Vijay Kumar Gaba

Thursday, July 13, 2023

Between (Head)lines

It seems like billions of gallons of water have flown down the Ganga since the first page of a newspaper made some gratifying headlines. It’s mostly the same disappointing narrative every morning. The positive news, if any, comes mostly in the form of government claims, which I find hard to accept on their face value.

Yesterday (Tuesday, 12 July 2023) was apparently one of the usual days. The newspapers were full of disappointing news relating to accidents, crimes, disasters, and platitudes. However, I found five headlines which appeared particularly alarming. These headlines highlight apathy, inconsistency, and incompetence of policymakers. While it may not be a revelation to anyone; what amazes me is the steadfast refusal of a majority of newspaper readers to question the otherwise claims of the government.

As an investor, I find it critical to take note of these headlines, because these underline the risks to the India Story, which is gaining currency again.

Hill states devastated again

The hill states of Uttarakhand and Himachal Pradesh have suffered tremendously from rather frequent episodes of cloud bursts, floods, and landslides etc., in the past one decade. Despite several objections from the environmentalists, local residents, and geology experts the governments have continued with mindless deforestation and construction. The authorities have ignored strong warnings from Mother Nature on multiple occasions. The Kedarnath (2013) Uttarkashi (2019), Vishnu Prayag (2021), Joshimath (2023) flash floods/landslides being the most (in)famous ones.

I have also been frequently highlighting the unsustainability of the development efforts in hill states and apathy, and incompetence of the implementing agencies. (For example see Save the Dev Bhoomi, for God sake and Exploring India )

The destruction of the ecology of Himalayas could have a devastating impact on the Indian economy in the coming decades. The total failure of conducting a comprehensive impact analysis of the infrastructure projects in hill states and even poor execution of the ill-conceived projects highlights the incompetence of respective authorities.

We all need to appreciate that images and videos of these frequent disasters are not like usual Social Media reels. These will soon come to haunt every citizen of this country in the form of water scarcity, unusual hot and cold weathers, and erratic rainfall patterns.

Highways

A school bus, speeding on “wrong side” in “broad daylight” on “Delhi Merrut Expressway'' hit an SUV killing at least six passengers travelling in that car. The school bus was apparently taken off the school duty a while back and deployed to ferry staff of a garment factory; but it was still bearing school color (yellow) and carrying school name on it.

This is yet another episode that highlights the poor highway planning and management; total regard for traffic discipline; criminal apathy towards fellow co-travelers on highways; total lack of training and orientation for highway users and lack of oversight on highways.

I have been frequently highlighting the problems in the highway development program of India for the past many years. For example see This highway - my way and A road trip to Western UP and Uttaranchal and Highways Security and safety

Recently, the government claimed that India has surpassed China to become the second longest highway length in the world. What it did not mention was the sharp rise in the number of fatal accidents on our highways. The issue of poor quality of highways also did not find any mention.

The government also does not acknowledge that over 60k kilometers of highways need a dedicated highway police to ensure safety of travelers and prompt action on repairing needs.

28% GST on gaming

The GST council in its meeting on 11^h July 2023 recommended imposition of 28% GST on full value of online gaming, hors racing and casinos with no distinction between games of skill and chance.

Roland Landers, CEO of All India Gaming Federation (AIGF), termed this decision of the GST Council “unconstitutional, irrational, and egregious”. He said, “the decision ignores over 60 years of settled legal jurisprudence and lumps online gaming with gambling activities".

Without going into the morality issues concerning online gaming, casinos and other forms of betting and gambling, I would like to highlight the inconsistency and arrogance of policy making, especially the taxation policies.

In the past one decade, the government has knowingly allowed numerous gaming startups to flourish. All these startups have been eligible for various startup incentive schemes of the government. The government has also allowed casino licenses. Now when the industry has reached the take off stage, it has made this debilitating policy announcement.

I am not sure about the common narrative of the existential crisis for the industry that may imperil thousands of jobs and millions of dollars of investment. My concerns are two-fold:

1. This sends a strong signal to the global investing community about the tentativeness and volatility of the policy environment in India, discouraging them to invest in India. Remember, it has come at a time when the foreign investors are already witnessing massive write-downs in their investments in entities like Byjus, Pharmeasy etc.

2. The move is prima facie unsustainable legally. It may lead to avoidable litigation that could protract for years, keeping the entire industry on tenterhooks.

To a common man, chips in a casino are bearer instruments like currency notes. These could be converted into currency notes "on demand". Merely converting cash into chips does not constitute buying a "Good" or "Service". Taxing the conversion of cash into casino chips @28% is, as Roland Landers said, “unconstitutional, irrational, and egregious”, liable to be set aside by a court of law.

Corporate governance

The Taiwanese electronic giant Foxconn reportedly called off the joint venture to set up a US$20bn semiconductor fabrication (fab) unit in the state of Gujarat, announced a few months ago. The joint venture was widely hailed as a watershed in the manufacturing history of India. The JV was formed in pursuance of $10 billion government-backed financial incentive scheme (PLI).

Post the announcement of termination of JV, Rajeev Chandrasekhar, minister of state for electronics and information technology, tweeted that it was well-known that both companies had no prior experience or technology and were expected to source fab technology from a technology partner.

Reportedly, Foxconn has separately announced that it will pursue the plan to set up five Fabs in India, on its own or with other partners.

On 7 July 2023, Vedanta Limited had informed the stock exchanges in a filing that “that the Board of Directors at their meeting held today, July 7, 2023, have considered and approved the acquisition of 100% of Vedanta Foxconn Semiconductors Private Limited (“VFSPL”) and Vedanta Displays Limited (“VDL”), wholly owned subsidiaries of Twin Star Technologies Limited (“TSTL”) via share transfer at face value. TSTL is a wholly owned subsidiary of Volcan Investments Limited, the ultimate holding company of Vedanta Limited.”

