Lights, Camera, ….
Our sources suggest that the Government is about to launch a wave of
reforms over the next month as part of a strategy which is likely to
culminate in General Elections a year hence. With significant progress
now being made on critical structural issues such as the Coal-Power-
SEB mess, we: (a) Maintain our FY13 GDP growth estimate at 6.3%; (b)
Introduce our FY14 GDP growth estimate at 7.1%; (c) Raise our Sensex
target of 19K (a target first published in our Jan ’12 research) to 23K.
Given that a number of investors have been caught on the wrong foot
by the Indian Government’s appetite for reform, we expect panic
buying of Indian equities over the next month or so followed by a
cooling off during the Winter Session of Parliament in late Nov-Dec.
A three step strategy climaxing in General Elections a year hence
Our extensive discussions with sources in Delhi over the past month suggest
that the UPA’s recent burst of reforms is not a flash in the pan. In fact, it
seems to be a part of a three stage political and economic plan which looks
likely to climax in General Elections a year hence.
Step 1 involves announcing a barrage of reforms between now and mid-Nov
including reforms (eg. Land Acquisition Act, FDI in Insurance, Pension Bill, etc)
which are certain to be blocked by the Opposition (thereby enhancing the
Congress’ reformist credentials). Step 2 is to woo regional overlords in Q4
FY13 in states such as UP, Bihar and Orissa with a view to weaning them from
the Opposition and creating pre-poll alliances. Step 3 in H1 FY14 involve
accelerating spending on Food Security, universal healthcare and other social
schemes and then triggering General Elections during the Monsoon Session.
FY14 GDP growth of 7.1% YoY
The economic reforms announced in September 2012 and the series of
reforms the reforms expected in October should improve equity capital
availability in India thereby facilitating a cyclical recovery. Whilst we expect
GDP growth in India in FY13 to be recorded at 6.3% YoY, GDP growth in FY14
is likely to record a cyclical upturn at 7.1% YoY assuming: (1) Normal
monsoons, (2) A marginally lower crisis factor than that prevailing in FY13,
and (3) A jump in Central Government revenue expenditure in a pre-election
financial year.
Raising our Sensex target to 23K (from 19K)
Based on both top down and bottom-up estimates, we expect FY14 Sensex
EPS to be at Rs1350 (10% growth compared to our FY13 estimate of Rs1229).
Applying to this a forward P/E multiple of 17x, in-line with India’s average
over the last six years, gives us our new Sensex target of 23K.
This rally is unlikely to be a linear affair: three key risks to consider
(a) Corporate India’s Balance Sheets are in worse shape than they have been
for over ten years and the banking sector’s dysfunctional loans are almost as
big as the networth of the sector. Both of these factors will be major
retardants to a strong economic recovery in FY14. (b) The Government’s
disinvestment program in FY13 amounts to $3bn. Add to that another $2bn of
QIP raises from the private sector and we are likely to have around $5bn of
fresh paper hitting the Indian market. This could reduce the upside available
at the index level in FY13. (c) The Winter Session of Parliament is likely to
produce the usual antics that we have all got used to and some investors will
be disheartened by this. In combination with QE cooling post the US
Presidential elections, this could well lead to a fade in the rally in December
The UPA’s roadmap to General Elections
Over the last two years during our monthly visits to Delhi we have tried in vain to
understand the UPA’s and, more interestingly, the Congress’ political and
economic strategy. By and large, our success in this endeavor has been largely
restricted to being able to decipher reform announcements which are likely to
arrive in the coming weeks; none of our trusted sources seemed to understand
what the UPA’s longer term political and economic strategy was.
All of that has changed over the past month or so. Our extensive discussions over
the past month suggest that the Congress seems to be following a three part
strategy which looks likely to culminate in General Elections a year hence.
Step 1 (Sept-Dec 2012): Announce a barrage of measures which include
reform which is relatively to easy to activate and don’t require Parliamentary
approval (FDI in Retail & Aviation, clearances for Power and industrial projects)
and reforms (such as Land Acquisition, FDI in Insurance, Pensions) which do
require Parliamentary sign-off. Then wait for the Opposition to block the latter
in the Winter Session (in December) and before turning to the public to say
that “We are the good guys. You know who the bad guys are.” Such a strategy
puts the Opposition in a “no win” position and also predisposes Corporate
India to think more positively about the ruling party. Generous contributions
from the corporate sector towards campaign financing is something that all the
key parties are seeking at this point in time.
