Indianomics

Highlight of the last fortnight was RBI’s credit policy and Quarterly Economic Review. The RBI took a neutral stance and kept all the key rates unchanged given the state of economy. GDP growth is pegged at 6% with an upward bias. Inflation remains a worry for RBI and forecasted WPI for the fiscal year was revised upward from 4% to 5%.

Indian economy is precariously poised, walking a thin line. The government has been providing stimulus and has raised its expenditure to fill in the voids created by Private expenditure. In fact, the contribution of government final consumption expenditure to GDP growth expanded four-fold from 8.0 % in 2007-08 to 32.5 % in 2008-09, while the share of private final consumption expenditure nearly halved from 53.8 % to 27.0 % during the same period.

Given India’s high fiscal deficit, the trend is unlikely to continue and we may face severe issues if the economy fails to pick up with current stimulus.

Table: Contribution of Demand Components to GDP Growth

Share in GDP Growth (%)	2007-08	2008-09
Private Final Consumption Expenditure	53.8	27.0
Government Final Consumption Expenditure	8.0	32.5
Gross Fixed Capital Formation	43.6	42.5
Net Exports	-14.0	-29.5

Though the RBI and the Government have taken a number of steps, the credit flow and the monsoon picture is pretty worrisome. In the absence of adequate demand for credit from the private sector, commercial banks stepped up their lending to the Government which increased by 48%. The increase in net commercial bank credit to the Government reflected the accommodation of enhanced market borrowing program of the Government during 2009-10. Expansion in non-food credit to the commercial sector witnessed a sharp deceleration and remained below the Reserve Bank’s projected trajectory of 20.0 per cent growth for the year 2009-10.

However, the year-on-year (y-o-y) rate of growth in bank credit edged up for the first time this fiscal as per data released by RBI on 3 July. The y-o-y growth in bank credit was 16.3%. Between 10 April and 8 May, bank credit contracted by RS 19385 crore, while it went up by RS 15292 crore during the same period last year. Between 8 May and 5 June, bank credit increased by a mere RS 5154 crore, while it went up by RS 35243 crore last year during the same period. But between 5 June and 3 July, the increase in credit of RS 41537 crore was much more than the rise in credit of Rs22255 over the corresponding period of last year. If sustained, this could mark the beginning of higher credit off-take. An up-tick in the credit growth is seen as a lead indicator for acceleration in investments by companies fueling growth.

The IIP data has shown signs of stabilization in recent months. Consumer Durables and Intermediate goods have shown positive traction. Rural demand and increased purchasing power due to revised pay commission have been propping the indices up.

YoY Growth in IIP
May	5.5	3.7	4.5	2.5	2.0	3.3	4.4	2.7
Apr-May	5.8	3.8	5.6	1.5	1.7	5.1	5.3	1.9

Growth in IIP: USE-BASED

	2008 – 2009		2009 - 2010
	May	April - May	May	April - May
Basic goods	3	3.5	3.8	4.2
Capital goods	4.3	8	-3.6	-5.3
Intermediate goods	1.9	2.5	6.1	6.7
Consumer goods	7.4	8	1.2	-1.2
Consumer durables	2.8	3	12.4	14.7
Consumer non-durables	9	9.5	-2.3	-5.8

The Index of Six core industries having a combined weight of 26.7 per cent in the Index of Industrial Production (IIP) with base 1993-94 stood at 251.6 (provisional) in June 2009 and registered a growth of 6.5% (provisional) compared to a growth of 5.1% in June 2008. During April-June 2009-10, six core industries registered a growth of 4.8% (provisional) as against 3.5% during the corresponding period of the previous year. Sectors like cement, steel, electricity have shown signs of stabilization and strength in the preceding quarter.

Capital goods though seem to be an area of concern. Tight liquidity conditions and a drop in investment activity seem to be taking its toll on the industry. L&T, India’s premier conglomerate in its latest quarterly results reported a drop of 22 % in order inflow.

