quarterly data we further observe
that:
The add-on GDP (difference between new and old series) grew at a phenomenal 55%YoY
(average for FY05-FY10E) leading to an increase in overall financial services nominal GDP
growth from 13% YoY to 18%YoY. In addition, we notice that the new series has been
arrived at by adding almost constant amounts to the earlier series (Exhibit xx) indicating
that quarterly data has been computed from some annual number and not from any
additional data source.
Given that informal financial services have been in existence longer than formal financial
services and possibly over time the spread of formal sector should have increased, we
believe it is unlikely for informal services to have grown more rapidly than the formal.
Hence, the new series potentially embeds scaling factors resulting in significant blow up in
GDP numbers.
In addition, lack of visible leading indicators to capture informal services and mathematical
generation of quarterly data exposes us to large predictive error.
Notwithstanding the recent improvements in basic financial indicators like growth in broad
money supply, total liabilities of scheduled commercial banks, deposit growth and market
cap in stock exchanges, average growth for these indicators are more modest than revealed
by the new GDP series.
Assuming a modest FY11 38% YoY growth in GDP attributable to informal financial services
sector (63% average during FY07-FY10) and lower inflation of 6.7% (new series assumes
9%), we arrive at financial sector real GDP of 5.5% as per the old series compared to the
9.1% reported for the new series. Higher than 38% growth for the informal component and
higher inflation will imply lower growth for the old series.
Agri GDP: 8.9% YoY growth in Q3 helps shore up FY11 GDP, but surprises still
unexplainable
The high 8.9% Q3FY11 growth in agri GDP is broadly in line with the estimated 6.4% food-grain
production growth FY11 (CSOs advance estimates). While there has been some alterations in
GDP estimates (both nominal and real) in the new series (base year 2004-05) they are not very
significant. Nevertheless we do find some surprises:
a) The overall food grain production estimated at 232.07MT for FY11 (advance estimate) is 1%
lower than the peak of 234.47MT in FY09, but real agri GDP for FY11 is shown to be 5.8%
higher. The seasonal peak in Q3FY11 in Agri GDP (68%QoQ) is higher than in FY09 (66%
QoQ).
b) The positive 0.44% growth in real agri GDP in FY10 even with a 19% deficiency in monsoon
which was nearly as bad as 20% in FY03 when real agri GDP contracted 7.24%. A flat
growth is also in contrast with the 12% and 1.9% contractions in Kharif and Rabi crop
production in FY10. In its initial estimates for FY10 CSO had indeed indicated 2%
contraction in real Agri GDP growth. The swing from -2% to 0.44% is unexplainable.
While historical trends indicate strong correlation between real Agri GDP growth and food
grain production (Exhibit 18) recent surprises suggest structural changes in estimation process
or a break in historical trend, both of which are difficult to comprehend.
Industrial GDP: Propped up by reducing deflator; Large recent volatility out of sync
Upside bias in industrial GDP: Elevation in nominal GDP (average 4% for FY08-FY09) and
downward revisions in deflators amplified upward revision in real GDP for industrial sector
(Exhibit 20) and the impact came largely from the manufacturing sector. Critical thing to observe
is that downward revisions in the deflators for industrial sector are contrary to the upward
revisions for other components of GDP. Larger revisions for FY09 has however, resulted in slower
YoY growth for FY10 compared to the old series (1999-2000).
High dependence on volatile components: Break up of the manufacturing sector (from
industrial production data, Exhibit 23) shows that the bulk of manufacturing sector (76% weight
in manufacturing index of IIP) grew modestly at 5% YoY during Q1-Q3FY11 compared to the
overall manufacturing sector at 9.2% YoY. The manufacturing sector GDP data however shows
higher growth of 9.5%YoY.
Our analysis indicates that the dependence of manufacturing GDP growth on volatile
components has increased in the new series (Exhibit 23-27). Balancing out the abnormalities
(giving higher weight to broader trend in manufacturing sector, Exhibit 28) would probably scale
down FY11 (Q1-Q3) manufacturing GDP growth by 270bps to 6.7% from 9.5% reported by CSO.
High volatility in industrial production growth and industrial GDP growth has been caused by four
sectors or Big 4 sectors (machinery, transport equipments, metal products and other
manufacturing, 24% weight in manufacturing index of IIP) which posted a growth of 26% during
Q3FY10-Q2FY11, which is a 20 year high. While some of this is explainable, given the concentrated
rebound in auto sector, a large part of the abnormality is attributable to reduction in deflators
which resulted in significant over estimation in capital goods sector3.
In addition, trends in leading indicators such as electricity production (4.5% YoY during Q1-
Q3FY11), cement (4.4%), coal (0.8%), mining ex-crude and investment trends indicate a slowdown
in industrial growth. Recovery in FY09-FY10 has largely been concentrated in consumption
sectors (autos and durables in particular) and consumption dependent sectors.
Industrial GDP: Propped up by reducing deflator; Large recent volatility out of sync
Upside bias in industrial GDP: Elevation in nominal GDP (average 4% for FY08-FY09) and
downward revisions in deflators amplified upward revision in real GDP for industrial sector
(Exhibit 20) and the impact came largely from the manufacturing sector. Critical thing to observe
is that downward revisions in the deflators for industrial sector are contrary to the upward
revisions for other components of GDP. Larger revisions for FY09 has however, resulted in slower
YoY growth for FY10 compared to the old series (1999-2000).
