Geared To Vault The Hurdles

Not very far back in the past, we had delved into why the economic situation is not as bad as it is believed to be, and had clearly stated that there is a ‘silver lining to the dark clouds’. One month since then, the situation has shaped once again in a way that has cast a shadow on the future course of the economy and the market. We are sure that there is a growing sense of unease among investors with respect to the overall situation. Here is a closer look on whether we need to be concerned about the latest developments and their impact.

From an impending drought in the Indian subcontinent to one already confirmed in the US, scanty rainfall has turned out to be a major worry for economies globally. The Euro zone crisis, on the other hand, continues to rear its head time and again, fuelling the negativity surrounding the economy and the markets. As if all this wasn’t enough, the Indian political scenario has not been very encouraging either.

Will all this blight the markets further? Or are these just blips that one should not be overly worried about? Here are the answers to some of these troubling questions.[PAGE BREAK]

Drought Watch: Green Shoots Wilting?

Agriculture was seen to be one of the few bright spots in an otherwise moderating US economy. Now, this too seems to be turning dark after the US is affected by one of the most severe and extensive droughts it has seen in the past 25 years. According to the United States Department of Agriculture (USDA), 40 per cent of the agricultural land in the country is facing a drought that will affect 31 per cent of the total value of crops produced by the US. For the year ending 2011, US agriculture contributed a total of 1.2 per cent to the USD 15.29 trillion US economy.

The impact of such a drought will be reflected immediately in the prices of commodities and with a lag effect on livestock, which uses these farm products as feed. The prices of corn and soya bean, the two important crops that have suffered the most, are already witnessing an upturn. The prices of corn have raced to touch a new high at USD 8.2 per bushel. From the start of the year (till July 30, 2012) the prices of corn and soya bean have already increased by 26 per cent and 35 per cent respectively, with most of this rise coming in after May 2012 when the drought conditions intensified. Besides corn and soya, another crop whose output is likely to suffer is wheat, the prices of which have firmed up by 26 per cent since May.

Is such a rise in prices of these commodities really going to impact India? We are struggling with our own set of problems as it is, both on the inflation and weather fronts. Will the current wave of concerns further depress the situation, or are we fairly insulated?
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Well, regardless of what is happening in the US, we believe that such a rise in the prices of these commodities will not have a direct bearing on the Indian economy. This is because India hardly imports corn, soya bean or wheat. On the contrary, India is an exporter of these three commodities and thus, the spiraling prices of these commodities is actually a blessing in disguise.

India’s corn exports are estimated to have touched 3.8 million tonnes for FY12, that of soya has increased by around two per cent and wheat exports have touched 178 million tonnes during the fiscal. Going forward too, the country is aiming to export increased quantities of wheat, as the inventory of the grain in government warehouses surged to a record 50.2 million tonnes at the end of May 2012. Therefore, there is very little for us to worry about with respect to the US drought. Moreover, according to a report by Barclays Capital, the prices of agricultural commodities will not increase dramatically, and the fact that the global economy has much more slack, lower freight and energy costs is likely to offset any increase in production costs.

In short, we believe that the US drought is not as bad for the Indian economy as it is perceived it to be. What we should be more worried about is how the monsoon pans out in India over the next month or so.[PAGE BREAK]

Euro Zone: The Crisis Prolongs

The Euro zone has been in the throes of an economic crisis that is threatening the existence of the EU as a monetary union. A few days ago, Mario Draghi, President of the European Central Bank (ECB), said that he would do “whatever is needed to save the union’s common currency”. This cheered equity markets around the globe, which rose in unison, and all the major indices closed in the green. Economists and analysts interpreted this statement as an indication of some action in terms of a new bond purchase scheme, a cut in the interest rates in the Euro zone or a new Long Term Refinancing Operation (LTRO). However, it proved to be merely lip service, and nothing concrete emerged from the ECB meeting held on 2nd August, 2012.

