This month we choose to put a title “2013 - A Year of Declining Interest Rates and Lower Commodity Prices". This title we have
chosen not because we forecast it, but more because we seriously need to see it
materializing for the revival of Indian growth momentum. Two most important
catalysts for the economic activity to expand are low commodity prices and
lower cost of funds. A series of interest rate cut can be predicted with a
reasonable degree of certainty in the calendar year 2013 on the premise that
sub-par growth in developed countries coupled with China slowing down rapidly and
thereby easing actual demand for commodities. It will put pressure on prices
and thereby would diffuse concerns of commodity prices escalating. Depressed
commodity prices are certainly going to be a boon for Indian economy which is
otherwise reeling under high inflationary pressure and higher interest rates.
But the moot question is that whether RBI’s hawkish stance on inflation rather
than growth is justified or is the policy framework remains reactive only to
inflation data? If RBI choose to be reactive on cutting down rates once it
see’s inflation coming down, it may have serious ramification. Reason being,
the longer the interest rate stays elevated the more it damages the
fundamentals of India Inc. Already we are witnessing two pronged losses on RBI’s
policy stance, i.e., higher interest rates seriously denting the profitability
of companies who are exposed primarily in the power, telecom, construction,
infrastructure and other capital intensive sectors. Secondly with deteriorating
socio-economic fabrics of the country and because of scams and unethical
practices and coupled with it higher interest rates, it has restrained
entrepreneurs to commit any fresh capital expenditure and many of the existing
investment commitments have been shelved as well. At present Indian private
share of capex in GFCF has fallen from 43% in FY-08 to 33% in FY-11 and the
overall GFCF has declined to 29% from 36% in 2008. A potential reform will be
of key importance if the NIB (National Investment Board) is approved legally. This
is will be potential kicker in terms of implementation of key infrastructure
projects of national importance and will bypass the hassles of bureaucratic
decision making process. NIB will be directly under the control of Prime
Minister and hence it will have the power to overrule ministers in taking
decisions of national importance and implementing big-ticket investment
projects.
It’s almost clear that for the economy to revive and the job
condition to improve requires higher profitability and higher growth
opportunities for the businesses in general. And a momentum can be gained with
capital formation from the private sector coming back. For the last couple of
years, capex cycles have been on a declining curve and the new wave of optimism
has gained on the consumption story. But, serious questions need to be asked is
whether the consumption spiral is because of higher income of the people? It
doesn’t seem that the middle class or the upper middle class (which comprises
of the majority of the population for consumption bracket) have gained any
serious wealth out of wage inflation post the 2008 crisis. Persistent inflation
have eroded the value of money and dented the pockets of salaried class, the
labor class and the small businessman (be it for any product price or the real
estate price). So, probably the consumption spree remains unabated, may be
because of the 1>changing consumption pattern of the people and propensity
to consume remains high as the savings rate for India have been over and above the
30% mark for many years 2> may be because of the rise in gold price, since
gold prices have had a phenomenal run in the past couple of years and Indians
have a tendency to buy and hoard gold as a store of wealth. A scanning from
various research reports reveals that Indian household hoards gold with
estimates ranging from 11,000 tons to 30,000 tons. Even if we take 18,000 tons,
it is almost worth USD 1 trillion and is more than 50% of nominal GDP. 3>May
be because of higher real-estate prices for those who hold land since ages.
4> Rural wage inflation is consistently growing above 15% since 2010 and
NREGA and other social schemes are giving more purchasing power in the hand of
rural India. So, it can be concluded that higher consumption may be because of
the above factors mixing up and giving a feel good factor to their income
status which otherwise is not true in real sense. It’s almost certain that
these factors cannot push up the consumption curve higher to infinity and
reality may descend at some stage. In a country like India, we are witnessing
investments drying up and enough capex is not getting channelized into roads,
factories, and infrastructure. Hence this is leading to a constraint in
capacity and the demand of final goods for consumption is running short of
population migrating into the middle class bracket, changing spending pattern
and higher propensity to consume because of the elevated asset prices is
inflating the final product prices for consumption. Coupled with it the
government favoritism and graft in recent years is further accentuating the
demand/supply equilibrium.
Our real focus for 2013 is to see a series of rate cuts and
commodity prices coming down. Inflation cooling off in 2013 is not because of
RBI’s efforts of last couple of quarters by its monetary policy stance, but
more because of slowing economic growth and lower discretionary spend in the
hands of people in the Indian context and global commodity prices cooling off
significantly because of serious slowdown with the commodity guzzlers of the
world. Moreover, supercycle in commodities as per the Kondratieff 30 to 40
year’s cycle has come to screeching halt and it coincides with the Chinese
demographic and the slowdown ahead, after decades of huge commodity demand.
