Vijay Kumar Gaba

Thursday, April 9, 2015

Significant slack and structural rigidities hold back revival

Thought for the day

"It is with our passions as it is with fire and water, they are good servants, but bad masters. "

- Aesop (Greek, 620-560BC)

Word for the day

Caustic (adj)

Severely critical or sarcastic.

(Source: Dictionary.com)

Malice towards none

Maharashtra and Haryana CMs have apparently joined Deepika Padukone in "My Choice" campaign.

Will someone please bother about My Choice too?

Significant slack and structural rigidities hold back revival

The April 2015 RBI Monetary Policy Report further strengthens the trend seen in presentation of rail budget and general budget for FY16, viz., globalization of the "policy presentation". Like the two budgets, the jargon and techniques distinctly have imprint of global practices.

It would make an interesting study to evaluate whether the process of policy formulation has also become global!

The policy making at RBI appears to have moved to global standards inasmuch as it is now more data driven, It perhaps no longer rely on the subjective assessment of RBI and political expediency.

In fact the recent monetary policy report prominently mentions that "the Government of India and the Reserve Bank have committed to an institutional architecture that accords primacy to price stability as an objective of monetary policy. The Monetary Policy Framework Agreement envisages the conduct of monetary policy around a nominal anchor numerically defined as below 6 per cent CPI inflation for 2015-16 (to be achieved by January 2016) and 4 +/- 2 per cent for all subsequent years, with the mid-point of this band, i.e., 4 per cent to be achieved by the end of 2017-18.

Failure to achieve these targets for three consecutive quarters will trigger accountability mechanisms, including public statements by the Governor on reasons for deviation of inflation from its target, remedial actions and the time that will be taken to return inflation to the mid-point of the inflation target band.

This flexible inflation targeting (FIT) framework greatly enhances the credibility and effectiveness of monetary policy, and particularly, the pursuit of the inflation targets that have been set. The commitment of the Government to this framework enhances credibility significantly since it indicates that the Government will do its part on the fiscal side and on supply constraints to reduce the burden on monetary policy in achieving price stability."

It is perhaps for the first time that RBI policy report has presented professional forecasters 5qtr, 5yr and 10yr inflation expectations, the trends that will be primarily driving the monetary policy stance.

Going by this there is little probability that RBI will cut policy repo rate materially in next three quarters. The governor has adequately hinted this in his media interactions.

Any relief on lending rate will therefore have to come from lower cost of funds driven by excess liquidity in the financial system.

The five major sources of incremental liquidity as I see at this point in time could be:

(i) Buying of USD by RBI to prevent INR from appreciating and augment fx reserves for a likely exodus post US Fed rate hike ("the Lift").

(ii) Rise in government spending.

(iii) Release of stalled payments by the central government (expected to be Rs1500bn).

(iv) Rise in financial savings of household due to gold monetization, various tax incentives, lower inflation and PM Jan Dhan Yojna (PMJDY).

(v) Cut in statutory reserve ratios (SLR and CRR).

I find none of these sources to be reliable/sustainable. Moreover, there are serious headwinds for the liquidity which could neutralize the incremental flows from these sources. For example:

(a) Outflows of foreign investments especially due to (i) unwinding of dollar carry trade, (ii)erosion in confidence of foreign investors due to political failure of the government.

(b) Poor farm income.

(d) Shrinkage in informal (cash) lending markets due to tighter compliance and surveillance.

(e) Lower government spending due to lack of clarity in administrative procedures.

(f) Large disinvestment program (Rs600bn)

I personally would like to see the liquidity augmentation coming from:

(a) Regularization of restructured assets.

(b) Release of huge tax money stuck in litigations.

(d) FDI in infrastructure and realty sector.

(e) Improvement in working capital cycle.

Another noteworthy highlight of the policy report is the concern over "Significant slack and structural rigidities continue to hold back a sharp revival in investment demand".

The report reads:

"The latest round of the Order Books, Inventory and Capacity Utilisation Survey (OBICUS) of the Reserve Bank reveals that capacity utilisation (CU) remained range-bound in Q3 of 2014-15 as compared to the previous quarter and declined over its level a year ago.

