Vijay Kumar Gaba

 Historically, at some point in time copper, gold and/or silver coins had been legal tender in India; and in many other economies as well. Traditionally in Indian society, these metals have enjoyed acceptance as ‘sacred metals’ having religious, medicinal and economic importance.

With the rise in its industrial usage, copper may have lost its ‘precious’ status, but gold and silver still continue to enjoy ‘precious’ status, even though these are no longer legal tenders in India; and most other jurisdictions. With advancement of technology and globalization of Indian socio-economic milieu, the ‘sacred metal’ aspect of gold and silver is also diminishing gradually.

In past few years, the government of India has made significant efforts to encourage people to own gold in non-physical form, through sovereign gold bonds (SGB). These bonds offer interest income at the rate of 2.5 percent annually, beside capital gains benefits to the holders. In recent years, the digital gold has also been gaining popularity due to ease of transaction and holding. This comes after many decades of discouraging the gold for investment and consumption.

Cryptocurrencies (e.g., Bitcoin) are relatively new phenomenon in the global financial ecosystem. Unlike their nomenclature, these are not exactly currencies so far. Only El Salvador has declared Bitcoins as legal tender; whereas there are some jurisdiction (e.g., China, Indonesia, etc.) that have put a total ban on use of all cryptocurrencies as medium of exchange.

Crypto NOT currency as yet

To achieve ‘currency’ status, cryptocurrencies would need to gain much wider and deeper acceptance; which usually comes with time and awareness. Gold took centuries to gain wide acceptance as medium of exchange and ‘valuable asset’ status. Few cryptoes may gain this status in next few decades, simply because modern technology has made things much faster.

In India, the cryptocurrencies have gained tremendous popularity in past five years. It is estimated that there are over 100 million people in India owning one or more cryptocurrencies; the largest number for any country in the world. This number is materially higher than the number of people owning publically listed shares in India. The value of cryptocurrencies owned by Indian citizens is estimated to be close to US$900bn.

Regulating cryptocurrencies

The government has proposed to introduce a Bill in the forthcoming session of the parliament to regulate cryptocurrencies. The Bill titled ‘The Cryptocurrency and Regulation of Official Digital Currency Bill 2021’, aims to “create a facilitative framework for creation of the official digital currency to be issued by the Reserve Bank of India” and prohibit all private cryptocurrencies in India, with certain exceptions to promote the underlying technology and its uses."

Earlier, a high level inter-ministerial committee had suggested ban on private cryptocurrencies in India, except any virtual currencies issued by state. However, the government refrained from pushing the legislation in the Budget session. It was felt that a balanced approach is required in the matter, for which wider consultation with all stakeholders is important.

The Standing Committee on Finance recently highlighted many serious concerns over the obscurity of cryptocurrencies, operations of crypto exchanges and impact on the economy.

The stakeholders like RBI, Finance Ministry, Home Ministry, Blockchain and Crypto Assets Council (BACC) and industry and commerce bodies, the CII and ASSOCHAM, etc. made detailed presentation to the prime minister regarding opportunities and threats posed by cryptocurrencies and the need for appropriate regulatory framework.

Most significantly, the BACC represented that crypto assets could be treated as “utility”, “security”, “property tokens”, “intangible commodities”, or “virtual assets” that would ensure that the usage of tokens was governed appropriately and they were not confused with legal tender.

From the indications available so far, it appears that the government is totally against the use of cryptocurrencies as a medium of exchange (legal tender), but it supports the development and use of blockchain technology. It is therefore likely that a regulatory framework may be provided for ownership, transfer, sale and taxation of (select or all) cryptocurrencies. In that case the permitted cryptocurrencies may be treated as “capital assets” under the taxation laws.

It is also likely that the proposed legislation may permit a digital currency based on blockchain technology, to be developed by RBI or any other public agency. Obviously, such currency will not have the traits like Bitcoin, which is a decentralized and distributed digital token with finite supply. RBI’s digital currency will most likely be a centralized currency with infinite supply, just like fiat currency. In simple terms, RBI’s digital currency may be a dematerialized currency note that is delivered as a book entry in the receivers’ account.

Therefore, a fiat digital currency should not be confused with a decentralized and distributed cryptocurrency.

An idea whose time has come

In every democracy, especially the socialist ones, the governments have the natural tendency to regulate every innovation; simply because most new innovations make few people richer than the rest. With every new innovation, the fear of rise in inequalities also rises. The tendency to overregulate the innovations is therefore usually driven by the concerns to assure the majority of population that stays at the bottom of the pyramid.

A classic example of this was the attempt of British government to ban the use of cars on public roads in early years of automobiles. The argument was that this may have negative implications for the employment of poor people running horse carts on streets of London.

The good thing is that there is no historical evidence of a government regulation killing an innovative idea which was ready for adoption by the wider sections of public. Expansion of organized retail is a classic example in recent Indian context.

The dematerialization of securities is inarguably the single most important reform in the history of Indian capital markets. The idea was initially opposed by the market participants and bureaucrats. Computerization of banks and stock trading were other ideas that were not accepted easily by various stakeholders.

Failure to self-regulate is also a major catalyst for the overregulation. Securities’ market in India was mostly self-regulated for first 100 years. It was the colossal failure of self-regulation during late 1980s and early 1990s that pushed the government to intervene. BSE, a self-regulatory organization (SRO), that enjoyed more than 50% market share in a 29 players market till mid-1990s, is now contended with less than 10% market share in 2 player market.

“Most of the cryptocurrencies may not pass the test of time and fail, causing material losses to investors” is not a valid argument against cryptocurrencies. During 19^th and 20^th century, thousands of banks and insurance companies failed causing instability in markets and material losses to investors and depositors. More recently, many private airlines, telecom companies, infrastructure builders, private & cooperative banks, NBFCs, HFCs etc have failed in India causing huge losses to investors, lenders and the exchequer. Would anyone accept this failure as valid argument for banning these activities in private sector!.

Cryptocurrencies a bad omen for Gold

A well regulated market for cryptocurrency could be a bad omen for demand for the traditional “valuable assets’ like gold and silver. Arguably, the factors like popularity and spread of technology in common man's life; rising fascist and communist tendencies due to worsening socio-economic disparities; rise in electronic transactions (personal, social and commercial) thus lower risk (less travel, less physical transactions & deliveries); emergence of new articles of luxury to serve the vanity needs of the affluent; stronger and deeper social security programs; demise of monarchy and feudalism; popularity of spiritualism over rituals; dissipation of church & temples, etc., are all leading to sustainable decline in traditional demand and pre-eminence of gold. There is nothing to suggest that this trend may not continue in near future.

