Indian economy facing speed bumps on road to growth

From PWM Asia / Country profiles 19 July 2012

Esty Dwek

HSBC Private Bank

By Tanya Ashreena

Internal issues such as persistently high levels of inflation and political logjams are combining with external factors such as the eurozone crisis to leave many with a relatively downbeat view of the Indian economy. But there is value to be found in some of the country’s stronger companies and the long-term outlook remains healthy

An English banker lands at the airport in Mumbai, where he is picked up by a driver.

"First time in India?" the taxi driver asks, amused at the startled expression on the man's face as he gazes through the window to see cycle-rickshaws and a stray dog passing by, amidst the construction boom throughout the city.

"I'm not from around here," he replies, rather surprised as a red convertible zooms past. "And you've always lived here?"

"Born here," the driver says, passing multi-storey blocks with rooftop swimming pools. "Back then this was all a barren land."

"You're a lucky man. Think you'll ever leave?" asks the visitor, alluding to the developing world’s dream of migrating to the West.

"Why?" the driver asks. "Everyone is here."

At HSBC we expect a bank to know when a market has emerged, rolls the end credit of the advertisement.

This advert clearly reflects HSBC's admirable, long-term strategic aim of being a banking leader in India for many years to come. But currently, wealth and asset managers, including HSBC's private banking division, are going underweight India in response to a wide set of pressures on the economyThe bank holds a relatively downbeat outlook on the Indian economy in the short-term, as growth continues to slow, with a wide current account deficit and high inflation preventing the Reserve Bank of India from acting more forcefully to support growth.

“External demand is weak because of the global slowdown and the eurozone crisis and this is impacting the export sector,” says Esty Dwek, global investment strategist at HSBC Private Bank.

Many private banks have scaled down investments in India, in the wake of political logjam and policy paralysis during 2011, as a result of widespread protests against corruption. Though the populist movement led by Anna Hazare may have long died down and been forgotten about, there have been several political roadblocks to economic policymaking.

Last year’s much awaited pro-liberalisation move to open up foreign direct investment in the country’s $450bn retail sector was aimed at allowing foreign multi-brand retailers, such as Tesco and Carrefour, to own stakes as high as 51 per cent in Indian joint ventures and also raised the cap on foreign direct investment in single-brand retail from 51 per cent to 100 per cent.

CAPITAL FLIGHT

Although the bill was expected to tame India’s persistently high inflation and boost investment, protests from the opposition and a key member of the ruling coalition led the government to roll back the decision. This is by no means the first instance of political interests severely limiting the opening up of key sectors. Problems relating to bureaucracy and red-tape further prevent the country from attracting much-needed foreign investment.

Such uncertainty is causing capital flight from India. The country’s rate of GDP growth declined to 5.3 per cent last quarter, from 6.5 per cent a year earlier, while the trade deficit widened to a record $184.9bn in the fiscal year ending in March. This period has showed the slowest pace of growth in nine years.

“India has twin deficits which it is not addressing as it keeps government subsidies, in particular for food and oil prices, in place, weighing on government finances,” says HSBC’s Ms Dwek. “Lack of policymaker action to reduce supply-side pressure and improve the fiscal picture has led to a loss of confidence in India, and as a result to foreign direct investment outflows and an underperformance of Indian assets.”

The flight of foreign investors is causing the rupee to depreciate. It has fallen over 17 per cent against the dollar since the start of February, though signs of recovery are present.

With inflation high and sticky, the central bank has been unable to support growth. Inflation has been a problem since the start of the year, with high oil prices, rising food prices and rupee weakness.

“We have to work to reduce inflation and once that happens, the cyclical slowdown will recover to pull back towards structural growth rates,” says Sankaran Naren, chief investment officer for equities at ICICI Prudential Asset Management, India’s third biggest money manager.

He attributes the slowdown to rising crude oil prices in 2007 to 2008 and then again from 2009 to 2011. “In these phases, when crude oil prices went up, the Indian government did not pass on the fuel hike to the people and that led to a huge subsidy on the fiscal side and also increased the current account deficit because India had much lower prices than anywhere else in the world barring the US and a few countries of the Middle East,” comments Mr Naren.

FUEL PRICE HIKES

The situation, where energy prices were not passed on to consumers, brought problems to the Indian economy, including the current account deficit and inflation. Mr Naren sees two solutions: one is through crude oil coming down to $80 a barrel and the other through an increase in fuel prices in India.

“Though they have increased the petrol prices, they’ve not increased the diesel prices,” he says. “Our belief is that energy reforms are the heart of the problems in India and if we are able to tackle the energy reforms in India, the cyclical slowdown phase will stop within a few quarters of energy reforms being implemented.”

His view is shared by Prabhat Awasthi, managing director and head of India research at Nomura. “At some point we need a fuel price hike. Fuel prices are pending in non-controlled commodities such as diesel and kerosene,” he says.

