Dr.S.

Ananth - 11 February 2011

Indian Economy: The Winding Road with Pitfalls Ahead

This year’s budget has (probably inadvertently) gained prominence for importance that the last
five budgets did not find. Going by the daily dose of headlines, it seems clear that optimism
seems to reign supreme, but a reading of the reports of the government agencies it is clear that
the Indian economy is grappling with a number of structural inefficiencies, if not remedied could
have a negative effect on the Indian economy over the next few years. Overheating in all the
emerging markets has not helped matters. The task for this year’s budget is rather simple (but
Herculean): enable growth without inflationary pressures from getting out of hand. That is easier
said than done.

The Question on everybody’s mind is what will be the reaction of the FIIs to the Budget and will
they continue to park money in India or will they withdraw money (as they did in 2008). It is
prudent to note that FIIs are not a single homogenous category and are instead a homologous
category, who often use somewhat similar metrics for valuation. These would include valuations,
macro-economic indicators, currency fluctuations, government policy as well as company
specific factors. Out of the above factors, two critical factors are possibly considered by an FII:
(a) are the conditions conducive to the growth in a country and (b) the possible currency
movements.

In any economy growth would be directly related to economic conditions (including prices,
consumption, government policy as well as government balance sheet and interest rates).
Deciphering (or at least attempting to decipher) the answers may be important while considering
any investments. By any of those parameters, it is clear that India’s growth story may have
already peaked in the Financial Year (FY 2010-11). The markets seem to have belatedly
discarded their complacency about the India story. Since mid 2010, when some of India’s
structural deficiencies first came to light, the markets continued their relentless upward journey
much to the bewilderment of those who look for value. It was apparent even to those who rely on
the best investment rationale – commonsense, that the markets were moving into extreme
valuations. The problem that we often face with the irrationally bullish crowd (as well as the
irrationally bearish crowd) is that they always think that “this time is different”. It never is
different. Economic cycles are never different. The only important question is analysing which
part of the economic cycle we are at any given point. Decipher that, and we would have
deciphered a large number of questions we pose. For over four months I have pointed out that a
lot of economic conditions make me feel that we it is 2007-08 Déjà Vu all over again.

This may be a good entry point to first analyse FII investments before delving into a discussion
of the state of the current Indian economy and its growth potential over the next year or two.

FII Investments and Index returns are correlated, though it is debatable as to what percentage the
correlation exists. The index tanked by nearly 50% when the FIIs sold nearly Rs.55,000 crores in
2008, while it rose sharply by about 75% in 2009 when the FIIs invested a little more than
75,000 crores. Interestingly, in 2010 despite investments to the tune of nearly 120,000 crores the
index went up nearly 18%. But year-to-date in 2011, the markets have fallen by nearly 17% with
FII selling only to the tune of about Rs.5500 crores. One needs to be more circumspect when

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accepting the role of the FIIs as the principal movers of the Indian markets. They probably rank
third in the hierarchy of the promoters, domestic institutions and foreign institutions, high
networth investors, retail investor. The above assumption is based on a very broad classification
of the different category of investors in India. However, the returns (from sale or purchase by
FIIs is magnified) due to their concentrated buying.
There have been reports of FIIs exiting the Indian markets. These reports gained credence due to
the negative investments of approximately Rs.5000 crores since the start of 2011. FII stakes in
Indian companies had gone up by nearly 1.35% since December 2009. FIIs own 23.4% of the
Sensex, 20.1% of the BSE 100 and 18.8% of BSE 200. Their total investments are about
Rs.700,000 crores (US$155 billion). FIIs have invested more than Rs.500 crores in about 150
companies. Their investments in these companies amounts to nearly Rs.656,000 crores.
Interestingly, if we consider FII investments in Indian companies where FII investments are
more than Rs.2,000 crores then it would be nearly 66 companies that cumulatively account for
investments to the tune of nearly Rs.565,000 crores. Despite these concentrated investments, it
would be a mistake to believe that the FIIs are the only dominant players. They are one of the
dominant players, with the domestic institutions being much larger in size than the FIIs.
It may be prudent to ask the question, what exactly do the FIIs look for in a country like India,
before they invest, apart from institutional framework and easy entry and exit conditions? A
comment on some of the important reasons that may dictate FII investments may be in order.
One of the important reasons that dictate FII behaviour in emerging markets is the conditions in
the home markets of the FIIs. The most important markets for any foreign investors are USA,
UK, Europe, Japan and Canada. Other markets will be preferred only after the above markets.
Their allocation of money or withdrawal of money is mostly based on the economic conditions
in these countries and importantly the liquidity conditions in these countries. An important
consideration for investors is the current valuations. By that measure most of the emerging
markets are still very expensive. The following chart give the current valuation of the emerging
markets.

