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Indian stocks face power shortage
By Kunal Kumar Kundu
BANGALORE - The corporate sector profit performance in India has been quite
strong over the past couple of quarters, helping to drive up stock values, with
the benchmark Sensex index more than doubling since early March.
While revenues of non-financial and non-oil companies have hardly moved,
profits have, on average, increased by more than 20%, an analysis by the
Economic Times shows, and the market undertone remains quite bullish. This is
evident from the National Stock Exchange Volatility Index (VIX), which is
hovering near its lowest levels.
It is clear that the risk perception of the market is quite low. Yet, the Nifty
Index, which tracks the stock of 50 large companies, has recovered from last
year's collapse to be only about 20% down from its all-time high in January
2008, when the economic conditions were quite different. That could indicate
that the market is under-pricing risk. Three factors are worth considering -
liquidity, corporate performance and government intervention.
Liquidity: From early 2008, the Nifty nosedived from about 6,287
to just above 2,500 by late October and remained below 3,000 until late March
this year. This can be attributed mainly to the virtual stagnation of global
liquidity flows. With financial stress feeding through to the real economy,
markets fell like ninepins. Then a plethora of stimulus plans were announced
worldwide and liquidity suddenly increased.
The increase in liquidity was enhanced by the US dollar carry trade, with money
borrowed in near-zero interest dollars seeking higher gains overseas. This
liquidity did not percolate into the real economies, given increased risk
perception; instead, it started chasing equity assets around the world. Not
surprisingly, all the major global equity indices started moving up, as if
there were no tomorrow.
India was no exception. Inflows from foreign institutional investors (FIIs)
picked up by way of Participatory Notes, or P Notes. These are instruments used
by investors or hedge funds that are not registered with the Securities and
Exchange Board of India to invest in Indian securities. India-based brokerages
buy India-based securities then issue the notes to foreign investors. This,
coupled with domestic money moving to the markets through financial
institutions, led to the current rally. At the same time, despite availability
of enough liquidity in the system, credit flow to the real economy continues to
falter, indicating a lack of corporate confidence in economic growth going
forward.
Outstanding non food credit of Scheduled Commercial Banks (YoY gr.)
Corporate performance: A tapering credit flow does not make for a
positive corporate outlook, and with domestic demand remaining flat, corporate
revenues have hardly moved during the past two quarters. Companies have
improved net profits on account of depressed commodity prices, low interest
rates and low labor costs. Going forward, none of these will be able to boost
performance as they have in the past.
Commodity prices: After commodity prices peaked in 2008, they
went into a tailspin.
MGM Index
This is clear from the movement of the MGM Index. It is an index of base metals
(aluminum, copper, zinc, lead, nickel and tin) developed by Metallgesellschaft
(MG), the West German metals, engineering and chemicals group. Recently,
however, commodity prices have picked up sharply. This is attributable to
restocking, mainly by China, but also to a large extent to the inflow of
liquidity into commodities as an asset class. Whatever some experts might want
us to believe, the uptick in commodity prices has nothing to do with a
perceived likelihood of the global economy pulling out of recession.
The flow of liquidity in commodities has been further exacerbated by the
plethora of commodity exchange-traded funds (ETFs), that are attracting
investors in droves. Estimates put the value of investments in commodity ETFs
at more than US$30 billion, while the amount of cash chasing oil future energy
contracts is at around 15 times world demand for the actual commodity. With
commodity prices ratcheting up, companies will face heightened cost pressures.
Interest rates: The recent announcement by the Reserve Bank of
India clearly indicating a tightening of its monetary stance also implies that
the period of cheap liquidity is over for Indian companies. While I am not
expecting interest rates to rise soon, there are enough indications that as
inflation picks up, interest rates will go north.
Certainly, present inflationary pressure has a lot to do with excessive food
prices on the back of a poor monsoon, but food prices should moderate as output
from the rabi, or spring, harvest enters the market early next year.
However, rising commodity prices will start feeding into inflation and with
monetary policy in a tightening mode, a pick-up in credit demand will also lead
to a hardening of interest rates.