The following table makes it clear that gold and cryptocurrency are comparable assets in most respects. Some experts are arguing that gold has “intrinsic” value whereas cryptocurrencies have none. In my view, the intrinsic value of gold has developed over many centuries of wider acceptance by the state and religion. This intrinsic value has been on the decline for past few decades.

Insofar as the volatility is concerned, in past two centuries, gold has seen many bouts of wild volatility, correcting over 50% on many occasions. From December 1987 high of ~US$500/oz to February 2001 low of ~US$250, Gold yielded a negative return of 50% over a period of 13yrs. Falls of similar magnitude were rather quick during 1974-1976 and 1980-1982.

In January 2021, the 22^nd biannual Financial Stability Report (FSR) of RBI had raised many red flags over the Indian financial markets. The report, inter alia, highlighted the uneven economic recovery, accentuated credit risk of firms and households, and divergence between economic activity and asset prices. Commenting on the findings of FSR, the RBI governor had then cautioned investors and financial institutions that “The disconnect between certain segments of financial markets and the real economy has been accentuating in recent times, both globally and in India” and “Stretched valuations of financial assets pose risks to financial stability. Banks and financial intermediaries need to be cognisant of these risks and spillovers in an interconnected financial system.”

Incidentally, the benchmark Nifty has gained ~24% and total market capitalization of NSE has increased ~38% since release of last FSR in January 2021.

The economics team of RBI, in the latest monthly bulletin of RBI, has reiterated, “The Indian equity market has outperformed major equity indices in 2021 so far. The spectacular gains have raised concerns over overstretched valuations with a number of global financial service firms turning cautious on Indian equities. Traditional valuation metrics like price-to book value ratio, price-to-earnings ratio and market capitalisation to GDP ratio stayed above their historical averages. The yield gap (difference between 10-year G-sec yield and 12-month forward earnings yield of BSE Sensex) at 2.47 per cent has far outstripped its historical long-term average of 1.65 per cent.”

Expert opinion divided

Some prominent global brokerages have recently turned cautious on Indian equities. They have advised their clients to reduce exposure to Indian equities. For instance—

The global strategy team of CLSA advised lowering of India exposure to 40% underweight, citing 10 reasons for booking profits on India. It said, “We call time on the 20-month rally in Indian equities, lowering our exposure to India within an AC APAC ex Japan portfolio to 40% underweight. Our concerns range from elevated energy and broader input price pressures applying downward pressure to margins, the current account balance and thus currency outlook, the withdrawal of RBI stimulus, and a lack of upside implied by Indian equities’ typical macro drivers. Rich valuations, a high probability of earnings disappointment, and a potential lack of marginal buyers add to our motivation to book profits on India.”

Goldman Sachs lowered Indian equities to market weight after region-leading 31% gains in 2021. It said, “After gaining nearly 31% ytd and 44% since our upgrade in November last year, and being the best-performing regional market in 2021, we believe the risk-reward for Indian equities is less favorable at current levels. While we expect strong cyclical and profit recovery next year and remain medium-term constructive amid increasing digitalization in the index, we think the recovery is well priced at current peak valuations. We, thus, take profits on our India overweight and lower it to market weight within our regional allocations.”

Morgan Stanley also advised booking profit in Indian equities, despite retaining a structural positive stance. It said, “We move tactically EW on India equities after strong relative gains - we expect a structural multi-year earnings recovery, but at 24x fwd P/E we look for some consolidation ahead of Fed tapering, an RBI hike in February and higher energy costs.”

The “lower weight on India” is however not a consensus call. There are investors who are willing to look beyond the near term concerns and potential draw down in stock prices, and increase allocation to Indian equities. 

Mark Mobius, whose emerging market fund has over 45% allocation to Indian and Taiwanese equities, sounded extremely bullish on India, in a recent media interview. He said, “India is on a 50-year rally even if there are short bouts of bear markets.”

Another veteran, Chris Wood who writes famous ‘Greed & Fear’ report, recently wrote, “If GREED & fear is Overweight China, GREED & fear also remains structurally Overweight India. GREED & fear repeats the point that if GREED & fear had to own one stock market globally for the next ten years, and not be able to sell it during that period, that market would be India.”

Foreign investors continue to sell

Regardless of these divergent views on Indian equities, the foreign portfolio investors (FPIs) have been net sellers in six out of past seven months. So far in 2021, FPIs have net sold ~Rs240bn in Indian equities.

…as global investors’ preference veers towards developed markets

In fact, the global investors have been increasing weight on developed market equities for past many months. The latest global fund managers’ survey conducted by Bank of America (BofA) global research indicates that the global investors now have highest overweight on US equities since 2013

Promoters remain sanguine about their businesses

The recently concluded earning sessions did not throw up many surprises. The earnings were mostly in line with analysts’ estimates. The revenue growth was offset, to some extent, by higher raw material prices. The lower margins prevented any meaningful earnings upgrades. IT services companies witnessed strong earnings momentum and upgrades; while automobile manufacturers; insurance companies and chemical 7 paint companies witnessed downgrades. The results of financial stocks were also mixed.

As per MOFSL, “Key drivers of 2QFY22 performance: [1] IT- Indian IT services delivered one of its bestever quarterly performances with a sequential revenue growth of 4.8% (USD). Moreover, stable deal wins and the upbeat commentary on overall tech spending provide high visibility for future growth. [2] Oil & Gas (O&G) – The performance of OMCs was driven by a better-than-expected margin performance, led by both higher reported GRM and higher-than-estimated marketing margins. Sales volume witnessed a demand recovery post the second COVID wave. [3] Autos – High raw material inflation and operating deleverage impacted the sector’s 2QFY22 results. OEMs (MSIL, Bajaj and TVS) reported a commodity cost impact of 2-4pp QoQ, but expect semiconductor supply to improve from the 2QFY22 levels.”

The brokerage kept the Nifty EPS for FY22/FY23 largely unchanged at INR 731/INR873 (from INR 730/874).

