A rate cut is not critical to kick-start investment cycle: Mohini Singh Chauhan
The manager at Silverdale Capital says RBI took the right step by sticking to fundamentals and holding on to interest rates
Singapore: The Reserve Bank of India (RBI) took the right step by sticking to the fundamentals and holding on to interest rates, and not getting carried away by seasonally low inflation, said Mohini Singh Chauhan, manager with Silverdale Capital Pte Ltd, in an interaction. A rate cut is not critical to kick-start the investment cycle, and this is probably the first time since the independence of India that an RBI governor has explicitly spelt out the purpose of its monetary policy, which has been stated to be inflation targeting, and equally importantly, doing it in a transparent manner, she added. Chauhan shared the view that the testing period for the Modi government would start in the second half of 2015, post-budget and with the start of the Indian summer.
Edited excerpts from an interview:
Are India stocks over-owned? And are they too expensive?
Global emerging markets long only funds are about 110% over-weight on India as compared with MSCI Emerging Markets Index weight. The Indian market also looks expensive, compared with MSCI EM Index. This calls for a caution and partial profit-booking. However, to a large extent, the higher valuations are justified due to significantly better prospects of India. While Indian stock markets have appreciated by circa 28%, the PE (price-to-earnings) ratio of the Nifty at about 16.5X is just about 10% more than its own 10-year historical average. More importantly, it should be remembered that India is a capital-starved economy; hence, the ROC (return on capital) and ROE (return on equity) of Indian companies is traditionally much higher than say that of Thai, Indonesian, or Chinese companies. This explains why the PE of Indian companies should indeed be higher. On the other hand, other emerging economies have significant headwinds—Brazil is being weighed down with tumbling commodity prices and pulled by UPA-II (United Progressive Alliance’s second term) type corruption issues, Russia is sinking with falling oil prices and rammed by the Ukraine misadventure, and China is treading the fragile transition from credit-fuelled investment-led growth model to domestic consumption story. At Silverdale, we feel these two factors of ROC and no other alternative supported by a higher growth rate, make India not too expensive. Let me add one more point—Indian retail investors are under-invested in equities, and Indian pension funds are predominantly invested into fixed income securities. From these perspectives, Indian stocks are under-owned by Indians.
While everyone is getting excited about the recent fall in inflation, how sustainable is this?
While the jury is still out, prime facie the answer is—unlikely. About 45% of CPI (Consumer Price Index) consists of food items, of which vegetables and fruits have contributed to a major proportion of inflation. Now, about 18% of fruits and vegetables in India are wasted post-harvest due to poor infrastructure—lack of refrigerated trucks, cold storage. In winter, due to cool weather, less agri-products get spoiled—that is, supply is increased, leading to seasonally lower prices. Come summer, and India would again see price spikes starting from April-end. Also, given the marginally below average monsoon, if the MSP (minimum support price) is increased, it would push up inflation. Speaking of crude oil, it continues to be the single largest item in India’s net imports—about 4.85% of India’s gross domestic product (GDP). Hence, the about 30% reduction in crude price should boost India’s GDP by about 1.5%. However, the real impact would be lower as the government of India has increased taxes on petrol. Nevertheless, this would have a multiplier effect on the cost structure, and a salubrious impact on reduction of subsidies and reduction of fiscal deficit. Also, India is one of the largest importers and consumers of gold. It would stand to gain from the about 30% fall in gold prices over the past couple of years. We do not believe there is any structural change in any of these three determinants to give confidence that the fall in prices is systemic; hence, RBI will have to be behind the curve.
How important is an interest rate cut for India and can it really kick-start the investment cycle, lift the economy, boost stock markets and enthuse sentiment? Are investors from outside the country cursing the Reserve Bank of India (RBI) for its caution?
Let me answer the second question first—far from cursing RBI, we salute RBI for sticking to the fundamentals, and not being carried away by seasonally low inflation. It is probably the first time since the independence of India that a RBI governor has explicitly spelt out the purpose of its monetary policy, which has been stated to be inflation targeting, and equally importantly, doing it in a transparent manner. For the first time, we see an explicit expert committee debating publicly and setting interest rates. In these circumstances, playing to the gallery would have the worst outcome for RBI.
Of course, the stock markets would have given a huge thumbs-up for a rate cut. But we don’t think a rate cut is critical to kick-start the investment cycle. We have seen in the US and Europe that a rate cut does not, all by itself, stimulate an investment cycle, but is an important adjunct tool. Also, the Indian banking sector is awash with funds. We have seen several banks such as ICICI Bank Ltd, Axis Bank Ltd, HDFC Bank Ltd, and State Bank of India reducing deposit rates, and nothing in law prevents banks to lower their base rates. What is equally, if not more, important is to remove impediments to growth. Having said that, we do believe if crude continues to be benign and the deficit under control, RBI would be induced to reduce rates to prevent perverted appreciation of rupee, within the framework of accreting India’s foreign exchange reserves to sustain over 5% GDP growth.
After six months in power, what in your opinion has been the thrust of the Narendra Modi-led government? Have both industry and the markets responded to the government’s economic thrust? Has the Modi government convinced investors like you from abroad?