On 11 July 2023, the stock exchanges sought clarification from Vedanta Limited about the newspaper item titled "Foxconn Withdraws from Rs 1.5 Lakh Crore Vedanta Chip Plan In India". The company had not replied to the BSE communication till evening of 12 July 2023.

This development raises three serious questions:

1. How did the government approve and celebrate the US$20bn proposal of two totally inexperienced players in a highly advanced and mission critical technology project? This raises questions on the entire PLI scheme, which has seen a much below par execution so far.

2. Why did Vedanta not inform stock exchanges and shareholders about termination of plans a week ago?

3. Why Foxconn and Vedanta are not obliged to inform the government and public what led to the termination of their JV? Was it some corporate governance issues at Vedanta or Foxconn?

7^th Cheetah dies at Kuno national park

Not long ago eight Cheetah, imported from Namibia, were introduced in the Kuno national park, Madhya Pradesh, with much fanfare. The event led by the prime minister himself was made into a national celebration, with the entire union cabinet joining in congratulatory messages. Yesterday, seventh of the eight imported Cheetahs has reportedly died. Earlier, four Cheetah imported from Singapore in Gujarat, had also met the same fate. Apparently, nothing was learnt from the past experience.

The point is that the government has been repeatedly using frivolous issues to distract the citizens. Absolutely mundane events like introduction of an animal to a zoo; starting a new train or boat cruise etc., are turned into a massive show of nationalism and celebrated as a massive achievement with no follow up or consequence.

Wednesday, July 12, 2023

Internationalisation of INR - 2

The Reserve Bank of India constituted an Inter Departmental Group (IDG) in December 2021 “To examine issues related to Internationalisation of INR and suggest a way forward”. The Group submitted its recommendations in October 2022; and the same have been made public last week. The following are some of the highlights of the IDG recommendations.

Terms of References

The terms of reference of the IDG were as follows -

· To review the extant framework for use of INR for current and capital account transactions and assess their current levels;

· To review the extant position of use of INR for transactions between non-residents and the role of off-shore markets in this regard;

· To propose measures, consistent with the desirable degree of capital account liberalization, to generate incentives for use of INR for trade and financial transaction invoicing and denomination, official reserves and vehicle currency for foreign exchange intervention after analyzing data obtained from AD Banks on INR invoiced trading;

· To propose measures to bring greater stability in the exchange rate of INR determined by market forces and deep and liquid market with availability of wide range of hedging products, efficient banking system and world class infrastructure with easy accessibility to both residents and non-residents;

· To recommend measures to address concerns, if any, arising of the Internationalisation of INR;

Internationalisation of currency

“An international currency is used and held beyond the borders of the issuing country for transactions between residents and non-residents, and between residents of two countries other than the issuing country. Currency Internationalisation has thus been described as the international extension of a national currency’s basic functions of serving as a unit of account, medium of exchange and store of value. In other words, the internationalization of a currency is an expression of its external credibility as the economy integrates globally.”

Why Internationalisation?

Internationalisation of a currency helps both the government as well as the private sector the issuing currency, by—

· allowing a country’s government to finance part of its budget deficit by issuing domestic currency debt in international markets rather than issuing foreign currency instruments;

· allowing a government to finance part, if not all, of its current account deficit without drawing down its official reserves;

· allowing the country’s exporters and importers to limit exchange rate risk by allowing domestic firms to invoice and settle their exports/imports in their currency, thus shifting exchange rate risk to their foreign counterparts;

· permitting domestic firms and financial institutions to access international financial markets without assuming exchange rate risk;

· offering new profit opportunities to financial institutions, although this benefit may be offset in part by the entry of foreign financial institutions into the domestic financial market (to the extent that the government permits it); and

· reducing the cost of capital and widening the set of financial institutions that are willing and able to provide capital; thus, boosting capital formation in the economy thereby increasing growth and reducing unemployment.

Cost of internationalisation

The internationalisation of a currency does not happen without a cost. Besides resulting in higher volatility in the exchange rates, it usually has monetary policy implications as the obligation of a country to supply its currency to meet the global demand may come in conflict with its domestic monetary policies, popularly known as the Triffin dilemma. Also, the internationalisation of a currency may accentuate an external shock, given the open channel of the flow of funds into and out of the country and from one currency to another.

The costs also emanate from the additional demand for money and also an increase in the volatility of the demand. International currency use can also have an undesirable impact on the financing conditions.

The process of internationalisation

The IDG felt that internationalisation of INR is a process rather than an event. A series of continuous efforts would be needed to achieve the long-term goal of INR internationalisation. There is a need to build upon the small steps already taken.

Many factors play a role in internationalisation of a currency. The prerequisite for internationalisation is however “widespread use of a currency outside the issuer’s borders”. To popularize the international use of a currency, the factors like size of the economy; centrality to global trade; capital account openness, macroeconomic stability, and depth of financial markets, which provide global investors with a safe store of value, etc. are considered important.

The roadmap for internationalisation therefore includes:

· Removal of all restrictions on any entity, domestic or foreign, to buy or sell the country’s currency, whether in the spot or forward market.

· Domestic firms can invoice some, if not all, of their exports in their country’s currency, and foreign firms are likewise able to invoice their exports in that country’s currency, whether to the country itself or to third countries.

· Foreign firms, financial institutions, official institutions and individuals can hold the country’s currency and financial instruments/assets denominated in it, in amounts that they deem useful and prudent.

· Not only are foreign firms and financial institutions able to issue marketable instruments in the local currency, but the issuing country’s resident entities are also able to issue local currency-denominated instruments in foreign markets.