The Euro zone has been enmeshed in a crisis for almost two years now, and the rot is fast spreading from its periphery to the core. The worsening situation is reflected in the rising cost of borrowing for these countries. Recently, the yield on the 10-year government bonds of Spain touched a Euro-era record of 7.75 per cent. Moreover, according to a Citi report, the likelihood of Greece exiting the Economic and Monetary Union (EMU) in the next 12-18 months is about 90 per cent, up from previous estimates of 50-75 per cent, with a strong chance of this coming up in the next two-three quarters.[PAGE BREAK]

From an Indian perspective, how important are these developments and projections? Should we worry about what is happening in Europe?

As far as India is concerned, the countries in the European Union (EU) are major trade partners, accounting for as much as 17.6 per cent of the country’s exports for the nine months ending December 2011. Exports to the region have seen a continuous decline in percentage terms over the last two years, from 20.15 per cent in FY10 to 18.3 per cent in FY11. In absolute terms, however, exports to the EU have increased by 28 per cent in FY11 on a yearly basis. For 9MFY12, these have already touched 86 per cent of what they were in the whole of FY11. Therefore, we are not likely to witness any drop in exports to the EU in the foreseeable future.

If we dig further and try to find out how exports are performing countrywise, we find that barring France, India shipped more products to all other major countries in Europe (including Spain and Italy) in 9MFY12 as compared to what it did in the same period in FY11. Therefore, a fall in exports in percentage terms to the EU region has more to do with the overall increase in exports from India to other geographies, which increased by 40 per cent in FY11, rather than a crisis in Europe. (Data not available for FY12)[PAGE BREAK]

Another direct way in which the EU crisis impacts us is the prospect of a slowdown in Foreign Direct Investment (FDI) from these nations. Although the major FDI flows into India are routed through Mauritius, which accounts for almost two-fifth of the entire bulk, a majority of these may have originated from Europe. In FY12, the FDI from Mauritius has increased by more than 40 per cent in FY12. While we have definitely witnessed some slowdown in FDI in the last two months, nothing can be said conclusively and we might well see some slowdown in FDI.

The next major way in which the Indian economy is likely to get impacted by the crisis in Europe is by way of the possible de-leveraging process of the European banks. If we analyse data from the Bank of International Settlements (BIS), we see that there is a little bit of de-leveraging, but this was more or less made up by a rise in the exposure that Swiss and UK banks have in India. From USD 159.1 billion in June 2011, the direct claims of European banks on India fell to USD 146.1 billion in December 2011, as the banks started liquidating their Indian assets. However, these claims then rose to USD 150.6 in March 2012 due to a rise in exposure of banks in UK and Switzerland.

Even if we add up the total claims by the EU banks as a percentage of our GDP, it stands at 7.2 per cent at the end of June 20, 2012. Consequently, we believe that a potential de-leveraging by EU banks is also not a major threat to our economy like some economists are predicting it would be.[PAGE BREAK]

Oil Prices: The Crude Reality

The prices of crude oil, the single-most important commodity for the Indian economy, have been on a rollercoaster ride. After remaining in three digits for most part of last year (CY11), crude continued with its upward momentum till the beginning of March 2012, when it touched a yearly high of USD 128 per barrel.

Thereafter, however, the prices started declining for the next three months and touched their 18-month low of USD 88.9 per barrel. The reasons for such a decline were both fundamental and sentimental. Macroeconomic uncertainty, both domestically and internationally, led to global risk aversion that culminated in a stronger dollar and the weakening of commodities. In addition to the gloomy sentiments, an excess supply of crude over the demand aided the downward trend in the commodity’s prices. OPEC’s output in May 2012 averaged 31.6 million barrels per day (mbpd), the highest since October 2008. Against such a rise in supply, the demand largely remained subdued due to a slowing global economy.