An overall assessment of the state of the real economy points to recovery gaining ground slowly. Signifi cant slack and structural rigidities continue to hold back a sharp revival in investment demand. Lack of certainty about cash fl ows from new investment projects is contributing to the lacklustre investment cycle.

Unless structural reforms unleash productivity gains going forward, lower saving and investment rates could become a risk to stronger recovery. Recent reform measures in the infrastructure sector, including target-based progress on national highways, encouraging FDI in railways and defence, plans to start power plants in the private sector with all approvals in place, bringing in the requisite amendments in the Land Acquisition Act to expedite project clearances and coal block auctions are expected to address infrastructure bottlenecks and boost medium term growth prospects."

Many readers have appreciated the new format of this morning letter, where we have done away with reproducing select news briefs. However, some readers feel that news briefs were useful as a quick morning catch up.

We would request some more feed back to decide whether to go back to the earlier format. Kindly mail your feedback at investrekk@gmail.com.

Trivia

The Finance Minister has rightly pinpointed that foreign investors should not assume India to be a tax heaven or banana republic.

It would be completely naive on investors' part to expect their all gains to be tax free.

The point to ponder however is - what led these investors to believe that in India they can get away with anything?

Whether the miscommunication started with the road shows done in 2012 by P. Chidambaram to alleviate concerns over GAAR?

Has the miscommunication continued with "Red Carpet in lieu of Red Tape" call of PM Narendra Modi?

Or it is legacy issue from 1990's, which no politician has tried to address directly?, Instead IT department is being used to convey the message in a rather impolite way.

Interesting reads:

15 Years Of Stimulus—–Nothing To Show

Liquidity Returns to the Markets with Surprising Gains by the U.S. Dollar

Wednesday, April 8, 2015

Figure it out yourself

Thought for the day

"Appearances are often deceiving."

- Aesop (Greek, 620-560BC)

Word for the day

Diddle (v)

To cheat; swindle; hoax.

(Source: Dictionary.com)

Malice towards none

Snow, hail storm, rains and dust storms in April - is Mother Nature trying to tell us something?

Figure it out yourself

There is a famous fable I like to keep reminding myself rather frequently. It goes like this:

Once the king rodent called a general assembly of all rats to ponder over the rising feline threat. Everybody was bothered and concerned about the menace.

After a long deliberation, it was unanimously agreed to appoint a strategic consultant to advise on the matter. The consultant so appointed studied the problem in great detail and came out with this famous and voluminous report, that primarily highlighted that cats are far more powerful, wise and smart animal than mice. Therefore it is extremely difficult for the mice to put up a credible defense against the menacing felines.

The only way to counter the threat, the report egregiously suggested, is that all rats should become cats.

The rodent populace was extremely thrilled to receive the report and instantly went jumped into a celebration.

The celebrations was however halted abruptly when a tiny mice raised his hand and asked the king - "O' My Lord without an iota of doubt it is a great moment in the perennially miserable life of ours and we must celebrate it. But if you pardon my naiveté, may I ask Sir - would it not be appropriate to first find out how do we all become cats?"

Pushed into serious contemplation, the King called the consultant to ask the question "How"?

"Well, Sir, I am afraid that I may not be of any help in this regard. You Lordship will have to figure it out himself", the consultant replied promptly.

Our McKinsey consultant turned Finance Minister for State, Shri Jayant Sinha told an august gathering at a CII function that to overcome persistent poverty and unemployment, India needs "to accelerate growth and sustain those high levels of growth for a long time."

May I ask my Lordship - "Sir how do we do that?"

What to do?

Mr. Sinha impressed by suggesting some noble ideas for alleviating poverty and making India grow faster. Some notable suggestions were as follows:

* There is a need to develop and create a new India growth model and grow at 7-8% in the next 10 years.

* There is a need for increasing the tax to GDP ratio from the current 12-13% to 20-25%.

* There is a need to increase the size of the banking system by 4-5 times to help boost growth.

* There is a need to increase price to book multiples of PSBs and bring them at par with Private sector banks, so that the government holding in these banks could be brought o targeted 52%.

The Minister highlighted that the current valuations of PSBs are distressed and there is no possibility of government diluting its stake in public sector banks at current valuations. He underscored that his government would chose to do so only once it manages to push up the price to book multiples of these banks and bring them at par with private sector banks.

"How?"