· International financial institutions, such as the World Bank and regional development banks, can issue debt instruments in a country’s market and use its currency in their financial operations.

Internationalisation of the INR and capital account convertibility are processes which are both closely and symbiotically intertwined with each other.

Recommendations of IDG

In view of the IDG over the long term (5yr and above), India will achieve higher level of trade linkages with other countries and improved macro-economic parameters, and INR may ascend to a level where it would be widely used and preferred by other economies as a “vehicle currency”. The IDG recommended that keeping in mind the long run goal of inclusion of INR in IMF’s SDR basket, the following measures should be taken in the short and medium term.

Short term (upto 2yrs) measures

· Designing a template and adopting a standardized approach for examining the proposals on bilateral and multilateral trade arrangements for invoicing, settlement and payment in INR and local currencies.

· Making efforts to enable INR as an additional settlement currency in existing multilateral mechanisms such as ACU.

· Facilitating LCS framework for bilateral transactions in local currencies and operationalising bilateral swap arrangements with the counterpart countries in local currencies.

· Encouraging opening of INR accounts for non-residents (other than nostro accounts of overseas banks) both in India and outside India.

· Integrating Indian payment systems with other countries for cross-border transactions.

· Strengthening financial markets by fostering a global 24x5 INR market and promoting India as the hub for INR transactions and price discovery.

· Facilitating launch of BIS Investment Pools (BISIP) in INR and inclusion of G-Secs in global bond indices.

· Recalibrating the FPI regime and rationalizing/harmonizing the extant Know Your Customer (KYC) guidelines.

· Providing equitable incentives to exporters for INR trade settlement.

Medium-term measures (2 to 5yrs)

· A review of taxes on Masala bonds.

· International use of Real Time Gross Settlement (RTGS) for cross border trade transactions and inclusion of INR as a direct settlement currency in the Continuous Linked Settlement (CLS) system.

· Examination of taxation issues in financial markets to harmonise tax regimes of India and other financial centers.

· Allowing banking services in INR outside India through off-shore branches of Indian banks.

The IDG discussed in detail the steps already taken by the government and RBI to achieve the larger objective. From the recommendations however it appears that the steps already taken are too small. The government needs to accelerate the process to earn the confidence of domestic and international businesses and investors to improve the acceptability of INR over the next five years. The most important step seems to be “decontrol”; something the incumbent government has not been very fond of. The volatility, opacity and subjectivity in the policy making seems to have led to erosion of faith in INR. These are perhaps the factors which prevented IDG from categorically saying that INR could be internationalised in the next 10yr or so.

Also see: Internationalisation of INR - 1

Tuesday, July 11, 2023

Internationalisation of INR - 1

One of the elementary principles of economics is that the price of anything is determined by the equilibrium of demand and supply. Though sometimes, in the short term, a state of inequilibrium may exist leading to higher volatility in prices; the equilibrium is usually restored by operation of a variety of factors. This principle usually applies to all things having an economic value, including currencies, gold and money (capital). The traits of human behavior like "greed", "fear", "complacence", "renunciation", and "aspirations" are usually accounted for as the balancing factors for demand and supply and not considered as determinants of price as such.

However, the case of currencies and capital is slightly complex given currency’s dual role as a medium of exchange and a store of value; and use of money as a policy tool to achieve the objectives of price stability, financial inclusion, poverty alleviation, social justice etc.

As a medium of exchange, price of currency is mostly a function of demand and supply of that currency at any given point in time. Higher supply should normally lead to lower exchange value and vice versa. The demand of the currency as medium of exchange is determined by the factors like relative real rate of return (interest), terms of trade (Trade Balance etc.), and inflation, etc. in the parent jurisdiction.

As a store of value, the price of a currency is, however, materially influenced by the faith of the receiver in the authority issuing such currency. For example, to the transacting parties, promise (since the currency is nothing but a promissory note) of the US Federal Reserve may hold much more value than the promise of, say, the Reserve Bank of Australia; regardless of the fact that the Australia runs a current account surplus, has lower interest rate, a similar inflation profile and a much stronger central bank balance sheet (as compared to the US Federal Reserve) and public debt profile. (1.50AUD=1USD)

Similarly, price of money (Interest rates) is usually a function of demand and supply of the money in the financial system. Demand for money is usually impacted by the factors like level of economic activity and outlook in the foreseeable future; whereas supply of money is mostly a function of risk perception; relative returns and policy objectives.

In Indian context, exchange value of INR, 10yr benchmark yield and crude oil prices evoke much interest. Interestingly most economic growth forecasts appear predicated on these, whereas logically it should be the other way round. Politically also, the USD-INR exchange rate is a popular rhetoric of the politicians on all sides of the Indian political spectrum. Recently, the rise in the international acceptability of INR has become a popular plank of the incumbent government; though there is little evidence of this happening as yet. The politicians refuse to acknowledge that INR depreciation is a normal economic phenomenon, and there is nothing at present that can reverse it.

To further emphasize my point, I may reiterate the following narration from one of my earlier posts.

“In the summer of 2007, I had just moved to the financial capital Mumbai from the political capital Delhi. The mood was as buoyant as it could be. Everyday plane loads of foreign investors and NRIs would alight at Mumbai airport with a bagful of Dollars. They would spend two hours in sweltering heat to reach the then CBD Nariman point (Worli Sea link was not there and BKC was still underdeveloped), and virtually stand in queue to get a deal where they can burn those greenbacks.

Mumbai properties were selling like hot cakes. NRIs from the Middle East, Europe and US were buying properties without even bothering to have a look at them. Bank were hiring jokers for USD 100 to 500k salary for doing nothing. I was of course one of these jokers!

