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It is a perfect case of tailwinds turning into headwinds.

We alerted on 15th May, 2018 to exit from equities when Nifty was exactly trading at 10900 (click here to see the alert). Nifty is now at a PE multiple of 26.5 which is at a very high historical level from which it has always come down. High valuations may be justified if there is ample scope for growth, but that also looks difficult as the economy is now facing several headwinds, some of which were tailwinds few years ago.

The key issues are –

  • A Real Crude Shock
  • Weak Rupee
  • Under Investment in Infrastructure
  • Halted Key Reforms
  • Demographic Dividend may turn into Disaster, Ending the India Growth Story

Rising Oil Prices – A Real Crude Shock

Crude above 70 USD per barrel is serious news for Indian economy that relies on imports for nearly 80% of its requirements. In fact India is the third largest oil importer in the world after US and China.

The BJP government had a windfall gain from crashing oil prices in its earlier two years but thereafter the prices are steadily rising and the trend is expected to continue for next few years based on the following concerns –

  1. OPEC and global protectionism: Since mid of 2015, crude is on a rising trajectory due to OPEC supply cuts, geopolitical events, and US sanctions on Iran. Any deterioration in mid east will further aggravate the situation for India.
  2. Regulations from 2020 – Even Greater Threat than OPEC: Forget OPEC and Iran, there is an even greater issue that will keep oil prices in uptrend for 2-3 years according to a report from Morgan Stanley which expects Brent to reach $90 by 2020. By January 2020 new shipping rules would require vessels to consume lower sulfur fuels leading to a boom in demand for middle distillates including diesel and marine gas oil. This in turn will trigger demand for more crude. The US shale will not be able to compensate for this as that is not ideal for producing middle distillates, Morgan Stanley noted. This will keep prices at elevated levels even after 2020.

   

     

Oil is already above USD 70 and coupled with India’s chronic current account deficit problem, the economy is set to face tough times. Apart from causing reduced energy security and high inflation, it will directly affect industries that rely on cheap oil prices, i.e. aviation, transportation, auto, and chemicals.

Weak Rupee

A weak currency increases import costs as well as inflation. It becomes a vicious cycle, rising oil prices cause higher deficit, that cause weak currency, which in turn further increases oil import costs…

Government may be forced to reduce excise duty on diesel and petrol to calm the consumers against rising fuel costs and political concerns. This will surely add burden on Rupee.

Rupee also faces a new threat, India’s external debt, the money that Indians have to repay in foreign currency, has ballooned past half a trillion mark that is a serious concern about the strength of currency. And more than half of that is due for repayment in next one year; that is the bigger cause of worry and will definitely lead to more volatility.  

USDINR crossed above 68 and is near its all time high. Though we have strong forex reserves this time compared to 2013, but the situation is nonetheless alarming.

Under Investment in Infrastructure

The biggest growth phase in the history of US was just after the World War II, fuelled by building its national highway system.

Similar infrastructure investments in high speed railways, power grids, clean water; were instrumental in fuelling economic growth and building of manufacturing/export sectors in post-WWII Japan, and in more recent times, Taiwan, China, and South Korea.

The proven East-Asian growth model is – attract FDI, build infra and manufacture goods using cheap labor, export cost competitive goods to developed countries. India should have worked on war footings to attract FDI, but due to several restrictions in infra sectors and poor land and labor policies, this has failed. Unless these areas are improved, sustainable long term growth will elude India.

Halted Reforms

GST is the biggest success of government’s long term reforms, but two most crucial reforms as mentioned above – land and labor, are still to be done. Land reforms will enable states to purchase land for infra and manufacturing. Labor reforms are needed to relax government controls over downsizing. Without these two reforms, infra and manufacturing can never grow. Even the business friendly environment is still not friendly enough.

Demographic Dividend may turn into Disaster, Ending the India Growth Story

Another tailwind is on its way to turn into a headwind.

It was mentioned on this website in one article that unorganized sector jobs may solve India’s unemployment crisis, but the numbers are making this task daunting and almost impossible.

In fact we are sitting on a volcano that is slowly but steadily building up and we will all be there to see it erupt one day. 

Look at these numbers –

  1. About 80% of India’s 470 million workforce are in unorganized sector
  2. Just 0.41 million jobs were created in 2016-17 against 7 million new workers
  3. India needs to generate about 15 million jobs every year, but only 5 million jobs were created between 2012 and 2016.
  4. About 115 million are unemployed, and this will double in less than ten years.  

This is the reason we see Jat agitation, Maratha agitation, Patels agitation etc. Social unrest leads to political instability, the greatest risk for markets.