Now, the sentiments are playing a dominant role again and the crude oil prices are perking up. The prices are already up by 20 per cent from their March lows on expectations of the major global central banks infusing liquidity into the system. However, the meetings of the Fed and the ECB are already done with, and have turned out to be non-events in terms of providing liquidity to the system. Hence, crude prices seem to have stabilised at levels of USD 100-105 per barrel.[PAGE BREAK]

From the Indian perspective,this price is still 10 per cent below that considered in the Union Budget 2012 to calculate the subsidy outgo. However, a 12 per cent depreciation of the rupee during the same period has wiped out any benefit that a fall in the oil prices would have earned us. Nevertheless, a fall in crude prices is a much-needed relief to both the RBI and the Finance Ministry.

Looking at the fundamentals, we believe that the crude prices will remain at these levels as the supplies from Saudi Arabia (which is pumping oil at its fastest rate in the last 30 years), and Libya as well as the oil from America’s shale fields have all but plugged the gap caused by disruptions to supplies from Syria, Yemen and South Sudan. Moreover, Saudi Arabia’s Oil Minister, Ali Naimi, has said that a rate of USD 100 per barrel is fair, and reckoned that a rate of USD 80-85 per barrel is required to maintain a programme of lavish social spending designed to avoid an ‘Arab Spring’ in the kingdom.

Hence, we believe that the recent surge in the price of ‘black gold’ is not going to impact the Indian economy particularly, and that the prices would stabilise at this level. Moreover, if the rupee appreciates from here on, we will definitely see a positive impact on the economy.[PAGE BREAK]

Chinese Slowdown: Rising From The Trough

The data emanating from the world’s second largest economy over the past few months is not at all encouraging. Profits of the state-owned enterprises have declined by 11.6 per cent in the past six months on a YoY basis, and the growth in the demand for electricity in China for April 2012 was just 0.7 per cent as compared to 7.2 per cent in the previous month and 11.7 per cent in April 2011. All this clearly shows that the sprinter in global economic growth is slowing down. This is perfectly mirrored in the latest (second quarter) quarterly GDP growth figure of 7.6 per cent, the slowest in the last three years.

To spur growth, the People’s Bank of China (PBoC) has slashed the benchmark interest rates by 31 basis points to six per cent on July 5, 2012, in what was the second cut in a month. However, given the doubts over the reliability of data received from the Chinese authorities, many investors and analysts are interpreting such aggressive rate cuts as an indication of expectations that the Chinese economy will slow down at a rate faster than what the outside world perceives.[PAGE BREAK]

Broadly speaking, a slowdown in the Chinese economy will not directly impact India much. If we look at the export figures from India to China, they stand at just USD 15.48 billion for FY11, which forms 6.17 per cent of India’s total export value. However, if China decelerates at a faster clip from here and its growth rate dips below seven per cent, then there is reason for us to worry.

According to a report by global ratings agency Fitch, a slowdown in China would result in excess capacities across many manufacturing sectors and would alter the global demand-supply dynamic, especially given China’s low cost of production. This could result in intense competition for India’s manufacturing exports due to low-cost Chinese goods flooding the markets, which would put pressure on the profitability of Indian exporters.

The domestic market would also be hit by the overcapacity in China, which would then focus more sharply on external markets like India. This would result in potential margin pressures in the Indian markets as well. India already had a negative trade balance of around USD 28 billion with China at the end of FY11, and this will further increase with a slowdown there.[PAGE BREAK]

However, there are also some positive outcomes of the slowdown of the Chinese economy as it will lead to a fall in the demand for commodities and hence, a downward movement of their prices. This will definitely help India Inc., as it is struggling with the increase in commodity prices, which is reflected in the rise in raw material costs (increased by around 21 per cent last quarter on a yearly basis).

Moreover, new streams of data coming from China suggest that the economy is responding to the stimulus measures taken by the government. According to this data, we may have seen the trough of the current economic slowdown, and the Chinese economy might just pick up from here on. The most important data point is China’s HSBC manufacturing PMI, which climbed to 49.5 in July 2012 from 48.2 in the previous month. This represents a three-month high and the highest month-on-month increase in the last 21 months. Although it is still contracting, the pace has slowed down. Therefore, we believe that such a mild slowdown in China will only help India as it will ease the commodity prices.[PAGE BREAK]

Indian Politics: Emerging From Its Cocoon

After three years of the UPA II’s regime, one thing that has become clear is that most of the government’s energy is going into pacifying its allies rather than in handling more important issues of governance. This situation was expected to change after the Presidential elections, and the latest developments indicate towards the same.