A majority of the market participants however seem to be of the view that the present earnings estimates may be little ambitious to achieve and we may see more downward revision in 2HFY22.

Given the mixed signals from investors, corporate performance, policy makers et. al., the Indian markets have turned indecisive in past few weeks. The benchmark indices are moving in a narrow range waiting for clear signals to choose a direction. Volatility has increased and volumes are plunging much below the 12month average. Institutional participation is diminishing. The sectoral movements are sharp and random. Accordingly, the divergence in sectoral performance is stark. The strong response to expensively priced IPOs has added to the randomness of market behavior.

Next week, we shall have a look at market internals to discover more about the market behavior and likely outcome in the short term.

 The “Young India” may soon begin to age. As the era of demographic dividend wanes, many new business and investment opportunities may arise. It may be the right time for investors to anticipate these opportunities and begin taking positions.

Presently, India is home to the largest number of youth. With close to half of her 1.4bn people below 24yrs of age, India is like a vast reservoir of youthful energy. However, this distinction might not last for long. India is expected to become a middle aged country in next 15years and an old country by 2050 - since with the faster economic development over past three decades, India has managed a consistent decline in crude birth rate (CBR), total fertility rate (TFR) & infant mortality rate (IMR); and improved healthcare facilities, better access & improved affordability have also resulted in a consistent rise in life expectancy of an average Indian to about 70yrs.

As per a 2019 report of the Technical Group on Population Projections for India and States 2011-2036, set up the Government of India, the below 24yr population is expected to fall from 50.1 percent in 2011 to 34.7 percent by 2036. The average age of Indians is expected to be of 34.7 years in 2036 as compared to 24.9 years in last census (2011).

TFR is expected to decline to 1.73 by 2036, much below the ideal replacement TFR of 2.0. This implies that Indian population will begin to grow “old” at a faster rate. Over the next 15yrs, the population of India is likely to witness material rise in the number of old people (60yr and above) and number of potential workers (15 to 59yrs), while the school going children (5-14yrs) will decline materially.

By 2036, the share of old people in the total population may increase to 15 percent (230 million) from 8.4 percent (100 million) in 2011; the number of potential workers is expected to rise to 65.1 percent from 60.7 percent in 2011; and the school going population may decline to 14.9 percent from 19.3 percent in 2011.

It is critical to note that the regional demographic imbalances shall continue to exacerbate in future. By 2036, about 23 percent of the population in southern state of Kerala may be old, as compared to just 12 per cent in northern state of Uttar Pradesh. The median age in the Eastern State of Bihar is expected to be 28.1yrs in 2036 (19.9yrs in 2011), while in the southern state of Tamil Nadu, it would be 40.5yrs (29.9yrs in 2011). Andhra Pradesh may have a CBR of 9.9 per thousand in 2036 (15.2 in 2011) whereas Bihar’s CBR may be 19.6 (27.5 in 2011).

With the projected rise in population to 151bn by 2036, the density of population shall also increase to 462 people per square kilometer from the present 368 people per square kilometer. This shall lead to further acceleration in the trend of urbanization of India. Of course, the urbanization trend will not be uniform across India. Delhi and Kerala will lead with 93-100 percent urbanization rate, with Tamil Nadu, Telangana, Gujarat, Maharashtra, Karanataka etc following with 50-60 percent; whereas Himachal, Bihar, Assam and Odisha will lag with 10-20 percent urbanization rate.

With the decline in number of school going children, the focus will shift from primary and secondary education to higher education and skill building. Beside more parents will be available for working. Skilling and managing this new set of workers could be a good business opportunity.

The global experience suggests that rise in middle ages urbanized working population invariably results in rise in demand for civic amenities like housing, public transport, sanitation, communication etc.; recreational activities like entertainment and travel; personal use items like clothing, footwear, cosmetics and fashion accessories; and consumer durables etc. Rise in demand for healthcare, social & financial security, elderly care etc. is a natural corollary of the aging demography. The age related pharmaceuticals and devices, chronic disease management, pension management, nursing care, estate planning, old age homes, usually see significant rise in demand as the demographics shift to the higher age. Obviously, we shall see sustainable investment opportunities arising in these areas over the course of next few decades.

Personally, I believe that the demographic shift in India offers immense opportunities in the financial services segment. The demographic changes shall inevitably result in significant widening and deepening of the financial services. With the evolution of earning, savings and spending patterns, the financial product mix, design and their delivery will also have to evolve. Significant opportunity shall arise in the businesses like financial planning, lending, insurance, asset management, etc.

One of the economic positives of Covid-19 pandemic is material rise in digital payments and e-commerce. The steep rise in adoption of digital payments by household consumers and merchants in past one year should have arguably led to lower currency in circulation. However, the recent data released by RBI indicates that the cash in circulation is highest in 6 decades relative to GDP. In absolute terms also, the cash is materially higher than the pre demonetization levels.

It may be argued that holding more cash during the times of distress (e.g., Pandemic) is natural instinct; and this trend has been seen globally. Nonetheless, in the Indian context, the issue needs deeper examination by the policy makers.

Digital payments rising exponentially

The initial public offer (IPO) by One 97 Communication Limited, the owner of India’s largest payment brand PayTM, celebrates the exponential growth in digital payment in past few years. As per NASSCOM, digital payments in India have grown ~10x in five years, from Rs352cr in FY15 to Rs3435 in FY20. The apex body of IT Services Industry in India, expects, the digital payment volumes to grow another ~16x to Rs54,800 crores by FY25. The fastest growth during FY20-FY25 is expected to be in UPI payments, which are expected to grow 26x, from rs1251cr in FY20 to Rs32,500cr in FY25. Payments using Aadhar enabled payment system (AePS) are also expected to grow 23x to Rs3800cr over this period.

The NASSCOM’s 2020 Country Adoption Report for digital payments, highlighted that all economic segments (Individuals, Merchants and Enterprises) have high adoption maturity, insofar as the preference for digital payments is concerned. But the adoption maturity is limited for digital payments for business transactions, government transactions and higher value transactions. In 2020, about 75% of digital payments were Rs5000 or below; and only 1% transactions were over Rs1,00,000.

…triggered by Covid-19 pandemic

The lockdown forced by the Covid-19 pandemic has definitely given a strong push to the digital payments in India. As per the available data, the digital payments have increased to 25% of the private consumption expenditure in 1QFY22 from mere 4% in FY15.

