Download When the Elephant Gets Sick: India at a Crossroads

When the Elephant Gets Sick: India at a Crossroads
BlackRock Investment Institute
June 6, 2012
Declining growth, gaping fiscal deficits, capital flight and a sliding
currency: the days of India as an emerging markets’ darling brimming
with self-confidence seem over.
But India still matters. The country has been an understated achiever, unlike
barnstorming neighbour China, in our view. India was a top-5 contributor to global
growth in 2011 and now boasts the world’s 11th largest economy. A flailing India adds
to already high investor anxiety around the globe.
Neeraj Seth
Head of Asian Credit,
BlackRock Fundamental
Fixed Income
India’s economy has backtracked from the halcyon days of 8–9% expansion, and
stubbornly high inflation and a weak rupee currency is likely to limit the Reserve
Bank of India’s (RBI) manoeuvring room to cut interest rates.
Persistent current account and fiscal deficits are starting to hurt India’s capacity
to finance growth. A record number of projects has been stalled.
Policymaking is slow-moving and erratic at times. Optimists hope the current
impasse will become so acute that policymakers will feel compelled to undertake
1991-style reforms. These kick-started India’s economic ascent from a long
slumber. Alas, we have not arrived at a 1991 moment yet. We also question
whether bold policy initiatives are possible in today’s considerably more
fragmented politics.
High energy prices have caused India’s current account to deteriorate (although
this is partly offset by oil exports) and has widened the fiscal deficit because of
the ballooning costs of domestic subsidies. Gold has also become a swing factor:
imports have recently fallen off, but are still triple the ratio to GDP compared with a
decade ago.
Domestic consumption underpins economic growth of around 7% – for now.
Appetite for durable goods and staples has held up thanks to a more prosperous
rural population. Recent signs of a rural slowdown such as falling tractor sales
are worrying, in our judgment.
India’s stocks, bonds and currency are hostage to global risk-on/risk-off investor
sentiment. Short-term portfolio investing dominates capital flows rather than
long-term direct investments.
So What Do I Do With my Money?™
Equities could dip by 10% in the next six months if global investor
sentiment sours further. Valuations are entering the compelling realm,
and we think investors with a stomach for volatility could see a 10-15%
upswing over the next 18 months.
Opportunities and valuations in credit seem less attractive. Short-term
credit is held hostage to high inflation while the key area of corporate bank
debt is under pressure. Security selection is crucial.
The currency is a key driver of returns and great indicator to gauge overall
sentiment. The rupee currently may be fair value at 53 to the US dollar, but
it is tough to hedge and it is hard to see a catalyst for improvement in the
short term, we believe.
The opinions expressed are as of June 2012 and may change as subsequent conditions vary.
Naganath Sundaresan
President and Chief
Investment Officer, DSP
BlackRock Investment
Managers Pvt. Ltd.
Ewen Cameron Watt
Chief Investment
Strategist, BlackRock
Investment Institute
Political Logjam
A Tough Combo: Fiscal Deficit and Inflation
The nature of coalition politics makes it difficult to arrive at
decisions quickly and creates a logjam. India’s parliament
is considering more than 95 bills, including 17 dealing with
financial services. Changing rules keep both foreign and
domestic investors in limbo.
India has a yawning budget deficit of 5.7% of GDP. We believe
the (justifiable) fiscal boost of 2008 has run for too long. The few
claw-backs have not been anywhere near enough to rein in the
federal deficit. See the chart below. India’s deficit is structural –
and will need structural fixes.
A series of official probes has paralysed decision-making by
civil servants – slowing down key project approvals and
investment plans. A record 10% of all projects (by value) are
stalled, and new project announcements have dropped sharply,
according to J.P. Morgan.
Even India’s entrepreneurial corporate chiefs seem to be
voting with their wallets. They are expanding overseas rather
than investing in the domestic market. Overall investment has
dropped off a cliff. See the chart below.
Investment Dries Up
Payback Time
India’s Fiscal Stimulus and Deficit to GDP, 1998–2012
4
-9.0
3
-7.5
2
-6.0
1
-4.5
0
-3.0
-1
-1.5
-2
Fixed Asset Investment to GDP, 2000-2011
0
1998
20
2000
2002
2004
2006
Fiscal Stimulus (LHS)
15
2008
2010
2012
Federal Deficit (RHS)
Source: J.P. Morgan.
Note: Fiscal years ending on March 31.
10
5
0
-5
-10
2001
2003
2005
2007
2009
2011
Source: J.P. Morgan.