That was the time, when sub-prime crisis has just started to grab headlines. Indian economic cycle started turning down in spring of 2007, with inflation raising its head. RBI had already started tightening. Bubble was already blown and waiting for the pin that would burst it.

INR had appreciated more than 10% vs. USD in the first six months of 2007. However, since January 2008 (INR39=1USD) INR has depreciated over 112% till now (INR82.6=1USD). In the meantime, the Fed has printed USD at an unprecedented rate; and there has been no shortage of supplies of EUR, GBP and JPY either.

The point I am making is that in the present times when the balance sheets of most globally relevant central bankers are running out of space to accommodate additional zeros and their governments are still running fiscal deficits are with impunity to service the mountains of their debts and profligate policies, the value of currency is definitely not a function of demand and supply alone. Regardless of economic theory, it is the faith of people in a particular currency that is the primary determinant of its relative exchange value.

2005-2007 was the time when the Indians had developed good faith in their currency, due to high economic growth. Local people were happy retaining their wealth in INR assets, despite liberal remittance regulations and NRIs were eager to convert a part of their USD holding in INR assets. The situation changed in 2010 onwards. There is no sign of reversal yet. Despite the huge popularity of the incumbent prime minister amongst overseas Indians, we have not seen any material change in remittance patterns in the past six years. Despite tighter regulations, local people appear keen to diversify their INR assets. Most of the USD inflows have come from "professional investors" who invest others' money to earn their salaries and bonuses. These flows are bound to chase the flavor of the day, not necessarily the best investment. Whereas the outflows are mostly personal, or by corporates with material promoters' stakes. Even FDI flows have reportedly slowed down in the past one year.

In my view, no amount of FII/FDI money can strengthen INR if Indians do not have faith in their own currency. Yield and inflation have become secondary considerations.

Recently, the Reserve Bank of India released the “Report of Inter Departmental Group on Internationalisation of INR”. The IDG recommended a pathway to be followed for inclusion of INR in IMF’s SDR basket in the “long run”. Tomorrow, I shall discuss the recommendations of IDG tomorrow, in light of my assumptions.

Friday, July 7, 2023

Some notable research snippets of the week

Monsoon, agriculture, prices (Yes Bank)

The focus for economic agents over the last few weeks was the onset of the SW monsoon, especially as the El Nino risks have been now moved to an “Alert” from “Neutral”. This year, the monsoon had a delayed start as was predicted, and its progress was also initially stalled by the cyclonic conditions that developed over the Arabian Sea. However, monsoons have now covered the whole country. From, a deficit of around 55%-60% in the initial part of June, cumulative rainfall till 3rd July shows a deficit of only 8%. This is good news, but the worry comes from an uneven spread of the monsoon. Southern Peninsula is currently seeing a large deficit of around 43% while the North-West region has a large surplus of 40%. East and North-East India sees a deficit of 16% while the deficit for Central India is 4%. Even as the IMD has predicted a normal monsoon for July, tracking the temporal and spatial progress of the SW monsoon in July and August remains important as these are the most crucial sowing months.

El Nino is forecasted to strengthen over August/September. However, apart from the El Nino, SW monsoons for India critically depends on another weather condition, known as the Indian Ocean Dipole (IOD). Currently, the IOD is neutral, and models predict a positive IOD to develop over the coming months. Only if El Nino is associated with a neutral or negative IOD does precipitation suffer. In the current situation, we are hopeful for a positive IOD developing that can neutralize the negative rainfall impact of El Nino.

As of date, Kharif sowing is 0.4% higher than last year, with rice (-26% YoY), cotton (-14% YoY), jute and mesta (- 12% YoY) and oilseeds (-3.3% YoY) registering a decline. Globally, rice market is facing significant production deficit and lower stocks, putting pressure on prices. Based on fears of lower rice supplies, mandi prices in India has started to rise. In FY23, domestic rice inflation stood at 8% YoY and in September 2022 India had banned exports of broken rice and imposed 20% export duty on non-basmati varieties, except parboiled to keep prices in check. Presently, India has adequate rice buffer stock that gives enough space to the government to intervene and keep prices in check. India has already announced open market sale of rice, even as the quantity is not known. Importantly, the major rice producing states have higher irrigation cover such as Uttar Pradesh, Punjab, Telangana, Tamil Nadu, and Andhra Pradesh.

On the other hand, pulses could be a bigger worry if rains fail as the all-India average area under irrigation is just 23%. In recent months, retail prices of vegetables and pulses have been on the rise. If late onset of rains also leads to late withdrawal of rains, onion crop can also be at risk. Having said, correlation between weak monsoons and food prices is unclear. It is a demand-supply game and food prices remain hugely dependent on global food prices and the ability of the government to draw down on domestic stocks. And domestic stocks of rice seem adequate and comfortably placed vis-a-vis the buffer norms. A recent RBI study indicates that a negative IOD (weak India SW monsoons) is a bigger risk for food prices than El Nino. IOD is currently in the neutral zone, and as indicated earlier, IOD is expected to develop into the positive zone soon.

Overall, we think that Headline CPI inflation will broadly pan out as per the RBI estimates. Our model however indicates a slightly higher average print for Q4FY24 compared to projections made by RBI. In this context and with global central banks remaining hawkish, there appears little chance for any rate cut from the RBI in FY24. The resolve from OPEC+ to keep oil prices at the current levels appear strong. Despite a not-too-robust China story, most commodity price indices appear to be finding a floor.

Crude oil: Hubbert’s peak is here (Goehring & Rozencwajg)

Conventional oil production has now unequivocally rolled over. Unconventional production, the only source of growth in global oil supply over the last 12 years, has also significantly slowed. The only growing non-OPEC basin is the Permian in West Texas. Never before has oil supply growth been so geographically concentrated. Six counties in West Texas are now 100% responsible for all global production growth.