As per a recent report by brokerage firm Sanford C. Bernstein, “The pandemic has changed user behavior – more people are buying things online. This has given a boost to online payments. Further, buyers are shifting towards digital payments for in-store purchases as well. Mobile payments, driven by UPI, has been a big factor in the rising adoption of digital payments in India during the pandemic. 

Digital merchant payments stood at ~25% of PCE for Q1FY22 in India. The number stood at ~22% for Q4FY21, and at ~18% for FY20. The first boost to penetration came from demonetization when higher denomination currency notes were discontinued for three months. The rise of UPI has supported the increased adoption over FY18-20. The pandemic has provided another step-jump in the adoption of digital payments by merchants and consumers. The rapid adoption growth comes from the rising share of mobile payments, mainly from UPI. UPI has grown from 3% of PCE in FY20, to 9% of PCE in Q1FY22.”

Informal economy is shrinking

As per a recent note released by SBI Research, share of informal economy in India may have shrunk to 20% from 52% in 2018. The note “estimates that currently informal economy is possibly is at max 15%-20% of formal GDP. There is wide variation across sectors, though, with formal sectors like finance and insurance expanding post pandemic.”

Though many experts have challenged the data and method used by SBI Research to assess the formalization level in the economy, it cannot be denied that the level of formalization of economy has increased in past one decade or so.

“For India, post 2016 plethora of measures which accelerated digitisation of the economy, emergence of gig economy have facilitated higher formalisation of the Indian economy - at rates possibly much faster than most other nations”, the note reads.

The note highlights that “E-Shram is a big step towards the formalisation of employment as our calculation indicates that till date the rate of formalisation of unorganised labour due to E-Shram is around 17% / Rs 6.8 lakh crore / 3% of GDP in just 2 months. Even in Agriculture, the usage of KCC cards has increased significantly and we estimate Rs 4.6 lakh crore formalisation only through KCC route, with more marginalized farmers coming under the banking sector ambit through such usage. The total number of insurance and pension accounts that have been opened across several schemes for the unorganised as well as organised is as much as 68.9 crore.”

Paradoxically currency in circulation is highest in six decades

The currency in circulation (cash in pocket) grew to six decade high of 14.7% of GDP by the end of FY21. The currency in circulation grew at staggering 17.2% in FY21 to Rs28.6trillion. The amount was Rs16.63trillion five years, before the demonetization of higher denomination notes in 2016.

Moreover, the proportion of high denomination currency (Rs2000 and Rs500) has also increased to 85.7% in March 2021, against 83% share of Rs1000 and Rs500 currency notes in November 2016.

Financial inclusion progressing at modest speed

Financial inclusion has been one of the primary thrust areas for successive governments in past two decades. Indubitably, the access to basic banking services has improved materially in past one decade. Nonetheless, in absolute terms, the access to basic banking services is much below optimal levels and growing at very modest speed. The rate of improvement in accessibility to banking services has actually declined in past five years as compared to the previous block of five years.

Denominator (Nominal GDP) growing at much slower rate

Rise in election spending

Corruption might be rising again

After declining sharply post 2014 general election, India’s positioning on the Corruption Perception Index, published by Transparency International, has begun to worsen again. Though the methodology used for this Index is questionable, it does give some sense of the situation on the ground.

The sharp rise in corruption perception in past couple of years, could be one of the explanations for rise in the cash in circulation.

Recently, the President of US, Joe Biden, laid out a framework for nearly US$1.75trn in social sector funding. The plan, inter alia, proposes a spending of $400 billion to help provide subsidized childcare for more than 6 million children and tuition-free preschool for 3- and 4-year-olds, along with $555 billion for clean energy initiatives, including $320 billion in tax credits, to help Americans pay for environment friendly home improvements and corporation’s transition to clean-energy manufacturing, over the next 10 years.

The President has proposed to fund this spending through a 15% corporate minimum tax on large corporations, tax on stock buybacks and a surcharge on the top 0.02% of high earners.

However, the proposal to tax the superrich (700 odd billionaires) on their unrealized gains on assets could not be pushed for lack of necessary support. Nonetheless, the proposal has reignited an intense debate, as the opinions are vertically divided on the legality and morality of the proposal.

Those opposing it are arguing that taxing the unrealized gains on stocks etc. would not stand the legal scrutiny as such gains are mostly notional and do not meet the criteria of “taxable income”. Even Democrats like Senator Joe Manchin opposed the proposal on the ground of disparity. He reportedly said, “I don’t like it. I don’t like the connotation that we’re targeting different people.”

Elon Musk, one of the Billionaires who would be most affected by the proposed tax, argued that the proposal could open the door to future tax hikes that would cover a wider range of middle-class Americans with investments. “Exactly. Eventually, they run out of other people’s money and then they come for you”, he reportedly commented on the proposal.

The supporters of the proposal however appear convinced that it is morally and ethically appropriate, that the superrich pay taxes on their entire income and not just the meagre salaries and dividend they draw from their corporations.

Chuck Marr, Director of Federal Tax Policy at the Center for Budget and Policy Priorities thinktank, cited the example of Jeff Bezos, Founder of Amazon.com Inc. Jeff Bezos, reportedly draws a salary of about $80,000 a year from his company, though his Amazon stock holdings increase in value more than $10bn a year. “If Mr Bezos does not sell any of his Amazon shares in a given year, the income tax ignores the $10bn gain, and effectively he is taxed like a middle-class person making $80,000 a year”, Marr tweeted.

In view of the supporters of the proposal, it is not correct to argue that the rise in value of shares is totally notional. The superrich are able to leverage their shareholding to borrow substantial money to grow their wealth even more, giving rise to the already wide and deep inequalities. In that sense, the rise in value of the shareholding is tangible and could be taxed.

As per some estimates of the White House economics team (see here), the top 400 wealthiest families in the US paid federal taxes at an average rate of 8.2 percent; whereas an average American citizen pays federal taxes at an average rate of 14.6 percent. Therefore, apparently, the present tax code is regressive and needs to be reformed.

Though the plan did not find favour with a of majority law makers, there appears to be a strong popular support for such a measure. As per a Vox and Data for Progress poll, ‘71 percent of voters support raising taxes on the wealthiest 2 percent of Americans to pay for the bill. Eighty-six percent of Democrats and 50 percent of Republicans backed the idea. Other tax provisions focused on the wealthy that could be included in the bill — such as tax increases on corporations and capital gains — found 65 percent or more support overall.”