Step 2 (Sept 2012 – Feb 2013): Since the electoral arithmetic for the next
General Election suggests that the Congress will not get anywhere close to its
current 205 Lok Sabha seats, the party has to sign-up more allies in advance
of the next election. One way to do so is to target regional overlords in states
like UP, Bihar and Orissa where the Chief Ministers can each command
around 20 seats in the Lok Sabha and where the Chief Ministers are close to
the Opposition. The current discussions about giving “special status” (i.e. more
money from the Centre) to these states seems to be part of the Congress’
efforts to woo these Chief Ministers. The greater the Congress’ success with
Step 1, the greater would be its chances of success with Step 2.
Step 3 (March 2013 – Oct 2013): Hopefully, by then the economy would be
in recovery mode thus boosting tax revenues for the Central Government. In
any event, the usual bout of pre-election spending should be activated via the
passing of the Food Security Bill and via universal healthcare related spending.
Farm loan waivers, a pre-election staple in India, are also likely to be pressed
into service. Since all of this would stretch the FY14 budget deficit, the sensible
thing to do would be to use the 2013 Monsoon Session of Parliament to
trigger General Elections. That would mean that the compromised FY14
budget deficit becomes a political non-issue.
The UPA’s upcoming reform agenda
‘The UPA in no way is a minority Govt’
In our email dated 19th September, 2012, we made the point that the TMC’s (19
Lok Sabha seats) pullout from the UPA Government is likely to be irrelevant for the
stock market.
Our sources in Delhi say that TMC’s shenanigans are inconsequential from a
political stability point of view mainly because both the SP (22 Lok Sabha seats)
and BSP (21 Lok Sabha seats) have explicitly expressed their support to the UPA in
the form of letters to the President last week. Therefore, the current Government
has a clear simple majority in the Lok Sabha with 300 seats (i.e. 276 (Congress ex-
TMC) – 19 (TMC) + 22 (SP) + 21 (BSP) =300).
The Government is likely to ‘go for broke’ on the reform front
Several of our sources in Delhi are of the view that a second wave of policyfireworks
is likely to be announced in the coming weeks as the FM sees October
2012 as ‘the one month window of opportunity’ for administering reforms.
Whilst experts were uniformly of the view that ‘the parliamentary road to reforms
is over’, our sources highlight the three key sets of out-of-parliament reform that
the Government is likely to deliver by October 2012:
Key reform 1: Resolving the Power-Coal-SEB Tangle
Dr. Govinda Rao is the country’s leading fiscal expert and is also an independent
Board member of REC and NTPC. In a conference call with our clients of 21st Sept,
Dr.Rao highlighted that the State Electricity Board (SEB) debt restructuring scheme
has been finalised and would be put before the cabinet on 25th September.
State governments have agreed to this scheme where they have to take 50%
of the short term debt on their books and bring down SEB losses by regularly
increasing tariffs and decreasing T&D losses.
As per Dr.Rao, this will give lifeline to SEBs and the entire ecosystem around it.
However, the real challenge would be forcing/motivating state governments to
carry on these reforms. He is of the opinion that state governments being
asked to fund SEB losses from their respective state budgets would be the best
way to bring reforms in the sector.
Since SEB losses were not part of state fiscal deficits, state governments did not
care about these losses and hence the 14th Finance Commission might
propose to include SEB losses in the calculations of state budgets and fiscal
deficits.
Dr.Rao further highlighted the possibility of Power Purchase Agreement (PPA)
tariff revisions being allowed (i.e. the Independent Power Producers (IPPs) will
be allowed to pass on higher fuel costs) as the financial health of the SEBs
improves. This point has been corroborated by other experts.
According to our panel of Power experts, tariff revisions for IPPs’ can be justified
despite no “fuel pass through” clauses embedded in the PPA documents as:
(a) The sector is at an evolution stage (only since 2003 private sector started
participating aggressively) and hence it is highly possible that these power
purchase contracts entered into three to four years back were not fully able to
envision the risks on multiple fronts (availability of coal, SEBs financial health).