 

 

 

Published in Macros
Tuesday, 26 September 2017 15:22

Revival of Indian Economy?

Weakest Performance of last four years :

 

The Indian economy expanded at its weakest since 2014 first quarter. It grew at just 5.7 percent year-on-year in the second quarter of 2017, below 6.1 percent in the previous period. In this article we will look at the current health of economy, which parts of GDP are falling, what is causing it to fall, and when will it be able to recover.

 

Key culprits for recent fall are private consumption and exports.

The GDP fell by 6.4% in first quarter compared to previous quarter and 72% of this fall is due to reduction in private consumption, rest was due to fall in exports.

The strongest driver of GDP in recent years – private consumption (represented by PFCE, Private Final Consumption Expenditure), fell 8.5% in first quarter of 2017-18 compared to previous quarter from Rs 24.36 lakh crores to 22.27 lakh crores. It has the largest proportion in GDP out of the four engines of growth, the other three being government expenditure, investments, and net exports. As a percentage of GDP, private consumption fell to 57.3% in first quarter compared to 58.7% in previous quarter. Though compared to same quarter in last year, the fall was negligible.

Second biggest reason is a drop in exports which fell sharply by 11.3% in first quarter of 2017-18 compared to previous quarter from Rs 7.98 lakh crores to 7.08 lakh crores.

Government spending increased by a massive 30% to Rs 5.19 lakh crores in first quarter of 2017 compared to Rs 3.99 lakh crore in previous quarter. Private investments were modestly higher in this quarter.

Falling GDP since 2014

We described above the reasons for fall in GDP for the first quarter of 2017-18 but if we look at the fall in GDP since 2014, we find that except private consumption, all other three growth drivers – investments, government, and exports, are sharply falling. Consumption has declined only in recent quarter. Investments and government spending were in decline since 2007, and exports started dropping from 2014.

 

Source World Bank - General government final consumption expenditure % of GDP

 

Source World Bank - Gross capital formation as % of GDP

 

Source World Bank - General government final consumption expenditure % of GDP

 

Source World Bank - Exports of goods and services as % of GDP

 

Reasons for declining economy

Consumption:

When the government froze 86% of India’s currency on November 8, it was definitely going to hurt the economy in the short term. Cash accounts for 40% of India’s GDP and 75% of employment. This is still affecting the consumption demand, some sectors have recovered, but some like real estate will remain under pressure for long time. Since a large number of industries like cement, steel, electrical, aluminum, paints, capital goods, etc are strongly based on real estate, the slowdown in real estate will affect labor wages, rural demand, and demand in these connected industries. Government tried to boost demand by sharply increasing the government spending on infra and related sectors, but it was only able to absorb some shock from demonetization and in spite of this front loading of spending, the private consumption fell by 8.5% in first quarter 2017.

Exports:

Exports have been declining since 2013 due to appreciating rupee and restrictive global trade policies. GST has also affected the exports negatively in last two months. Due to GST, working capital of exporters is getting locked up. Before GST, exporters used to get exemption from duties. Now, they have to pay the duty first and then seek a refund, a process that ties up a portion of their working capital with the government and pushes up manufacturing costs.
According to industry estimates, over Rs 1.85 lakh crore of exporters may get stuck with the government due to GST every year. Exporters have to arrange money for inputs, manufacturing and payment of duties and taxes.

Investments:

India’s non-food credit growth has fallen to a 50 years low indicating that private sector is still not increasing its investments. Gross capital formation has been in declining trend since 2008 mainly due to excess capacity and partly due to inability of debt-laden banking sector to fund investments. Banks are saddled with $150 billion of sour debt which has constrained their ability to grant loans, especially to businesses perceived as riskier. Revival in private investments is crucial for growth, job creation and social and political stability.

When to expect a revival in economy?

Demonetization was introduced when all growth engines except consumption were not firing. Demonetization at such a time when growth was already weak caused further acceleration in its decline. But demonetization impact is a one-time phenomena and it does have some crucial long term benefits. It will definitely give push to digitalization of economy, though it had no positive impact on curbing black money. Similarly, GST is causing some serious problems to growth but with time, the hurdles are expected to be removed and it will achieve its intended benefits of tax simplification, less administration, one nation-one market, and wider tax net.

Government spending has already been utilized mostly and one can expect little from this area. Private investments are expected to take 1-2 years before we see any revival, as they already have excess capacity. One immediate positive area is exports which may see a pickup due to a reversal in appreciating rupee. Fed hike chances are rising substantially that would cause rupee to weaken and would help exports.

