The rise of the prodigal son...in the East!

Japan goes back to bigger quantitative easing; American recovery quickens; European and Chinese inflation also lower and more stable.  Competitiveness concerns may finally force RBI’s hand to lower rates.

In the weekend before Christmas, as the world’s financial markets sauntered into holiday-hibernation, Shinzo Abe - Japan’s Prime Minister-Elect - bettered Santa Claus (or Attila the Hun, depending on your perspective) by declaring that his coalition, which holds an unassailable two-thirds majority in the lower house of the Japanese Parliament, may change the law governing the coy Bank of Japan (BOJ) if it refuses to accept a 2 per cent inflation target at its January meeting. In any case, Masaaki Shirakawa, the relatively hawkish BOJ governor will be replaced with a more dovish, pliable candidate by April 2013. At the December 20th meet, he already declared to engage in more easing by expanding asset-buying and lending program by a tenth to $1.2 trillion, and hinted at an upward review of its 1 percent inflation target.

Japan following Europe in moving from inflation targeting to dual targeting

The BOJ, like the European Central Bank (ECB), is at least in theory an inflation-targeting central bank but Abe wants it to have a dual target of inflation and employment much like its American counterpart - the Federal Reserve (“Fed”). But a year ago, of course, the ECB had de facto reneged on or at least expanded its inflation-targeting mandate by launching its first series of Long Term Refinancing Operations (LTRO) with 489 billion freshly-created Euros, the full (bullish) effects of which took months to play out. The Fed of course must itself be confused about its Quantitative Easing (QE, a term first used in Japan) historiography, with its even larger and multifarious rounds since late 2008 or early 2009 (depending on how QE is defined).

Yet, Japan has no real short-term alternative policy plan given its political economy. October 2012 figures show that CPI or consumer price inflation was negative 0.4% (or deflation), inflation has been largely negative or zero for the last few years and nominal interest rates cannot really go down any more. Differences on monetary easing therefore is on the margins, and imaginative solutions are politically locked as of now – immigrants a.k.a new tax payers are still frowned upon, an aging population creates more fiscal dependents, free trade in agriculture is taboo, and finally there is no political force that can resist the asymmetrical Keynesian orthodoxy in Japan. “Bridges to nowhere” are still being touted as an economic solution, whereas structural supply-side reforms and targeted growth-supporting tax cuts are relatively frowned upon.

All this combined with even slower growth rates since the financial crisis of 2008 has ballooned Japan’s government debt to GDP ratio from 167% in 2008 to 212% in 2012. Yes, interest rates have fallen since 2008 and the flow of debt servicing has been easier to manage. But this huge stock of debt will still be around, when – not if – interest rates rise. Yes, even China’s economic size at market exchange rates (as opposed to purchasing power parity rates which are more favorable to poor per-capita countries like India and China) has now clearly overtaken Japan’s and is almost half of America’s size, yet the Government of Japan’s debt at around 12 trillion USD is comparable to the US Government’s 15 trillion (whereas the American economy is almost three times as large as Japan’s).

The Yen depreciates, re-establishing itself as a carry trade generator?

Moreover, the situation is not radically different in the US or EU, and easing there – along with the continuing slowdown - had forced the Yen up and weakened Japanese exports (Japan posted a larger-than-expected trade deficit in November). While a few large countries or economic blocks could sit together and theoretically stop down competitive devaluation, this is unlikely to happen because democratic governments come to appreciate seigniorage and inflation as hidden taxes that also re-adjust the balance between labour and capital in favour of the latter without having to force the former into nominal wage cuts.

Already, the Yen has depreciated from 79.5 in mid-November 2012 to above 84 before Christmas in anticipation of Abe’s victory and policies. That is a 5 percent short-term competitive advantage for Japanese exporters and manufacturers and will help at the margins.  Such overall Yen structural weakness might mean borrowing in yen and investing in foreign currencies, which might be a boom for Indian and other emerging market (EM) equities, if not commodities (where supply-side booms and demand-side drops due to technical innovations continues apace)

Jump off fiscal cliffs or not, American central bankers will still ease for now.