There are several external risks to investing in India. If no concrete measures are taken to address the moderating economic growth and expanding fiscal and current account deficit, then India might face the risk of a rating downgrade, classifying its debt as non investment grade. “We feel that the recent outlook downgrade by rating agencies, namely Standard & Poor’s and Fitch, is a clear indication for that which is acknowledged by the federal government as well,” says Robert Aspin, senior investment strategist at Standard Chartered Bank, who is currently neutral on Indian equities. He says a concerted effort by the government is required to alleviate the bottleneck in economic development by clearing the pending reform bills, removing tax uncertainties and create a benign investment climate.

“A large part of the rupee moves is because of global risk aversion. India is a capital dependent country and needs foreign capital. If the eurozone crisis worsens, the rupee will weaken,” says Mr Awasthi.

In the longer-term, he awaits policy changes in the 2014 elections. “Policy needs to be managed more towards growth than populism. If Indian heads towards populism, it will cause much more damage than it has in the past, because we’ve slowed down quite a bit.”

Overall, the impairment in India’s economic growth is short-term, feels Deepak Lalwani of Lalcap, a London-based investment consultancy specialising in India. He sees lack of consensus among coalition partners for reforms, inadequate education and skill, poor infrastructure and the lack of a developed bond market to help finance infrastructure growth as the “speed bumps” towards returning the journey back to 9 per cent growth.

Nevertheless, Mr Lalwani feels the recent proposal by the Indian government to introduce a $2.9bn retrospective tax on Vodafone on its 2007 takeover of Hutchison Whampoa’s Indian unit will hamper foreign investment into India. “The recent proposals on retrospective tax and the “Vodafone case” has damaged foreign sentiment and limited their appetite for what was once a very attractive investment destination.”

STOCK SELECTION

Against this changeable economic backdrop, there is still some optimism in the outlook for equity and bond markets during the next 12 months, with appetite remaining for selective investments.

Despite setbacks, ICICI’s Mr Naren remains bullish on the telecom sector in the long-term, stating the digital revolution is yet to start in India, although it has taken place in the rest of the world. The recent policy logjam has led to a sharp fall in stock prices of all companies across the telecom industry, so this may prove a buying opportunity.

“Telecoms should be a growth sector for India because we have favourable demographics in which the number of people in the age group of 15 to 18 will increase. India also has one of the lowest telecom tariffs in the world,” he says.

He is also positive on the infrastructure sector, citing the relative inactivity on that front, along with healthcare, technology and industries because of the depreciating currency.

“We believe there are many small and midcap stocks where the valuations are reasonable and outlook on growth looks pretty good and we have a lot of deals to capture these small and midcap companies in the market,” he says.

FLIGHT TO QUALITY

But during the current uncertain times, it would be prudent to invest in large capitalised stocks with matured businesses and a strong record of accomplishment with experience of weathering troubled waters in the past, believes Standard Chartered’s Mr Aspin. “We thus prefer high quality blue chip names, which is also true for most other markets,” he says.

Standard Chartered is overweight on the materials sector, which is to benefit from the government’s focus towards infrastructure. The bank continues to recommend healthcare, but less so than in the past due to impending regulatory action on drug pricing being a near-term concern.

“We are less favourable to staples because of valuations and financials due to expected moderation in GDP growth, which is expected to weigh on asset quality and credit growth,” Mr Aspin says.

ECONOMIC PROSPECTS

“India is known for [moving] three steps forward and two backwards, but should not be written off in the middle of the two steps back,” says Deepak Lalwani of investment consultancy Lalcap.

There are strong drivers to achieving India’s economic potential, including a mature democracy, an established institutional framework, demographics, an entrepreneurial spirit, a growing, educated middle class and a judicial system which, although very slow, has also passed judgements in favour of foreign investors.

“What we see different in the Indian economy is that there isn’t any credit bubble or excessive leverage,” says Sankaran Naren at ICICI Prudential. “If you look at the Indian debt to GDP ratio or Indian banking debt to GDP ratio and corporate debt to debt ratio, all these numbers are very low. So luckily, unlike other parts of the world, we don’t have a credit bubble, but a cyclical slowdown.”

The potential is undeniable, says Nomura’s head of Indian research, Prabhat Awasthi, stating investors need to look at Indian households, which had greater savings last year, as well as the corporates. “Indian corporates are larger in size, more competitive globally and just require favourable policies to invest the money needed.”

As weak global risk appetite has been one of the main drivers of poor Indian equity performance, HSBC’s Ms Dwek says that renewed investor confidence should help boost stocks. “In addition, if much-needed long-term structural reforms are implemented, we believe this would start to restore confidence in the Indian market and support assets. This would also then be reflected in the appreciation of the rupee.”