Conventional non-OPEC oil production peaked in 2007 at 46.2 mm b/d and now stands at 44.2 mm b/d – 4% below its peak. Including OPEC, conventional global output peaked in 2016 at 84.5 mm b/d and now stands at 81.3 m b/d – 5% below its peak. Even if OPEC has its alleged 4 mm b/d of unused production capacity (something we do not believe), conventional production would barely regain its 2016 peak.

Non-OPEC oil production between 2006 and 2015 grew by 8.6 mm b/d. Conventional oil supply contracted by 1.4 mm b/d. Unconventional oil supply more than offset these declines, surging by 10 mm b/d and broken down as follows: US shales grew by 6.8 mm b/d (65% of all growth), bio-fuels grew by 1.9 mm b/d (19% of the growth), and Canadian oil sands increased 1.4 mm b/d (14% of the growth). Please note that out of this 10 mm b/d growth figure, the Permian represents only 1.4 mm b/d or 14%.

Between 2016 and 2023, unconventional production surged by another 7.4 mm b/d, representing all non-OPEC supply growth. US shales accounted for 85% of the increase. However, whereas all the major shale basins grew from 2006 to 2015, only the Permian grew afterward. The Bakken and Eagle Ford peaked at 1.5 mm b/d in 2015, and this year are each expected only to be between 900,000 and 1 mm b/d. Significant unconventional growth also came from natural gas liquids production in the liquids-rich Marcellus and Utica, which we estimate each added 1 m b/d. This source of production growth is now set to fade, while the plateauing of the Marcellus will turn into a decline.

Between 2006 and 2015, the Permian represented only 14% of unconventional supply growth. Between 2015 and 2023, the Permian represented almost 75% of this growth.

Conventional production started declining in the non-OPEC world over a decade ago. Conventional oil production has most likely turned negative in the OPEC world as well. Over the last thirty years, global oil supply growth has come from multiple geographic areas, including the North Sea, Mexico, Brazil, West Africa, and the Former Soviet Union. Over the last decade, however, these areas have had slight growth, and specific basins, such as the North Sea, have experienced considerable declines.

Consensus opinion believed global oil demand would peak in 2019 and gradually decline through this decade. Just the opposite has occurred: demand has come roaring back post-COVID. Global demand in 1Q23 surpassed 102 mm barrels per day -- three million barrels above the 1Q19 (pre-COVID) level and almost 2 mm b/d above the International Energy Agency’s (IEA) 1Q23 estimate. Strong demand and faltering supply led OECD countries to release 250 mm barrels of oil from their strategic petroleum reserves to keep prices from surging. Given the seasonality in demand and China’s ongoing reopening, the 4Q23 demand could surpass 104 mm b/d.

From here on out, just six counties in West Texas must meet all global demand growth. Given the strategic importance of the Permian, it’s imperative to understand its underlying health. Using our neural network, we have updated our basin analysis, and the results are shocking. The Permian is likely less than a year from peaking and starting its decline. The only source of non-OPEC supply growth is now primarily tapped out.

After many false starts, Hubbert’s Peak is finally here.

Electronic Manufacturing: India the Next Stop (Morgan Stanley)

Reconfiguration of global supply chains from growing multipolarization is leading to major adjustments in the tech sector. Re & friend-shoring along with India's ongoing structural transformation could see India play a major role in technology-related production, while Apple and its supply chain coming to India would bring in fresh investment. We estimate a 21% CAGR in electronics manufacturing in F22-32.

Global multipolar thematic driving tech supply chain shift: Geopolitical risk, rising costs in China and supply chain diversification has seen a move from Made in China to Made around China (Global Technology: Multipolarization – The New Normal in Tech [1 May 2023]). De-risking in the form of regionalization has gathered pace as China has expanded its move toward localization for higher value-added types of manufacturing. Vietnam has been a key beneficiary but we think India will be next. Apple has made it clear that India will be the destination for fresh new investment, and recent reports have indicated Google and HP aim to boost local production,as they diversify supply chain exposure.

Outlining key implications from this tech manufacturing transition: We look at how a changing perception among multinationals towards India from one of low-cost outsourcing to one of collaboration in advanced technologies, strong supplier ecosystems, and enabling regulatory policies is the necessary path forward to ultimately evolve into a high-tech manufacturing hub. The global tech hardware supply chain is already a growing presence in India, especially in smartphone assembly, e.g., Samsung and Foxconn, though a move up the value chain towards establishing a semiconductor supply chain could take longer to play out given the complexity.

India is uniquely positioned: In our Blue Paper, Why This Is India's Decade, we said India is set to become the world’s third-largest economy and stock market by the end of this decade. One of the key pillars of this transformation is off-shoring driven by transition to a multipolar word. Indian policy makers have taken meaningful steps to boost infrastructure investment, lower corporate tax, improve the ease of doing business and launch production-linked incentive (PLI) schemes with the goal of lifting India’s participation in global supply chains.

India's electronics manufacturing (EM) at an inflexion point: We forecast structural EM growth of 21% CAGR over the next 10 years (F22-32) to US$604bn by F32 driven by: 1) rising disposable income per capita;2) increasing number of households;3) rising urbanization; 4) improving access to electricity;5) easier availability of financing; and 6) the expansion of e-commerce. On the supply side, India has a large, increasing working age population and surplus low-cost labour.

Indian pharma: On a strong footing (ICICI Securities)

Pharma companies under our coverage are likely to report revenue/EBITDA/PAT growth of 15%/33%/28% YoY in Q1FY24E. The growth is likely to be led by new launches, market share expansion in key products and acquisition in US & India. Aggregate gross margin to improve marginally QoQ (+250bps YoY) at 64.8% as higher RM cost and mandated price cut in India may offset the benefit of better margins from niche US launches. However, operating leverage may drive a 90bps QoQ (+300bps YoY) surge in EBITDA margin to 22.4%. Aggregate PAT is expected to surge 28% YoY to Rs86.6bn.