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Tight liquidity conditions in those countries invariably mean that money will be withdrawn from
all the markets (just as in 2008). It is pertinent to note that most of the institutional investors are
under-owned in US and European assets and over owned in emerging markets (on a historical
basis and not on a relative basis). One should probably ask pertinent questions including those
related to the state of the bond markets in USA and EU. Among the questions that we should
pose include (a) what is likely to be the reaction of FIIs if the US bond yields touch 5% and what
would their reaction be if there were to be cascading defaults by EU nations?

An analysis of the prospects of the Indian over then next year clearly indicates that there is no
reason for FIIs to come back to India in a hurry, even at the current valuations. Indian markets
have fallen nearly 19 per cent in comparison with the MSCI and 12 per cent YTD.

Inflation:
As in late 2007 and early 2008 inflation seems to have taken the centre stage. The components
that have contributed to the current inflationary spiral are, however, markedly different. Unlike
last time around, food inflation is the main contributor (along with oil prices). The factors
contributing to food inflation are however, more tricky. The current inflationary spiral may have
more to do with the rise in various commodities, especially those like Milk, vegetables,
petroleum produces due to global oil price rise. A cursory glance at most of the factors causing
the rise in inflation seems to indicate that these factors may be beyond the control of the
Government. The saving grace has been that we have not seen any sharp rise in Wheat, Rice and
to an extent Sugar (though it was responsible for rise in the early part of the year). The rise in
prices of these (especially wheat and rice are reserved for the next year). Milk production is a
problem for the simple reason that production has been declining while consumption has
increased. Vegetable prices have been impacted due to the La Nina phenomenon. Unfortunately
we may have to live with rising prices for some more time due to two predominant factors: the
onset of summer months and the reports that La Nina will last well into June. Either way we are
stuck with a choice between the sea and a hard rock. Since our policymakers have run out of
options, one would be hoping that inflationary spiral does not get out of hand. Drought in China
does not augur well for food prices. Since China is consumes nearly 17 per cent of the wheat
produced world (and there is a drought that is expected to reduce wheat yields), it is now the turn
of what to rise. Nearly 42 percent of the total areas planted with Wheat in China are facing a
drought.

Inflation may take a minor dip over the next one month or 45 days and come back roaring due to
a variety of factors. I would assume that inflation will come down meaningfully only after
October 2011, along with increased supply due to the new crop. However, the major Black Swan
for 2011 will be the monsoon. If La Nina were to be quickly dissipate and its place taken by El
Nino, then literally all bets are off on inflation and with it the possibility of 6 per cent growth in
the Indian market. The marginal decline in the next few months would be due to the base-effect
(which makes a headline comparison look good rather than anything else) and increase in supply
due to seasonal factors. However, the government decision to allow Wheat and Rice may be
detrimental in the long-term, though this may be a positive for those beneficiaries.

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Economic Growth, Interest Rates and Banking Sector

The cash shortage that the exists among the banks has often been misunderstood. It is often
claimed that the daily shortage of Rs.75-100,000 crores in the banking system is due to the
central government not willing to spend the money. One view that has emerged is that the RBI
wants to contain inflation and hence it prefers to maintain a negative balance (preferably at Rs
50,000 crores per day) so that it would keep the liquidity spigots on a tight leash. This reasoning
claims that it would like to carry over its surplus cash into the next financial year. I have another
interpretation for this. I would be more amenable to the view that this carrying forward surplus
may have something to do with trying to dress up the balance sheet of the government (fiscal
deficit) over the next financial year. This would enable the government to reduce its fiscal deficit
in the next year. Next year is particular important for the government as it would be in a hurry to
meet its XII Plan targets (the plan ends on 31st March 2012), hence the need to conserve cash this
year. Moreover there are five important State elections (Tamil Nadu, West Bengal, Kerala,
Assam and Pondicherry) in May and another five elections in year after that, hence politically it
makes a lot of sense to save this year and spend from April.

