Vijay Kumar Gaba

Wednesday, September 25, 2019

1HFY20 - Eventful 6months

The first half of the current fiscal (1HFY20) is almost over. On the domestic front, the past six months have been quite eventful for the country in general, and the economy & financial markets in particular.

Politically, the six month period witnessed the PM Modi led NDA returning to power with unexpectedly strong majority. Continuing with the tradition of unpredictable policy responses, the government has rewritten the rules for engagement with Pakistan and China by abrogating the controversial Article 370 of the constitution. Besides, a definitive move has been made towards implementing a uniform civil code by outlawing the practice of triple talaq (The right of men to divorce their wives instantly through oral or text communication) prevalent amongst Indian Muslims. A long standing dispute over the construction of Sri Ram Temple in Ayodhya has been fast tracked and a final Supreme Court Verdict on the dispute is expected in next 2 months.

These developments have removed some splinters that have been hurting the toe of Mother India for many decades. The procedure to remove the splinters is painful and full recovery may take some time. Nonetheless, if proper care is taken to heal the wound without letting the infection to spread, it will be a major relief for the country in medium to long term.

Economically, the growth continued to decelerate to lowest since global financial crisis. More and more sectors joined the class of slowdown. Three noteworthy events have taken place. The inflation is persisting at the lowest levels in a decade and manufacturing growth has almost stalled. Accordingly, tax collections have fallen much short of the budgeted targets weighing on the fiscal balance.

Firstly, the concept of Universal Basic Income (UBI) has been introduced to supplement the rural job guarantee (MNREGA) that was in place for past one decade.

Secondly, the process to restructure the scheme of income tax has been initiated with restructuring of the corporate tax. The process of simplifying and streamlining of GST has also gathered pace with further consolidation of slabs and classifications. A simplified GST and Corporate Tax structure shall provide a strong foundation for reorganization of Indian enterprises. Eventually, we may see large consumer facing businesses adequately supported by a vast network of smaller feed suppliers, contract manufacturers and service providers etc.

Thirdly, the process of bank consolidation has accelerated with on the tap licensing for smaller banks. This shall straighten the structure of Indian financial system that got distorted post demise of development financial institutions two decades ago. Two separate financing verticals one to finance the growth (infrastructure, projects and corporate) and the other to finance consumer and ensure financial inclusion shall get established in due course of time, of course with some overlap.

Financially, 1QFY20 was one of the weakest quarters in past 8yrs insofar as the corporate earnings are concerned. The asset quality remained under pressure with many some new areas of stress emerging. The household debt levels have increased while corporate have deleveraged.

RBI continued to ease monetary policy with rate cuts and liquidity infusion. The policy stance was changed to "accommodative" from "calibrated tightening" earlier.

The logjam between NCLT and Judiciary continued to plague the process of resolution of stressed assets under IBC.

Financial Markets have been volatile. The benchmark stock market indices are little changed from their six month ago levels, thanks mainly to the massive rally in past few day. INR is weaker by couple of percentage points due to 60bps fall in benchmark yields and FPI outflows.

Tomorrow, I shall present my current investment strategy and market outlook.

1QFY20 weakness driven by both consumption and investment

Business and Consumer Confidence Worsens

Inflation remains benign, signs of bottoming

Monetary easing continues, as growth remains below potential

Corporate Earnings growth remains weak

Bonds yields soften, INR weakens

Tuesday, September 24, 2019

Change in corporate tax structure - What does it mean for me

The sudden changes announced in corporate tax structure last week galvanized the Indian stock markets. It has turned the sentiments by 180 degrees from extreme pessimism to extreme optimism within a matter of few hours.

Not only the stock market participants, but all the corporates have also been positively surprised by this sudden announcement. The move has been welcomed by businessmen almost unanimously.

The decision to change the structure of corporate tax is not totally unexpected as this structure has been part of almost all versions of "New Direct Tax Code" that has been a work in progress for past one decade at least. However, the timing and method (through Ordinance) just 2months after announcement of full budget caught the markets by surprise.

Many readers have asked for my views on this decision to suddenly change the corporate tax structure, which I am happy to share as follows:

(a) I believe this decision is very good.

It shall serve to enhance the competitiveness of Indian businesses (i) as exporter of goods and services and (ii) manufacturing location for global corporations which are either looking to diversify their manufacturing facilities away from traditional bases like China and Malaysia etc., or want their manufacturing closer to their target customers in South Asia.

The new structure being a simple one shall also lead to significantly less litigation and disputes.

Since the new structure does away with exemptions and incentives related to SEZ, Backward Area investment etc. it could lead to significantly more efficient industries. This combined with GST and improved logistic infrastructure, may enhance the efficiency of Indian industry materially.

(b) In my view, this change in corporate structure is primarily aimed at attracting FDI in manufacturing and must be based on the expression of interest and/or feedback of global corporations.

It is basically a supply side measure and may not immediately result in higher consumer demand. If the stock market reaction and analysts forecast revisions are to be believed not many companies shall be passing on the benefit of lower tax to the consumers.

In my view, however the assumption of 1 to 1 gain in profit after tax (PAT) is totally unjustified. The gains, if any, will be shared between the consumers and shareholders. A 2-3% cut in tax liability therefore may not result in 2-3% higher PAT.

Therefore, the government may need to supplement these changes in the corporate tax structure with changes in personal income tax and GST to aid the consumer demand.

Insofar as investment demand from the domestic companies is concerned, the current capacity utilization level do not augur well for further capex. We may see some revival in investment demand only towards second half of next fiscal in my view.

(c) To make the new corporate tax structure sustainable and credible, the government must almost immediately announce an aggressive disinvestment plan that involves privatization of a large number of public sector enterprises (PSEs). The practice of disinvestment through book entries (one PSE buying the other or buy back of shares) may not be sufficient to fill the fiscal gap that may be created by the new proposals.