Labor costs: Anecdotal evidence suggests that the downturn in
India's domestic job market is over. As companies come up with hiring plans and
seek to retain talent, cutting workforces or holding back on wage increases
will no longer be an option.
As cost reductions cease to be a feasible alternative for companies,
maintaining a 20% or more growth rate in profits will clearly not be possible
unless there's a dramatic increase in revenues. This would require a
substantial increase in domestic demand, which does not seem likely. Added to
this, a likely increase in interest rates will act as a dampener for leveraged
consumption through loans and credit cards that many consumers have become used
to in the past few years of cheap financing.
Government intervention: This is the third leg of the India
growth story. In India as elsewhere, government intervention in the form of
various stimulus measures has enabled the economy to grow at a relatively high
rate, which raises the question of how sustainable will the impact of these
measures be on future growth.
A recent Center for Economic Policy Research paper by Ethan Ilzetzki and others
shows that the cumulative multiplier (referring to how many times a dollar put
in as stimulus adds to the GDP) in high-income countries rises from an initial
value of 0.24 (the impact effect) to a long-run value of 1.04. Hence, even
after the full impact of a fiscal expansion is accounted for, output has
essentially risen by the same amount as government consumption.
On the other hand, the cumulative long-run multiplier for emerging countries is
just 0.79. In other words, in the long run, an additional dollar of government
consumption crowds out some other components of gross domestic product (GDP) -
investment, consumption, or net exports - by 21 cents. However, for highly
indebted countries, the output response to increases in government spending is
short-lived and much less persistent than in countries with a low debt-to-GDP
ratio, although the short-term response is larger.
Indeed, while the output response for high-income countries remains
significantly positive for the 24 quarters covered, it becomes zero
(statistically speaking) after about only 10 quarters for developing countries.
According to the research paper, there is not much room in emerging markets for
active counter-cyclical fiscal policy - such as cutting taxes during an
economic downturn; and a worse combination is an emerging open economy with
exchange-rate flexibility and high indebtedness.
India falls into this bracket. Given the level of national indebtedness and the
level of fiscal constraint faced by the government, the multiplier effect
tapers off sooner, rather than later, and leads to the crowding out of private
investment. As mentioned, growth has been supported by increased government
spending, inventory buildup and payment of arrears under the revisions by
the Sixth Pay Commission. What all these mean is that the demand induced
by the stimulus essentially results in bringing forward what would have been
demand in the future. Hence current growth aided by stimulus-induced demand
will essentially shave of a few basis points from India's future GDP growth
numbers.
Future growth will also be hit by the eventual withdrawal of stimulus by a
fiscally constrained government, with the fiscal deficit for the year already
expected to be between 12% and 13% of GDP. That the government is also feeling
the heat of its profligacy is clear from the rising rhetoric about selling off
state-owned assets and a stated desire to spend the proceeds in the social
sector, unlike earlier, when the government was very clear that the proceeds
would be channeled into the National Investment Fund (NIF).
Hence, while the impact of the past stimulus will fade slowly, the exit, as and
when it happens, will reduce the short-term multiplier effect on growth.
Similarly, support for an exit strategy is coming to the fore in other nations,
both developing and developed. The exit will not take place at the same time
across the board, but what this does indicate is that the excess liquidity that
has been moving all over the world chasing assets will slowly ease.
Hence, with the performance of Indian companies likely to be less robust going
forward, coupled with a slow drying up of liquidity in the near future, the
performance of the stock markets in India is expected to be moderate next year.
Note
1. "How big
are fiscal multipliers", Ethan Ilzetzki, Enrique G Mendoza and Carlos A
Vegh, Center for Economic Policy Research, October 2009.
Kunal Kumar Kundu is Principal Consultant, Financial Research Knowledge
Service, Infosys Technologies Ltd. The views expressed are those of the author.
(Copyright 2009 Asia Times Online (Holdings) Ltd. All rights reserved. Please
contact us about
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republishing.)
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