Undoubtedly these factors are already in force in a subtle
way and may get pronounced in 2013 and will set the stage for a new growth
momentum.
ECB Relaxation:
Recently ECB window is being explored by Government. Earlier
RBI came up with foreign exchange regulations tweaked with ECB regulations to
promote dollar inflow and curb excess weakness in the rupee.
Now government is broadening the ambit of external
commercial borrowings and is incorporating a new definition of infrastructure.
This will help companies involved in various sectors like the education,
hospitals, cold storage, agriculture markets, tourism facilities, capital
investment in fertilizer companies and various others to seek funding through
ECB route and lower their borrowing cost. Already the government liberalized
ECB norms in the budget for sectors including roads, civil aviation, power and
affordable housing. Already it’s operational in all except affordable housing
which is also expected to be granted notification in coming months. With these
actions of the government it’s clearly evident that it is hard-pressed to
revive the capex cycle and address concerns with regards to higher cost of
funds which is a hindrance to growth. Though the cost of ECB would have three
variables 1> Libor rate 2> Premium over Libor rates 3> Exchange rate.
Effectively, Libor plus a premium would cost roughly 3.5% to 4% and add to it
hedging cost of grossly 5% to 6% (one year dollar NDF market quoting at a
premium of 5.6%) will approximately fixate the borrowing cost at around 9%.
Generally taking into consideration all the cost a gap of atleast 2% prevails
between ECB and the domestic term loan. Though for hedging purpose there are
interest rate swaps, principal money swap and cross currency interest swaps to
optimize the transaction and it requires better understanding before
implementation.
In April 2012, Government allowed power companies to use 40%
of the funds raised through external commercial borrowings (ECBs) route for
refinancing rupee debt, raised from Indian financial institutions and banks.
The rupee refinancing window would be allowed only if the balance 60% ECB funds
are used for financing new power projects. Earlier, companies operating in infrastructure sector were
permitted to utilize 25% of the ECB loan to refinance their rupee debt. Further
in June 2012, the RBI allowed Indian companies in manufacturing and
infrastructure sector and having foreign exchange earnings to avail of ECB for
repayment of outstanding rupee loans towards capital expenditure and/or fresh
Rupee capital expenditure under the approval route. The overall ceiling for
such ECBs would be $10 billion. In September 2012, RBI further liberalized
norms on ECBs to repay loans, capital expenditure and trade credit availed by
infrastructure companies and enhanced limit to 75% of average foreign exchange
earnings realized from 50% of export earning in last three years.
Infrastructure companies were allowed to use trade credit (up to five years) to
import capital goods. However, the trade credit must be contracted for atleast
15 months and should not have element of short term credit roll-overs. In
September only, the Indian government reduced tax on overseas borrowings by
domestic companies to 5% from 20%, making it easier for local companies to
raise funds abroad. However, the reduced tax rate will be applicable to the
funds borrowed between July 2012 and June 2015. Liability of the Indian company
to withhold tax on such income would also be at the reduced rate of 5%. And now
government is also treading the same path which RBI choose in order to
effectively promote companies to avail cheap funds from abroad and as well put
a break to currency weakness by promoting dollar inflows in the country.
Credit led Investment Cycle:
Last decade, Infrastructure growth was backed by serious
investments in power, roads, ports, factories etc. Credits led infrastructure
boom witnessed credit growth averaging at 25% a decade and now post the 2008
crisis; it has tapered down to just 14%.
This coincides with the fact that money supply (M3) has
fallen at 13% growth rate. Lower money supply is a function of RBI’s tight
monetary stance and is a sign of weakening economic activity, and hence may be
an argument for lower rates, taking into consideration other signals of
inflationary pressures.
*Source: RBI
A crude rule of thumb is, subtract the inflation rate from
the rate of growth of money to estimate the growth of real output. The reason
for lower credit growth is because of obvious reason that Gross non-performing
asset for banks stays elevated at roughly 3% and restructured assets remains at
5%. So the total bad asset for all the scheduled commercial banks stands at 8%.
Though most of it will not turn out to be bad but historically after a decade
long credit led strong expansion, outcome of such magnitude is a reasonable
expectation. This phase of bad loans takes its own time to clean itself out
before which banks would be reluctant to lend aggressively and this phase will
last till we see the interest rates ease off considerably and corporate
de-leverage their balance-sheet and becomes healthier.
