Indian debt capital markets require serious overhauling: Priyanka Pradhan

The Silverdale Capital investment analyst on the factors that will keep the Indian economy robust in 2016


Singapore: India is the only significant economy that is growing at a pace faster than the pre-2008 financial crisis levels. It is also less susceptible to the continuing rout in commodity markets.

This, coupled with the fact that inflation is under control, and India’s fiscal deficit is manageable, will keep the economy robust in 2016, said Priyanka Pradhan, an investment analyst at Silverdale Capital Pte Ltd.

Global factors such as China’s painful transition from investment-led to consumption-led growth, expected currency turmoil in West Asia and a recalibration of the commodity-based economies of Russia and Brazil, among others, will continue to make India a relatively attractive investment destination, she added.

Edited excerpts:

How bullish are you on India in 2016?

India has indeed come a long way from 1991, when her foreign exchange reserves fell to less than $1 billion. From being among the Fragile Five in 2013 to having a forex reserve of $350 billion—covering about 10 months of imports—is indeed commendable, especially in the context of an over 10% fall in foreign exchange reserves of China as well as of Saudi Arabia. Today, India is the only significant economy in the world with a growth rate higher than the pre-2008 crisis level; so much so, it has also overtaken China’s growth rate, albeit on a lower base. Also, being a net commodity importer, India is less susceptible to the continuing rout in the commodity markets. While some of the green shoots seen in Q2FY16 have been trampled in Q3FY16, there are still many bright spots in sectors such as pharma, passenger vehicles, and e-commerce. While over-leveraged real estate and infrastructure companies continue to drag, we are seeing a creeping up of utilization rates of capital goods companies. While two consecutive (below-par) monsoons and rationalization of MSP (minimum support price) have taken a toll on rural incomes, we see sporadic signs of an uptick in consumer durables. With inflation under control and a manageable fiscal deficit, the Indian economy continues to be relatively robust. 2016 should end with stability in the US and Europe, which will open up markets for higher Indian exports. In the interim, domestic triggers such as the Seventh Pay Commission, likely rural sops in the budget, multiplier effect of rail-road government capital expenditure should keep India in good stead.

When we look at India from here (Singapore), are we correct in linking the slow recovery to policy inaction by the Narendra Modi government?

The reasons for sub-optimal growth are embedded both in domestic and in external environment. It is true that the rout in commodity sector is led by global factors, and that exports are anaemic due to poor global demand. However, even if we overlook lack of big bang reforms such as GST (goods and services tax) and land bills, the implementation of many headline-grabbing policy announcements leave much to be desired.

For instance, one of the big successes of the Modi government has been the coal (block) auction. However, many of the clarifications on terms of computation of recoverable cost have been provided after the bidding has been completed, making many bids economically unviable. The witch-hunting in case of wrong executive decisions has resulted in files moving across various departments but without any significant decisions. The Modi government has done very well to grab the fall in crude (oil price) to eliminate fuel subsidy as well as to raise revenue, but it has failed to tackle food and fertilizer subsidy, which is a bigger drag on the economy. It is often said the devil is in the detail. Some of the biggest impediments to growth have been a painfully slow judiciary system, less than 5,000 IAS (Indian Administrative Service) officers for a population of 1.2 billion with no provision for the lateral entry of technocrats who understand the intricacies of modern enterprise, lack of limitation to powers of a minister, who is supposed to provide only strategy rather than be involved in implementation, which is the arena of civil servants. The Modi government, as its predecessor governments, has failed to remedy them. As a result, there are frequent policy flip-flops, which, in turn, destroy the growth ecosystem. For us, the distinction between lack of policy decision and external environment provides useful clues for investing in India.

The key talking points are issues such as delay in goods and services tax (GST). But is not a protracted investments slowdown, high non-performing assets (NPAs) more of concern than the GST delay?

At Silverdale, we have always maintained that GST would be a game-changer, but embedded with high set-up costs. Last January, when Malaysia implemented a nationwide GST, the entire economy came to a grinding stop for almost a week. For India, with millions of taxable items and a multitude of languages, it could be worse. Also, implementation of GST would result in closure of a host of small warehouses and namesake factories created to arbitrage the local taxes, which would result in significant labour dislocation. The lack of a freight corridor, refrigeration chains, and warehouses would further impair consolidation of warehouses and factories. Add to this the hurdle of arriving at a consensus for a GST rate agreeable to all. If GST rate is a crazy 20%+, as is being suggested, it would provide a perverse incentive to evade (tax). Also, some of the key high tariff items such as alcohol and petroleum products are being kept out of GST purview, which compromises the entire exercise; add to it 1% non-creditable inter-state tariff which makes GST a lame duck! Anyways, the Modi-government has an extremely short fuse to implement GST as its implementation causes an economic shock for the initial couple of years, making the situation politically unacceptable with general election in 2018.

As regards the issue of high NPAs in the banking sector, it could indeed constrain India’s growth trajectory. NPAs cannot be wished away, especially so because about 53% of NPAs are linked to iron and steel, infrastructure, mining, textile and aviation sectors, none of which have natural mitigating factors. While NPAs would drag the banking sector, especially public sector banks, the pain can be used to induce much-required changes in capital markets. Except for the top couple of PSU (public sector) banks, none of the PSU banks are economically viable. The largest PSU (bank)—State Bank of India—with an asset size of $433 billion is less than 15% of China’s largest bank—Industrial and Commercial Bank of China. The smaller PSU banks are irrelevant from a macro perspective and it is high time they are merged or closed. The stars are perfectly aligned to trigger this consolidation, with the prevalent NPA pain, retirement of almost half of managerial-level employees at PSU banks in the coming 24 months, open architecture banking software, differential banking licences, and deep pockets of global investors—made deeper with the prevailing low international interest rates.