It may be relevant to note in this context that the concept of taxing the unrealized gains on investments is not new to the US tax code. US taxpayers are taxed on their unrealized gains on the investments in Passive Foreign Investment Company (PFIC), e.g., mutual funds, every year. The unrealized gains on employees stock options are also taxed.

Context for India

Like the US administration, the government in India has also embarked on a massive social sector and infrastructure building plan. In the latest Independence Day speech, prime minister Modi had outlined a Rs100trn Pradhan Mantri Gatishakti Bharat Master Plan for integrated infrastructure growth. As part of the comprehensive Covid-19 relief plan, a Rs20trn Self Reliance (AatmNirbhar India) program was also announced last year.

To muster financing for these plans and mitigate their fiscal impact a number of measures have been proposed - aggressive sale of public assets and hike in duty on fuel being the two prominent ones. A committee has also reportedly proposed hike in duty on cigarettes from the next fiscal year.

It was widely anticipated that the government will impose some kind of surcharge on rich in the union budget for the current fiscal FY22 to raise additional resources. However, the government refrained from doing that.

The current status is that the sale of public assets has started to gain some momentum with privatization of Air India and scheduling of LIC public offer. This shall help in keeping the fiscal math balanced. We may not see the interest rates rising materially from the current level. The interest on savings shall also remain low, which essentially means stress for pensioners and small savers.The persistent hike in duties on fuel and cooking gas (except one major cut on Diwali) has also significantly impacted over a billion common people directly, or through a second round inflation impact.

The question now is what would be a better course of action for the Government of India—

Should it consider taxing the superrich Indian billionaires on their wealth and/or unrealized gains? Or

Should it continue taxing over a billion commoners who are already struggling with Stagflationary conditions for the past few years now?

Prima facie, the tax structure in India appears to be progressive as the effective rate of tax on tax payers with taxable income of over Rs10million being substantially higher than the tax payers in lower income groups. Also a large majority of households have been kept out of tax net by keeping the threshold higher. Less than 15million people in India are liable to pay tax on their income. Even out of these 150million, about 100million report an annual income of less than Rs one million, and have an effective tax rate of less than 20%.

Obviously, this debate does not suit the stock markets and equity investors. Nonetheless, the issues are important and need to be discussed objectively and intensively.

Household now largest borrowers

As per the latest data released by the Reserve Bank of India, the share of personal loans in total outstanding bank credit in India has grown to 27%. For the first time, the share of personal credit in the total bank credit is higher than the credit to the industry. In past 12 months, the share of personal credit has increased by 2%, from 25% in September 2020 to 27% in September 2021; whereas the share of industrial credit has declined by 1% from 27% to 26% over the same period. The share of credit to agriculture sector has remained mostly stagnant at around 12%.

(a)   Rising institutionalization of the personal credit due to accelerating financial inclusion and digitalization of financial transactions.

(b)   Decline in share of NBFCs in the personal credit, due to a variety of reasons.

(c)    Deleveraging of balance sheets by large corporate, due to better business conditions (primarily commodities), resolution of debt, slowdown in new capex, and better working capital management.

Personal loans growing at fastest pace

During the 12months period (September 2020 to September 2021) the personal loan category recorded the highest growth.

·         Personal loans grew 12.1% in this period, almost at twice the rate of growth in total bank credit. In the previous 12month period, the growth in personal credit was 9.2%.

·         The credit to industry grew at anemic 2.5%, though better than the previous period growth of 0.4%.

·         The growth in credit to service sector, which suffered most of the brunt of the Covid-19 pandemic induced lockdown, declined sharply to 0.8% from the 9.2% recorded in the previous period.

·         Agriculture sector credit growth remained healthy at 9.9%, as compared to 6.2% in the previous period.

The change in personal loan mix during past 12months clearly indicates towards the impact of pandemic on the household finances. It highlights how the pandemic changed the circumstances, affordability and priorities of the Indian households.

Traditionally, Indian households borrowed to create assets (house, vehicle), build skills (education) or meet emergencies (medical loans). However, in past 12months vehicle, education and housing loans growth witnessed contraction.

The loans for consumer durable witnessed sharp growth. Anecdotal evidence suggests that communication devices (smartphone, laptops etc.) and household appliances may have topped the priorities of the locked up Indian households, as against borrowing for vehicles and higher education.

Institutionalization of farm credit

The total bank credit to the farm sector is about Rs16trln. Out of this, pre-harvest (only farmers) credit is Rs8trln, post-harvest is Rs5trln and agri infrastructure funding is Rs3trln.

Overall, agri credit industry is expected to grow at a CAGR of ~10+% over the next decade, as the government’s focus on materially raising the size of agri economy yields results.

In past two decades the structure of agriculture financing has witnessed remarkable changes. From mere 19% in FY01, the share of direct institutional credit to the agriculture has grown to 43% of the nominal agriculture GDP in FY21.

As per India DataHub study, “Over the past three decades, direct institutional credit (Commercial Banks and Cooperatives) to agriculture has increased more than fifty times – from Rs300bn in 1991 to Rs15,000bn as of 2021. The output from the agriculture sector has increased by less than half of this (23x) during this period. Thus, in both absolute and relative (to output) flow of institutional credit to agriculture has increased massively. Outstanding Institutional credit is now at over 40% of agriculture GDP, more than two times of what it was in the 1990s.”

FinTech gaining ground in credit market

In an industry, traditionally dominated by moneylenders, banks and cooperatives, the online lending applications (FinTech) are fast gaining ground.

As per “A review of India’s Credit Ecosystem”, a report published jointly by Experian Services India (P) Limited and Invest India –

“Fintechs have carved out their own market share by targeting customers who were earlier not eligible to borrow due to lack of credit history and lack of collateral. Improved credit evaluation processes and digitization has allowed new-age players to lend to this segment cost-effectively. This brought a whole new section of customers into the lending industry and this customer segment is far from being saturated as of now. Many financial technology companies and NBFCs have emerged solely to enable lending to the previously unbanked population, creating a niche in the industry.”