A more worrying sign that will become more pronounced over the next two years is the state of
the banking sector. This is not to claim that the banks are in trouble as of date. On the contrary
their troubles are just starting. There is little hint from the banks themselves. As yet, they are
rationing credit and the truth. RBI, which has a longer term perspective in mind, however is less
economic with the truth and has clearly cautioned the banks - a good sign that our central bank
is not sleeping at the wheel (like the US Fed in 2007). RBI has indicated that it is worried about
the growing asset-liability mismatch of the banks. They seem to be lending at long-term which
borrowing short-term. Nearly 50 per cent of the Indian banks’ liabilities fall due in less than one
year while nearly 58 per cent of their investments are those above 3 years. Another problem that
the banks will have to grapple with in the era of high interest is that over the past year they have
increased their exposure to interest rate sensitive sectors, especially like the real estate sector.
The Real estate sector saw an increase of nearly 20 per cent in the banks exposure by the end of
2010. With RBI warning that the credit-deposit ratio of the banks was too high (it was nearly 102
percent), indicating that banks have not been able to raise deposits while increasing credit. This
will invariably lead to a decline in loans, especially of the short-term genre while concurrently
increasing the deposit rates. The net result will be the that over the next 2-3 quarters we are
likely to see a reduction in interest rates, deposit rates, reduction in net interest rate margins and
an increase in Non-performing assets. Needless to say that the banks are frequently going to
approach the RBI to reschedule loans (remember Microfinance loans) and importantly continue
their ‘ever-greening’ on the sly. It is pertinent to remember that till date NPA’s have not
increased at an alarming rate simply because credit demand and disbursals are up (compared to
last year). They will become a problem only when credit growth expansion stops and moves into
reverse gear.

When this likely to happen? I would assume that it is likely in the next 2-3 quarters. In the past
whenever interest rates have crossed 13-14 per cent range (SBI PLR could be used as a ball park
figure), growth has tapered off. It goes into decline once the rates touch 15 per cent. I would
assume that the fundamental factors would continue to deteriorate and would largely be negative
till the end of October 2011. Banks will face additional losses on the government bonds that they
hold, especially if it is held in the trading category rather than the hold-to-maturity category.

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They would then have to take mark-to-market losses. However, at a practical level we need not
worry too much about this factor as the RBI is bound to change the goal posts mid-way and
provide succour to the banks who may be beleaguered on this count.

Growth in the Indian economy is dependent on four important variables (a) Government
Spending, (b) Credit (c) Domestic Consumption and, (d) Exports (to the tune of about 15% of
our economy). The above four become important in the background that one important
consideration that the FIIs would look at is how amenable to business the government of the day
and its approach to important issues that make the business conducive in the country. This is
particularly important for those like pension funds. Unfortunately, government spending and
policy are not on the best of health. Sleaze and Scams have taken a toll on the government
cohesion and wherewithal. This is unlikely to change. Luckily for the UPA, the NDA is a master
at shooting itself in the leg and hence they may remain safe for a little bit longer. Government
policy has been stuck due to the conflicts that have arisen because of the need to balance growth
(combined with cronies’ intent on grabbing scarce resources) with sustainability and importantly
create stakeholder value rather than merely shareholder value.

There is a dilemma that the government will have to grapple with in the next six months. It
would have to increase its spending but at the same time, it would have to see to it that the
money spent will not add fuel to the inflationary fires and at the same time it should keep its
fiscal deficit under check. I believe that it is keeping with these dilemmas in mind that the
government is not willing to spend its money as the next financial year will be the year when all
these contradictory forces come into play. We should consider India to be lucky if the fiscal
deficit does not touch 7 per cent by the end of March 2012. The only way that it will not touch
that level would be if oil prices average about US$75-80 range in the next six months and
importantly if their tax revenues remain constant, if not increase –both of which are not assured,
though plausible.

There is greater clarity when it comes to RBI policy on credit and interest rates. Interest rates
will rise by at least another one per cent in the calendar year 2011 and credit will continue to be
in much demand. In other words RBI will not loosen policy and this would have a drastic impact
on the availability of credit as India continues to be a country that is dependent on the banks for
their credit. As long as this credit flows, there may not be too many obstacles to India’s 7-8 per
cent growth. Since there is less clarity on those aspects, one would have to find hard
justifications as to how India can grow at that pace. A more measured 6 per cent may be what we
may have to accept. While 6 per cent does not look bad (and it is not) on paper, in reality, six per
cent growth would strain the government’s fiscal strength, thereby undermining the ability of the
government to spend. All those asking the government to reduce inflation and the fiscal should
probably be careful as to what they wish for.

Corporate Balance sheets

Even Pharma companies (which are considered to be a defensive sector) have seen margins
being eroded. Sun Pharma margins are down by 2.8%, Cipla by nearly 5.9%. The latest to
declare a fall in margins is M&M which saw its margins erode by about 1 percent in its
consolidated balance sheet. Other corporate results were no better. It is pertinent to note that an
analysis of nearly 1600 (excluding banks and financial companies, ONGC and Chennai petro)

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corporate results (for three months up to December 2010) indicates that while revenues have
grown by 22% (year on year) their operating profits have declined by 1.1% year-on-year.
Interestingly the revenue growth in the quarter ended September 2010 was 23.6%. Net profits for
the December Quarter are up just 10%. The corporate have to realise that the era of cheap
liquidity is over and that the next 2-3 quarters will be one of an increase in interest rates. As a
number of the companies are over-leveraged, they will have to pay out more in the form of
interest costs, which will only rise. Those with foreign borrowing will be particularly hurt as they
will face dual pressure – general aversion to emerging market debt and more importantly
volatility in the currencies as FII money flows out.

