Growth Cycle – Taking Indian Stock

May 14, 2009 By Chetan Ahya Singapore & Tanvee Gupta India Overall Growth Trend Still Close to a 16-Year Low We believe that, in the context of assessing the overall growth trend, particularly for the corporate sector, industrial production (IP) has been the most relevant indicator. Corporate revenue growth has closely followed IP growth. IP growth touched a 16-year low of -2.3%Y in March 2009, from the peak of 13.6%Y during the quarter ended January 2007. We believe that both domestic and external demand have been extremely weak. Private Consumption Trend to Bottom First Discretionary spending has started showing signs of improvement. After a decline of 1.8%Y during the quarter ended December 2008, consumer durables production growth accelerated to 5.4%Y during the quarter ended March 2009. As per press reports, sales of refrigerators and air conditioners have picked up. Similarly, two-wheeler sales increases accelerated to an average of 8.2%Y over February-April 2009 numbers, compared with a decline of 9.9% in October-December 2008. Passenger car sales gains also accelerated to 13.3%Y over the three months ended April 2009 compared with a 1.2% increase registered in the previous three months. However, the consumer non-durables segment, which tends to lag the consumer durables, has now started to weaken significantly, declining by 4%Y in February-March 2009. This pushed overall consumer goods production growth to a low of -1.5%Y during February-March. We believe that consumer non-durables and overall consumer goods production will start recovering over the next 3-4 months. Policy Traction Supporting Gradual Recovery in Discretionary Consumption Many market commentators have given credit to an acceleration in rural demand for the slight improvement in private consumption segments like durable goods and auto sales. We believe that, while rural consumption likely remained steady at healthy levels, the main reason is a function of the government’s policy response. Government spending has increased sharply since October 2008, from an average of 25.2%Y growth during April-September 2008 to 67.1% during October-December 2008, and 51.7% during the two months ended January-February 2009. We estimate that the consolidated fiscal deficit (including off-budget expenditure) will be 12.4% of GDP in F2009 (12-months ended March 2009) compared with 6.8% of GDP in F2008. A large part of the expansion in the deficit came through in the last six months of the financial year. The aggressive monetary policy measures of the Reserve Bank of India (RBI) are also beginning to gain traction. Although initially banks were reluctant, over the last two months they have been cutting lending rates across the board. The improving liquidity environment is also reflected in narrowing spreads. The spread of 3-month CP rates over 91-day T-bill yields has compressed to 191bp currently from the peak of 763bp at end-October 2008. External Demand – Worst Is Likely Behind Us… Exports are estimated to have declined again in April by 23.6%Y (provisional, according to Live Mint newspaper), albeit at a slower pace than the 33.3%Y decline witnessed in March 2009. While we maintain our view that exports will remain weak over the next 3-4 months due to the global slowdown, we expect the year-on-year decline to narrow from here (i.e., exports will still decline, but to a smaller extent). The second-order derivative for the US ISM New Orders Index (3-month moving average), which leads export growth by about four months, has improved for the fourth consecutive month (40.5 in April versus 35.8 in March and 29.8 in February). …but Capex Growth Should Decelerate for Longer Capex growth has been decelerating sharply but has held up better than private consumption so far. We expect capex growth to weaken further. Private corporate capex, which was one of the main drivers of overall investment growth, will likely take the biggest hit. The excess capacity burden remains high. The corporate sector is suffering from large operating leverage. The gap between corporate capacity for growth and realized growth is expected to be much wider in the current cycle than in the mid-1990s; that is, the capex binge has been much larger in the current cycle. Private corporate capex to GDP increased to 15.9% as of F2008 from 6.8% in F2004. However, IP, which is a proxy for utilization of capacity created, contracted by 2.3%Y in March 2009 from the peak of 13.6%Y during the quarter ended January 2007. Even with the recovery in IP, we believe that capacity utilization for the corporate sector will remain relatively low, dissuading companies from initiating any major new capex plans. IP Growth Recovery to Begin in June-July, but at a Gradual Pace While consumption should start improving over the next three months, private corporate capex will be a drag, in our view. We expect IP growth to start recovering only gradually, to reach 6-7% by March 2010. This would still be lower than the average of close to 9% during January 2004 to mid-2008, when the global economy started suffering from a credit crisis. Apart from a tepid recovery in G7 economies, we believe that India’s growth trend will be constrained by the effect of the loose monetary and fiscal policies pursued during the last four years. These effects are now showing up in rising non-performing loans in the banking system and a high fiscal deficit burden in addition to public debt. Upside Risks to Our View The first upside risk to our estimates is a potentially faster recovery in global growth than currently implied in our team’s forecasts. Our economics team currently estimates global growth of -1.6% in 2009 and +2.7% in 2010. Stronger global growth would help India by way of an increased financial risk appetite, implying greater capital inflows and stronger export growth. This, in turn, would mean lower real interest rates, a quicker improvement in capacity utilization and greater corporate confidence for investments. The second upside risk is a surprise in the outcome of the general election on May 16. If either the Congress or the BJP were to win about 170-180 seats out of a total of 543 seats in the parliament, the winning party would be allowed to form a coalition that would be narrow compared with the current ruling coalition, and this would likely increase the pace of reforms, boosting business confidence, in our view