The current fight over the “fiscal cliff” in the United States exemplifies the inability of the political class the world over to lead its societies to defer more consumption and gratification for the well being of their children and grandchildren. American Democrats would not countenance any stricter criteria for redistribution payments, and many congressional Republicans would not accept any higher taxes on upper-middle class families. Ben Bernanke’s Fed, blessed with America’s size and credit history, is in a unique position to further ease and yet attract lower yields with every economic downturn (including a fiscal tightening), despite the total government to debt ratio having breached 100%. But signs of American solvency – any ratings downgrade hysteria notwithstanding – are inaccurate and overly pessimistic: US GDP increased at an annualized inflation-adjusted rate of 3.1 percent in the third quarter of 2012 (that is, from the second quarter to the third quarter). In the second quarter on the other hand, GDP had increased by “only” 1.3 percent –strengthening the recovery thesis. The Consumer Price Index for All Urban Consumers (CPI-U) declined 0.3 percent in November on a seasonally adjusted basis, hinting at perhaps more room for easing at least in the short run. Over the last year, the overall price index increased by just 1.8 percent.

The Fed therefore said it will buy $45 billion a month of Treasuries (and 40 billion additional dollars worth of mortgage securities) starting in January, expanding its asset-purchase program indefinitely until 6.5% unemployment is not reached, and so long as inflationary expectations one to two years in the future does not breach 2.5%. Total nonfarm payroll employment rose by 146,000 in November, and the unemployment rate went down to 7.7 percent. An additional drop of 1.2 percentage points in official unemployment rates will take at least two more years by current estimates. But why is all this easing not leading to inflation (yet)?

As the financial economist Dr. Scott Grannis writes, the US public holds $6.5 trillion of bank savings deposits (up 64% in the past four years) paying almost nothing – 1.5 trillion of those could be diverted (as they are excess bank reserves) to entrepreneurial activities or consumption. Therefore, while the monetary base has exploded in recent years the M2 measure of money supply in the United States has grown only slightly faster than its long-term average of 6%, partially because the public does not see that many organic or structural investment opportunities.

Moreover, the American economy (and more specifically the housing market) continues to “optimally” strengthen, as Ray Dalio of Bridgewater Capital might say - because of moderate monetary policy led-leveraging (mortgage refinancing help, and demographic expansion) with fiscal policy and private sector partial deleveraging. 2011’s brisk revival was continued this year, with a 22 percent increase in housing starts in the last 12 months.

Whither Europe?

Just like politicians from India to US have not had the courage to pass many genuinely short-term austerity and long-term liberalization measures, Mario Draghi’s ECB has nudged Germany to repeatedly cave in to the demands of smaller, profligate countries like Greece which refuse to fully accept painful restructuring.

The European fiscal union – and indeed the single European nation-state – is being molded and merged in the cauldron of its fiscal, economic and finally demographic crisis; with this dream of the idealists of yore being suitably lubricated by the ECB. In this pursuit, it is being helped by falling inflation (2.2% in November, down from 2.5% in October; last year was around 3 percent)

Moreover, the year-on-year Euro Area industrial production in October also fell by 3.6% (seasonally adjusted) – calling for further creating/printing of new Euros. While the ECB still remains more cautious and conservative than the Fed, it will have to step in even more given the reality of at-best zero-growth-rate economies. The election of Hollande’s socialist party in France has played out as expected – discouraging entrepreneurs, and strengthening government unions. Moreover, the resignation of the reformist, technocratic Prime Minister of Italy, Mario Monti, has put a question mark on another too-big-to-fail European nation. While a Greece and Portugal can be “bought off” for now, an Italy or France or Spain faltering seriously will be the end of the Euro project, which would not necessarily be cataclysmic if managed well (a big “if” that).

