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January 6, 2012

India 2012: What the Economy indicates?
Economic Outlook on India for 2012

by Danish Sayyed

India 2012: What the Economy indicates?

In 2011, India’s Market was characterized by volatility as investor’s sentiment was negatively impacted. The poor Investor’s sentiment was a result of various factors such as an unfavorable economy, rising inflation, monetary tightening (interest rates hikes by the Reserve Bank of India (RBI)), a depreciation of the Rupee, prolonged Government Divestment Programme, a lack of Policy Reforms, and the unresolved European Debt Crisis among others. Declining by almost 24%, the Indian market was one of the worst performers in 2011. Looking ahead into 2012, investors are likely to remain concerned over India’s economic outlook. In this article, we explore some of the issues the India economy is currently facing as well as which of these should garner investor’s concern going forward.

Inflation:

India's annual inflation based on wholesale prices continued to remain at elevated levels, though moderating slightly to 9.11% in November 2011. Inflation has been sticky and has remained elevated for more than two years. November 2011 is the 12th straight month in which annual inflation has been over 9%.

The drop in the Wholesale Prices Index (WPI) from 9.73% in October 2011 to 9.11% in November 2011 is the first sign that slowing growth and a good monsoon are finally reducing inflation in the calendar year 2011. But it doesn’t mean that Inflation will start sliding downwards. A closer look at November 2011 figures narrates the actual picture.

One of the reasons why the WPI in November 2011 moderated to 9.11%was because food prices have fallen after a good harvest. Traditionally, food prices tend to fall in winter due to higher near term supply after summer’s harvest, a seasonality effect. Hence, this seasonality effect on inflation is not likely to be sustainable as is not a result of anti-inflationary policy or monetary action. Meanwhile, inflation on both food and primary articles, which account for a weight of around 20% in the WPI, are the only things falling. They have fallen from 11.4% in October 2011 to 8.53% in November 2011, attributing to almost all the moderation on the WPI. On the other hand, Manufacturing, and Fuel and Light, which constitute 65% and 15% of the WPI by weight respectively, or nearly 80% collectively, are still rising. Inflation on Manufacturing crawled up from 7.66% in October 2011 to 7.7% in November 2011, while inflation on Fuel and Light rose from 14.79% to 15.48% over the same period. In the coming months, they may create all the difference. If the inflation on Manufacturing, and Fuel and Light keep on rising, then we may see higher inflation numbers in near future.

At the same time, with the Rupee depreciating against most other major currencies since July, cost of imports has been trending higher. This leads to cost-push inflation and such additional costs are bound to pass-through to energy prices and manufacturing costs in the coming months. Hence we are of the view that inflation is not yet over even though it has been weakened slightly.

However, both the government and the RBI are taking steps to contain inflation. So far steps taken by government include reducing import duties on various pulses like green moong beans, green peas, yellow peas, toovar whole, kidney beans, etc., and edible oil to zero and banning the exports of certain edible oil and several pulses. In addition, the government has also reduced custom duty on crude oil. The RBI on its part has adopted a tighter monetary policy since March 2010 by raising policy rates by a total of 375 basis points over 13 times to combat inflation.

However, while inflation, which has not fallen below 9% for the past 11 months, is now beginning to show signs of easing. It is mainly due to the base effect and the good kharif harvest. The vegetable prices have started declining subsequent to the good harvest, which has resulted in a substantial easing of the food price index recently. We therefore expect the prices to remain low for the last quarter of this fiscal year.

Nevertheless, there is a scope for further moderation in inflation due to softening impact of primary articles and also due to base effect. Therefore, we expect WPI to trend down, leading near to 7% by March 2012.

Interest Rates:

After increasing Key Policy Rates 13 times since March 2010, RBI has paused hiking interest rates in its recent Mid-Quarterly Review of Monetary Policy, held on December 16, 2011.

The Central Bank has maintained the Repo Rate (rate at which banks borrow from RBI) at 8.50%, and Reverse Repo Rate (rate at which the RBI borrows from banks) at 7.50%. The Central Bank also maintained Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) at 6% and 24% respectively.