Rather than kick-start the economy with higher risk big-bang reforms, the Modi government’s thrust has been to lubricate the Indian economy by making various parts agile—from babus (bureaucrats) coming on time to disbanding of numerous committees and defrosting the policy paralysis. Being global investors, at Silverdale, we are cognizant of the risks of perestroika—we also appreciate the lack of majority of the Modi government in Upper House.
Several government initiatives are laudable such as Web-based single window system for business compliance, move to dispel archaic laws, diesel de-regulation, etc. An interesting development is the allocation of entire collections from coal block re-auctions to state governments and using the goodwill generated to push for nationwide GST (goods and services tax) implementation.
As for the Indian stock markets, like the other stock markets, they have been front-running economic growth, starting with euphoric reception to the clear electoral mandate given to the Modi government. It is well known that the election impact fades in about six months of elections. The new highs in stock markets indicate a thumbs-up to the momentum in the economy.
Do we see action at industry level? The answer is—in a very limited manner. But the stable-doors have been opened, and we expect the industry-horse to fly. Already, November PMI (purchasing managers’ index) for India at 53.6 has been higher than that of China, and ceteris paribus, this positive gap for India is likely to prevail on an average in the coming decade.
Now, this is very interesting…the contribution of India’s manufacturing sector to GDP is currently at 14%, which is nearly half of its peer group. The labour productivity in India is nearly 42% that of China. While India’s urbanization is just above 30%. What we know from other economies is when urbanization moves to circa 40%, it reaches peak GDP per capita growth. At Silverdale, we are looking at “Make in India" initiative not only as a key lever to growth, but also as the principal driver of employment in coming decades. These structural changes take years to manifest. However, the green shoots in terms of investment support from foreign governments from China to Japan and, hopefully, the US in January 2015, are heartening. Having said that, the testing period for the Modi government would start in Q2 of 2015, post-budget and with the start of the Indian summer.
Why is that despite the optimism about medium- and long-term economic prospects, India’s economic revival continues to be tentative and uneven?
It is natural to be tentative and patchy, when one is unsure. We believe what India requires is vision and self-confidence. GAAR (general anti-avoidance rules) yes, GAAR no: doesn’t help investors. Five percent withholding tax on INR (rupee) debt for a couple of years at a time—cannot attract serious long-term investors. FDI (foreign direct investment) yes, FDI no, FDI yes with a but…does not work. How do you expect banks to provide long-term loans for long-term infrastructural products when average maturity of their deposits is less than two years? The key is in having well-thought-out long-term policies. The Indian government needs to significantly cut down barriers to growth: from removing artificial FSI (floor space index) limits in housing, to inspector raj in industry, to archaic laws in the service industry. One of the most important and least debated reforms urgently required in India is a fast and competent judiciary system. There are over 30 million cases pending in Indian courts. If judiciary becomes efficient, not only would it support and grow commerce but will also rein in excesses and inactions of government and of the police.
Will Indian banks be able to fund fresh investments because they are weighed down by bad loans? Is corporate debt in India a concern?
To appreciate the issue, let’s triangulate the banking sector into three different segments. The first segment of private sector banks such as HDFC Bank, ICICI, and Kotak are well capitalized. These banks not only have sufficient loanable funds, but also have open access to the global capital markets.
The second segment is of well capitalized public sector banks such as SBI and Bank of Baroda. These banks are just about fine and would be able to raise AT1 (additional tier-I capital) as needed.
The problem case is the third bucket of small PSU banks with no unique proposition. These banks have huge NPAs (non-performing assets), their appraisal systems are grossly deficient, and their internal control lax—be it UCO Bank or Indian Overseas Bank. The government would have to come with clear strategy to manage them, say, by merging them and closing overlapping branches; which would mean huge redundancies. Admittedly, it would not be easy. Alternatively, the government has to find innovative ways to reduce stake, say through a holding corporation or ETF (exchange traded fund) or converting them to small banks, etc.
I should also point out that about 40% of NPAs are due to cyclical factors. If the Indian economy takes-off, many of these will become regular assets. The good news is the world is awash with liquidity and large corporations can very well access these markets. Large industrial houses such as Tatas, Bhartis and Biyanis have directly and indirectly accessed them. The amount of funds raised by Indian corporates offshore exceeds $20 billion—this is over and above circa $25 billion invested by foreign investors into Indian papers. The key areas of concern remain in the real estate sector and infrastructure sector.
How do you see 2015 for India? Do you think that growth will continue to remain at around the 5.5% mark? What can the government do to boost growth rate?
The government can take several measures to boost economic growth. For instance, we have profit-sharing for petroleum as well as telecom spectrum. However, there is no profit-sharing for other national resources. We do hope the resolution of coal scam would lay guidelines for profit-sharing in all natural resources, including iron-ore and bauxite. This would induce fairness and revitalize the entire mining and heavy equipment sector. Another area which requires serious thought is resolution of unviable projects won in auctions, such as power projects. Obviously, it is unfair that in case of profits, the private sector enjoys, and in case of losses, say due to increase in coal prices, the government is asked to bail out. There needs to be a mechanism for restructuring these assets expediently. Chapter 11 sort of resolutions would be welcome. Another area is procurement of land for infrastructure and industry—it needs to be made much more pragmatic. We hope crude, gold and monsoon would remain benign in 2015—in which case, exceeding 5.5% should not be difficult.
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