Note: The year-over-year measure of fixed asset investment includes foreign direct
investment, but excludes inventory buildup and households’ investments in valuables such
as gold. Fiscal years ending March 31.
India appears to be moving toward a 1991 moment of
decision. At that time, a current account crisis drove then
Finance Minister Manmohan Singh (the current Prime Minister)
to implement historic reforms. Those liberalisation measures
and follow-up steps unshackled India from its historic lowgrowth pattern to emerge as one of the world’s most
promising economies.
Investors can only hope for similar boldness in the future.
It is easy for outsiders to complain. India requires study and
patience: even two decades of (laudable) economic progress
cannot pave over deep fault lines.
20
Per capita income remains low, inequality is considerable, the
social safety net is minimal, infrastructure is bursting at the
10
seams, policymaking
and rules have lagged economic progress,
and regional differences are huge. A society of such complexity
is likely to disappoint anyone hankering for quick reform.
0
-10
There is agreement across the political spectrum that a national
goods and services tax (GST) would bring in much-needed,
permanent revenues. A number of states already have a GST. A
national GST would require a constitutional change – which is
unlikely to happen soon given the currently frayed politics.
Fiscal deficits are compounded by persistent inflation.
Wholesale prices accelerated to a worse-than-expected
annual clip of 7.2% in April while consumer inflation jumped
to 10.4%. India’s inadequate infrastructure, labour market
rigidities and susceptibility to food price spikes will likely
keep it vulnerable to this problem.
In the absence of policy breakthroughs to tackle these
entrenched supply constraints, it is tough to see inflation
subsiding meaningfully. In fact, India’s output gap (the
difference between the economy’s potential and actual growth)
is small. This suggests that a pick-up in economic activity will
likely trigger
more inflation.
4
The RBI 3is in an unenviable position. It cut its policy rate by
50 basis points to 8% on April 17, breaking a string of 13
2
consecutive rate hikes dating back to 2009. Now it has little
1
wiggle room
left. Relatively high interest rates are needed to
keep inflation
under control and to support the embattled
0
rupee – but they also put a damper on economic activity.
-1 fiscal policy necessitates high interest rates.
Expansive
Rather -2
than working in tandem, fiscal and monetary policy
are at loggerheads.
Oil and Gold Can be a Drag
India-watchers have long anguished over the country’s exposure
to global oil prices. Higher energy prices cause India’s current
account to deteriorate and raise the cost of domestic gasoline
and fertiliser subsidies. A $1 rise in the global oil price adds 23
billion rupees (about $400 million) to India’s gasoline subsidy
bill, we estimate. Gasoline and fertiliser subsidies equalled
1.6% of GDP in the fiscal year ended 2012, according to
official data.
Oil price spikes, however, do not hurt India’s external financal
position as much as they used to. India is a sizeable oil importer
to the tune of $100–$150 billion annually. But the country has
also become an oil exporter, earning around $50 billion a year in
foreign exchange. This is taking the edge off India’s historic oil
price vulnerability – but not the cost of subsidies.
Arguably, gold has displaced oil as a swing factor for India’s
current account deficit. Gold imports last year equated to more
than 3% of GDP – triple the ratio about a decade ago, according
to J.P. Morgan. The gold fever has subsided a little this year. Gold
demand slid 29% in the first quarter as higher import duties
and the effect of the falling rupee took a toll.
A lot is made of India’s social and ceremonial reverence for
gold, but gold consumption is driven as much by hard-nosed
economics as by tradition. Persistently high inflation makes
gold a store of value. The same is true in China, which replaced
India as the world’s largest gold consumer in the last two
quarters, according to the World Gold Council.
Rural Power
Despite all this, India’s economy is still growing at an annual clip
of about 7%, anchored by the Indian consumer. Consumption,
which was encouraged by the 2008 fiscal stimulus, remains
resilient. Appetite for durable goods and staples, has held up –
in part thanks to demand from a more prosperous rural India.
India’s National Rural Employment Guarantee Act (NREGA)
has been a driving force for consumption. NREGA guarantees a
hundred days of employment every year to adults of any rural
household doing public work-related manual labour at the
minimum wage.
Its impact has been transformative. Rural consumption is now
higher than urban consumer spending. Worryingly, there are
signs a rural slowdown is afoot. One example is a fall in tractor
sales this year. It is sobering to think what the economic picture
would look like if consumption were to drop off.
Equities: Reversion to the Mean
Indian equities have lost their traditional premium over other
emerging markets as earnings expectations have come down.