Sustaining a 8% growth rate for a decade, doubling the tax GDP ratio, increasing the size of financial system by 5x and managing 3-4 P/B ratio for PSBs!

Well these are extremely noble and highly desirable thoughts.

But the moot question is how do we achieve this?

The few and scattered indications of the new model on growth that are available in public domain suggest that the new model is definitely a capital intensive model involving huge capital investments in long gestation infrastructure and manufacturing projects.

With this model achieving higher growth rate (7-8%) would take many years. The problems are that:

(a) The huge unemployed and poor youth population needs jobs today morning;

(b) The capital needed to implement this model is not available within the country and foreign capital is likely to become scarce, choosy and expensive in following years;

(d) With huge spare capacities available cheaply across the word, the financial viability of new general manufacturing revolution in India could be doubtful; and last but not the least

(e) People may not be willing to give the government those many years.

The minister also suggested that he wants pension funds to become larger and stronger and provide long term capital to the market. He also highlighted that tax incentives are being provided to encourage people to invest their savings in long term instruments.

(a) The incentivized investment in past three decades has mostly resulted in misallocation of capital as well as inefficient use of funds.

(b) The household savings rate has shown a consistent declining trend in recent years. So has the real wage rate.

(c) The RBI commentary yesterday highlighted that global deflationary and disinflationary tendencies are providing support in maintaining an accommodative policy stance. Under such circumstances expecting serious rise in household financial savings would sound little unreasonable.

The most amusing part is that the government would like to manage pushing up to book ratio of PSBs 4-5x from the current level.

Three questions instantaneously crossed my mind on hearing this:

(a) Are our capital markets so inefficient that something worth Rs100 is being traded at Rs.20-30, not for few weeks but for few years?

If yes, then there is a serious rethink required in pushing household savings towards Indian equities through tax incentives and pension funds.

If not and PSBs are trading at large discount to their private sector peers, we need to evaluate whether the "B" in "P/B" is truly what is reflected in the balance sheets of PSBs.

I believe, adjusted for restructured book, higher credit cost, lower return on assets, and higher operating expenses PSBs may not be at a material discount to private peers.

(b) Growth of banking sector is a function of economic growth. I am afraid, vice versa may not be true in the context of an emerging market like India, at the least.

Banking sector will grow 5x if our economy grows 3x.

It straight and simple. No chicken - egg issue involved here.

The impact on the carry trade

I have been thinking and talking about eventual reversal of USD carry trade as the US Fed begins the "lift". The following views of Chris (Capital Exploits) make an interesting read:

"Should the Fed raise rates in June, the impact on the carry trade will only be exacerbated.

We’ve spoken at length about the carry trade, both in our detailed USD Bull Market report as well as my explanation of the anatomy of a carry trade bubble. It’s important to understand how interconnected world markets are. Nothing happens in isolation.

Consider investors, hedge fund managers, pension funds, and other financial flotsam and jetsam will now have added incentive to pay back borrowed dollars after their forays into emerging market debt and high yield instruments. Not only has the yield differential moved against them as dollar returns on a yield basis outperform. Equally importantly, this itself will simply fuel demand for the already strengthening greenback.

A rate rise by the Fed will act as a margin call on carry trade assets as the yield differential widens in favour, this time of the dollar. This is why I fully expect some hair raising events in the 3rd and 4th quarters of 2015 as levered players who are currently coughing up blood actually die. It promises to be a good show.

I should point out that a strengthening dollar is deflationary on a global scale. I struggle to see how this is anything but bearish for commodities and commodity currencies.

As terribly managed as the dollar is, we believe that global capital flows increasingly favour the USD. This will likely have the perverse effect of sending the wrong signals to US policy makers who understand global capital flows in the same way my young daughter understands quantum physics – not so much.

This dollar rally and periphery debt default we’re expecting will set the stage for the Fed to eventually attempt to reverse the strong dollar, bringing about a rise in US bond yields and a loss of faith in the mighty dollar. We have more of the show to enjoy though before we get there.

(Capitalist Exploits)

Trivia

In a not surprising event, most of the socialist parties appear to have agreed to merge and present a united opposition to PM Narendra Modi led NDA government.

