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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). About Us The BlackRock Investment Institute leverages the firm’s expertise across asset classes, client groups and regions. The Institute’s goal is to produce information that makes BlackRock’s portfolio managers better investors and helps deliver positive investment results for clients. Lee Kempler Executive Director Ewen Cameron Watt Chief Investment Strategist Jack Reerink Executive Editor This paper is part of a series prepared by the BlackRock Investment Institute and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of June 2012 and may change as subsequent conditions vary. The information and opinions contained in this paper are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily alt-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. 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