Fintechs embarked on their journey by focusing on onboarding ‘credit invisibles’ and the ‘sub-prime’ population, mostly younger generation by leveraging alternative data and advanced analytics. Customizing product portfolio as per customer’s needs and focus on small ticket size loans across the board (personal loans (PL), business loans (BL), consumer durable (CD) etc.) has proven to be game changers in driving their top line growth.”

 The new year of the Goddess of Wealth (Mahalakshami) has started on a rather somber note for the Indian equities. After a very strong year since Diwali of 2020, the markets appear tired and uncertain.

The tailwinds of easy money and lower borrowing cost, which were among the factors that supported strong market performance since Diwali of 2020, appear weakening; whereas the headwinds of inflation, tighter money, and slowing growth appear gaining strength.

The valuation comfort that aided investors’ sentiments last year, is no longer available. The opportunity provided by the panic reaction to the Covid-19 pandemic has been mostly exploited by investors. Most of the low hanging fruits have already been plucked. The risk reward ratio is no longer favorable at the broader levels at least.

The Covid-19 pandemic itself, and the response to the pandemic created numerous opportunities in past one and a half year. The market readily identified these opportunities, and investors positioned themselves well in time to benefit from these opportunities in next few years. There is therefore little element of positive growth surprise in most of these opportunities; to the contrary the chances of negative surprises do exist. Some of the trends where investors are well entrenched could be listed as follows:

·         Acceleration in the process of consolidation of businesses, at the expense of smaller and unorganized enterprises that started a few years ago.

·         Enhanced role of technology in business and household management. The trend is most visible in digitalization of financial services, retail selling of products and services, entertainment & socializing, and education & skill enhancement, etc.

·         Rise in public expenditure to support employment and capacity building.

·         Enhanced policy support for private enterprise for capacity building to achieve the goals of sustainability, self-reliance, employment, higher growth etc.

·         Commodity inflation due to global imbalances in demand-supply equilibrium for many commodities. The inflation could have been resulted due to logistic constraints, underinvestment in capacity enhancement in past one decade, sudden and sharp rise in localized demand due to opening of economies post pandemic caused lockdowns; and speculative positioning aided by cheap and abundant money.

There is little margin for error in the market, as evident from the recent episodes of violent market reactions to marginally below expectation results and adverse policy decisions. Significantly increased jitteriness before most routine market and policy events like scheduled policy meets, declaration of quarterly results and monthly sales numbers etc., is also indicative of the dithering investors’ confidence in the markets.

Multiple downgrades of emerging market equities in general and Indian equities in particular; acceleration in the selling by foreign investors and sharp correction in some bloated pockets of the markets in past three weeks has further added to the nervousness of the investors.

Outlook for the new Diwali year

The market outlook for next 12 months is uncertain. For the next few months, the markets will be guided by the direction of global monetary policy and consequent direction of flows. The expected slowdown in growth due to elevated commodity inflation and exhaustion of policy stimulus may also adversely impact investors’ sentiments. However, there is nothing to indicate a substantial decline in the market or a protracted phase of uncertainty. The sentiments shall improve as the time progresses and investors adjust their return expectations and asset allocations.

It is important to note that the government has very well protected the fiscal position and managed to overcome the external vulnerabilities while managing the pandemic. The twin deficits, which have traditionally bothered the Indian equity markets during the periods of slower growth and global monetary tightening, may not be matter of material concern this time around. Indian equities may therefore not witness any material sell off as the global monetary tightening cycle kicks off.

Having fully recovered from the economic contraction caused by the pandemic, the Indian economy is now faced with the challenges to find new propellers for the economic growth. The policy initiatives to accelerate growth appear promising. Substantial public outlay for infrastructure capacity building and incentives for private investment in new capacities augurs well for a strong new growth cycle which may have already taken root and show accelerated growth in FY23.

Accordingly, my outlook for the Indian equities for next 12 months is as follows.

·         For next few months, the markets may remain volatile and weak. This volatility and weakness may provide good opportunities for restructuring the portfolios and positioning for new growth drivers. Overall, benchmark indices may yield single digit returns for the new Diwali year.

·         Investors might consider moderating their return expectations and altering their asset allocation accordingly. The equity returns of past 18months were exceptions and should be seen as such only. Benchmarking portfolios to these returns and taking avoidable risk is totally unadvisable.

·         Any precipitous rise in bond yields in next few months may be a decent opportunity to increase the debt allocation.

·         While technology remains a key driver of growth, buying anything at any price might not be the best strategy for investors.

·         Real estate appears to be one of the preferred spaces for now. However, sharp rise in domestic rates could suddenly change the sentiment for real estate. The investors need to therefore tread very cautiously in this sector. For smaller investors taking leveraged bets in illiquid asset is not advisable. It is important to note that unlike the previous real estate cycle, this time the investors have an opportunity to invest in good quality real estate through liquid, affordable and dematerialized instruments, viz., REITS.

Trivia

India is a fascinating amalgam of diverse cultures and traditions. Most ethnic communities here follow a lunar calendar. However, there are many which follow a lunar/solar calendar, Some communities also follow a solar year. Accordingly, there are numerous “New Year” days in our country.

The Government of India follows two calendars - Lunar calendar based on Saka Samvat and Solar based Georgian calendar. The new financial year and academic years (mostly) follow  April-March cycle based on Georgian calendar. Most Hindu communities follow a Lunar based calendar based on Vikarm Samvat. The New Year for these communities starts with the first day new moon in Chaitra Month (March/April). Only in Gujarat and Rajasthan, Balipratipada (first day of new moon in Kartik month) is celebrated as New Year.

The fact that the stock markets in India celebrate Balipratipada as New Year, signifies the important role Gujarati and Rajasthani communities have played in the development of financial markets in the country. To some it may also imply the overwhelming influence of these communities on the financial system of the country.

Nonetheless, it is important to note that Vikarm Samvat 2078 actually started om 13 April 2021 for most of India. For the Government of India, the new year (Saka Samvat 1943) started on 22 March 2021.

(One version of this article was published at moneycontrol.com on 4 November 2021)

Stagflation is an economic environment with rapidly rising prices, a weak labor market, and low GDP growth.

The recent corporate commentary throws light on some important economic trends. These trends, which might have been developing for few years, are becoming more established on ground now.