The RBI policy in the last two years has been focusing on inflation in the economy in varying degrees. Now, the focus has started to shift to growth, since, as explained by the RBI: “downside risks to growth have clearly increased”. With the Repo Rate and CRR unchanged, the cost of doing business in India continues to remain high.

Going forward, we expect RBI to pause the interest rates hikes for some time and then start cutting rates in the first quarter of FY2013. As the interest rates were raised to tame inflation, RBI may cut the rates only after seeing the definite signs of inflation coming down.

Index of Industrial Production:

India’s Industrial Production (IIP) growth in October 2011 fell for the first time on month-on-month basis since 28 months on the back of falling consumer demand and declining corporate investments. IIP for October 2011 moved to negative territory and came at -5.1%, the lowest reading since March 2009.

The decline was broad-based. Mining and Manufacturing sectors both contracted while Electricity sector moderated. The growth for the Mining, Manufacturing and Electricity sectors was -7.2%, -6.0% and 5.6% respectively. Within Use-based Categories, Capital Goods saw a sharp decline while Intermediate, Basic and Consumer Goods all saw some contraction. The growth for Capital Goods, Intermediate, Basic and Consumer Goods was -25.5%, -4.7%, -0.1% and -0.8% respectively.

A low industrial production number would make achieving GDP growth of 7.5% extremely challenging. We expect IIP to continue to be bashed down due to lower exports as well as high interest rates deferring most new investments.

Gross Domestic Product:

India’s Gross Domestic Product for July-September quarter (Q2) grew at a pace of 6.9% year-on-year, down from the prior quarter's 7.7% expansion. This was the slowest growth in nine quarters.  High inflation combined with global uncertainties was the probable cause for the slowdown. The government has cut its growth forecast for the year to around 7.5%, down from a previous forecast of 9%. However, fall in industrial output has raised doubts about the economy’s ability to meet even this new target.

During the first half of the current fiscal year, the economy grew at 7.3%, which suggests that it would be rather difficult for the government to meet its deficit target for 4.6% for 2011. Economists expect the deficit to cross 5.5% owing to higher borrowing, lower revenue accrual and the increasing burden of subsidies. The government has also admitted that it wouldn’t be able to meet the current fiscal year’s targets for growth, fiscal deficit and disinvestment, and pinned its hopes on the economy bouncing back next year.

However, as the RBI started moving from inflation management to growth management, we expect it to start easing monetary policy somewhere in the first quarter of financial year 2013. In the mid-year analysis of the economy for the fiscal year 2012, we expect growth may possibly slow to 7.25%-7.75% from its budget estimate of 9%.

Fiscal and Current Account Deficit:

India has recently been running large current account and fiscal deficits due to a deadly combination of a high inflation, interest rates, and rupee depreciation, all taking a toll on the fiscal and current account deficits. India aims to pare its fiscal deficit to 4.6% of GDP for the fiscal year 2012, a target that seems increasingly out of reach. With a gap of Rs. 2.8 lakh crores between revenue and expenditure in the first six months of 2011-12, fiscal deficit has already touched 68% of the budget estimate.

A high fiscal deficit has been identified as the biggest concern for India. The central government’s deficit is likely to be higher in FY12 as compared to FY11. This is because last year’s telecom–related revenues will not flow in again this year. The slowdown in growth and dampening of world economic activities has impacted both the direct and indirect tax collections. Slower growth and weak markets may lead to government missing its disinvestment targets.

Also the depreciation in the Rupee has become a major concern, as a weak currency is expected to impact the domestic treasury as India meets 80% of its energy needs with imports. This will increase the bill for energy subsidies. In fact, it has already increased the fuel subsidy by more than Rs. 60,000 crores. The loss borne by the government due to price controls at the domestic level is high, and is likely to exceed Rs. 1,30,000 crores this financial year on selling diesel, kerosene and domestic cooking gas at discounted rates. This huge revenue loss will have a significant impact on the government's fiscal deficit target for the current financial year. The increasing expenditures on account of oil subsidies, fertilizer subsidies and development schemes like National Rural Employment Guarantee Act (NREGA) are making it difficult for the Government to meet its fiscal deficit targets. Taking all things into consideration, the fiscal deficit would be wider than initially projected by 1 to 2% of GDP.