High dependence on volatile components: Break up of the manufacturing sector (from
industrial production data, Exhibit 23) shows that the bulk of manufacturing sector (76% weight
in manufacturing index of IIP) grew modestly at 5% YoY during Q1-Q3FY11 compared to the
overall manufacturing sector at 9.2% YoY. The manufacturing sector GDP data however shows
higher growth of 9.5%YoY.
Our analysis indicates that the dependence of manufacturing GDP growth on volatile
components has increased in the new series (Exhibit 23-27). Balancing out the abnormalities
(giving higher weight to broader trend in manufacturing sector, Exhibit 28) would probably scale
down FY11 (Q1-Q3) manufacturing GDP growth by 270bps to 6.7% from 9.5% reported by CSO.
High volatility in industrial production growth and industrial GDP growth has been caused by four
sectors or Big 4 sectors (machinery, transport equipments, metal products and other
manufacturing, 24% weight in manufacturing index of IIP) which posted a growth of 26% during
Q3FY10-Q2FY11, which is a 20 year high. While some of this is explainable, given the concentrated
rebound in auto sector, a large part of the abnormality is attributable to reduction in deflators
which resulted in significant over estimation in capital goods sector3.
In addition, trends in leading indicators such as electricity production (4.5% YoY during Q1-
Q3FY11), cement (4.4%), coal (0.8%), mining ex-crude and investment trends indicate a slowdown
in industrial growth. Recovery in FY09-FY10 has largely been concentrated in consumption
sectors (autos and durables in particular) and consumption dependent sectors.
Services sector GDP: Significant ramp-up in estimated financial services GDP
The ramp-up in estimated services sector GDP has been the largest and it is the largest
contributor to the upward revision of both nominal and real GDP in the new series (2004-05 vs
1999-2000). Netting off the change in deflators the readjustment has resulted in upward
revision in real GDP; there is a downside bias to FY07-FY09 growth and upside bias for recent
growth.
A break-up of services sector shows that there has been disproportionately large upward
revision in financial sector GDP which contributes nearly 70% of added on nominal FY09 GDP.
Since social services GDP is closely linked to government spending, data for which is largely
available, there has been little change in this component.
In the following two sections we examine trade services (trade, transport, communications and
business services) and financial services. Broadly, while industry data indicates downtrend in
trade services growth since Q3FY10 contrary to official claims we believe there is
disproportionate upside bias in the reported financial sector GDP growth.
Trade services: Leading indicators contradict the robustness in trade services GDP growth
In case of trade services (trade, transport, communications and business services), the nominal
GDP has been scaled up on average by 4% (FY05-FY10) over the old series, the deflator has
increased by 2.7% leaving an upside of 1.3% in real GDP. However, with larger impact happening
at the earlier period the growth rates have been generally lower (Exhibit 39).
But the key issue is the higher average growth of 11.2% for CY10 vs 10.3% during FY05-Q2FY10.
While Q3FY11 has shown a decline to 9.4% it remained fairly strong (in excess of 11%) in the
preceding three quarters. Leading indicators (principal component of growths from six
industries), however suggest that the sector has consistently slowed since Q3FY10 (Exhibit 40).
RBI has often relied on data such as aviation (cargo & passengers) and foreign tourist arrivals to
suggest robust trade services growth; industry level data show deceleration since Q4FY10.
Conventional indicators such as cargo handled by major ports, railways and even outstanding
mobile connectivity have shown clear softening (Exhibits 42-43).
Inclusion of IIP growth along with the services industry data (principal component) in our
regression equation shows strong fitness for trade services GDP growth (Exhibit 42). But as
explained earlier, large upside aberrations in IIP growth prompts us to rely more on trade
industry data which indicates nearly a 120bp upside bias in the services sector GDP data for
Q1-Q3FY11.
Investments have indeed slowed; revival requires series fiscal consolidation
The recent data of both GDP and industrial production substantiates our long held view that
investments have been slowing. Gross fixed capital formation (GFCF)/GDP declined to 27.3% in
Q3FY11 (Exhibit 53) and capital goods growth contracted 19% in Jan 2011. Earlier IIP data for capital
goods gave gives an impression of a very strong investment cycle-it shows a huge average of 43%YoY
for 12 months ending Jun 2011. However, excluding the aberrations in IIP date it was clear that
investment growth started slowing since Dec 2009 (Exhibit (54). Over estimation of capital goods
growth were found to be related to aberrations in insulated cables (grew at 500%+YoY in few months)
and readjustments for reduction deflators for components for which data is collected in nominal
terms.
Additional data corroborating investment slowdown include:
Tepid 10% YoY growth in capital goods imports in FY11YTD compared to the steep 44% in
FY08.
FDI flows in FY11 have contracted 50% over last year.
Sharp decline in growth of order book of capital goods and construction companies: 26% in
Q3FY11 from 47% a few quarters back (Exhibit 56)
Continued softening investment projects under implementation for manufacturing and
services industries (Exhibit 57-60)
In our view, the slowdown in investments has been caused due to decline in domestic saving rate to
sub 30%. Private import of gold contracted 18-19%.
Reversal in investment cycles will likely emerge from a meaningful fiscal consolidation and reduction
in inflation. We believe, H2FY12 and FY13 will see emergence of a sustainable investment cycle.
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Summary
The macro challenges reinforce our view of a new normal growth, lower than the much claimed
9% (vs our expectation of 7.6%) for FY12E. A moderation in broader earnings estimates is
camouflaged by steep upgrades in a few companies, leading us to a selective market view.