Let me add: in India, about 80% of corporate borrowings are still from banks, while US corporate entities rely on banking sector for only 20% of their borrowings. Indian debt capital markets require serious overhauling.

The issue of lack of private sector interest in capital formation is particularly serious. It has its roots in hyper-growth of GDP (gross domestic product) at circa 9% in FY04-08. This hyper-growth was fuelled by explosive investments in the economy, funded mainly by bank credit, which came to an abrupt halt in 2009 led by the (US) sub-prime crisis. This has resulted in over-leveraged balance-sheet of the private sector, which, in turn, is forcing the private sector to focus on debt-reduction rather than profit maximization through capacity expansion. This, in turn, has resulted in a drastic reduction in investment growth to GDP growth of 0.4x inducing the anaemic GDP growth. Hence, as global investors, we at Silverdale are indeed concerned.

Your take on interest rates and the rupee?

We see a marginal tightening of international interest rates but still a very long way from the long-term average interest rates. In India, we see a marginal scope to cut the interest rates, around 25-50 bps (basis points), but nothing more significant due to inflation concerns and protecting the economy from the gyrations of a US interest rate hike. More than cutting the repo interest rates, the transmission of rates by the banks to lower lending rates will be the real story to watch. That the NPA-laden banking sector is not keen to lend is evident from the fact that banks are a maintaining SLR (statutory liquidity ratio, or investment in government bonds) securities of around 30% against the Reserve Bank of India (RBI) requirement of only 21.5%. The private sector, with its highly leveraged balance-sheet, is also not keen to borrow. As a result, for one of the first times in recent history, the rates of commercial paper have fallen below the bank rates.

As regards INR, we believe it would and should continue its 25 years’ trajectory of 5-6% depreciation per year. At the current level, INR is overvalued on REER (real effective exchange rate) basis against its 36-country basket, rendering Indian exports less competitive globally. As enunciated by RBI, we expect RBI to continue to intervene to avoid perverse appreciation of INR.

Earnings growth has failed to come back so far. How do you see this in this year and next?

2015 has been a year of divergence between economic fundamentals and the corporate sector. The key economic parameters being inflation, fiscal deficit, exchange rate, real growth rate…all have been sanguine while corporate sector performance has been lacklustre to downright poor, be it corporate revenue, profits, debt servicing or tax contribution. As mentioned earlier, quarter four results in calendar year 2015 have been disappointing due to severe global headwinds and a lack of demand pick-up both domestically and globally. Even within the corporate sector, growth has been vastly divergent. Sectors such as real estate and commodities continue to reel under over-leveraged balance-sheets, low demand and soft global prices. Whereas sectors such as specialty chemicals, healthcare and consumer durables continue to post robust numbers. Idiosyncratic factors such as many multi-billion dollar drugs going off patent, increasing GDP per capita, etc., would continue to provide tailwinds in 2016 and beyond. The stabilization of US and European economies in the latter part of the year would provide wings to Indian exports.

Seventh Pay Commission and allied wage increases would put $24.5 billion in the hands of 23.5 million Indians, which would provide a fillip to consumption expenditure. Historically, we have seen pay commission awards result in short-term increase in financial investments and medium-term increase in demand for consumer durables. With top investment choices of Indians—gold and real estate—faring poorly, we would continue to see more investments into financial assets. Already, domestic Indians have poured over $11 billion into mutual funds in CY2015 which is more than the entire investment in the previous 10 years. In the latter part of 2016, we would also witness the trickle-down impact of the massive rail-road governmental capital expenditure.

With macroeconomic parameters under control, especially inflation, exchange rate, and fiscal deficit and further aided by a better global outlook, we expect a higher growth rate in 2017. Of course, sensible government policies, especially as regards domestic subsidy and global investors, can create a positive multiplier effect.

Also, global factors such as the painful China adjustment from investment-led growth to consumption-led growth, the expected currency turmoil in the Middle East, a recalibration of commodity-based economies of Russia and Brazil, etc., would continue to make India a relatively attractive investment destination. We see 2016 as a year which shall be a stock-picker’s delight.

India trades at record valuation premiums to its peer group. Is this sustainable?

The valuation of any market is an indicator of its relative growth prospects. On a stand-alone basis, the current Sensex PE (price-to-earnings multiple) of 15.9x is lower than its long-term average of 16.5x, and significantly lower than the CY2015 high of about 22x. Even if we consider marginally lower growth prospects in 2016, the ratios are not alarming. It is true MSCI India trades at about 80% premium to MSCI Emerging Market Index, which is significantly higher than long-term average premium of about 45%. This is principally because many of the other emerging markets, such as Brazil, Russia and China, are growing at a much lower pace. The sustainability of these premiums will depend on India’s ability to continue to outgrow its peers, relative attractiveness of capital markets versus gold and real estate for domestic investors, and relative attractiveness of India as an investment destination for global investors.