P Chidambaram’s shift to the North Block signals that some changes that can be expected. During his last tenure as Finance Minister (2004-2008), the Indian economy grew by an average of nine per cent, second only to that of China. Therefore, it is expected that he will do everything possible to revive the economy, whose growth has hit its lowest point over the last nine years, and to bring back the confidence of investors.

The FM has already hinted at the actions needed to be taken in order to revive the economy. These boil down mainly to four points. First is the increase in capital investment, which has dropped to 32 per cent of the GDP against the 38 per cent level clocked in the year ended March 2008, during his last tenure as FM. While with the objective of reviving investment, one cannot ignore interest rates, which are at their peak levels in the major economies around the world.[PAGE BREAK]

After the RBI maintained status quo on interest rates for the second straight time in its monetary policy announcement made on 31st July, 2012, the minister hinted about “taking calibrated risks in order to stimulate investment” as “high interest rates inhibit the investor and is a burden on every class of borrowers”. But such high interest rates are more due to sustained and persistently higher inflation levels (WPI at 7.25 per cent and CPI at 10.02 per cent for June 2012) and a lack of fiscal action. This is likely to change when the FM implements what he has said. According to Chidambaram, “Fiscal policy and monetary policy must point to the same direction and must move in tandem. Government will work with the RBI to ensure that inflation is moderated in the medium term”.

The next major area that he touched upon is fiscal consolidation, under which the government aims to bring the fiscal deficit down from 5.76 per cent last year to 5.1 per cent in the current year. To achieve this, a panel has been set up to map out a plan to rein in the fiscal shortfall.

Last, but not the least, the FM also spoke about tax measures, which have remained a primary concern for foreign investors. The minister summed his actions in this regard saying, “Obviously, where necessary, our policies have to be modified or fine-tuned in order to meet the expectations of different stakeholders”.[PAGE BREAK]

Before we come to any conclusion, we need to watch out for the actions taken now and how they unfold. Moreover, not all of what Chidambaram has promised is under his portfolio, and thus, will require concerted action by the entire government. However, his past performance as a tough taskmaster and the few changes that he has already made at the secretary level gives hope that the government will walk the talk this time and will come out of its policy inertia. This will be the single most important event that has the potential of putting the economy back on the fast track and India on the radar of foreign investors yet again.

How The FM Is Trying To Revive The Economy

• Increasing capital investment from the current 32 per cent (dropped from 38 per cent in 2008) by taking calibrated risks.
• Reducing interest rates by aligning the fiscal policy with the monetary policy.
• Fiscal consolidation by setting up a panel to map out a plan for reining in the fiscal shortfall.
• Fine tuning the tax policies to put a stable and non-adversarial tax regime in place.[PAGE BREAK]

Building On The Optimism

From the aforementioned five factors and their possible outcomes, we believe that despite a deluge of concerns that have the potential of worsening the already poor shape of the economy, we will not only stay afloat but will emerge winners in this quest of leading the world economically. All this will have a direct impact on the equity market, which we believe, is on verge of a takeoff.

Our readers would appreciate the fact that we have been among the rare optimists who have maintained that the Indian equity market is poised to take a big leap upwards. We first elaborated on this in our cover story Silver Lining To The Dark Clouds (DSIJ Vol. 27, Issue No. 15, dated July 15, 2012). We further reiterated this  point in our next cover story Warming Up (DSIJ Vol. 27, Issue No. 16, dated July 29, 2012). Now, more and more voices are joining in to  repeat what we have been saying for quite a while now. The latest among them is Morgan Stanley, which has said in one of its reports, “We believe that the market is preparing itself for the next big bull market, though we are not quite there yet”.

So, gear up to invest smartly in the markets in the next bull run so that you can create the wealth which you have always thought of.