Agriculture and allied activities fuel Indian rural demand that everyone is banking on. Agriculture contributes only 17.5 % to the GDP, but its performance is critical as it employs over 55 % of the total work force. A good monsoon is essential not only for reigning in food prices, which are hitting higher highs each passing day, but also for healthy rural demand.

Unfortunately, Indian farmers are dependant on monsoon for irrigation. More than 73% of annual rainfall in the country is received during the monsoon season. Annual average rainfall is 1160 mm in India out of which 85% is concentrated in 100-120 days of southwest monsoon.

The cumulative rainfall during the season so far (up to July 22, 2009) has been less than satisfactory, with rainfall over the entire country being 19.0 % below normal as against 2.0 % below normal during the corresponding period of the previous year. Of the 36 meteorological subdivisions, cumulative rainfall was excess/ normal in 17 sub-divisions (21 sub-divisions last year). The north-west region faces a deficiency of 44%.

As on July 23, 2009, the total live water storage in the 81 major reservoirs of the country was 23.0 % of the Full Reservoir Level (29.0 % during the corresponding period last year). The figure is less than 50% of the last 10 years’ average level. This has serious implications for India’s food output. As per the latest reports from the ministry or agriculture, the area planted so far under Kharif crops has fallen by 25% as compared to last year. The area sown under food grains has fallen by 28% as compared to last year. Area under cereals has decreased by 29% and pulses by 19%. Even the area under non-food grains like oilseeds also has declined by 35%.

Crop output, which is a product of area and yield, is severely affected only if there is a deficiency of rainfall in 3 consecutive quarters –March-May, June-September and October-December. Coming to the current kharif season, the pre- monsoon (March-May) rainfall was deficient by about 32% and the monsoon rainfall so far has been below LPA by 24 %.

India has been witnessing an improving state of affairs in domestic production and consumption, but the fiscal situation of the country is pretty grim. With current monsoon worries, India could face prolonged slow-down as consumption slows down due to lag effects of slowdown in agricultural sector. Higher food prices and large Government borrowing may result in higher interest rates derailing the ongoing improvements we are witnessing.

The Solvency Crisis

Last 45 days have been quite eventful for the Global economy and more so for India. If the global markets witness mixed economic data from US and perhaps a stellar Chinese GDP number (on face value), India wasn't far behind with its budget and numbers from IT biggie Infosys.

Amidst all the developments global markets went through a slight pull-back and only to gain again in the last week. China has been leading the pack and have given tremendous returns over the year. With Chinese Government's continued thrust on public spending, many believe things will be quite rosy. The commodities across globe have been rising due to Chinese stockpiling and huge speculation. With the Chinese Central Bank tightening things may start to unwind. Another important factor to note is if all the monetary loosening led to real lending. I doubt that.

India markets are not far behind in their performance largely driven by hopes. The corporate numbers so far have been mixed. While Infosys was just OK, TCS did quite well. On the other hand infrastructure giant L&T disappointed with its profit from core operations quite dismal and a steep decline in the order inflow. The budget was rather disappointing but lets be realistic, the Finance Minister didn't had much breathing space.

The monsoons in India have so far been disappointing or below averages. Even if it catches up now, the damage has been already done to crops. The whole of rural economy which everyone is banking upon may not deliver given the present circumstances. Moreover country is facing a huge deficit in hydro power generation as a consequence. The rural juggernaut may fail to impress and food inflation may hit the roof.

The bank credit growth in India is far finally showing some signs of bottoming, but the truth is that banks are still parking money with the RBI and are reluctant to lend. How long can the corporates sustain without the lifeline from banks and what happens to majority of projects is debatable. But things don't look on ground.

It seems that global liquidity push by Central banks have resulted in a swift rally across equities and commodities, but is the rally sustainable? With valuations already rich or no more cheap, slightest of disappointment may lead us downward. I am no economist and still learning my lessons but I don't quite understand how a thing - the excess money supply and leverage that got us into this situation can help us get past.