Overstatement of GDP growth; FY11 probably inflated by 90bp: Over the past two years,
several changes have been made in GDP numbers, including disproportionately large revisions,
change in base year to 2004-05, change in deflator, and expansion in coverage for various
components. While these changes have resulted in an obfuscating flux and increased frequency, of
errors the disconnection with a wide set of leading indicators suggest inconsistencies. Our analysis
indicates widespread up-scaling, but the largest bias to GDP growth comes from financial & trade
services and manufacturing. Working backwards to extend the old series leads us to real GDP
growth for Q1-Q3FY11 of 7.7% vs CSO’s estimate of 8.6%
“Negotiating the new normal” is intact; FY12E GDP at 7.6% with an upside bias: While the
finance minister maintains an optimistic 9% GDP growth forecast in FY12, the RBI’s statements are
sombre. In our view, FY12 will see a transition from the stimulus-driven economic rebound to a new
normal trend around 7.5-8% growth. In our view, the near-term downside risks would dominate the
upside impulses, which would likely emerge gradually and more strongly in FY13. We maintain our
7.6% GDP growth estimate for FY12 with an upside bias. Contraction in real fiscal spending would
potentially create positive supply impulses, its instant impact will be contractionary. Every 100bp
negative shock in real fiscal spending growth translates into a 50bp fall in GDP growth. The factors
weighing on our outlook include subdued investments, lagged negative impact of past fiscal
expansion, downward inelastic interest rates. Amplified inclusion of informal sector in CSOs is an
estimation risk for our projections. Low risk could arise from tightening of global financial
conditions – rate hikes in the US and Europe and decline in savings in Japan.
Declining food inflation and rising cost pressures: Inflation in Feb 2011 rose to 8.3% from 8.2%
in Jan 2011 despite the sharp fall in food inflation. While manufactured product inflation climbed
up, it is relatively small compared to persistent rise in cost of raw materials. Implying intensifying
margin pressure and declining pass-through coefficient. While the risk of further escalation of costs
persists, we believe the onward trend in inflation is likely to decline due to demand moderation. We
expect WPI inflation to decline to 5-6% in FY12 with a reasonable probability of a 100bp upside
from potential increase in fuel prices.
Food surplus beats the facile structural demand-supply shortage thesis: Qfficial position that
food price shocks resulted from structural supply-demand deficit, a thesis we have consistently
refuted, is challenged by recent government decision to lift export ban on rice, sugar and onions to
stabilise declining domestic prices. Wheat export is expected to follow. These imply an oversupply
situation. WPI for most protein based items have declined from their 2010 peaks
Ballooning under-recoveries of oil PSUs: If crude prices remains at US$115 levels (Brent), underrecoveries
would be fairly large (Rs1.75-1.8trn with INR/USD at 46). Our oil analyst believes average
crude price would be US$95 in FY12E, translating into under recovery of around Rs1trn. While this is
manageable, sustenance of crude prices at US$115 would imply intense liquidity pressure.
Rural theme – Rising NPA in agri-lending: We maintain our theme “Fragility of rural growth”. As
per recent reports, PSU banks are reporting sharp rises in farms loan NPAs, between 80%-2,000%
during Q1-Q3FY11. While Budget FY12 enhanced agri credit target to Rs4,750bn, we believe
volatility in farm income arising from supply surpluses, high indebtedness and rising NPAs will force
banks to concentrate on recoveries. While aggressive lending may have fed into consumption
spending, rising indebtedness will result in a bigger default and fiscal problem in the future.
Market strategy: The continued moderation in earning estimates for the boarder markets, though
camouflaged by steep upgrades in a few companies, reflect better expectations for global-oriented
companies and domestic macro stress. While structural changes in the composition of index
earnings make historical comparison less relevant, we believe at 15.32 x FY12E EPS, the market may
still be expensive. Factors that are likely to be critical in the coming quarters are margin pressure,
volume growth moderation, upside risk to lending rates, and the multiplier impact of fiscal
contraction. Hence, we are overweight global/export-dependent themes (tactical positive on IT),
sectors less sensitive to commodity prices (pharma), and consumer non-durables. Rate-sensitive
like infrastructure and real estate sectors would continue to be under stress. While not so positive
on two-wheelers and commercial vehicles, we have a constructive view on LCVs and passenger
vehicles. The steel sector will likely see margin pressure beyond the short-term improvements.
Summary – Overstatement of GDP growth: FY11 probably inflated by 90bp
Estimation process in a state of flux: All parts moving: Over the past two years several changes
have been made in GDP numbers including disproportionately large revisions, change in base year
to 2004-05, change in deflator and expansion in coverage for various components.
While change in base year should not result in a change in nominal GDP, as it results from a
change in base year for the deflators and hence, also the real GDP, recent modifications have
resulted in all three parts moving simultaneously. Nominal GDP in the new series (base year
2004-05) shows a widening trend over the old series (base year 1999-00) with a projected upside
deviation of 20% in FY11. From our analysis it appears that FY11YTD GDP growth is inflated by
90bp.
While the new GDP deflator and the embedded inflation (a) has been scaled up, it has been
lesser than for the nominal GDP growth (b) there by resulting in an upside bias for the estimated
real GDP growth (b-a) potentially by about 100bp.
The Central Statistical Organisation (CSO) has chosen to make these changes incrementally –
first the annual GDP figure and later adjusting each quarter. Hence, quarterlies do not add up to
annual numbers
The result – Frequent errors
1. Q1FY11 initial release showed real expenditure GDP growth at 3.7% which was corrected to 10%
subsequently citing an error in the deflator used.
