As the Modi government completes a year at the Centre, it is obvious that investors are asking the ‘promise versus performance’ question or the ‘expectations versus reality’ question. Many economic, especially growth indicators like IIP, exports, non-farm credit growth, volume growth across sectors like infrastructure, cement, metals, auto (barring HCVs) and consumers are still either in negative territory or in low single digits, begging the question – have things really changed on the ground? In fact, the only indicator that seems to have grown is GDP based on the new series.
To be fair, many other macro indicators have improved – the twin deficits, the rupee, that has been stable barring the recent few weeks and the lower inflation trajectory. But the lack of growth and the slow pace of industrial/capex cycle recovery is worrying investors.
The reasons are well known – still relatively high interest rates, problems plaguing the infra sector, weak and highly leveraged corporate balance sheets, weak bank balance sheets especially those of PSU banks, poor agri commodity prices and a combination of unseasonal rains and lower wage growth which have negatively impacted rural demand.
While these are relevant observations, we believe that there is an alternative take to the growth conundrum that has not been well debated.
The inventory effect – lower top line growth and postponement of buying
Substantially lower commodity prices have meant that many companies were sitting on previous high cost inventory of both raw material and finished goods. Usually, it takes a couple of quarters for the high cost inventory to work through the system. Especially, traders and intermediaries would be staring at immediate loss on inventory reducing their ability to buy immediately to build inventory, especially if they believe that prices will continue to come down. For value added producers, that means a lower top line as prices have to be reduced. This can be seen in the top line growth of BSE-500 companies in the current quarter which has degrown by -5% (for 158 companies reported so far). Even after adjusting for financials and oil & gas (RIL), the BSE-500 reported sales growth is weak at 4.2% (for 122 companies reported so far ex-financials and ex-RIL).
The wealth effect-real estate and gold
Over the last few years i.e. pre 2014, household savings have got locked into hard assets like gold and real estate. Gold prices have fallen from a peak of $1,800 to now below $1,200 (with customs duty and the rupee depreciation, that has meant an even lower price). The real estate is now seeing oversupply, declining prices and lower demand, resulting in a sharp fall in volume of transactions. Our interactions with mortgage finance companies and real estate dealers bear this out. According to them, a lot of liquidity has got locked up in real estate. If interest rates fall further, it would be possible to liquidate inventory or borrow against property at lower rates to use that liquidity elsewhere.
Back money and corruption
Corruption was amongst the major reason (other than inflation) why the UPA lost elections and the BJP came to power. The spectacular win of the AAP party also added to the environment where black money and corruption have taken centre stage in India’s politics. No wonder, the current BJP government wants to enact a very strict anti corruption and black money law. The recent regulatory noose on corruption, with investigating agencies like the CBI, CAG and CVC actively pursuing alleged corruption practices, has brought fear into both recipients as well as givers. It would be fair to assume that the fear of getting caught would have considerably reduced consumption.
Balance sheet reform versus P&L cutback
Other than corruption, inflation was the major issue in the last election. The government has moved swiftly to combat inflation through decontrolling petroleum prices, cutting subsidies and targetting them better through the rollout of Aadhar and UID (Unique Identification Number). The rate of increase in rural wages has been contained and minimum support prices paid to farmers has seen the lowest increase in many years. But a cutback on giveaways is also one of the reasons why demand, especially in rural India, has been so soft. Many reforms initiated by this government are what we would term balance sheet reforms – e.g. lifting FDI in several sectors, clearing stuck projects, trying to improve ease of business – however, all of these will hopefully have impact over the long term but the emphasis on cutting government spending and subsidies directly impacts current demand.
Disintermediation in several sectors
The rapid growth of e-commerce and the mobile revolution is putting pressure on some old business models. Though the trend is still young, it has started impacting some businesses like traditional retailers. The VC/private equity players have been funding startups at a furious space. In the last 2 years, total funding by private equity players has been of the order of $ 22.4 billion. The aggressive rollout of services and price discounting has left the traditional business models unprofitable. How long will e-tailers be able to survive with ever increasing losses is anybody’s guess but currently, it is putting tremendous pressure on traditional trade channels. It is weaning the incremental buyer away from them curtailing demand for the traditional retailer. The recent consolidation in the retailing industry (merger of Future group with Bharti) is clear indication that on a standalone basis, they are finding it difficult to operate and make profits. It will take some time before the traditional businesses adapt to the this new competition or private equity dollars dry up funding these new startups. However till then, this creative digital disruption is causing short term pain.
We believe that some of the above factors are co-mingling with traditional factors and creating some short to medium term dislocations and challenges to growth. Hopefully, stakeholders in the economy will adapt to the new normal, but till then investors and policy makers will need to have patience till growth picks up again.
The writer is the director and chief investment officer of Alchemy Capital Management