The Japanese crisis of 90's offer enough evidence that quantitative and credit easing may not be the solution to the problem. What most households and corporates are facing as of today is not only a liquidity crisis but a solvency crisis. We have been bitten hard due to our excessive leveraged spending and speculation. The word leverage is of utmost importance here.

In the end, I want to add a few thoughts about green shoots that people are talking about. Though we have stopped declining at a rapid pace in terms of economic numbers, but it is not prudent to say that the demand has picked up or is picking up. A few facts that all of us may shall take up with a pinch of salt and think of before talking of recovery, follow

1. The Riskbank, Sweden’s central bank and the world’s oldest central bank, effectively cut interest rates to minus 0.25% and started a program of quantitative easing a.k.a printing money on July 5.
2. Piles of Corporate Debt will be due for refinancing across globe in years to follow starting from 2011 till 2014.
3. The cut down in global liquidity due to de-leveraging is estimated at around 15 Trillion dollars. How on earth could the combined liquidity injection of not more than 3 trillion dollars, can fill this void?

Indian Market Valuation

Whoa!!!! As if there is no tomorrow, as if the new government has a magic wand to rectify all that is not working. That is what current Sensex and Nifty levels tell me.

I took a break to concentrate on my CFA Level 2 exam and indeed it was a pleasant break - with Indian markets delivering their best ever monthly returns. Like many, I am also trying to find reasons that could justify such a rise. Plenty of reasons have been floating around including the possibility of material reforms, India playing catch up with other BRIC nations.

But the truth is that markets have been largely driven by a change in sentiment due to lot of hopes. Now that is something to be cautious about. Given the high level of expectations, any failure to meet them will result in disappointment and sell off. FII’s have been fueling the rally and invested more than 4 Billion dollars in the month of May. Now that figure is quite staggering considering that highest ever inflow for an entire year in the Indian markets have been around 13 billion dollars.

The question however is whether these levels are sustainable or not? Are the Indian Markets fairly valued, under-valued or over-valued? Investing is as much about facts as it is about hopes and opinion. A look at the most simple metrics – P/E and P/B exhibits and to some extent explains the current uptrend and its sustainability.

Sensex Historical Valuation
Year	P/E	P/B
1992 – 93	36.25	6.32
1993 – 94	36.21	5
1994 – 95	41.24	5.63
1995 – 96	19.92	3.46
1996 – 97	15.34	2.91
1997 – 98	14.5	2.73
1998 – 99	12.86	2.27
1999 – 00	19.78	3.78
2000 – 01	23.86	3.6
2001 – 02	16.55	2.38
2002 – 03	14.51	2.23
2003 – 04	16.19	2.82
2004 – 05	16.56	3.33
2005 – 06	16.98	4.17
2006 – 07	20.73	4.9
2007 – 08	22.65	5.49
2008 – 09	-	-
Median Values since 1995	14.92	3.33
Lowest Levels (October 1998)	10.27	1.73
Source RBI Handbook

Now, what this tells me is that Sensex was trading near its lowest multiples ever since the Indian economy opened up in both October 2008 and March 2009. The forecasted range for Sensex 2011 EPS is 900 to 1100 including the most pessimistic and optimistic scenario. Based on simple calculations the current level of 15 K discounts the most optimistic scenario with a P/E of 13.6, and that too almost 6 months ahead the curve. That means at current levels we are almost tilting towards the over valuation zone if we take into account the EPS and growth estimates for current Fiscal.

It is entirely possible for us to trade at higher levels and make further gains, but for that to happen either we shall trade at premium from our historical levels or the growth in earnings has to beat the estimates.

Markets level are a function of both facts and hope, however an excess of any factor may lead to irrational exuberance and deviation from fundamental reasons for investing.