China – falling inflation point to monetary easing here too

In November 2012, the Chinese consumer price index (CPI) went up by 2.0 percent year-on-year. The food prices went up by 3.0 percent, while the non-food prices increased by 1.6 percent. In the third quarter of 2012, Chinese GDP grew by 7.4 % year on year and almost 9 % annualized seasonally adjusted quarter on quarter. Therefore, while the annual expansion was one of the slowest since 2009, the quarterly change has shown improvement. On the trade front, like the growth front, also we have mixed signals – only inflation seems to be a relatively clearly indicator.

Structurally, the Chinese growth is chugging along well despite no new major government stimulus and still weak global demand, which is a testament to the diligence of the Chinese people. The property markets of free market havens, Hong Kong and Singapore, have had to take unprecedented protectionist/stamp duty measures to thwart rich Chinese buyers (so as to prevent bubbles) in the wake of Western monetary easing washing up on Asian shares rather quickly. Yet, China has not exactly turned corners. Also, the Chinese national bond regulator has temporarily stopped approving debt sales by governments below provincial level, thereby sending out a signal, however credible, against implicit federal guarantees and thereby strengthening the stimulus reservoir strength at the national level in some future contingency (sub-national Chinese insolvency was causing some prominent investors a lot of jitters).

It seems that while the Americans are expanding the monetary base, but not subsequent layers of credit, the Chinese are to some extent accelerating investment credit outflows through their banking systems while not necessarily focusing on the monetary base per se. This latter plan of action is of course only possible in more tightly controlled banking systems, and has its own downsides in efficiency and corruption. The Chinese economic expert and “bear”, Dr. Michael Pettis, remains pessimistic about China in the mid term noting that “of the dozens of developing economies that have experienced investment-driven growth miracles in the past 100 years, the only ones that have managed the transition to developed country status are South Korea, Taiwan, and maybe Chile” and hence China will have to face a painful transition from its mercantilist, centralized model to a more market-finance based one.

Probable impact of all this on India - short-term equity bullishness

Besides some domestic reforms (FDI policy in retail being passed in both houses of the parliament), the Indian markets have been buoyant for these external factors as well, and this could be the beginning of another mini-rally with higher tops and higher lows. But, India’s monetary policy remains cautious and fiscal policies remain reckless – slowing growth have resulted in advance tax receipts growing by just (annualized) 10.4% in December so far (collections grew even slowly at 7.5% on year between April and December, with the nominal growth rate all along being just shy of 15%, 6 percent growth plus 9 percent inflation roughly speaking).

In a battle of wills between politicians and central bankers, the latter are more likely to blink first. Tax breaks to invest in Indian bonds were declared earlier to attract foreign and/or privative investments, and this is already showing results.  Ennore Port in Tamil Nadu is already issuing bonds worth Rs. 1000 cr within this scheme.  On the other hand, there have been many “deforms” as well. Life Insurance Corporation (LIC) and now even the Employees’ Provident Fund Organization (EPFO) are being raided by the Government of India (GoI) for its fiscal purposes, destroying more necessary firewalls between various quasi-arms of the state. The Food bill, like NREGA, is going to be high on redistributive expenditure and low on allocative efficiency – there is no plan to currently use private retail outlets (existing ration shops would be used)

Indian foreign reserves have been stable at around 300 billion USD for many years even as the economy continued to grow, showing that any dramatic appreciation of the rupee is very improbable now. In fact, our overall macro policies are fairly balanced with remittances providing a solid support that needs to be always remembered given the sticker shock of our trade deficit numbers. India is the only huge nation with a demographic surplus for the next few decades, and emigration should be an “export” for our accounting purposes, just like “gold purchases” need to be considered at least partially as investments. With rating agencies likely to be even more involved because of the government’s gradual and further opening up to foreign financial capital, invariably a fiscal-political balance will also be found. The long term growth story of the capitalist democracy of India is intact, despite the hysterical headlines every now and then.

*A special contribution by Harsh Gupta....Economist from Dartmouth University

Best Regards

Paras Bothra

paras.bothra@ymail.com

+919831070777

2013 - A Year of Declining Interest Rates & Lower Commodity Prices...

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. 

*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.