The first test of the unity will occur in next few weeks as the modalities are worked. In my view, TINA (there is no alternative) factor should help the erstwhile Janta Dal colleagues to come together rather comfortably. The relationship of MSY and LY should provide the cement.

The real test will however be during Bihar election. A successful campaign there will catalyze a strong national front.

The question is whether Akhilesh Yadav will achieve in 2019 what Rahul Gandhi could not in 2014.

Interesting reads:

History Lesson for Hypocrites, Warmongers, and Fools

The Solar Price Revolution

Asian Values RIP

Tuesday, April 7, 2015

Bear herd is watching ya!

Thought for the day

"Every truth has two sides; it is as well to look at both, before we commit ourselves to either."

- Aesop (Greek, 620-560BC)

Word for the day

Fallow (n)

Not in use; inactive:

(Source: Dictionary.com)

Malice towards none

Deeper and stronger the root of prejudice, least it is spoken about!

Bear herd is watching ya!

As per a report published in the Financial Times, in past few months the developing economies have suffered their biggest capital outflows since the 2008-09 financial crisis.

Brazil is faced with recession, decade high inflation, a fiscal crisis and water rationing. China is struggling to maintain 7% growth as property prices are collapsing and financial system is reeling under severe stress. The geo-political crisis in Russia at a time when energy prices are collapsing is driving citizens to desert Ruble and switch their savings into US dollars.

"Such snapshots of growing distress in the world’s largest emerging markets are echoed among many of their smaller counterparts. Several countries in Sub-Saharan Africa are beset by dwindling revenues and rising debts. Even the turbo-powered petroeconomies of the Gulf, hit by a halving in the price of oil over the past six months to $55 a barrel, are moving into a slower lane.

Though these expressions of distress derive from disparate sources, one big and insidious trend is working to forge a common destiny for almost all emerging markets .

The gush of global capital that flowed into their economies in the six years since the 2008-09 financial crisis is in most countries now either slowing to a trickle or reversing course to find a safer home back in developed economies."

India has been an exception to the trend, so far. The flow of capital to the country has not only sustained in past couple of years, it has actually accelerated in recent past 12 months. During FY15 the net foreign flows into Indian assets exceeded US$44bn. Consequently, the Indian Rupee has also materially outperformed its peers.

While it is worthwhile to examine the reasons behind the love for India, still more important is to assess the consequences if the love is lost, like in case of other emerging markets.

Hope driven by circumstantial factors

The divergence in foreign investor's India strategy vis a vis general emerging market strategy became conspicuous in summer of 2013 when an IMF economist Raghuram Rajan was appointed the governor of RBI.

The trend has strengthened since the new government assumed office at center in May 2014. Prime Minister Narendra Modi's outreach to global investors and appointment of couple of more prominent market economists to important posts has helped in boosting the confidence. Improvement in macroeconomic data driven by lower energy prices, fiscal tightening, and benign inflation expectations has further cemented the trend.

However, if we consider that most of the improvement in macroeconomic factors may have occurred due to circumstantial factors like cyclical trough in global demand leading to lower commodity prices; lower domestic consumption demand due to a variety of factors like lower social sector spending, poor employment level, decline in real wages, leading to benign inflation expectations, poor investment demand supporting comfortable liquidity and lower rate environment, etc.

The recent comments of RBI governor - implying that the infrastructure development model adopted by India during past decade may be faulty inasmuch as it pushed infrastructure building at the expense of financial stability - suggest that the fresh investment cycle may not start in a hurry. Not at least till the alternate source and model of infra development funding are firmly put in place. More on this in later pages.

There are little structural changes to show that Indian economy will escape the deflationary contagion should one engulf the global markets.

Bear herd must be watching keenly

I am sure the herd of bears that has been suffering for past couple of years, must be watching Indian markets keenly. They should pounce as soon as they smell the blood.

With little margin for error in monetary and fiscal policies, the Indian markets are more vulnerable to a bear attack then ever in past five years.

Continued poor show by corporate earnings, elevated level of stress in financial system, rise in consumer inflation beyond RBI's comfort zone on the back of crop damage due to recent unseasonal rains and a poor monsoon due to El Nino conditions developing in Pacific Ocean could be a setback to the investor's sentiments.

However, the most irksome sentiment dampener could come from rise in number of tax litigation with foreign tax payers.