2. Over-reporting of capital goods production – over 200% YoY growth for insulated cables for most
of FY10-FY11. The 20.4% QoQ fall in real gross capital formation in Q1FY11, the steepest fall since
Q1FY98, was subsequently revised to -8.4%.
3. Understatement on import data in recent months.
Inconsistencies galore
Disconnect between leading indicators and GDP data (detail list in Exhibit 63, page 23).
1. Investments: While real gross fixed capital formation in GDP grew 20% during Q4FY10 - Q2FY11
(6% in Q3FY11), and also reflected in a huge 34% growth in capital goods production, capital
goods imports grew modestly at 10%. FDI has been contracting consistently since Q2FY10.
2. Agriculture: Food grain production estimated at 232.07MT for FY11 (advance estimate) is 1%
lower than 234.47MT in FY09, but the Real Agri GDP for FY11 is shown to be 5.8% higher.
3. Manufacturing: Bulk of the manufacturing sector (76% weight) grew modestly at 5% YoY during
Q1-Q3FY11 vs 9.2% for overall manufacturing, which is influenced by volatile components. The
manufacturing sector GDP data shows even higher growth of 9.5%YoY.
4. Core sector: Leading indicators such as electricity generation (4.5% YoY during Q1-Q3FY11),
cement (4.4%), coal (0.8%) and mining ex-crude do not support claims of robust recovery.
5. Construction: Recovery in construction GDP (9% YoY CY2010) coincides with rebound in steel
production (8% in CY2010). Cement growth on the contrary declined (5.6% in CY2010). Growths
for seven construction related industries (bars & rods, cranes, construction equipments, pipes &
tubes, steel-railways, structures & telecom cables) have been much softer in FY11 than in 2004-
2008.
6. Trade services: GDP for trade services grew 11.2% in CY10, stronger than 10.3% during FY05-
Q2FY10. Q3FY11 has shown a decline to 9.4%. Leading indicators however suggest slowdown
since Q3FY10. These include aviation (cargo & passengers), foreign tourists, cargo handled (ports,
railways) and outstanding mobile connectivity.
7. Financial services: Notwithstanding recent improvements, average growth in M3, total bank
assets, bank deposits and market cap, are far too modest to generate the 10.6% FY11 real growth
as per CSO’s advance estimates. Gap between the new and old nominal GDP series may have
widened by a huge 40%. It will require 57% YoY in Q4FY11 to match CSO’s advance estimates.
Inflated FY11 real GDP growth
Our analysis indicates widespread up-scaling, but the largest bias to GDP growth comes from
financial & trade services and manufacturing. Working backwards to extend the old series leads us to
real GDP growth for Q1-Q3FY11 of 7.7% vs CSO’s estimate of 8.6%.
1. Industrial GDP: Dependence of manufacturing GDP growth on volatile components has
increased. Balancing out abnormalities would scale down FY11 (Q1-Q3) GDP growth by 270bps
to 6.7% vs. 9.5%.
2. Financial sector GDP: Disproportionate revision in financial sector GDP contributed nearly 70%
of added on services GDP in FY09. Financial services GDP growth is potentially scaled up 3-3.5%
due to wider coverage of informal services. Assuming a lower 38% YoY FY11 growth for the addon
component would imply real GDP of 5.5-6% for Q1-Q3FY11 vs 9.1% as reported by CSO.
3. Trade services: The key issue here is the lack of supporting evidence from leading indicators.
Trends in leading indicators and normalised IIP growth (adjusted for aberrations) prompt us to a
trade services GDP growth of 9.7% in Q1-Q3FY, 110bp lower than the reported 10.8%.
Outlook: “Negotiating the new normal” is intact; FY12E at 7.6%
Mixed official views – RBI sounding less optimistic than the finance minister: While the finance
minster maintains 9% GDP growth in FY12, recent RBI statements have been more sombre. With
concerns on global crude prices and non-food inflation rising, the RBI is now finding it difficult to put
into context its anti-inflationary stance given its recent acknowledgement that investments are
declining. Misjudgements on both growth, engendered by inflated GDP numbers and inflation
profile can result in RBI overacting on the tightening side, thereby hampering growth.
Outlook – Upside risk will emerge; but downside to dominate the near-term: We believe FY12
will see a transition from the stimulus-driven rebound during Q2FY10- Q2FY11 to a new normal
trend around 7.5-8% (Exhibit 2). In our view, the near-term downside risks will dominate the upside
impulses. Positive impulses would likely emerge gradually and more strongly in FY13. We maintain
our 7.6% GDP growth projection for FY12 with an upside bias, which will be roughly similar to our
estimate of effective growth of 7.7% in FY11 (lower compared to 8.6% projected by CSO’s advance
estimates).
Downside risks arising from:
Initial negative shock from contraction in fiscal spending – 3.4% expansion in expenditure
budget for FY12 will imply contraction in real term after 20% average growth during FY08-FY11.
Our estimates show that for every 100bp negative shock in real government consumption
spending translates into a 50bp cumulative four quarter fall in GDP growth (Exhibit 4).
Subdued investments in the past three years would constrain future growth. Gross fixed capital
formation/GDP fell to 27.3% in Q3FY11 after a rebound to 33% in the previous three quarters.
Lagged negative impact of huge fiscal expansion during FY08-FY11 reflecting in elevated cost of
production & living, downward inelastic interest rates and higher taxes. Risk of further
tightening in policy rates and lagged impact of earlier tightening on lending rates.