Commodity Conundrum:
China’s massive growth momentum of last decade was its surge
in investment share of GDP from 35% to 50%, a level that is unprecedented by
any standard. China boomed in an old fashioned way, by building roads to
connect factories to ports, by developing telecommunication networks to connect
business to business, and to put underemployed peasants to work in better jobs
at urban factories. Now it seems that these drivers are reaching a mature stage
where the labor pool is fast depleting, factory employment reaches a maximum
capacity and highway network reaches a total length of 46,000 miles, just
behind the US with 62,000 miles. The favorable demographic profile for China is
likely to work its decaying effect on growth in coming years. In 1999, for
China to grow its $1 trillion economy by 10%, it had to expand its economic
activity by $100 billion and consume 10% of world’s industrial commodities- the
raw-material that include everything from oil to copper and steel. Now a $7
trillion economy to grow at the same pace requires $700 billion of economic
activity and which is more than 30% of global commodity produce looks an
unfeasible growth target. Other important factor which led to expansion after
the crash of 2008 was aggressive lending of $4 trillion cumulative loans by
banks till 2011 which was almost the size of the economy by that time. Now it
is pushing more towards consumption led growth as it sees serious implication
to pursue with its investment led growth for a command- and- controlled capitalism
of China. China’s growth tapering, Euro-zone fighting with its sovereign
crisis, Japan showing no growth and US showing sub-par growth is going to put
downside pressure on commodity prices in 2013. It will be hard to predict the
course of liquidity seeking the nature of asset classes as Quantitative easing
and liquidity injection is thrown at large in 2013. But incremental QE’s and
LTRO’s will be less effective in pushing up asset prices beyond a point until
we see economic activity ticking higher.
Crude also reflects a bearish outlook if we look at the spot
prices and the 5-year future oil price. More logical reason for the bearish
outlook in the future market is because of large shale-gas production in US
with newer technology is likely to flood the global market with oversupply at a
time when the global growth is sluggish and energy consumption is declining.
*Source: Research reports
Corporate India Result Outlook:
Corporate India surprised the street by posting better
results in 2QFY13, amid sluggish macro factors plaguing the country. However
risk of further slowdown is still haunting our domestic economy, which clearly
reflected on slowing sales growth. CNX 500 Companies excluding Banks and Oil
Companies posted a sales growth of 11% on YoY, the slowest growth since 2QFY10.
CNX-500 companies (excluding Banks & Oil companies)
*Source: Capitaline
The decline in sales growth was largely on account of low
industrial production numbers, which was hitting new lows in last few months.
Softening of commodity prices positively impacted the operating profit of the
companies, which surged 20% on YoY as compared to 13% (YoY) posted in 1QFY13.
Margins also improved by 100 bps on YoY during the quarter. Muted stance from
RBI on lowering interest rates during 2QFY13 has affected the capex of
corporate India, which was reflected in lower depreciation growth. Depreciation
growth has slowed down from 21% in 3QFY12 to 16% in 2QFY13. Lower depreciation
cost coupled with lower interest cost led 25% profit growth on YoY basis for
CNX 500 companies (excluding Banks & Oil companies). Interest cost which
was growing over 30% on YoY for past 6 quarters rose 19% in 2QFY13 owing to
lower credit growth and relatively unchanged interest rates and the
de-leveraging effect as well. However there is an expectation that Central Bank
on coming policy meet (probably in 2013) could reduce Repo rate, considering
the current slowdown in our economy. So going forward, this could be a big
boost for corporate India to post better margins and bottomline.
Macro Indicator:
A segmental view of the current account and how it is
supported by the capital account flows, specifically the FDI, Foreign Portfolio
Investment and the Loans/ECBs.
.bmp)
.bmp)
*in Rs Crore
FDI in the proposed sector will boost capital inflows and
ECB relaxation would take care of the current account imbalances for next year
and will act as a stabilizer for weak INR. Government’s proposed reforms are in
the right direction, the real effect of which will be gradually felt in the
coming years. FDI and FII flows comprise a large part of capital account. FII
flows are volatile to predict and are subject to global financial conditions
which keeps on changing rapidly with time. So promoting favorable reforms and
policies can only attract long-term productive FDI flows. Government is also
putting effort to attract capital through the ECB route. These efforts if
percolates down to the economic system will help in stemming INR weakness,
correcting current account imbalance and promote growth.
