India?s macro-economic weaknesses will get exposed over the next few months unless it can take decisive steps to prepare for (i) the US Fed?s potential exit from the QE (quantitative easing) programme and (ii) weaker global sentiment for EMs (emerging markets). India?s purportedly better relative positioning among EMs is cold comfort weighed against certain absolute facts.
Absolute fact #1?CAD of $6-7 bn per month against uncertain capital flows: We do not see a short-term resolution to India?s high CAD (current account deficit) without further restrictions on gold consumption and imports. Against a likely CAD of $72-84 bn in FY14 (based on crude price of $100-110/bbl), India would require $15-25 bn of portfolio inflows to have a comfortable BOP (balance of payments) position . FYTD (fiscal year-to-date) net portfolio flows are negligible with equity (cash and futures) inflows of $4.3 bn being offset by $5 bn of debt outflows. The latter worries us tremendously, given its volatile nature and risk of outflows emanating from possibly higher US yields. India also faces large refinancing of short-term external debt in the next one year though we believe most of it will be refinanced.
Absolute fact #2?FY14e GFD will be 5.5% of GDP without some luck and pluck: We believe the market is ignoring another source of threat to India?s fiscal stability. India?s FY14 GFD/GDP (gross fiscal deficit/gross domestic product) will likely be closer to 5.5% unless it can take a few decisive steps. We see slippages in (i) the divestment target of R560 bn, (ii) oil subsidy amount of R650 bn (of which R450 bn pertain to FY13) in the light of rupee depreciation and high oil prices, and (iii) tax revenue targets, given the weak economic growth. The government can and should (i) sell minority stakes in Axis Bank, Hindustan Zinc, ITC, L&T (ii) seek one-off dividends from cash-rich PSUs and (iii) expedite diesel price deregulation (higher monthly increase versus the current R0.45/litre).
Absolute fact #3?Economic growth will take a long time to recover: In our view, continued high CPI (consumer price index), large CAD, high potential NPLs (non-performing loans) in the banking system, limited time before the next general elections to implement structural reforms and potential political uncertainty preclude a strong economic recovery for the next two years. In fact, continued weak economic data like IIP (index of industrial production) and auto sales and lack of investment visibility raise risks to GDP growth estimates of the Street.
Absolute fact #4?India is expensive (at least the stocks that one wants to own): The valuations of stocks in retail private banks, consumer staples, pharmaceuticals and media sectors are quite expensive on an absolute basis. Also, these stocks have high FII ownership and large overweight FII positions already. We are not sure if the stocks will continue to see FII inflows irrespective of their valuations. As for the rest of the market, there is very limited interest unless regulatory, operating and financial issues are resolved. We do not see that happening quickly or interest levels improving in the latter lot for some time.
Predicting outcomes at this stage seems like a mug?s game: India will be unable to take drastic steps to offset any negative fallout from tighter global liquidity. India?s BOP position is quite weak due to a large structural CAD deficit. Also, India faces general elections over the next nine months with the prospects of an early election (by the end of CY2013).
The government is unlikely to implement structural reforms over the next few months in the run-up to the general elections. Its entire focus over the next few months is likely to be on (i) expedient measures to tackle CAD/BOP (NRI bond floatation seems likely) and (ii) populist politics. The government passed the Food Security Ordinance recently and we expect it to be passed into a ?proper? law in the monsoon session of Parliament. As we have repeatedly argued, India?s approach to solving its long-term problems through short-term measures will compound its problems.
Global markets are likely to be volatile as the market dissects every statement of the US Fed to glean its QE strategy over the next few months. Given India?s large external dependence on capital flows, the Indian market is likely to be quite volatile. Also, investors, particularly foreign, are likely to continue with ?more of the same thing? with continued focus on favoured sectors and indifference to other sectors. The market is unlikely to perform in such a scenario. A range-bound market is the most likely outcome in such a scenario.
If the US Fed?s exit strategy were to coincide with general elections in India, we would expect acute financial and political uncertainty, for a short period, leading to potential large outflows (debt and equity) from the market and further pressure on the rupee. The market is clearly not prepared for this outcome. It would be interesting to see if the favoured stocks hold up in such an environment.
As a portfolio strategy, we continue to favour (i) ?middle-of-the-road? defensives that are more reasonably valued (regulated utilities and telecom stocks, for example) versus traditional defensives that are very expensive (retail private banks or consumer staples) and (ii) stocks that offer a high degree of protection from currency depreciation (private sector energy, pharmaceuticals, technology and regulated utilities with pass-through of all costs).
?Kotak Institutional Equities