The most discussed trend since demonetization (November 2016) and GST (July 2017) has been the transfer of market share from smaller unorganized businesses to the large organized businesses. Import substitution (Make in India) has been another trend that has gained significant currency in past 4-5 years. This has manifested most prominently in the capacity building in chemical and renewable energy space. These trends have obviously helped the larger publically traded companies to grow bigger and more profitable. The buoyancy in stock market, a representation of these larger companies, is aptly reflecting these trends.

One trend that has escaped the popular narrative and closer scrutiny is selective stagflation in the economy. We may say this is an integral part of the overall ‘K” shaped economic growth. The rising inequality and falling affordability of a larger part of the population has happened with sharp rise in prosperity in the top decile of the society.

The recent corporate commentary hints that this divergence in affordability might have started to impact their performance now.

Mass affordability worsening with rise in premiumization

As per a recent survey conducted by the brokerage firm Nomura Securities the affordability of mass segment has been adversely impacted, leading to slowdown in consumption demand. In the case of automobiles, the survey indicates that festive season sales for two-wheelers and entry segment cars have been slower whereas for premium segment (cars priced >INR 1mn, mostly SUVs) has been significantly strong as higher income segments continue to do well (SUV mix up from ~39% in FY21 to ~55% in Sep-21). The sharp price increase for vehicles since Mar-20 seems to have impacted affordability for the mass market.

In the case of Consumer segment, rural market growth for FMCG (as per Nielsen) has seen a substantial slowdown in Aug/Sep (+2.5% y-y) vs. Jan-Jul (+12.5% y-y). In contrast, urban consumption has held on much better due to the easing of restrictions. Since rural consumption is driven more by mass segments, poor affordability has likely hit the demand. On the other hand, urban consumption should benefit from re-opening-led recovery. In the case of Durables segment as well, while retail sales sustained healthy growth in July, the momentum has slowed substantially from August with likely low single-digit growth in Sept. In electricals, while housing sales have picked up, supported by a cut in stamp duty rates, they are still annualizing close to 2018-19 levels only.

The brokerage concludes that the prices of white goods/appliances have increased by ~10-15% and W&C by ~35% in the past one year. Current commodity prices (Aluminum and Copper) are further up ~20% q-q. Unless commodities/oil cool off, firms will face a difficult choice of raising prices further and risk demand impact or endure margins pressure. The brokerage believes latter is more likely.

…as consumption demand return to pre Covid levels

The brokerage firm India Infoline highlighted in a recent note that “FY22/23 sales for some consumer sectors can be higher than even previous pre-Covid estimates, as unaddressed demand, in addition to the normal demand, is fulfilled. We have seen this play out in paints, and believe that this is now unfolding in jewellery too. Further, this could also materialise, albeit to a lesser extent, in Apparel. While there is no pent-up demand in Grocery, a full normalisation is not built into the consensus estimates We believe that in QSR, though, significant normalisation is already built in.”

The note emphasizes, “Apart from market-share gains from the unorganised segment and

income impact on the target audience being lower than on the overall economy, return of unaddressed demand is a big factor in certain sectors.”

Inflation replaces the pandemic as risk in the Corporate commentary

The ongoing corporate quarterly results reporting season is progressing rather well. Most of the companies that have reported till now appear to have recovered from the Covid-19 pandemic shock. The business leaders appear to have gained market share. Balance sheets have strengthened with deleveraging and/or higher cash. The working capital management has improved sharply across businesses. This may reflect on slightly lower RoE for now. Margins are under pressure, as the companies have not been able to pass on the raw material to the customers.

Employee cost a mixed picture

The sectors like manufacturing and construction have witnessed cut in employee costs, whereas the IT Services etc. have seen rise in employee cost. Read with strong inflationary trends, this clearly indicates that a large section of population may be facing Stagflationary situation.

Rural vs Urban demand

The trends in rural demand growth vs urban demand growth are also mixed. For example, Colgate reported strong rural demand, while Nestle & HUL reported moderation in rural demand.

Market consolidation accelerates

Most market leaders emphasized focus on market share gains at the expense of profitability, while mid and small cap companies emphasized focus on protecting the profitability. Obviously, we are witnessing a shift from small to large in terms of market share.

Covid-19 no longer a key concern

The commentary for future prospects is much better this quarter, as compared to the previous 4-5 quarters. In the last quarter, most companies had highlighted the likely third wave of the pandemic as a key risk. However, in this season, the Covid-19 is not highlighted as a key risk by most of the companies which have reported so far.

Banks’ results have not shown any notable rise in stress on asset quality due to the pandemic; though credit growth remains below par.

Ecommerce and organized distribution channel growing fast

Most consumer facing companies have reported acceleration in growth in ecommerce channel.

Working capital improvement

Most companies are reporting substantial improvement in working capital due to better channel financing, efficient inventory management, internal controls, efficiency in collection, etc. This is reflecting on credit growth, especially short term borrowings from banks.

Highlights of corporate commentary

The following are some of the key results of the consumer facing companies, that are indicative of the underlying economic and industry trends.

Polycab India Limited (Wires, Cables, Home Appliances) – Earnings downgraded

The revenue for the quarter was 48% higher yoy, with cables growing 44%; Appliances growing 41% and EPC revenue was higher by 60% yoy.

Cable business, where the company is market leader, saw increased competitive intensity, as the demand environment was poor. Most of the revenue growth in cables was due to price hikes. Though the price hikes were inadequate to cover for the raw material inflation. Gross margins contracted sharply by 690bps while operating margins were down 510bps. PBT was down 7%.

The company was however able to gain market share across categories. The management emphasized that for now the focus shall remain on market share gain, rather than margin improvement. Accordingly, the management has guided for low double digit EBIDTA (11-13%) margins in the second quarter.

RoE of the company is expected to decline by 200bps in FY22 to 16.5% from 18.5% in FY21, despite marginal improvement in EPS. Working capital improved.

Havells Ltd (Wires, cables, lighting, switches, Appliances) – Earnings downgraded

Revenue grew 31% yoy, driven by (a) strong volume growth due to higher demand from real estate, industrial and infra segments; and (b) higher prices due to sharp rise in raw material cost. EBIDTA margins declined 340bps yoy, due to lag in taking price hikes to pass on the higher raw material cost. Steep cut in advertisement and promotion (A&P) cost helped in checking the sharp decline in margins.

The company reported market share gains from unorganized sector. The management expects the trend to continue. It also expects the margins to improve as price hikes are taken. Working capital improved.