(d) The other countries vying for the business fleeing China, e.g., Indonesia, Vietnam and Thailand etc al. have also cut corporate tax rates to stay competitive. Therefore, only tax rate cut may not be sufficient motivation for the foreign businesses.

The government must follow this up with adequate non fiscal measures like easier land acquisition norms, necessary labor law changes and perhaps higher degree of INR convertibility.

These changes need to be considered and implemented promptly before the investment decisions are taken by the target global businesses.

I am sure the "surprise" has not been a pleasant one for many of the market participants. I know a lot of traders are caught on the short side.

The option writers in particular may have suffered "once in a decade" 6 or 8 sigma event that snatches away a large of profits made by the whole decade. If my memory serves me right, last time an event of this magnitude occurred in 2008. A lesser degree event occurred in 2016.

Besides, many investors who had decided to sit and wait on the sidelines have also been caught totally off guard. Most of them could be heard regretting the missed the "opportunity".

Friday, September 20, 2019

Overcome the inertia first, rest will follow

Since 2014, Prime Minister Narendra Modi has been consistently exhorting the foreign investors to invest in India to take advantage of 3Ds - Democracy, Demography and Demand; a unique strength not possessed by any other major economy of the world.

After 5years of NDA rule under his leadership, many are now challenging this claim.

A large section of domestic and foreign media, and many senior political observers & commentators have raised questions over the present health of the democracy in India. We may heavily discount their stance as deeply prejudicial and driven by ulterior motives, but rejecting it outright may not be totally logical.

The Union Labor Minister himself recently raised question over the quality of human resources in the country, especially the northern states where about two third of the youth population lives. Most business leaders, both from manufacturing and service industries, have frequently expressed grave concerns about the employability of the engineering and management graduates. A host of government and private studies have shown that the level of average students at middle school level in most populous states like UP and Bihar is unacceptable. In many cases class 6 students failed to answer 2nd standard questions. The government has failed miserably in formulating a nation youth policy or even an integrated education policy. If this trend continues, the demography could soon become a liability rather than strength of India. (Also see)

The third dimension, i.e., demand has always been an inarguable strength of Indian economy since early 1990s. The common refrain was that India is so short on the supply side that you could sell virtually everything here. I remember attending an investors' conference in late 1990s, where The CEO of a large automobile company presented that demand is something business manager in India do seldom care about. That was the time when a large FMCG company had launched a 25gm pack of Multani Mitti (Fuller's earth) for Rs40. A Google search would show that even today there are numerous listings on various ecommerce sites for this product at crazy prices.

Earlier this week, the principal economic adviser in the union ministry of finance Sanjeev Sanyal admitted that "The current economic situation is unique in India. All these years, we saw a slowdown in India because of supply-side constraints. This time, we are witnessing a genuine demand-driven slowdown." (see here)

The question is whether Indian Economy has lost its key strength (3Ds) in past five years.

I would not like to make it a political debate and reduce it to BJP vs Congress slugfest. In my view, the weakening of 3Ds is a reality and a deeper independent research study is required to assess since when, how and why the Indian economy lost its key strength. My gut feel is that this trend started more than a decade back and still continues.

On a structural note, I believe that the 3Ds of economic growth are intricately intertwined. The weakness in demand could be arrested and reversed only if some deep rooted reforms are implemented to strengthen the democracy and demography.

Nonetheless, the government may take some short term measures to begin the process from somewhere.

In this context, it may be pertinent to note that the businesses, consumers and markets, all are getting more frustrated with each set of "support measures" being announced by the government to lift the sagging sentiments. The measures announced by the government are misdirected, half hearted, inadequate and in most cases just repackaging of the already prevalent schemes and incentives. This gives a feeling that either the government is not able to comprehend the magnitude of the problem, or it is totally helpless.

In my view, the first thing government must earnestly focus on is to stimulate the economic activity at the lowest level in economy.

To break the negative feedback loop, the traders, investors and businessmen must be encouraged, nudged and coaxed into increasing their level of activity materially. We need to increase the velocity of money. Some small concessions having only notional fiscal impact can do the trick, in my view.

For example, consider the following examples, as suggested earlier also:

(a) In most parts of the country, the Ready Reckoner or Circle Rates (minimum property rates considered for levying stamp duty) are much higher than the prevailing rates of property. The government must consider bringing this minimum threshold to 10% below the prevailing market rate to stimulate transactions in property market.

(b Capital gains of upto Rs25lacs on all constructed properties may be exempted from income tax for two years, i.e., AY21 and AY22.

(c) Capital gains on sale of gold may be exempted, provided the entire sales proceed is invested in buying one or more constructed property (residential or commercial).

(d) Concessional Housing advance by companies to their employees in next 2years may not be treated as perquisites during the term of the advance.

(e) Trading in agri commodities may be exempted from cash transaction limits completely for 2yrs, i.e, till March 2021. Post that restrictions may be applied in graded manners over next 5yrs.

(f) GST input credit for automobile purchase may be allowed for six months, i.e., October 2019 to March 2020.

(g) Upto 50% discount may be offered on power tariffs to all green field industrial units that are approved before March 2020 and begin commercial operation before March 2022.

(h) Long term corporate bonds (10yrs or more original maturity) may be treated at par with equity for capital gains taxation purposes. Periodic Interest on such bonds may be taxed @10% without any limit.

(i) CSR spend in setting up rural schools and health centers may be made tax deductible at 125% of the amount spend. The operating and maintenance expenses on such schools and health centers may also be made tax deductible.

(j) An aggressive scrappage policy for old automobile (10-15yrs) may be implemented forthwith.