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30th June 2012 |
Scoring self goalsShiv Puri
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- “For a country as poor as India, growth should be what Americans call a “no-brainer.” It is largely a matter of providing public goods: basic infrastructure like roads, bridges, ports, and power, as well as access to education and basic health care.”
- The government took the growth story for granted and decided that they don’t need to work as hard on reforms or infrastructure development and can focus on winning elections through populism.
- The time to meaningfully increase investment allocation in India in our view will come when there is concrete evidence that the government is making decisions on two things - infrastructure approvals and fiscal management.
- In the 1997 to 2002 period, a series of many small positive actions on the ground cumulatively set the stage for a powerful rally in the markets. In the five years ending March 2002, the market was virtually flat. Thereafter it went up 5x in the next four year period.
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An article by renowned economist and Professor at the University of Chicago Raghuram Rajan titled "What Happened to India?", sent by an investor, is an excellent one to read. In this article, Raghuram Rajan, states “For a country as poor as India, growth should be what Americans call a “no-brainer.” It is largely a matter of providing public goods: basic infrastructure like roads, bridges, ports, and power, as well as access to education and basic health care.” Sounds perfectly reasonable.
Not only should growth have been a “no brainer” but India was to have done very well because it is a largely domestic growth driven economy. Exports are only 17% of GDP. The benefit of a global slowdown, i.e. softening commodity prices, is good for India. India also has a very strong entrepreneurial culture, a large and well-educated middle class, and a number of world-class corporations. But it appears over the last twelve months instead of capitalizing on all of this, what resulted was rising inflation, weakening fiscal deficit and a weakening currency - all symptoms of an underlying problem. So what happened? The problem as Raghuram Rajan says is, “The momentum created by previous reforms, together with strong global growth, carried India forward. Politicians saw little need to vote for further reforms, especially those that would upset powerful vested interests. The lurch toward populism [via] a rural employment-guarantee scheme and a populist farm-loan waiver [meant] the need for further reform only increased.”
But, the government took the growth story for granted and decided that they don’t need to work as hard on reforms or infrastructure development and can focus on winning elections through populism. Thus, government spending and the inability of the supply side of the economy to keep pace, led to elevated inflation. In addition, the government made retrospective amendments to tax laws and introduced General Anti Avoidance Rules on taxation that affected Vodafone and other international investors. (Since then the government has deferred GAAR to 2013 and proposed to significantly water down the provisions). The assumption that India’s growth “sells itself” and foreign capital inflow was a “given” turned out to be false. The rupee’s slide from 45/dollar to 56/dollar was the real wake up call for the governing class. It now remains to be seen whether the government in the next 18 months of their term can restart the reform process.
More recently, the somewhat deficient monsoon rains have also been causing concern regarding food inflation. While this would be an additional headwind, the impact of monsoon on the Indian economy has been steadily reducing. Agriculture is now only 14% of GDP down from 25% of GDP a decade ago. Government stock of food grain is at an all-time high and it is likely that any pick up in food inflation would be limited. The monsoon season runs until early September and the final outcome here is awaited.
To summarize, the bear argument on India states that because of populism and lack of infrastructure related reforms, inflation is entrenched and fiscal deficit is systemic. The lack of foreign capital to fund the fiscal deficit means not only a weak currency but a vicious cycle that is difficult to break. As per this argument, the monetary easing process will be slow and the non-performing assets in the banking sector will rise sharply. The bull case in India is hardly discussed these days. In our view, the bull case is simply that the domestic consumption and capex spend will allow the country to continue deliver a 5 - 6% GDP growth rate, which along with a healthy banking system and lower interest rates, will enable companies to deliver earnings growth in mid to high teens and valuations appear very attractive in that context.
For the economy to be able to sustain a higher rate of growth, the investment cycle must return. The most likely catalyst for this is going to be spend by government run infrastructure sector companies. This is then be followed by the private sector. The government companies are in excellent financial condition with strong cash balances. The decision to investment will not be limited by balance sheet strength or return metrics (which are very attractive) but in getting approvals. It is likely that coal, power and road infrastructure companies will kick off this infrastructure spend. While there is no clarity yet on the timing of approvals, it does appear that things are getting incrementally better with the Prime Minster taking charge personally. While the “underachiever” tag by Time magazine may or may not be fully deserving, he is the best hope that the government has over the next 18 months before the elections get underway.
The time to meaningfully increase investment allocation in India in our view will come when there is concrete evidence that the government is making decisions on two things - infrastructure approvals and fiscal management. The former would put a timeline on the order book growth of companies and ease supply side bottlenecks and the latter will set the pace of easing of interest rates. Together they will lift overall economic activity meaningfully and will be reflected in corporate earnings with a short lag.
There are a few “green shoots” of good news. Last month, Coca Cola announced a $5 billion investment plan to expand its presence in India. Ikea, the Swedish furniture company is considering a Euro 1.5 billion investment to set up stores in India. The government is also in the final stages of approving the much delayed $12 billion steel plant to be set up by Posco. In addition, oil prices going from $125 to $100 a barrel will lower the fiscal deficit by nearly 100 bps. If this sustains, this will enable the central bank to cut rates aggressively. The government is actively considering cutting the subsidy on diesel, which would also ease pressure on the fiscal deficit by another 100 bps. Perhaps the move two months ago to raise petrol prices by 10% is a sign of things to come. These steps would certainly be viewed positively by the central bank and the currency markets. On the subject of currency, an interesting anecdote is that last year India imported gold valued at $55bn. Due to an import duty introduced at the start of this year and the general slowdown in gold consumption, India’s gold import last quarter was $8.5bn down 47% on a year on year basis. This trend itself will shrink the current account deficit current account deficit by 60bps to 2.6% from the projected 3.2% levels and can only help alleviate currency pressure.
It is steps like these that will eventually make a big difference. In the 1997 to 2002 period, a series of many small positive actions on the ground cumulatively set the stage for a powerful rally in the markets. In the five years ending March 2002, the market was virtually flat. Thereafter it went up 5x in the next four year period. In the last five year period ending March 2012 the market is again flat. Valuations of assets and equities, especially in dollar terms are cheap, as can be expected when the consensus is uniformly bearish.
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