Lingering impact of high inflation for raw material inflation averaged 25% in FY11 and possibility
of further increase in fuel prices due to elevated crude prices.
Low risk arising from tightening of global financial conditions: potential rate hikes in US and
Europe. Decline in savings in Japan in response to post-quake reconstruction activities.
Upside risks arising from:
Fiscal moderation should create positive supply responses - Lower the pace of inflation, ending
of rate tightening cycle after a quarter. Reversing the crowding out effect will result in positive
investment impulses, translating into a firming up of the investment cycle. Estimated impulse
response function indicates a lag of 4 quarters for the positive multiplier to emerge (Exhibit 4).
Risks to our view of 7.6% in FY12E with upside bias:
The biggest risk arises from potential changes in GDP estimation. CSO can potentially post a 9%
GDP growth due to amplified inclusion of intractable informal sector.
Early correction in commodity prices can be a big fundamental positive, in our view.
Summary of our recent macro thoughts
Declining food inflation and rising cost pressures: Inflation in Feb 2011 rose to 8.3% from 8.2% in Jan
2011 despite the sharp fall in food inflation. The rise is attributed to the sharp increase in global cotton
and oil seed prices. While manufactured product inflation climbed to 4.9%, it is relatively small compared
to persistent rise in cost of raw materials – 11.5% and 25%, respectively, for fuels and primary ex-food,
implying intensifying margin pressure and declining pass-through coefficient. While the risk of further
escalation of costs persists, we believe the onward trend in inflation is likely to decline due to demand
moderation. Recent decline in food inflation and moderation of prices of some raw material components
are indicative trends. While we expect WPI inflation to decline to 5-6% in FY12 there is a reasonable
probability of a 100bp upside from potential increase in administered fuel prices.
Food surplus beats the facile structural demand-supply shortage thesis: While the official position
has been that food price shocks resulted from structural supply-demand deficit, a thesis we have
consistently refuted , recent developments substantiate our view. Government has decided to lift export
ban on rice, sugar and onions to stabilise declining domestic prices. Wheat export is expected to follow.
The expected 82mt wheat production in 2010-11 is in excess of annual consumption of 76mt. Total food
grain production of 232mt and large buffer imply an oversupply situation. RBI till recently argued that
rising incomes and consequent increase in protein diet resulted in increase in prices of milk and nonvegetarian
items. But we do not hear that argument any more. The reason: WPI for most protein based
items have declined from their 2010 peaks: pulses (-14%), milk (-2%), poultry (-17%), eggs (-8.2%) and
mutton (-4%). Overall, misplaced assessment is bound to lead to misplaced policy responses. Along with
the declining trend in manufactured food prices, food inflation declined to 6.5% in Feb 2011 (10% in Dec
2010). Going forward, it will be cost factors that will be more important for food economy than demand
pressures.
Monetary policy – RBI’s stance could be a reaction to cost pressures: In our view, given the cost
pressures and recent moderation in manufacturing sector and investments growth, the RBI’s antiinflationary
stance can result in the central bank erring on the tightening side, which could adversely
impact growth. The RBI increased the inflation target to 8% in its March 2011 statement. Rise in crude
prices continues to pose serious risk to inflation and fiscal management. We believe beyond maintaining
the current level of monetary tightening, the RBI can do little to control it. In our view, rising cost pressures
can itself contract demand. RBI will find it difficult to increase rates beyond mid-2011. Liquidity conditions
may not ease substantially due to increased borrowing by PSU oil companies to fund their under
recoveries which will balance out moderation in government gross borrowing in H1FY12 atRs2,500bn.
Fiscal – Pro-stability FY12 budget, but managing subsidies will be tricky: The moderation in spending
in budget FY12 to a modest 3.4% and lower fiscal deficit comes from lower budget for both non-plan
revenue and capital expenditure, despite higher commitment for plan spending. Lower fiscal deficit of
Rs4,128bn vs our expectation of Rs4,500bn is arrived at based on an optimistic disinvestment target of
Rs400bn and conservative spending. This translates into an optimistic fiscal deficit/GDP number of 4.6%.
Lower net market borrowing of Rs3,580bn also assumes an optimistic 36% growth in mobilization through
small-savings schemes. We believe a realistic net market borrowing number could be around Rs4,200bn.
Overall, we expect significant compromises on social and capital spending in the consolidation process.
Ballooning under-recoveries of oil PSUs: If crude prices remains at US$115 levels (Brent), the under
recovery would be fairly large (Rs1.75-1.8trn with INR/USD at 46). Our oil analyst believes average crude
price would be US$95 in FY12E, translating into under recovery of around Rs1trn. Out of this, about 40-
45% would be borne by upstream companies and oil marketing companies (OMCs), and the balance by
the government. Given the budget provision of Rs236bn, the government needs to provide for another
Rs300-400bn. Overall, this means higher fiscal borrowing or credit demand by OMCs, thereby putting
pressure on liquidity. While this is manageable, sustenance of crude at US$115 would imply intense
liquidity pressure.
Rural growth theme – Rising NPA in agri-lending: We continue hold our macro theme view “Fragility of
rural growth” (May 2010 and update in Nov 2010). As per recent media reports , PSU banks are reporting
sharp rises in farms loan NPAs - between 80%-2,000% during Q1-Q3FY11 (Exhibit 5). SBI reported bad
loans of around Rs372mn (80%YoY). While Budget FY12 enhanced agri credit target to Rs4,750bn, we
believe volatility in farm income arising from supply surpluses, high indebtedness and rising NPAs will
force banks to concentrate on recoveries rather than lending. We maintain that while aggressive lending
may have fed into consumption spending, rising level of indebtedness and rising risk of default will result
in a bigger default and fiscal problem in the future.