Note that globally no developer exposes itself to fuel costs for a period of 25 years
and hence the competitive bidding happens on fixed cost and plant efficiency
which is completely different from what happens in India (wherein developers also
locks the fuel purchase cost for a period of 25 years); and
(b) As in the transportation infrastructure (Noida Toll bridge and airports) and in
the Telecom sector (linking license fee to revenue), the Government has a history
of changing the clauses of revenues post the partial/full completion of these
projects so as to make these projects ROE positive.
One of the methodologies to determine the quantum of tariff hikes highlighted by
our expert is project rebidding, wherein it’s a take or pay arrangement for the
existing project developer. In other words either the existing developer matches
the lowest bid or surrenders the project at book value to the lowest bidder. The
rationale of rebidding is to determine the new tariff in a fair and transparent
manner.
Key reform 2: Capital Market reforms
Vijay Kelkar, the Chairman of the Thirteenth Finance Commission, is in the process
of advising the Ministry of Finance on possible capital market reforms. This
package of capital market reforms are likely to aid: (1) The FII community by
reducing compliance costs, (2) Domestic mutual funds and (3) SMEs as well as
unlisted companies by facilitating access to affordable capital.
Key reform 3: Real economy reforms
The Government is likely to ensure that the Pharma sector remains open (as
against the Commerce Ministry’s demand to check investment beyond 49% in local
pharma firms), limit the sugar subsidy bill and actively clear infrastructure projects.
Additionally the Government is likely to make an announcement that can facilitate
the use of Government as well as PSU land banks. However, the passage of the
Pension Bill as well as the Land Acquisition Bill is likely to be delayed as the
Parliament is likely to remain dysfunctional in the Winter Session.
The Congress plans to cement its coalition
Political-economy experts are of the view that the key reason why the UPA remains
stable despite TMCs (19 Lok Sabha seats) support withdrawal is simply because
there exist three substitutes to this party namely the SP (22 seats), the BSP (21
seats) and the JD(U) (20 seats). Besides a Cabinet reshuffle that interests these
parties, each of these 3 parties stands to gain financially by the possible grant of a
‘special status’ to UP and Bihar. In addition, our sources say that ‘special status’ is
also being discussed for Orissa (where the Chief Minister’s party, BJD (14 seats in
the Lok Sabha) is currently a member of the Opposition).
It is worth noting that 11 Indian states (namely Arunachal
Pradesh, Assam, Himachal Pradesh, Jammu and Kashmir, Manipur, Meghalaya,
Mizoram, Nagaland, Sikkim, Tripura & Uttarakhand) currently enjoy special status
which makes them eligible for extra financial support from the Central
Government.
The Central Government’s fiscal deficit is likely to remain a sore point
Whilst the Kelkar Committee report is likely to add to the Government’s stated
goal of fiscal consolidation (through improved tax administration, restricting
subsidies and cutting-back on unproductive expenditures), our fiscal expert,
Dr.Rao, expects the Central Government’s fiscal deficit to remain an area of
weakness in FY13.
Dr.Rao expects the Central Government fiscal deficit to be in the range of 5.5-6%
of GDP in FY13 (v/s the budgeted 5.1% of GDP) owing to: (1) Gross tax revenue
growth being recorded at ~15% YoY v/s the 20% YoY budgeted growth; and (2) A
high petroleum subsidy bill (of ~INR800bn as per our estimates) v/s the INR440bn
that has been budgeted. Whilst Dr.Rao expects the disinvestment target of
INR300bn to be achievable owing to the improved capital market conditions, the
Government is expected to cut-back on capital expenditure to restrict the quantum
of fiscal slippage.
Assumptions made
Assumption 1: FY14 is characterized by an incrementally better risk
environment v/s FY13
As highlighted in our previous notes, India’s economic growth process is affected
meaningfully by the global risk environment and domestic availability of equity
capital.
We build in an incrementally improved macroeconomic risk environment in FY14
(quantitatively, we build in a crisis factor of ‘0.4’ v/s ‘0.5’ in FY13). This is so
because: (1) Domestically we expect the policy momentum to drive higher capital
inflows; and (2) Globally we expect European sovereign debt concerns to affect risk
aversion levels adversely but the simultaneous administration of monetary stimulus
by developed country central banks to counter this dynamic.