However, with the Government adopting the Fiscal Responsibility & Budget Management Act, the Finance Minister has indicated that the Centre would take harsh steps to contain sovereign debt and fiscal deficit. The government needs high domestic savings to control the fiscal deficit and high foreign savings to control the current account deficit. This means it must attract sufficient foreign money to close the gap. Currently, foreign savings have declined sharply, leading to the depreciation in the value of the Rupee.

Rupee Depreciation:

Rupee (INR) fell to a record low of 54.17 per USD breaking the 54 level for the first time in history. It has fallen by nearly 18% since the start of this year, depreciating sharply since July 2011 even though it stayed range-bound (between 44 to 45 rupee per USD) in the first half of this calendar year. Among the Asian currencies, it has performed the worst.

Global uncertainties (especially Eurozone Crisis, which is so far unresolved) has led foreign investors to turn away from the Indian market leading to a constant foreign capital outflow. This has reduced the demand for the Indian Rupee as compared to other currencies. Also rising concerns about domestic economy, negative growth in industrial output recently, slowing GDP, high inflation, and high borrowing costs have been major reasons for the Rupee’s weakening.  

The RBI and the government have taken certain measures to support the Rupee recently. The RBI sold dollars and bought rupees in last couple of months. The RBI has reduced the net overnight open position, or trading limits, for banks in the foreign exchange market. Secondly, the RBI allowed microfinance institutions to raise up to $10 million during a financial year through external commercial borrowings for permitted end-uses. It also raised the ceiling on interest rates that companies can pay on foreign loans, subject to the funds being brought into the country immediately. By this step, the overseas borrowing by Indian firms has become easy and foreign money may flow in. The government also increased the ceiling on Foreign Institutional Investment in Government and Corporate Debt by $5 billion each. The Government is doing its best in launching some reforms in various sectors to boost the economy. 100% FDI in Single-Brand Retail Stores is one among them. The government hopes the provision of full ownership in single-brand retail will bring in much-needed foreign investment. By all these steps taken by RBI and Government, Rupee appreciated slightly against the Dollar.

At the end of the day, sentiment on the Rupee is subjected to various external factors and the RBI has very limited control on it. The major domestic issues, slowdown in growth, widening fiscal deficit may be seen further due to which Rupee is expected to continue weak in near future.

Outlook:

We discussed some of the big issues faced by the Indian Economy in the calendar year 2011. Looking at overall economic scenario, we would like to advise Investors to be cautious and careful before investing in any of the asset classes in 2012. In the short term, equity market is likely to be more volatile whereas debt looks more attractive. However on long term, we are bullish on equity as valuations are attractive and investing for 3-5 years now will be very beneficial.
With the next movement in interest rates likely to be down, we favor Longer dated bonds as this bond sector should benefit more than the shorter dated one due to their higher duration. Investors can also consider Dynamic bond funds and Income Funds as the managers of such funds have more flexibility in managing duration. Nevertheless, we would like to advise investors:

  • For investment horizon of less than 1 year, Short and Medium Term Funds are looking attractive as they will offer better risk adjusted returns once interest rates start coming down. Currently the Yield Curve is slightly inverted and as liquidity improves in the system and central bank takes accommodative monetary policy, the yield on shorter maturity paper will decline which will give capital appreciation to the short and medium term debt funds.

  • For investment horizon of more than 1 year, Dynamic Bond funds are more attractive as they may deliver better risk adjusted returns given their flexible mandate. They have the flexibility to invest across money market, gilts and also corporate bonds. Apart from the flexibility of changing allocations within the debt categories, the dynamic bond funds also have the mandate of aggressively altering the portfolio duration in response to the evolving market dynamics.

  • We are positive on long term Debt funds like Income Funds and Gilt Funds as we expect that the fall in interest rates will benefit longer maturity funds more. These categories are likely to get more capital appreciation in falling interest rate scenario. Hence we recommend investors to stay invested in long term debt funds even though there will be short term volatility in these funds.

  • For investment horizon of more than 3 years, equity mutual funds are definitely good options to invest. As markets are volatile, investing regularly in equity mutual funds through SIPs is the best way to create wealth over the long term.


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