A poor performance by BJP in Bihar elections, not unlikely, could queer the political pitch for Modi led NDA government.

Conspiracy theory

The most popular conspiracy theory doing rounds is that the foreign money flowing into India is nothing but domestic black money making a round trip. Even if this is the case, the mount may not be infinite.

5/95 model may not be a way to go forward

The Reserve Bank of India (RBI) chief said on Thursday the country's push to build infrastructure should not come at the expense of financial stability, adding banks already had too much exposure to the sector.

Instead, Governor Raghuram Rajan said, India needed to find new sources of funding for infrastructure so that debt levels remained "moderate".

The comments, at a financial event organised by the RBI that was attended by Prime Minister Narendra Modi, come as the government says it wants $1 trillion invested in infrastructure in the five years to 2017, with half of the funding coming from private companies.

"The nation has enormous financing needs in infrastructure, and far too many of our banks already have too much exposure," Rajan said.

"Big corporate infrastructure players have also taken too much debt. The required national push to finance infrastructure should not override financial stability, which is key to national security."

Funding for infrastructure is expected to pose a challenge to India, whose banks, especially state-owned lenders, continue to struggle with non-performing loans.

The gross bad loans ratio at banks could rise as high as 5.7 percent by March 2016 from 4.5 percent last December, rating agency ICRA estimates. (Reuters)

This statement in my view, casts a shadow on the most popular model of infra development in India. The projects are often undertaken with 5:95 equity to debt ratio. It is popularly believed that some promoters even avoid putting 5% equity using scrupulous methods. In case project is successful, they make lot of money. However, if the project fails, the loss is absorbed by the lenders (mostly public sector banks) and tax payers.

The undercapitalized infra developers that have mushroomed in every nook and corner of the country would have no reason to exist if the intent is followed with honesty.

Another set of companies that should face extinction are the contractors who have been successful in obtaining construction contracts due to the political and administrative patronage enjoyed by them. Given that to keep his image and Kurta clean, PM Modi would want e-tendering to be introduced for most government and semi-government (PPP) contracts.

Another question on the sidelines would be "whether PSU banks are good investment sans patronized portfolio?"

I would like a study to be conducted for examining what was the growth rate for PSU banks in past decade if we take out (a) Discounting of oil bonds for OMCs, (b) financing to power sector against coal mines, (c) financing to Telcos against spectrum and (d) financing real estate developers under the garb of schemes such as 20/80 and (e) farm sector loans which the banks did want to give at the place.

Make in India - Is this the way to go forward

Last week the Union Cabinet approved revival of two shut urea plants in Uttar Pradesh and Bihar at an investment of up to Rs. 12,000 crore.

Currently India imports ~25% of its urea requirement. In last decade no new investment has been made in the sector in India. The reason is that urea production in the country is highly uncompetitive in global perspective. Currently, the landed cost of imported urea is US$30/tonne cheaper as compared to locally produced urea.

A similar situation exists in edible oil and a host of other sectors. If the things remain the same as they are, we might see a similar condition emerging in sugar sector also.

The points I am trying to make here are:

(a) Whether it is good economics and/or politics to produce locally if you could import at much cheaper price.

(b) Whether Make in India model is financially viable without dealing with the political model which focuses on short term expediency at the expense of long term sustainability.

Blood diamond

The prime minister claims that his government has turned coal mines into diamonds for the exchequer.

It is worthwhile to ask the following questions from his government:

(a) Whether the government of the day had any other option but to go for transparent auctioning of natural resources after the Supreme Court decided on cancellation of spectrum and coal block allotments.

(b) The Rs2,00,000 crore will accrue to the government over next 30yrs. The present value (NPV) of this money is much smaller.

(c) Does the government has any viable plan to ensure that Coal India Limited does not go the MTNL, BSNL and Air India way post privatization of coal production for commercial sale.

In my view it does not have and CIL may be a much weaker company in two decades from now.

Trivia

The whole financial sector seems to praying for poor US economic data. It seems that a very poor data could only delay the "lift" (new jargon for rate hike).

I do not know what to wish.

I believe a stronger US economy could only save the world from slithering into a deflationary vicious cycle.

The reversal of US carry trade closer to "lift" may crush the spirits of market bulls for a month or so.