Slippery steps in an ascending escalator

India?s corporate sector continues to impress. The first 150 results announced by companies over April show corporate earnings (net profits) during 2005-6 have surged by over 35%. Although their pace has slowed somewhat, profit growth numbers remain impressive. As one looks to the future, it appears the growth story is intact. But bad things usually happen during good times and even as one prepares to take advantage of the unfolding growth environment, it may be useful to get proactive on the risks lurking around the corner and take into account the costs of hedging that risk.

First, the good news. India?s growth story continues to look robust and GDP may advance by 7.5-8% in 2006-7. What is impressive is that economic momentum is spread across almost all segments of manufacturing and services, that account for 80% of GDP. There are three major differences between the high growth boom of the 1990s and the ongoing one. First, India?s services exports ($67 billion in 2005-6) have acquired critical mass and created a rapidly growing middle class that is driving consumption. Software and BPO exports of $23.5 bn in 2005-6 are creating a huge consumption multiplier. The IT industry alone would expand employment by nearly 300,000 people this fiscal and create huge new middle class consumption demand. Add to this the middle class jobs to be created in financial services, retailing, hospitality and tourism, entertainment, telecom, etc.

Second, and partly linked to the first, there is a momentum in all-round construction activity that was missing in the 1990s. With the rising spend on infrastructure, this has added a new dimension to the economy that is generating demand for both manufactured goods and services, and also creating job linkages with rural and semi-urban areas. Third, India?s manufacturing sector has become a lot more competitive over the past decade and segments of it are now making impressive inroads into the global market and are also less vulnerable to import competition. This makes capacity additions more sustainable and less risky, as industry has the option of selling both at home and abroad.

Agriculture remains a weak spot, but that is partly being compensated by strong performance of the non-farm rural economy. There is also evidence that the strong performance of services and manufacturing segments is now creating opportunities for rural youth. The increasing consumption of manufactured goods and services in rural areas indicates economic growth is now generating backward linkages. The other positive development for the rural economy is the surge in investor interest in food processing and the entire value chain that links the farmer to the consumer. The shrinking contribution of agriculture to GDP means that growth is getting less susceptible to monsoon failure.

The continuing bull-run in stock markets needs to be appraised against this backdrop. Strong inflows of domestic and foreign money are chasing high growth and good returns being provided by large and medium companies. It is being said the P/E of around 20 for Sensex stocks is too high and unsustainable. There is no hard rule about high and low P/Es. If Japan with 2% GDP growth has a P/E of 17, India with four times that GDP growth figure can surely sustain much higher P/Es, provided there is demand (liquidity) chasing Indian stocks.

At present, there seems no expectation of a slowing in liquidity inflows into the stock market, as the growth story remains strong. What should strengthen the sentiment are the huge cash reserves accumulated by Indian corporates, giving them the ability to incur large sums on capital expenditure without worrying too much about the rising trend in interest rates. That investment activity is gathering momentum is evident by a 32% jump in imports of capital goods and 16% increase in their domestic production.

While the domestic story looks strong, it cannot be ignored that rapid globalisation of the Indian economy has made it more susceptible to the confidence (or lack of it) that investors have in the global economy as a whole. There are stress signals here that need to be assessed and factored into investment and expansion strategies. The first and perhaps most dangerous signal is the ongoing tussle over Iran?s nuclear facilities and its implications for global oil prices, investor confidence and the global economic environment.

Any sign of a confrontation in the Persian Gulf will send oil prices soaring and rock the leading stock and commodity exchanges. Once the confidence is dented, it may be a while before it is restored. Each company must analyse the implications of a sudden spike in global oil prices for its production process or the demand for its products. What companies also need to do is to assess the impact of turbulence in stock markets and prices of commodities, define the likely risks and take measures to hedge against these. The need to do this would be greater for small and mid-cap companies that have just begun to find their place under the sun.

The second area that needs a close watch is global and local asset markets. At a time when asset price inflation is rising, corporates must clearly map their exposures in assets of all kinds, whether stocks, commodities, real estate, etc. Third, the health of the US economy and the dollar, and the implications for global growth, export demand, liquidity flows and currency markets must be monitored.

India is experiencing one of the most exciting episodes in its economic history and investors, foreign and local, must make the most of this. However, there is need to safeguard against some disquieting trends in the global economy.

?The writer is an advisor to Ficci. These are his personal views