Market strategy: Macro stress still significant
Wider earnings downgrades overwhelmed by sharp upgrades in few companies: While the
BSE Sensex EPS estimates for FY12 and FY12 has undergone only a moderate corrections (2.4% for
FY11E at Rs1,067 and 3% for FY12E at Rs1,269), the underlying components show a fairly
divergent trend. 18 companies have seen an average downgrade of 10.4% (FY11E) while the
remaining 12 have seen an upgrade of 13.6%, dominated by 187% for Tata Motors and 20% for
Hindalco Industries. Similar pattern holds true for FY12E. Overall, better expectations for global
oriented companies have helped keep index EPS stable reflecting domestic macro stress. Hence
overweight global / exports dependent companies will be a good theme to play. While structural
change in the composition of index makes historical comparison less relevant we believe at 15.32
x FY12E EPS, the market may still be somewhat expensive. The key risk would arise if developed
markets undergo renewed slowdown.
Margin pressure – Overweight sectors less sensitive to commodity prices: Commodity prices
have been rising since mid 2009 and have sustained longer than our expectation. Inline with our
long standing view, earnings expectations are moderating and would possibly intensify due to
contraction in fiscal spending against the backdrop of modest pricing power pricing power and
rising cost. In our view, there is a strong likelihood for this scenario sustaining in the coming
quarters. To summaries our earlier findings (Feb 2010), while sectors like automobiles, FMCG, oil &
gas, power and metals are more susceptible to rise in commodity prices, pharma and real estate
are less impacted. Auto and auto ancillary being the most vulnerable. Consumer durables seem to
have a low correlation and the cement sector has no meaningful correlation. For most sectors, rise
in commodity prices impacts the raw material/sales ratio with a lag of two quarters. Hence,
overweight sectors enjoying strong pricing power or low sensitivity.
Moderation in government spend to result in lower cash for rural India: Moderation in
government spending support on social, correction in food prices and focus on recoveries of farm
loans will imply lower cash flow for the rural story. We believe the agri-driven story would sober
down. Consumption-led demand recovery would be oriented towards non-durables, but the
volatility in food grain procurement-related flows would slow growth for durables and autos.
Concerns on credit risk would have implications for PSU banks.
Interest rate sensitive — End of the tightening cycle still some time away: Notwithstanding
the positive signals from the budget, we believe the lending rates would continue to harden
given the RBI’s hawkish stance. Liquidity scenario will likely ease in the initial quarters due to
lower government gross borrowing of Rs2,500bn in H1FY12 (60% of total annual of Rs4,171bn).
Gsec yield curve will likely undergo bull flattening implying short-term positive for banks. Overall,
the rate scenario will continue to impact infrastructure and real estate sectors adversely. Our
stand can potentially change if crude price corrects below USD 100/bl in a sustainable fashion.
Overweight sectors benefiting from rising commodity prices: We would overweight selective
energy stocks (which benefit from higher crude price, GRMs, pet chem margins).
Consumer space: Overweight non-durables, underweight durables and pharma (non-correlated
with interest rates). Decline in prices of primary food articles will benefit FMCG companies
dependent on cereal inputs.
IT services sector: We are tactically positive on the sector due to our cautious stance on interest
rate sensitives. The sector is also likely to benefit from upgrades in economic growth estimates of
US and Europe. Structurally, intensifying competition with MNCs would lead to slower growth
and pressure on margins. We are expecting 18-22% volume growth for Tier I IT companies in FY12
with an upward bias.
Automotives: Overall we see moderation in volume growth, particularly for 2Ws and CVs.
However, we are somewhat positively disposed towards LCVs and passenger vehicles. Broadly we
expect moderation in demand, weakening pricing power and margin pressures. The backdrop for
M&HCVs is not favourable, in our view, given the challenge arising from subdued cargo
movement data for both railways and major ports, notwithstanding the stronger performance of
the container segment. Port volume grew just 1.1% in the 11mFY11..
Metals: We are not very favourably inclined towards domestic steel industry though recent hikes
in product prices in Jan 2011 and stable to marginal increase in quarterly contract raw material
prices in Q4FY11 are expected to improve margins in Q4FY11. However, we expect this to be short
lived as product prices have corrected by 10-12% globally in last 6 weeks and contract prices of
raw materials are expected to show a significant jump from Q1FY12E (20-45% hikes expected in
iron ore and coking coal), we expect margins to get squeezed in H1FY12E.
Financial services: Estimated real GDP growth potentially scaled up 3-4%
Perhaps the biggest deviation in the GDP data (vs 1999-2000 series) comes from financial
services GDP. While the base year nominal GDP for the sector for FY05 was revised up by 7.6%
over the earlier series, it may have widened to nearly 40% in FY11 assuming CSO’s advance
estimate of Rs1,2990bn. Taking into account the released data for Q1-Q3FY11, CSO’s advance
estimate for FY11 implies nominal GDP growth for the sector at a huge 56.5% YoY in Q4FY11E
and 13.7% YoY in real terms, something we have not seen even during the most robust 2004-
2008 phase.