Synopsis of expected quarterly performance: Revenue for coverage universe is likely to grow ~15%/4% YoY/QoQ to Rs641bn in Q1FY24E. Growth is likely to be led by traction across key markets of US and India. Gross margin to expand 250bps YoY (+40bps QoQ) to 64.8% in Q1FY24E. EBITDA is expected to grow 33% YoY (9% QoQ) to Rs144bn, EBITDA margin may improve 300bps YoY (90bp QoQ) to 22.4%. Profit for our coverage universe was up 28% YoY (13% QoQ) to Rs87bn led by improvement in overall operating performance. Alkem, Zydus Lifesciences, Biocon, Glenmark and Dr Reddy’s are likely to grow their profits between 28-115%.

India margins to be under pressure: India business of our coverage companies is expected to grow at ~8% YoY in Q1FY24E to Rs198bn. Better volumes and acquisitions may help companies offset the impact of price cuts on growth, while margins may be under pressure. M&A may elevate the pace of growth in India business of JB Chemicals and Torrent Pharma to 20-24% while Abbott and Ajanta can grow organically at a faster pace of 15-16%. NLEM linked price hike of 12.2% will likely boost domestic growth and profitability Q2FY24 onwards.

Better market share, launches to drive robust performance in US: Aggregate US sales of coverage universe is likely to grow US$2.3bn, up ~6% QoQ and 24% YoY. Lesser price erosion in base business and improved supplies on account of few companies vacating the market may drive sequential growth across all the companies in our coverage universe. Zydus is expected to grow the fastest at 10% QoQ, driven by products like gRevlimid, gTrokendi XR, gChantix and gVascepa. Dr Reddy’s, Zydus, Cipla and Sun are likely to benefit from the launch of gRevlimid, while Aurobindo is expected to launch this product in Oct’23.

Operating leverage to drive improvement in EBITDA: RM cost is expected to remain elevated in Q1FY24E and mandated price cuts in India may further restrict the scope for gross margin expansion. We believe benefit of low-priced inventory may not be seen in Q1FY24 as companies are unlikely to have exhausted their high-priced inventory and full quarter benefit of it will likely be visible from Q2FY24. Better revenue traction in US and India to drive operating leverage and help EBITDA margin soar by 272bps YoY to ~22%. We expect significant recovery in gross and EBITDA margins for companies under our coverage in FY24E. Better traction in US may drive margins for the next couple of quarters beyond which price increase in India and normalization of RM and logistic cost are likely to play a pivotal role in restoring the margin profile.

Key risks: Adverse outcome of USFDA inspections, currency volatility and inclusion of more products under NLEM in India.

India Auto: Volume growth moderates to single-digit (IIFL Securities)

Volume growth across Auto segments came in at low-to-mid single digits in June 2023, confirming our view that FY24 would see sharp deceleration in growth, after the strong cyclical recovery seen in FY22 and FY23. PV industry volumes grew 2% YoY in June. 2W industry volumes grew only 4% YoY and came off 7% MoM, as we entered the seasonally weak period. Tractors grew 6% YoY and 20% MoM in June (seasonal spike). MHCV industry grew 8% YoY; this is an improvement vs recent months. Reversal of pre-buy impact in Jan-Mar (related to BS-VI Phase 2) had led to weak volumes in Apr-May. LCV industry declined 3% YoY, which is a continuation of weak trend in recent months.

Based on these numbers, we believe that risk to FY24 volume projections, if at all, is to the downside.

MHCV industry recovers after “pre-buy reversal” in Apr/May; LCV stays weak: MHCV industry volumes grew 8% YoY in Jun’23. MHCV SAAR, which had collapsed to 340k in Apr/May (due to reversal of pre-buy impact in Mar-2023), normalised to 385k in Jun’23. This is close to our estimate of about 400k volumes in FY24. Ashok and Tata Motors’ MHCV market shares are quite stable, at ~31% and ~47% respectively. LCV industry declined 3% YoY; we see this as a continuation of recent weak trend. We forecast zero growth for LCV in FY24.

PV growth moderates to 2% YoY: We estimate PV industry to have grown 2% YoY in Jun’23. We expect PV volume growth to stay muted in 2QFY24 (Jul-Sep). Maruti’s Jun’23 market share stood at ~41% — lower than May (43%), and is attributable to Maruti’s 1-week production shutdown in June. Tata’s market share stood at ~14% in Jun’23; similar to FY23. M&M’s UV volumes stayed at ~32.6k; volumes are not scaling up, despite high order book (close to 300k).

Tractors grow 6% YoY: Volumes grew 6% YoY in Jun-2023. The 20% MoM jump is seasonal. Sentiment for tractor sales was mixed, as markets with good rainfall saw good momentum, and markets with delayed monsoon saw soft demand. We currently forecast 5% growth for Tractor industry in FY24. If monsoon is impacted due to El Nino effect, there would be downside risk to our estimate.

Domestic 2Ws up 4% YoY; 2W exports see sequential improvement: 2W industry volumes grew ~4% YoY but declined 7% MoM (seasonal). We understand that underlying retails are clocking mid-to-high single-digit growth. Hero continued to underperform the industry with 9% YoY decline in dispatches. Coming to 2W exports, we continue to see YoY decline in volumes (down ~30% YoY). However, on a sequential basis, we saw volumes improve by high single-digit.

