There has to be a collaborative approach between states and the Centre to address the challenges of investment, says Sanjeev Prasad, senior executive director & co-head, Kotak Institutional Equities. As the private sector grapples with issues such as global slowdown, low commodity prices and broken balance sheets, Prasad believes that unlike the previous investment cycle, infrastructure funding has to come from the government or in the form of FDI. In an interaction with Devangi Gandhi, he also talks about the absence of any positive trigger for equity markets in the next six months.
How do you think India is progressing on the reforms agenda?
What many people don’t realise is that state governments are competing for investments and trying to do a better job of delivering economic development and governance, the same things that the Centre is working on.
States are trying to attract investments and are looking to implement their own policies, which suit their economic development. The only problem with this is that some states may grow faster and some comparatively slower. As long as there is sufficient amount of competition among the top-ten states and they try to do right things, it is a positive. Even if you look at the state budgets put together, after the 14th Finance Commission, about two-thirds of the consolidated revenue and expenditure are in the hands of the state government. For an infrastructure project for example, Mumbai Metro phase-3, the central government doesn’t have a big role to play. It can provide some equity but the work has to be largely done by the state government and local administration.
What the central government can do is two, three important things. The first is to manage the fiscal better, which will support the RBI in its attempts to bring down inflation. Second and linked to the first point is to ensure that supply-side challenges are addressed through a proper investment framework. Third, it is important to project India as a good investment destination and attract FDI, which the prime minister is working on.
What do you think of the latest logjam on GST?
There has to be some compromise on three of the issues raised by the main Opposition party. Unfortunately, some of them are in a way ‘non-negotiable’. The first suggestion is to have a certain rate of taxation, which is suggested at 18% and to put it in the Constitutional amendment bill. The rate is fine but putting a tax rate in the Constitution amendment bill seems impractical because then every time a government wants to change the rate, it will have to go back to Parliament and the states in order to amend the Constitution. The rate ideally should be part of the GST Bill and not the GST Constitution amendment Bill. The second issue with respect to the dispute resolution mechanism, which I think is manageable given that a GST council will be created later. This body will deal with the administrative issues and also address the concerns of the states since it will have representatives of states. The third issue is about the additional 1% inter-state tax, which makes the whole GST system less than optimal. Manufacturing states fear that they may lose out under GST. The third demand may open up a fresh round of discussions with states. However, it can still be tackled through some additional compensation to the states.
Given the differences in the views of the government and the main Opposition party, we fear that GST implementation may be delayed to April 1, 2017.
How far are we from a revival in private investments? Compared to the last cycle, private capex has completely dried out.
We are looking at a very different scenario than the last investment cycle between 2005 and 2008. First, the global economy is seeing a patchy recovery at the best. The second challenge is a terrible commodity cycle, which rules out investment in the metals and energy sectors in the short term. Finally, corporate balance sheets are broken, there is less confidence and low capacity to invest and the banking system faces serious NPL challenges.
The earlier business model was that the private sector will invest and the government will facilitate the investment.
The private sector invested in many of the sectors based on expectations of high IRRs (internal rate of return), either misreading the growth potential or the regulatory risks. Also, some companies were simply looking at playing the ‘regulatory arbitrage’. In our view, IRRs may not be attractive enough for the private sector, especially in the basic infrastructure sectors.
The government is trying to improve the investment climate in the country. Private sector may be involved in the E&C (engineering & construction) part, but the basic funding of infrastructure has to either come from the central or local governments or in the form of FDI at very low cost.
How are investors weighing India given a general dislike for emerging markets (EMs)?
Several EM countries are facing macroeconomic challenges and the interest in the EMs among global investors is waning due to their poor performance.
Within the EM universe, India is already quite overweight for the majority of foreign investors. They appreciate that India enjoys high degree of macroeconomic stability . Also, they have high expectations around the medium-term growth potential of India due to its demographic advantages.
The risk we run is that if any other large EM market starts looking more attractive from a valuation standpoint, investors may take a call to switch out of India into that market. They may decide that enough damage has been done to a particular EM market, both in currency and stock market terms, and it is time to revisit that market. Also, a change in the government or improved governance in other EMs may result in higher allocation towards those markets at the expense of India.
How do you think the market is likely to perform in the next six months given the impending Fed rate hike?
There are certain India-specific issues. The first concern is that we still have to go through earnings cuts. We started the year with Rs 520 FY16 EPS estimates for Nifty which now stands at R420 or 20% lower. We expect the next year earnings growth to settle somewhere near 15% versus the current forecast of 20% growth. We will go through further downgrades for one or two more quarters.
Secondly, on the monetary policy side, I don’t see the RBI reducing rates before May 2016. There is no scope for a rate cut right now as CPI inflation will go up for the next few months and despite it coming down from March-May next year, it will stay above 5% for some time. The RBI will also consider the fact that fiscal consolidation may be difficult in FY17 due to additional expenditure related to 7th Pay Commission and the OROP. There is also the risk of neither DBT nor GST contributing in a meaningful way in FY17. Finally, the RBI may want to get more visibility on monsoons and food prices before reducing policy rates further.
Lastly, while a 25-bps rate hike by the US Fed in December is already in the price, we do not know how the normalisation of the US monetary policy takes place after that.
I really don’t see any triggers for India in the next six months based on the aforementioned factors. EM apathy, domestic earnings downgrades, monetary policy limitations may result in muted interest among investors.
However, I am hopeful that from the second half of 2016, we will see a pick-up in investment based on the measures that the government has put in place in the roads, power transmission and railway sectors.
Do you think lower earnings growth is the new normal for India given that the downgrades have persisted in the last three years?
Structurally, India’s earnings growth will be in low teens. Anyway, I should highlight that the market’s earnings have doubled ‘only’ in the last ten years, which implies high-single digit growth for the period. Over the next one or two years, due to low base in certain sectors and the decimated base of PSU banks where we may see normalisation, we could see mid-to-high-teens growth. But beyond that, I think it may be very difficult to see 15-20% kind of earnings growth unless the real GDP growth is 10% and inflation is contained at 4% as per the RBI target for FY18. We also must realise that lower inflation will itself bring down the nominal GDP growth and the topline growth for companies, especially for consumer staple ones.