As per the CSO, the 2004-05 series covers a wider sample of informal financial services (non
bank and informal finance) and informal services relating to real estate, renting of machinery,
computers, legal, accounting, ownership of dwelling and research. Though forming a smaller
portion (about 24%) of the sectoral GDP, in the case of the latter, upward revisions have been in
the region of 120% for the base year.
We find these numbers inconsistent, and on assessment of quarterly data we further observe
that:
The add-on GDP (difference between new and old series) grew at a phenomenal 55%YoY
(average for FY05-FY10E) leading to an increase in overall financial services nominal GDP
growth from 13% YoY to 18%YoY. In addition, we notice that the new series has been
arrived at by adding almost constant amounts to the earlier series (Exhibit xx) indicating
that quarterly data has been computed from some annual number and not from any
additional data source.
Given that informal financial services have been in existence longer than formal financial
services and possibly over time the spread of formal sector should have increased, we
believe it is unlikely for informal services to have grown more rapidly than the formal.
Hence, the new series potentially embeds scaling factors resulting in significant blow up in
GDP numbers.
In addition, lack of visible leading indicators to capture informal services and mathematical
generation of quarterly data exposes us to large predictive error.
Notwithstanding the recent improvements in basic financial indicators like growth in broad
money supply, total liabilities of scheduled commercial banks, deposit growth and market
cap in stock exchanges, average growth for these indicators are more modest than revealed
by the new GDP series.
Assuming a modest FY11 38% YoY growth in GDP attributable to informal financial services
sector (63% average during FY07-FY10) and lower inflation of 6.7% (new series assumes
9%), we arrive at financial sector real GDP of 5.5% as per the old series compared to the
9.1% reported for the new series. Higher than 38% growth for the informal component and
higher inflation will imply lower growth for the old series.
Agri GDP: 8.9% YoY growth in Q3 helps shore up FY11 GDP, but surprises still
unexplainable
The high 8.9% Q3FY11 growth in agri GDP is broadly in line with the estimated 6.4% food-grain
production growth FY11 (CSOs advance estimates). While there has been some alterations in
GDP estimates (both nominal and real) in the new series (base year 2004-05) they are not very
significant. Nevertheless we do find some surprises:
a) The overall food grain production estimated at 232.07MT for FY11 (advance estimate) is 1%
lower than the peak of 234.47MT in FY09, but real agri GDP for FY11 is shown to be 5.8%
higher. The seasonal peak in Q3FY11 in Agri GDP (68%QoQ) is higher than in FY09 (66%
QoQ).
b) The positive 0.44% growth in real agri GDP in FY10 even with a 19% deficiency in monsoon
which was nearly as bad as 20% in FY03 when real agri GDP contracted 7.24%. A flat
growth is also in contrast with the 12% and 1.9% contractions in Kharif and Rabi crop
production in FY10. In its initial estimates for FY10 CSO had indeed indicated 2%
contraction in real Agri GDP growth. The swing from -2% to 0.44% is unexplainable.
While historical trends indicate strong correlation between real Agri GDP growth and food
grain production (Exhibit 18) recent surprises suggest structural changes in estimation process
or a break in historical trend, both of which are difficult to comprehend.
Industrial GDP: Propped up by reducing deflator; Large recent volatility out of sync
Upside bias in industrial GDP: Elevation in nominal GDP (average 4% for FY08-FY09) and
downward revisions in deflators amplified upward revision in real GDP for industrial sector
(Exhibit 20) and the impact came largely from the manufacturing sector. Critical thing to observe
is that downward revisions in the deflators for industrial sector are contrary to the upward
revisions for other components of GDP. Larger revisions for FY09 has however, resulted in slower
YoY growth for FY10 compared to the old series (1999-2000).
High dependence on volatile components: Break up of the manufacturing sector (from
industrial production data, Exhibit 23) shows that the bulk of manufacturing sector (76% weight
in manufacturing index of IIP) grew modestly at 5% YoY during Q1-Q3FY11 compared to the
overall manufacturing sector at 9.2% YoY. The manufacturing sector GDP data however shows
higher growth of 9.5%YoY.
Our analysis indicates that the dependence of manufacturing GDP growth on volatile
components has increased in the new series (Exhibit 23-27). Balancing out the abnormalities
(giving higher weight to broader trend in manufacturing sector, Exhibit 28) would probably scale
down FY11 (Q1-Q3) manufacturing GDP growth by 270bps to 6.7% from 9.5% reported by CSO.
High volatility in industrial production growth and industrial GDP growth has been caused by four
sectors or Big 4 sectors (machinery, transport equipments, metal products and other
manufacturing, 24% weight in manufacturing index of IIP) which posted a growth of 26% during
Q3FY10-Q2FY11, which is a 20 year high. While some of this is explainable, given the concentrated
rebound in auto sector, a large part of the abnormality is attributable to reduction in deflators
which resulted in significant over estimation in capital goods sector3.
In addition, trends in leading indicators such as electricity production (4.5% YoY during Q1-
Q3FY11), cement (4.4%), coal (0.8%), mining ex-crude and investment trends indicate a slowdown
in industrial growth. Recovery in FY09-FY10 has largely been concentrated in consumption
sectors (autos and durables in particular) and consumption dependent sectors.
Industrial GDP: Propped up by reducing deflator; Large recent volatility out of sync
Upside bias in industrial GDP: Elevation in nominal GDP (average 4% for FY08-FY09) and
downward revisions in deflators amplified upward revision in real GDP for industrial sector
(Exhibit 20) and the impact came largely from the manufacturing sector. Critical thing to observe
is that downward revisions in the deflators for industrial sector are contrary to the upward
revisions for other components of GDP. Larger revisions for FY09 has however, resulted in slower
YoY growth for FY10 compared to the old series (1999-2000).
