Calm seems to have descended on global financial markets for now. Investors appear to have gone back to betting on riskier assets by borrowing in yen. Whether they have actually done so or not, the movements in the US dollar-Japanese yen exchange rate and the rise in many risky markets indicate that the appetite for risk, licking its wounds, is back on track. Does it mean that the Mumbai Sensex would find its way back to 14,800? Some would quibble with the choice of Sensex to discuss a much larger market such as India. We could talk of Bombay Stock Exchange (BSE) 500 index that represents nearly 85% of market capitalization in BSE. Would it scale 5,500 again? This index corrected more than 30% in May-June 2006 and has corrected around 14% this time.
Somehow, one gets the sense that the high noon for Indian economic growth and asset prices in this cycle has passed. It is not that growth is going to fall off a cliff. Far from it. Even if we grow at 7.5-8.0% in real terms, that would be a very healthy growth rate and there is no reason why we should not. The problem with asset price is not whether reality, in absolute terms, is good or bad. One issue is whether it is better than what has been discounted already in the price. The second issue is whether asset prices have discounted some negative developments. Simply put, policy risk that hurts the prospects of earnings for different sectors is rising.
As the UPA government faces more electoral setbacks and prepares itself to fight the next general elections in two years, it seems more inclined to intervene in the economy, usually for the wrong reasons, and to wrong effect. First, there was the retail pricing of hydrocarbon fuels. Stocks of oil companies have not recovered still. A government that has sworn by the public sector has destroyed the market value of public sector companies, hurting the value of its own stake in the process. The government could have subsidized fuel users by monetizing the market capitalization increase that a proper energy-pricing policy would have facilitated.
The government continues to perpetrate differential pricing for agricultural commodities. Part of the responsibility lies with states and partly with the inaction at the Centre. Sale of sugar in the open market is restricted and its export is banned. The government promised amendment to the Agricultural Produce Marketing Committee (APMC) Act in 16 states nearly two years ago. It is yet to see the light of day. The ministry of agriculture should be spearheading the drive with single-minded focus. That is evidently not the case. Hence, various interest groups are actively resisting the amendments to the APMC law at the state level. India remains a fragmented market for agricultural commodities.
And now comes the blow on steel and cement sectors. Steel producers agreed to roll back or refrain from raising prices. Cement producers faced dual taxation depending on whether they sold at a government-determined fair price or above that. They initially defied. A “polite” meeting with the finance minister saw them retract a bit but with a caveat that the differential tax be rolled back. Then came the threat to ban export of cement. Stocks swooned last Wednesday before a global recovery saw Indian stocks bounce back on Thursday.
If aggregate demand is the problem in the short run and supply constraints cannot be removed quickly, the only way is to accept that demand be restrained. That is where Reserve Bank of India measures come into play. But, this government initially did its best to mute the impact of interest rate hikes. The list of examples of misguided price intervention can be extended to the interest rate offered on Employee Provident Fund holdings. The philosophy appears to be that if we don’t like the signals that prices send out, we shall shut the signal out or change it. Perhaps, India might come up with its own version of a core wholesale price index that excludes food prices!
It appears a reasonable working assumption for investors that economic policy-making would be as irrational as it would be populist. That raises the risk for corporate earnings. Unfortunately for investors, they had not provided for these risks in their earnings expectations. For example, Bloomberg shows that the expected earnings growth for BSE 500 companies is around 25% next year. That is optimistic and requires not only the economy to grow at over 8% but also a benign policy environment. Recent developments should give investors enough causes to pause and re-examine those assumptions. When they do so, they would realize that current stock prices are more than could be justified by the policy and economic fundamentals. Even a re-test of the lows of June 2006 is not beyond the realm of possibility.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer (Singapore) Ltd. These are his personal views and do not represent those of his employer. Comments are welcome at firstname.lastname@example.org