Roads: NHAI flags off FY24 awarding in June (nuvama institutional equities)

After a two-month pause, NHAI awarded three projects spanning ~87km in Jun-23 (compared with 303km in Jun-22). During the same period, 262km of roads were also constructed (versus 326km in Jun-22 and 413km in May-23). After Mar-23’s blockbuster awarding, NHAI’s awarding activity came to a grinding halt – no LoAs were issued during the months of Apr-23 and May-23. That said, road awarding in FY23 stood at 6,310km across 179 projects.

Pace of road construction slows down: In Jun-23, the NHAI constructed 262km of roads (compared with 326km in Jun-22; 413km in May-23). YTD FY24 road construction stands at 844km against 863km in the same period last year. In FY23, it constructed ~4,500–4,600km of roads (~4,325km in FY22) at a pace of ~12.5km/day. As per a recent media article, the ministry is looking to increase its road construction target to ~14,000km from 12,500km, at a pace of 38km/day in FY24E (link).

Outlook: A mix of hope and caution: As highlighted in our report Road awards: More speedbumps, While NHAI awarding was disappointing in FY23, higher budgetary outlay for roads provides hope for better awarding going ahead. While commodity prices have softened, high competition remains an issue (with knock-on effect on margins going ahead). RBI’s pause in interest rate hikes, the government’s thrust on roads and the improvement in credit availability from banks are encouraging factors.

Given the backdrop, we argue, road developers must work on segmental diversification since their ability to win adequate road orders at desired margins is now under question.

Specialty Chemicals: One of the worst quarters; A similar to follow (Phillips Capital)

Indian Specialty chemical Industry is all set to face one of the worst quarters in Q1 primarily driven by a broad-based disruption in global chemical demand caused by visible economic slowdown in advanced market of EU/US, ongoing inventory rationalisation and enhanced competition from China post their Covid lock down. Not only the revenue performance, the deteriorating profitability caused by weak spreads as well as negative operating leverage look like a reality. Moreover, the likelihood of the said situation extending into Q2 and early Q3 makes the near-term earnings outlook bleak.

We estimate PC’s Specialty Chemical universe’ is likely to see 33% decline in overall earnings (-21% qoq) as the revenues decline 12% and margins face sequential correction during the quarter.

The key input prices, energy cost, freight cost has certainly moderated sequentially in Q1 but those fail to protect the margin performance of Indian Chemical industry as the final product prices corrected faster led by aggressive Chinese competition and the industry suffered negative operating leverage due to weak demand.

In fact, the average input price for Q1 saw the following trend: - crude price (-29%/-5% yoy/qoq), Benzene (-24%/+5% yoy/qoq), Toluene (-4%/+5% yoy/qoq), Phenol (-10%/+4% yoy/qoq), caprolactum (-18%/+9% yoy/qoq), Indonesian coal (-3%/-13% yoy/qoq), etc.

Thursday, July 6, 2023

Indian banking – state of affairs

The latest credit and deposit statistics highlight some noteworthy trends in the Indian economy. During the first fortnight of June 2023, the credit offtake continued to grow at a healthy pace of 15.4% (yoy); though it slowed down on sequential basis. The deposit growth accelerated to 12.1% (yoy) narrowing the gap between credit-deposit growth to 337bps, the lowest in over a year. The gap recorded a high of 875bps in November 2022. Rise in deposit rates and withdrawal of Rs2000 denomination currency notes primarily led to the rise in deposits.

Credit deposit ratio at pre pandemic levels

The Credit to Deposit ratio has been generally improving since the later part of FY22 due to faster growth in credit compared to deposits. On a sequential basis in June 2023, it improved by 60 bps from the immediate fortnight (reported June 2, 2023, due to lower deposit growth than credit growth. The CD ratio is now closer to the pre-pandemic level of 75.8% in Feb 2020 and 75.7% in March 2020.

Liquidity tightening again

The liquidity in the banking system had shown significant improvement in the month of May due to deposits of Rs2000 currency notes and higher government expenditure, However, as per the latest statistics, the system liquidity had reduced to Rs0.83trn on 16 June 2023, as compared to Rs2.4trn on 02 June 2023. The weighted average call rate (WACR) was thus higher at 6.1% in the fortnight ended 16 June 2023, as compared to 4.5% in the comparable period in the previous year.

Personal and rural credit driving credit growth

The bank credit growth in recent months has been largely driven by personal loans, credit to NBFCs (largely consumer focused) and rural credit. A large part of incremental credit therefore could be unsecured.

In the month of May2023 about 42% of total outstanding bank credit was deployed in personal loans including credit card outstanding, and rural (non-food) loans. Personal loans (up 19.2%) were the fastest growing category in May 2023 (vs May 2022 as well as May 21). Credit card outstanding grew at over 30% (yoy) in May 2023.

Within personal loans unsecured loans grew 24% in May 2023, the fastest for any category. Food credit has been degrowing for almost two years, and now accounts for less than 0.25% of the total outstanding bank credit.

Housing loans (share of 47.3% within personal loans) grew by 14.6% y-o-y in May 2023 compared to 13.6% a year ago. Despite reporting healthy growth, the share of housing loans reduced to 47.3% in the personal loans segment as of May 19, 2023, vs. 49.2% over a year ago as unsecured loans grew at a faster pace.

Loans against gold jewellery also witnessed a strong growth of 22.1% y-o-y vs. a drop of 2.2% in May 2022 due to a sharp increase in gold prices in May 2023 vs May 2022. As the price of gold rises, it gives borrowers an additional opportunity to get more credit from the banks with the same quantity of gold.

Credit to NBFCs growing as faster pace

Lending to NBFCs grew by 27.6% y-o-y in May 2023. It continued to be driven by healthy growth reported by NBFCs for their loan disbursement and a shift of borrowings to the banking system. The Mutual Fund (MF) debt exposure to NBFCs also rose by 15.7% (yoy). The total bank lending to NBFCs has almost grown 3x in the past five years. The sharp rise in the popularity of equity funds in the past 5yrs has resulted in slower growth in the debt fund AUM of mutual funds; leading to the rise in reliance of NBFCs on bank credit. Besides, the international borrowings of NBFCs have also registered material decline in the post pandemic period.

