Concerns on Unfunded CAD are overdone

Sep 09 2013, 10:58 IST
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SummaryQ2 will be the most painful quarter we have seen in this downturn

Visibility on economic growth in India in FY14 is fading as neither monetary nor fiscal policy is in a position to support growth. With a new RBI governor in place, monetary policy seems also certain to be used to defend the currency (alongside a swap line from the Bank of Japan). That necessarily implies tight monetary policy (and high short-term interest rates) for the foreseeable future.

With regards to fiscal policy, given that the central government has already spent 63% of its full-year fiscal deficit by the end of July and given that slippage on the receipts side is likely to amount to a minimum of R400 bn (factoring in R100 bn of slippage each on disinvestment, spectrum auctions and tax revenue), the government will have to pare expenditure in the rest of the financial year; remember the finance minister has been very clear that he will deliver on his fiscal deficit target of 4.8%. This implies that between now and the end of the year, Government spending will grow at only 14% (as opposed to our previous estimate of 18%).

Over and above these adverse pressures from monetary and fiscal policy, we also have the small matter of the evaporation of growth in Q2. Whilst our discussions with management teams suggest that Q2 will be the most painful quarter we have seen in this downturn, in terms of economic growth, it is hard to get a fix on whether it will be a 3% or 4% GDP growth quarter. The precise number matters because it sets the tone for the rest of the year—with Q1 growth being 4.4%, if Q2 is 3% then H1 will see growth of less than 4%. In such circumstances, even if H2 growth recovers to 5% (say, due to higher power generation, a monsoon-fuelled pick-up in agriculture and a pick-up in exports), full- year growth could fall shy of our current estimate of 4.7%.

That being said, whilst growth falling shy of 4.7%, and going as low as 3.5%, is a distinct possibility, we find some pessimists’ estimates of 2% growth in FY14 (either on a full-year basis, or more realistically, by Q4 FY14) overly pessimistic. Here’s why.

o Agriculture (15% of the economy) should grow at well over 3% thanks to a bountiful monsoon (our FY14 estimate is 3.9%, the Q1FY14 figure was 2.7% and the five-year average is 2.9%), and o Services (60% of the economy) should grow at well over 3% (our FY14 estimate is 6%, the Q1FY14 figure was 6.6% and the five-year average is 9.1%).

If 75% of the economy grows at a rate significantly north of 3%, Industry would have to contract by 8% for FY14 economic growth to fall to 2%. For the record, Q1FY14 growth in the industrial sector was a measly 0.2%.

That brings me to the second issue of concern at present. At Ambit, we turned buyers of the Indian market in late-May 2012 when the Sensex was around 16,000. On 24th September 2012, emboldened (prematurely as it would turn out) by the UPA’s desire to move on with economic reforms, we raised our Sensex target from 19K to 23K. This 23K target was premised on FY14 Sensex EPS of R1,350 (implied y-o-y growth of 14%) and a forward P/E multiple of 17x (in-line with the six year average). Let’s revisit this target.

The actual Sensex EPS for FY13 came in at R1,184. At present our sector leads’ bottom-up FY14 Sensex EPS estimate is R1,282 (implying 8% y-o-y growth). Now assuming further EPS downgrades post the RBI’s tight monetary policy biting in Q2, we are likely to end up with FY14 Sensex EPS of R1,243 (5% y-o-y growth).

Multiplying R1,243 by 17x (the ten year trailing P/E is 17.6) gives us a Sensex target of 21,000, below our previous target of 23,000, but still implying 13% upside from current levels.

That being said, I am aware that a number of investors believe that the Sensex can’t rally given the gravity of the current account crisis facing India. Whilst the “unfunded CAD” is a worrisome issue, I believe that these concerns are being overdone.

The CAD in FY13 was recorded at about $90 bn. Assuming that: (i) full year exports growth for FY14 is recorded at 10% y-o-y i.e. a $30bn increment in exports receipts, and (ii) full year imports growth is recorded at 3% y-o-y with the slower imports growth being driven by lower imports of gold, the incremental imports bill for FY14 amounts to an increment of $15bn. This should then mean that India’s CAD for FY14 gets compressed to $75bn (i.e. 90+15-30 $bn). From thereon, a combination of import restrictions on electronic goods, iron & steel and defence goods is likely to compress the CAD by another $15 bn thereby leading the CAD to be recorded at $60 bn.

As regards the funding side, assuming that FDI inflows in FY14 are recorded at $10bn (v/s the five year average of $18bn), banking capital flows are recorded at $5bn (v/s the five year average of $7bn), loans based net inflows are recorded at $10bn (v/s the five-year average of $20bn), then the funding gap amounts to $35 bn (i.e. 60-10-5-10). This gap is likely to be funded using a combination of FX reserves, quasi-sovereign bond issuancebond issuance and the swap line that has been set up with the Bank of Japan. Whilst this is not an ideal situation to be in, this situation does not amount to an FX crisis.

The author is CEO, Institutional Equities, Ambit Capital

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