Rising margin pressure should be seen as a canary in the coal mine rather than as a passing
cloud. Indian companies seem so convinced about the future potential that they are expanding
their leverage – at exactly the wrong time. They have to understand that the export oriented
growth business model has come to an end, while internal consumption is heavily dependent on
the government spending or government largesse. Both these variables are dependent on
government revenues. There is little scope for government revenues to increase dramatically
from here in the current economic environment. If the revenues have to increase, it would be
dependent on better compliance, avoiding leakages in the system, higher taxes or big ticket
divestments. Big ticket investments are theoretically possible but they not very likely unless the
offer is at attractive prices for the blue chip PSUs (Coal India Follow on public offering is what
comes to my mind) as well as sale of BHEL or SBI. But this may not be possible due to the
political gridlock in the country. As more scams are unearthed, the government would have to
spend more time battling those issues rather than the pressing economic problems.

Global Headwinds
An Overview of some of the problems faced by the global economies is in order. There seem to
be few signs that China is able to overcome the over-heating of its economy. Far from it, there is
a clear danger that Chinese economy may be reaching a position where the government will be
forced to revalue the Yuan and increase interest rates, in order to combat the inflationary spiral.
It is pertinent to note that if China (as well as other emerging markets) cannot control inflation in
the next six months, then all of them are likely to witness a hard landing of their economies. The
Emerging Markets and the Euro Zone are the major problem areas. However, on a more cynical
note we may say that probably a drastic fall in growth of the emerging markets may be necessary
to cool commodity prices. The catch however lies in the fact that historically we have never been
able to predetermine mathematically how much an economy should or can slow down. Once the
downward spiral starts, things can easily go wrong, especially in the era of financialisation. If
history of the past bubbles is any guide then China may be about to hit a wall in the property
sector. That may be the major reason why the Chinese policy makers have decided that
increasing interest rates may be the better option than small incremental steps such as increasing
reserve ratio. The follow chart compares Chinese property loans to GDP when compared with
other countries. Unfortunately, if History turns out to be a precise guide, then China and its
banks could be in big trouble

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The daily dose of bad news (scams and sleaze, inflation, lending squeeze, food riots, dictators
fleeing or refusing to flee apart from the usual murders, etc) what has been rather lost in the din
are two important developments: (a) the steady increase in the problems in the Portuguese bond
markets and, (b) the recent decision of Vietnam to devalue its currency by about 7 per cent. To
this one may also add the sharp rise in yields of the US and German Bonds. The fact that German
Bond yields seem to be rising is due to fears that the Germany will have to pay a large part of the
bills in the form of bond guarantees to indebted nations. Increasingly EU resembles an old
creaky pipeline that bursts in a different place as repairs are taken up in one place. Even as the
ECB was buying Portuguese 10 year bonds to reduce the spreads with German bonds, it five year
bond yields soared.

US Markets
The interest fact about the US markets is that they are largely under-owned as the predominant
theme over the past two years seems to have been that the emerging markets will grow while the
USA will not grow. However, this may be due to a variety of short-term measures by the US
Federal Reserve. On a relative basis, the US markets may out perform the rest of the world till
the middle of this year. The problem with taking a call on the US markets is that the true state of
the US economy (minus the fiscal stimulus) will only be known from the June-September
Quarter. Undoubtedly, by October, US is unlikely to present a pretty picture, necessitating
further round of quantitative easing. As bond yields in the USA rise along with the political and
economic problems in the emerging markets, there should be no reason why we should not
expect money to flow back into the USA from the Emerging markets. Last week saw about
US$7 billion flow out from the emerging markets funds. Before we get too excited about the
marginal recovery in the USA, have a look at the following chart.
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Market Outlook
Indian markets have consistently underperformed their peers YTD (as we have already noted).
However, the markets are extremely oversold and due to the large short-position, we could
expect one sharp spike before they trend lower.
The best time to buy for the long-term would be sometime in September-October when the news
will be at its most bearish levels. However, speculators may enter the market with a tight stop
loss.

Longer term investors may do well to conserve cash, pay down debts and importantly load up on
Gold and especially silver on every decline as in next 2 years they will continue to remain the
safe haven.