Facing weak domestic demand, the US and Europe are looking for weaker currencies to support the trade sector. However, China is reluctant to allow any meaningful RMB appreciation. (Japan is also worried about JPY appreciation). This could lead to trade tensions building up. For financial markets, it is now concerns on growth vs the comfort of liquidity.
The economic momentum in India remains on a strong footing. Robust monsoons would sustain the growth momentum. Inflation concerns are easing; RBI is adopting a wait-and-watch approach. Credit growth is on a recovery path and will further accelerate in H2FY11.
However, concerns remain. The balance of payments situation remains a concern, with the current account deficit on a widening trend. Also, paper issuances are an overhang but FII flows are likely to remain supportive. Then, valuations vis-?-vis emerging markets appear higher but the pace of earnings revisions is also stronger.
Consumption would be boosted by the strong monsoon, easing inflation and raising income. In capex, power continues to be the dominant part with the focus now shifting to operational capex such as mining and material handling and transmission towers. Sectors to play are autos, media, airlines and real estate in the consumption space; and material handling, earth moving equipment for mining; and transmission towers for power evacuation in the capex space.
The US recovery is losing momentum, while the European growth is heavily reliant on weaker EUR and German exports. The Chinese economy is healthy, but is shifting to a lower gear. All major economies are trying to spur growth through a weaker exchange rate; e.g. Japan?s intervention in JPY market and Chinese reluctance to appreciate RMB. This could build up trade tensions. The Fed is preparing the ground for a fresh QE (quantitative easing.) Other major central banks such as ECB, BoJ and BoE are also likely to remain accommodative, suggesting ample liquidity globally.
What does it mean for EMs?
Scenario 1: The relatively healthy growth momentum in EMs (emerging markets) continues, but ample global liquidity conditions could challenge large capital inflows, putting upward pressure on these countries? exchange rates. In such a scenario, export-oriented Asian EMs are more vulnerable than India, the country being relatively less dependent on exports. Appreciating local currencies could trigger intervention by EM central banks banks.
Scenario 2: A deterioration in global growth expectations could trigger risk aversion among global investors, which, in turn, could hurt capital flows to EMs. This could hit business sentiments in EMs over the near term, particularly in the case of current account deficit countries like India.
India?s momentum to continue: The fear of overheating of the Indian economy is abating. Over the past 2-3 months, growth has been consolidating at sustainable levels. We feel that RBI has adopted a wait-and-watch approach. Domestic inflation and the global backdrop would be the key in this regard. If inflation continues in its downward trajectory, RBI may have to hit a pause button for now.
Credit growth has picked up and is in line with RBI?s indicative trajectory of 20% growth in FY11. Credit offtake should gather momentum in H2FY11, as has been observed historically. However, deposit growth is yet to catch up. High inflation is keeping the currency demand high, while low real deposit rates are discouraging deposits.
Going forward, we expect inflation to soften materially from the current levels, thereby, reducing demand for currency; a rise in deposit rates would aid deposits. This should support credit growth.
Strong momentum in industry in H1FY11 means that even if the IIP (index of industrial production) momentum slows down in the coming months, the overall industrial production in FY11 would be impressive. Agriculture, on the back of good monsoons, would ensure that government meets its GDP growth target of 8.5% YoY (year-on-year) in FY11.
The current account has widened in recent quarters, reaching 3.7% of GDP in Q1FY11, which is high by historical standards. Merchandise trade deficit has widened, while invisibles are stable. A weakening external demand, relatively strong domestic demand and a sharp appreciation in INR on a REER (real effective exchange rate) basis since April 2009 could keep trade deficit on the higher side. The government has recently extended benefits to some of the labour-intensive export sectors. The flows have been healthy so far, but in case of any unfavourable global event, risk aversion could rise, triggering high volatility in capital flows to EMs, including India.
There is an overhang of large paper issuances. An estimated Rs 360 bn worth paper issuances are expected over the next 3-6 months. However, foreign flows are expected to remain supportive. India has been one of the most favoured destinations amongst EMs, clocking about $18 bn of net inflows for CY10 (calendar year). South Korea is a distant second with about $10 bn of net inflows. FII flows into primary markets have also been healthy so far. Of the total net inflows of $18 bn, about 26% has been in primary markets alone.
India has been among the best performing markets in the world; valuations appear on the higher side. Currently, on a forward P/E (price-to-earnings) basis, MSCI-India is trading at 1.51x (times) MSCI-EM, which is higher than its long-term average of 1.40x. However, a strong macro and faster pace of earnings revision support multiple re-rating.