Assumption 2: India receives normal rainfall in FY14
We factor in ‘normal’ monsoons in FY14 in the absence of any logical reason to
assume otherwise. This translates into farm sector growth of 5.5% YoY in FY14 v/s
0.5% in FY13. Whilst the jump appears meaningful, history points to a larger
sequential improvement in farm sector growth when a year characterized by subnormal
rainfall is succeeded by a year that experiences normal rainfall. For
instance, whilst farm sector growth contracted by 7% in FY02 owing to sub-normal
rains, growth was recorded at 10% YoY in FY03 owing to normal rainfall.
Assumption 3: Wheat and Paddy MSPs are increased by 15% YoY in FY14
Given the historic relationship whereby an increase in the Government declared
minimum support price (MSP) results in an increase in agricultural output, our farm
sector growth model explicitly factors in this variable by focusing on MSPs of wheat
and rice which together account for 78% of foodgrain production in India.
We factor in a 15% YoY increase in the average MSP for paddy and wheat in FY14.
This is a fairly prudent assumption as MSP increases are typically high in preelection
financial years. For instance, MSP increases averaged 22% YoY over
FY08-09 which were the last two financial years in the run up to the 2009 General
elections.
Assumption 4: The repo rate is cut by 100bps over FY14
Our investment demand model factors in the monetary policy rate as one of the
explanatory variables as the cost of debt capital imposes a negative drag on
investment demand.
We expect the RBI to administer front-loaded cuts in GDP growth in FY14 thus
supporting investment growth. However, the quantum of cuts is likely to be limited
as inflation is likely to persist at high levels.
Assumption 5: Inflation adjusted Union Government revenue expenditure
increases in FY14
Growth in the ‘community social and personal services’ segment of the services
sector (14% share in GDP) depends directly upon the extent of inflation-adjusted
Government revenue expenditure. As the General Elections scheduled for CY14
approach, we expect Union Government expenditure to expand at a faster pace
and hence assume that revenue expenditure in FY14 would expand at 20% YoY
v/s an average of 13% YoY expansion over FY10-13. We expect FY14 revenue
expenditure to be record a substantial uptick as pre-election financial years are
typically characterized by a jump in revenue expenditure with FY09 recording 34%
YoY growth in revenue expenditure.
Investment Implications
Six months ago we announced our FY13 Sensex EPS forecast to be Rs1229
(implying around 5% YOY growth). We reiterate this forecast. For FY14, our sector
leads’ bottom-up Sensex EPS forecast is Rs1340 (implying 9% EPS growth). Our
Economist, Ritika’s, top down approach gives an FY14 EPS estimate of Rs
1360. Using an average of the two approaches gives Rs1350 (implying 10% YOY
EPS growth) and that’s what we will use as our FY14 EPS forecast.
Since early Jan ’12 we have been bullish on Indian equities. With our constructive
stance on Indian equities falling into place, we find the Sensex within touching
distance of our 19,000 target. While the consensus cautiously awakes up to the
changed reality, we expect markets to continue to rise for the following reasons:
1. A resurgent Government which is going for broke on the economic reform
front has helped assuage concerns around the ability of India’s political
leadership to push through meaningful reform. Even thorny issues like the
Coal-Power-SEB mess are being addressed by the Government.
2. With subdued return expectations around the globe and with a world awash
with liquidity (a back-of-the-envelope estimate shows that every year for the
last four years, central banks have injected at least $1 trillion per annum of
liquidity into financial markets), with China’s fortunes on the wane, India
should rank high in the list for the investors’ search for yields;
3. With the RBI now talking a more pro-growth language and with the
recent spate of liquidity enhancing measures, we are arguably close to the
bottom of the earnings cycle. Both top line improvements and interest burden
reductions should emanate from easier liquidity thus aiding earnings growth
for corporates;
The positioning on Indian equities has remained cautious (risk aversion as
measured by the “P/E of Defensives: P/E of Cyclicals” is at a ten year high) and
even a modest reversal of such risk aversion can lift share prices, especially in
cyclical sectors. Clients interested in understanding this in more detail should refer
to our 31st August note - ‘The rewards of contrarian investing’.
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