High dependence on volatile components: Break up of the manufacturing sector (from
industrial production data, Exhibit 23) shows that the bulk of manufacturing sector (76% weight
in manufacturing index of IIP) grew modestly at 5% YoY during Q1-Q3FY11 compared to the
overall manufacturing sector at 9.2% YoY. The manufacturing sector GDP data however shows
higher growth of 9.5%YoY.
Our analysis indicates that the dependence of manufacturing GDP growth on volatile
components has increased in the new series (Exhibit 23-27). Balancing out the abnormalities
(giving higher weight to broader trend in manufacturing sector, Exhibit 28) would probably scale
down FY11 (Q1-Q3) manufacturing GDP growth by 270bps to 6.7% from 9.5% reported by CSO.
High volatility in industrial production growth and industrial GDP growth has been caused by four
sectors or Big 4 sectors (machinery, transport equipments, metal products and other
manufacturing, 24% weight in manufacturing index of IIP) which posted a growth of 26% during
Q3FY10-Q2FY11, which is a 20 year high. While some of this is explainable, given the concentrated
rebound in auto sector, a large part of the abnormality is attributable to reduction in deflators
which resulted in significant over estimation in capital goods sector3.
In addition, trends in leading indicators such as electricity production (4.5% YoY during Q1-
Q3FY11), cement (4.4%), coal (0.8%), mining ex-crude and investment trends indicate a slowdown
in industrial growth. Recovery in FY09-FY10 has largely been concentrated in consumption
sectors (autos and durables in particular) and consumption dependent sectors.
Services sector GDP: Significant ramp-up in estimated financial services GDP
The ramp-up in estimated services sector GDP has been the largest and it is the largest
contributor to the upward revision of both nominal and real GDP in the new series (2004-05 vs
1999-2000). Netting off the change in deflators the readjustment has resulted in upward
revision in real GDP; there is a downside bias to FY07-FY09 growth and upside bias for recent
growth.
A break-up of services sector shows that there has been disproportionately large upward
revision in financial sector GDP which contributes nearly 70% of added on nominal FY09 GDP.
Since social services GDP is closely linked to government spending, data for which is largely
available, there has been little change in this component.
In the following two sections we examine trade services (trade, transport, communications and
business services) and financial services. Broadly, while industry data indicates downtrend in
trade services growth since Q3FY10 contrary to official claims we believe there is
disproportionate upside bias in the reported financial sector GDP growth.
Trade services: Leading indicators contradict the robustness in trade services GDP growth
In case of trade services (trade, transport, communications and business services), the nominal
GDP has been scaled up on average by 4% (FY05-FY10) over the old series, the deflator has
increased by 2.7% leaving an upside of 1.3% in real GDP. However, with larger impact happening
at the earlier period the growth rates have been generally lower (Exhibit 39).
But the key issue is the higher average growth of 11.2% for CY10 vs 10.3% during FY05-Q2FY10.
While Q3FY11 has shown a decline to 9.4% it remained fairly strong (in excess of 11%) in the
preceding three quarters. Leading indicators (principal component of growths from six
industries), however suggest that the sector has consistently slowed since Q3FY10 (Exhibit 40).
RBI has often relied on data such as aviation (cargo & passengers) and foreign tourist arrivals to
suggest robust trade services growth; industry level data show deceleration since Q4FY10.
Conventional indicators such as cargo handled by major ports, railways and even outstanding
mobile connectivity have shown clear softening (Exhibits 42-43).
Inclusion of IIP growth along with the services industry data (principal component) in our
regression equation shows strong fitness for trade services GDP growth (Exhibit 42). But as
explained earlier, large upside aberrations in IIP growth prompts us to rely more on trade
industry data which indicates nearly a 120bp upside bias in the services sector GDP data for
Q1-Q3FY11.
Investments have indeed slowed; revival requires series fiscal consolidation
The recent data of both GDP and industrial production substantiates our long held view that
investments have been slowing. Gross fixed capital formation (GFCF)/GDP declined to 27.3% in
Q3FY11 (Exhibit 53) and capital goods growth contracted 19% in Jan 2011. Earlier IIP data for capital
goods gave gives an impression of a very strong investment cycle-it shows a huge average of 43%YoY
for 12 months ending Jun 2011. However, excluding the aberrations in IIP date it was clear that
investment growth started slowing since Dec 2009 (Exhibit (54). Over estimation of capital goods
growth were found to be related to aberrations in insulated cables (grew at 500%+YoY in few months)
and readjustments for reduction deflators for components for which data is collected in nominal
terms.
Additional data corroborating investment slowdown include:
Tepid 10% YoY growth in capital goods imports in FY11YTD compared to the steep 44% in
FY08.
FDI flows in FY11 have contracted 50% over last year.
Sharp decline in growth of order book of capital goods and construction companies: 26% in
Q3FY11 from 47% a few quarters back (Exhibit 56)
Continued softening investment projects under implementation for manufacturing and
services industries (Exhibit 57-60)
In our view, the slowdown in investments has been caused due to decline in domestic saving rate to
sub 30%. Private import of gold contracted 18-19%.
Reversal in investment cycles will likely emerge from a meaningful fiscal consolidation and reduction
in inflation. We believe, H2FY12 and FY13 will see emergence of a sustainable investment cycle.
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