Today's Article - 26 March 2010

An interesting article from Business Standard -

The equity markets have rebounded strongly following the presentation of the Union Budget, rising by more than 10 per cent from their lows. This surge has been caused by a combination of strong global markets as Greece has seemingly bought itself some more time, and a generally favourable response by investors to the Budget and its fiscal targets. Inflows from foreign institutional investors (FIIs) have resumed as many of the large, long-only funds have received significant inflows, and we are in that part of the year when domestic insurance flows are at their maximum. The markets are trading well and seemingly want to go up. The recent move of the ratings agencies to take India off the credit watch status has been a further boost to market sentiments.

However, in my opinion, the next six months is going to be a difficult time, full of risk and an environment where one must exercise caution and not get carried away.

First of all, we are by no means over with these sovereign risk issues. Greece is still in trouble, and the EU is seemingly split as to how to bail out the country. Germany and France are opposite ends of the spectrum on using the International Monetary Fund (IMF) to help a bailout, and Greece has over 20 billion euros of funding needs in April and May. The country is running a fiscal deficit of close to 16 per cent, and not 12 per cent as commonly reported. And, to get this deficit down to a manageable number will involve huge economic and social costs. It is not clear if the country has the stomach and maturity to implement a double-digit fiscal correction. Post-Greece, we have similar issues with Spain, Portugal, Ireland and eventually Italy as well. All this will come to a head over the coming six months. Given the size of funding needs, the quantum of sovereign debt held by the EU financial system, and general political unease over sovereign bail-outs, risk aversion could reassert itself anytime. The euro remains weak and clearly headed lower.

Back home in India, the obvious problem is inflation. The Reserve Bank of India (RBI) governor has probably the toughest job in the country trying to calibrate monetary tightening so as to promote growth, stifle inflation and simultaneously still put through the huge borrowing programme of the government at a reasonable cost. India probably needs higher interest rates to prevent the current food-based inflation from spilling over into a more generalised price spiral, but higher interest rates will hurt the growth transition currently underway. We need to move away from government stimulus being a driver of growth towards private investment demand, and a spike in rates will hurt this transition meaningfully. A 300 basis points higher cost of debt affects project IRRs materially.

India has another problem in that at high rates of growth, anything over 8.5 per cent on a sustained basis, and everything starts falling apart in the country. From power, ports, airports, skilled manpower to railway wagons, everything goes into short supply, and inflation starts to spike higher. Remember, the last inflation scare in 2007 was not driven by food prices at all, but by surges in commodity prices and a general overheating of the economy. We are a fundamentally under-invested country, and to address the structural issues of an economy which cannot handle sustained growth of over 8.5 per cent without overheating, we need large-scale investments to improve the supply side response to growth in numerous areas of soft and hard infrastructure. To improve the supply side, we need huge investments. These investments are sensitive to rates, and will not be made in an environment of high and rising interest rates. Thus, ironically, one can argue that to tackle inflation on a more structural basis, we actually need low interest rates, not tight monetary policy.

The RBI governor thus has a thankless job, having to make a very delicate balance between growth and inflation. He cannot let the country move into an era of generally higher inflation and interest rates, as once out of the bottle, that genie is very difficult to control. But he cannot use a sledgehammer approach either. He anyway has to handle the inevitable crowding out issues as private sector credit demand picks up.

Interlinked with the above, the biggest risks on the horizon for India are the monsoons and oil prices. Another monsoon failure (God forbid) will throw the whole food price situation out of control, besides seriously damaging consumption, growth and the fiscal. We dodged the bullet of a poor monsoon in 2009 (in terms of economic impact), but two poor years back to back will put a huge strain on the economy. RBI will be forced to act, as no government will be able to withstand the political pressure that will be mounted following a second year of double-digit food price rise. Agriculture will dip by a lot more than the 2 per cent the government statisticians project for 2009, and rural consumption will slump with food subsidies spiralling out of control.

India is also extremely vulnerable to higher oil prices. There is a worrying tendency recently on the part of many global oil analysts to become more bullish and raise their price forecasts, which is a clear red flag.

High oil prices have a huge impact on the fiscal side in India through petroleum product subsidies and higher fertiliser subsidies, or on inflation in case prices are allowed to adjust. We can only hope that prices behave. Whether the impact is through the fiscal or inflation, the end outcome is the same — higher rates.

The next six months are also critical in that the government will have to demonstrate progress on tax reform through the direct tax code and goods and services tax. As pointed out before, both these reforms are absolutely critical to achieving the fiscal deficit targets outlined in the Budget. We will know within the next six months whether the government has been able to withstand the lobbyists and special interest groups, and deliver on these landmark legislations.

The markets, to my mind, should be stuck in a broad trading zone till such time as we get better visibility on the monsoons and oil prices. Normally, the rains do not have such importance, but given the inflationary and fiscal challenges already confronting the country and the policy-makers, we need to cross this hurdle for the markets to break out of their current range.

Markets can handle a 125-150 basis points rate hike over the coming 12 months, that is baked in the cake, but anything higher than that will be corrosive for PE multiples and market performance.

If the rain gods are kind, and the government does deliver on tax reform, then we are looking at a very positive market outlook in the second half of 2010.