Robust growth in credit to service sector

Service sector credit grew at a robust 21.4% in May 2023. Lending to NBFCs (27.6%) and Trade (17.5%) were the notable contributors in the service sector credit growth.

Industrial credit growing at slower pace

The credit outstanding of the industry segment registered a moderation in growth at 6.0% y-oy in May 2023 from 8.8% in the year-ago period. The outstanding credit to industry accounted for ~24% of the total non-food outstanding. The credit to large industries grew just 3.9% (yoy), while MSME credit grew 12.3%.

The credit to infrastructure segment rose by 1.8% vs. 9.8% over a year ago period due to a slower growth witnessed by the power and road, also a drop in telecommunication and port segments. Overall, slow growth in infrastructure impacted the industry growth. The power segment, which accounts for over half of the infrastructure sector credit, witnesses a marginal growth of 0.3% in May 2023 vs. 9.3% in May 2022.

Asset quality improves NPAs fall to historic lows

Net Non-Performing Assets (NNPAs) of SCBs reduced by 34.0% (yoy) to Rs.1.3trne as of March 31, 2023. The NNPA ratio of SCBs reduced to 0.95% from 1.72% in Q4FY22 which is significantly better than the 2.1% level of FY14.

The GNPA ratio of SCBs reduced to 3.96% as of March 31, 2023, from 6.04% a year ago, and 7.58% as of March 31, 2021.

Accordingly, the provision coverage ratio of scheduled commercial banks (SCBs) improved to 76.3% at the end of March 2023.

For 4QFY23, the credit cost of SCBs stood at 0.58% sharply lower as compared to 1.44% seen in 4QFY21.

(Inputs taken from reports of RBI, SBI, and CARE Ratings. All rights duly acknowledged.)

Chart for the day

Tuesday, July 4, 2023

1H2023 – So far so good!

The first half of the year 2023 has been good for risk assets. Despite strong headwinds in the form of aggressive rate hikes, banking sector turmoil, political & geopolitical events and credit warnings, the stock market made a steady move up with very low volatility. Another notable feature of the global market movement in 1H2023 was the stark underperformance of emerging market equities as compared to the developed markets – even though the development markets appeared to be facing serious growth challenges and financial sector stress. The emerging markets like India demonstrated much stronger economic resilience and price stability.

Equities and Crypto recorded strong gains in the first half of 2023; while commodities (especially energy), USD and bonds lost some ground. The rally in risk assets though lacks belief of investors, as underpinned by high cash levels.

Though at present equity markets appear strong on the back of a resilient demand environment, easing geopolitical conditions, controlled inflationary pressures and peaking interest rates – the uncertainty levels continue to remain elevated. The confidence in the economic growth in the developed world remains low, while valuations seem to be discounting a strong economic recovery. Consequently, the conviction in the present stock price levels is low.

India performance – 1H2023

Indian markets performed reasonably well in the first half of the year 2023. Though Indian equities underperformed the developed markets in line with the global trend, it did very well within the merging market universe. The key highlights of the India market performance could be listed as follows:

· The benchmark Nifty50 gained ~6% during 1H2023; while the Midcap (+13.5%) and Small Cap (+11.4%) did much better. Consequently, overall market breadth has been strong.

· The markets were negative for the first four months of the year. It rallied hard in the last two months (May-June) to recoup the losses and post strong gains. Considering this, the rally in broader markets has been furious but lacked larger participation.

· The total market capitalization of NSE is higher by 5%; much less than the gains in indices – implying that a significant section of the market may have actually lost significant value in the past six months.

· The number sector underperforming the benchmark indices outnumber the sector outperforming. The rally was counterintuitively led by the rate sensitive sectors like Realty and Auto; while energy and PSU banks were notable drags. Consumers (despite visible rural demand stress) and pharma also outperformed. IT Services and financials were other notable underperformers.

· Some Adani Group stocks, and Zee Entertainment etc were notable losers on corporate governance concerns; while some mid and small cap IT stocks were amongst the top performers for the period.

· The Capital Goods and Heavy Engineering sector has been flavor for the period. Particularly, the businesses catering to sectors like defense, railways, and road construction did extremely well.

· Indian equities have sharply underperformed the developed market and some emerging market peers like South Korea. However, it did better than BRICS peers and other emerging markets.

· Institutional flows to the secondary equity markets were positive for the all six months. 1H2023 witnessed a total flow of ~INR1562bn, with FPIs contributing over INR696bn. The correlation of institutional flows with Nifty returns however remained poor (~40%).

· The rates inched higher during 1H2023. Policy rates were higher by 60bps; while money market rates were higher on average by 70-75bps. Deposit rates did not see much change while lending rates were higher by upto 65-70bps.

· The overall Indian yield curve shifted lower; though at the lower end (upto 1yr residual maturity) it lifted sharply higher as RBI continued to withdraw accommodation.

· INR weakened against USD (-4%), EUR (-8.7%) and GBP (-9.1%) while it was marginally higher against JPY (+2.6%).

· The economic growth surprised on the higher side with the Indian economy recording a growth of 6.1% in 4QFY23. Overall for FY23 India’s GDP grew @7.3%, much better than the estimates.

· CPI inflation has inched closer to the lower bound of the RBI’s tolerance band of 4%-6% with May’23 CPI inflation number coming at 4.3%. The core inflation remained sticky at 5.4%.

· Corporate performance has shown resilience in recent quarters, with sales growth recovering and margins bottoming.