Management buoyant on 2HFY22 prospects; though the rate of growth could be lower due to higher base effect.

Market feedback: Some MSME component supplier to the appliances manufacturers have reported significant order cancellations, delays in payment, and poor inventory levels at smaller and mid-sized OEMs. There are clear indications that the market consolidation trend may continue and accelerate in coming quarters.

Orient Electric (Consumer electronics) – Earnings retained

The company reported 37% yoy rise in revenue and 290bps lower EBIDTA margins. PAT was up 7%.

ECD segment margin were impacted due to steep rise in input costs, however, Lighting segment saw improvement in margins due to high growth in consumer lighting business. Discretionary spends was lower than normal, whereas expenses other than discretionary resumed to normal levels.

The management highlighted Strong recovery in B2C demand; unorganized share will shrink more with change in star rating. OEL will gain market share, backed by its strong team, brand, and distribution (increasing presence in south and rural India).

Working capital has improved due to better channel financing and internal controls.

Colgate-Palmolive (Oral Hygiene) – Earnings downgraded

Colgate reported 5% yoy rise in revenue with 4% rise in volumes. EBIDTA margin declined by 220bps due to higher raw material cost; employee cost and ad spend. The management expects the cost pressures to continue in 2HFY22.

The management apparently stays focused on market share gains rather than margins. Increased promotional intensity and new product innovation is driving volumes with lower realization.

The management does not see any pressure on rural demand, which continues to remain resilient. Market share gains continue, with strong penetration trends.

Nestle (FMCG) – Earnings downgraded

Revenue grew by 10% yoy, whereas EBIDTA grew 6% due to margin contraction of 90bps. Gross margins were down 240bps due to surge in raw material and packaging material prices. Lower employee cost checked the margin decline.

The company reported moderation in rural growth, while the urban growth remained resilient. The management stays focus on volume led sales growth with new sales channels and new capacities coming on stream.

Hindustan Unilever (FMCG) – Earnings downgraded

HUL reported a strong 11% yoy sales growth and 9% EBIDTA growth. Gross margins declined by 140bps, despite 7% price hike across portfolio. Cost savings helped cheking the margin decline, but raw material inflation is expected to continue to keep margins under pressure.

The management highlighted improving trends in urban markets, while the rural demand has moderated. The management feels that the rural demand moderation appears transient, but this could be a risk to growth ahead.

Tata Consumer Products (FMCG) – Earnings retained

Tata Consumer reported a yoy revenue growth of 9% YoY and EBITDA margin contraction of 70bp. The margins compressed mainly due to higher A&P and other expenditure.

Revenue in India Branded Beverages/Foods grew 13%/23% YoY. Revenue from Tata Starbucks grew 128% YoY.

The company managed to reduce its working capital days by 16 days in 1HFY22 as it has moved towards a cash and carry model for the general trade channel.

The company had gained market share in Tea (+190bp YoY) and Salt (+160bp YoY) in FY21. The trend continued in 1HFY22). It doubled its direct reach to 1.1m by Sep’21. The company is establishing a strong S&D channel, which would act as a key growth driver.

Jubilant Foodworks (Food) – Earnings upgraded

The company reported 37% yoy rise in revenue and 33% rise in EBIDTA. Lower staff cost helped in protecting the margins.

Delivery and takeaway continue to drive growth with 36.8% and 72.2% growth respectively vs pre-Covid levels. The Management commented that there was an initial dip in delivery as dine-in started to recover, but it still continues to be meaningfully ahead of pre-Covid levels.

Company highlighted meaningful demand uptick helped it to more than make up for lost operating hours in closed stores. Growth was seen across town classes, with stronger growth in smaller towns and non-metros; stores are now operational at ~95%.

The management highlighted that the Ticket sizes are higher compared to pre-Covid levels and company expects it to remain high due to change in channel mix (delivery mix to remain elevated even as dine-in normalizes) and increase in delivery charge. Apart, the company is also using premiumization and personalization to drive ticket sizes higher.

Kajaria Ceremic (Building material) – Earnings upgrade

The company reported a 36.6% yoy rise in revenue and 25.6% higher EBIDTA. The maker of premium tiles operated at full capacity, as unorganized players in Morbi struggled with higher gas prices and poor export demand due to higher freight cost.

The company managed to pass on the higher raw material and logistic cost; improved working capital materially.

The management commented that Demand from tier II/III/IV towns is very positive and urban demand is good owing to keenness for large premises. The company is expanding tile capacity by 12.4m sq.mtr. by Q4 FY22 at Rs2.5bn-2.75bn capex. Despite the expansion, the headcount will be the same for the next three years.

The management highlighted that Freight costs increased from $1500-2000/container to $7000-8000 for China whereas gas prices increased by 300-400% in Europe in the last 1.5 months leading to €1.5/sq.cm cost increase.

Asian paints (Building materials) – Earnings retained

Asian Paints revenue grew 32.6% yoy. The company witnessed strong growth momentum in both urban and semi urban areas. The company reported strong market share gains from both organized as well unorganized firms. It strongly expanded its ‘Rurban’ footprint by adding 40k new retail points in the past two years.

The management highlighted that Pick-up in industrial activities and housing construction have led to strong double-digit growth in the industrial coatings business and in the bath and kitchen businesses.

Margin pressure (gross margin down 966bp YoY in Q2) was high, due to sharp cost inflation (20% YoY inflation impact on raw material basket). However, if input prices remain stable, APNT is confident of improving margins in the next couple of quarters – It guided for margin normalization by Q4, led by price hikes, efficiency in raw material formulations and overhead cost savings.

The company also reported RoE contraction and working capital improvement.

Titan Company Limited (Consumer discretionary) – Earnings upgraded

Titan reported 64%.6% yoy rise in revenue and 209% rise in EBIDTA. Lower staff cost and other expenses protected the gross margins which were down 690bps.

Jewellery sales grew 65% YoY and margin was up 500bp YoY to 12.2%. Watches sales grew 71.8% YoY to INR6.9b with EBIT margin coming in at 13.1% in 2QFY22 as against -3% in 2QFY21.

The company is witnessing market share gains across every region and city according to the management. TITAN has a strong growth runway, given its market share of less than 10% and the continuing struggles faced by its unorganized and organized peers.