Estimated profit growth of 7% for the fiscal year ending
March 2013 is half the historic range of 15–18%. The trend
of downward earnings revisions is running at 20 months now
and has led overall emerging market earnings downgrades,
according to J.P. Morgan. See the chart above on the right.
Expecting Less
MSCI India and MSCI Emerging Markets EPS Estimates
62
118
60
58
108
56
54
52
50
Nov
2010
98
Jan
2011
Mar
2011
May
2011
Jul
2011
MSCI India (LHS)
Sep
2011
Nov
2011
Jan
2012
Mar
2012
May
2012
MSCI Emerging Markets (RHS)
Sources: J.P. Morgan, Bloomberg and IBES.
Note: The EPS for the MSCI India Index and the MSCI Emerging Markets Index in this chart is
calculated by weighting the constituents in the same way that each individual index is calculated.
A bull could reasonably marshal an upbeat medium-term case
for Indian stocks: if performance were to simply move back
toward normal levels, shareholders would reap significant
rewards. Reversion to the mean is the investor’s ally.
Exhibit 1: Companies in the benchmark BSE 200 index now are
trading at 12 times forward earnings, a large discount to the
historic level of 16.
Exhibit 2: BSE-200 companies now have a 0.95 asset turn ratio
(a measure of capital efficiency), compared with a 15-year
average of 1.24. 62
This speaks to the current demand destruction
and low capacity60utilisation. An optimist would argue the
current sub-par asset turn ratio should gradually heal.
58
Exhibit 3: The group’s current return on equity is 15.5%,
56
compared with a historical average of 18.8%. This again shows
54 are in a difficult predicament, but have room
Indian companies
to improve.
52
It is easy to become
50 beguiled by the compelling valuations, but
we believe investors should treat shares with some caution.
Global markets have become locked into bouts of risk-on/
risk-off trading. Another blow-up in anxiety, stemming from the
118
eurozone or elsewhere,
could cause Indian shares to fall 10%
or so in the next six months.
113
Those willing to look beyond the near future could be rewarded.
Indian shares could rally 10–15% over the next 18-months,
108
we believe. The past is never a perfect guide to the future, but
it does provide a hint of what can happen. The Indian stock
103
market almost doubled between May 2009 and July 2009. We
are not tipping something similar, but anticipate a sizeable
98
upswing from current levels nonetheless.
Foreign investors’ attitudes swing between euphoria and
anxiety. Global capital flows mean Indian asset values can go
up dramatically – and come down abruptly. Bottom line: Indian
equities require investors to take a medium to long-term view.
Bottoms Up in Fixed Income
It is more difficult to make the bull case for Indian fixed income
over a similar time horizon. Overall bond supply has hit record
levels, pressuring prices. See the chart below.
New Bonds Abound
Gross and Net Issuance of Government Bonds, 2000-2012
The RBI has also deregulated interest rates on export credits,
allowing banks to charge higher interest on foreign currency
export loans. This compels Indian banks to go back into regional
credit markets and potentially face higher spreads.
Bank credit spreads already have widened, blowing out to more
than 175 basis points over South Korean banks versus a usual
gap of 50–100 basis points.
A sliver of good news is Moody’s downgrade of ICICI, Axis and
HDFC Bank by one notch to Baa3 resulted from a change in its
rating methodology – and was not a reflection of weakening
credit. Bottom-up credit investing is the way to go in the current
climate, we believe. An across-the-board approach is likely to be
less effective.
INR bn
6000
5000
4000
3000
2000
1000
0
2000
2002
2004
2006
2008
2010
Gross Supply
2012
India’s yield curve is inverted, with the short end exposed to
the high inflation and interest rates. The long end of the curve
is supported by the RBI’s bond purchase program, which we
believe makes it relatively more attractive.
Net Supply
Source: J.P. Morgan.
Notes: Local currency sovereign borrowing. Fiscal year ending March 31.
Banks, which make up the lion’s share of corporate bond
issuers, are under pressure. One signpost is the RBI’s freeing of
interest rates on Non-Resident External (NRE) accounts (fixed
rupee deposits for non-resident Indians) to attract foreign
exchange from India’s diaspora. The idea was to help bank
dollar-funding and prop up the rupee. Most banks now pay
NRE deposit rates of around 9%, up from about 3.5% before
deregulation on December 16. Inflows jumped at first, but more
recently have tapered off (and the rupee has resumed its slide).
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helps deliver positive investment results for clients.
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