Consumption and exports were the most affected areas by demonetization and GST, and it is expected that in next 1-2 quarters GST would become streamlined. With exports picking up, liquidity back to normal post demonetization, and GST hopefully streamlined, economy should bottom out in next six months. GST success is now the most important factor.

Published in Macros

There are plenty of problems in Chinese economy but to understand its true state and its longer term future, one has to start with its structural issues as mentioned below.

•    Demographics – growing proportion of aging people
•    Imbalanced growth – roots of social unrest and economic woes

Demographics

China has reached an important turning point this year in its demographics. Falling dependency ratio was one of the root reasons behind success of Chinese economic juggernaut that had been rolling on for about last 50 years. Simply put, it is a ratio of number of dependent people (below age of 15 years or above age of 64 years) to the number of working people (between age of 15 – 64) in a country. Lower ratio means fewer people need support from the working people. So a falling ratio can be a tremendous boost for an economy if accompanied by investments in education and job creation. In fact, historically almost all the major economies have made massive gains when they passed through this golden phase. China also fully capitalized by investing heavily in its economy during this phase. It has a simple logic, falling ratio means there are more young people available to work and less people that they have to support and if there are enough job opportunities, the economy has only one way to go – up.
Since this is a population trend, it can be fairly accurately forecasted. The trend for China is as shown below and it clearly shows that around this time the country’s dependency ratio is at turning point – from good to bad.

So from now onwards, China will face a rising burden of non working and old people. Fewer workers will be available to support them and government’s pension costs will start rising.

Traditionally in China, children, mostly sons, support their parents though it is changing now. Rapid aging also means that China faces 4-2-1 phenomena – each child supporting two parents and four grandparents. This setup is not sustainable and future generations are unlikely to take up this responsibility. It implies creating more social security measures by government.

Government unable to support aging population – may create severe social, political, economic troubles
China set up a pension fund in 2000, but it covers only about 365m and this setup is in deep crisis. The country's unfunded pension liability is roughly 150% of GDP and almost half the other pension funds run by provinces are in losses and some have skipped on payments.
But that is only tip of the iceberg – the main problem is a looming longer term crisis. Between 2010 and 2050 China's workforce will shrink as a share of the population by 11 percentage points, from 72% to 61%—a huge contraction. China's old-age dependency ratio will now escalate from 11 (It is 20 for USA) to nearly four times at 42 by 2050. Most damaging part is that by 2050, the number of older people will have risen by more than 10% whereas the number of working people will have halved.
This will be a paradigm shift – a catastrophe for the world’s manufacturing hub. Workforce will start to dwindle, and coupled with rising labor costs, China will lose its edge.
Though all rich countries are facing rising pension costs but China is at a disadvantage as it is not that economically strong on per capita basis. How Chinese authorities manage this particular issue will to a large extent decide the fate of China.


Imbalanced Growth

Social impact:
Chinese economy has focused more on investments as means of growth and job creation. It succeeded for a long time but there is a limitation to investment opportunities (mentioned earlier also in this article). China’s consumption as a share of GDP has declined steadily over the past decade to 35 percent, while its investment share rose to above 45 percent. No major country has as low a consumption share as that of the China’s and similarly none has as high as that of its.
A slowdown in investment will reduce jobs and it is one of the most feared scenarios for the leaders of world’s largest nation. They need to ensure enough jobs are being made available but their imbalanced economy may not generate more jobs on a sustainable basis from increasing investments any more. Unemployment has toppled many governments and though Chinese authorities are capable of handling social unrest, they may not be able to do it for long. Additionally, people don’t get what they want, the Graduates don’t want to work in factories; they have high ambitions and look for office jobs but most of the jobs are in factories. At present it is not a major problem but growing unavailability of jobs and suitable jobs is going to stir social unrest.
Economic impact – excessive investments in real estate:
China’s rising investment demand has been mainly for infrastructure, which will support long-term economic growth. But a large part of this investment is in residential property. Urban households have piled into property investment because of negative real interest rates on bank deposits, and also due to capital controls that prevent most households from investing abroad.
The real estate boom assumes that house prices will continue to rise and there may be only small price corrections. But when this expectation changes, investment demand in residential property could evaporate. Demand for output of steel, cement, copper, aluminum and many other products is derived from real estate, so if real estate slumps, whole of the economy may enter a long downturn. Excessive investment in real estate is a serious imbalance.
Hurdles in removing imbalances:
Removing imbalance means cutting on manufacturing but there are big banks, exporters and manufacturers who won’t easily let it happen. They are blocking reforms. Some even say that it is an effort by Americans and Europeans to get Chinese to import more goods and consume more. Though the Chinese premier has been trying for rebalancing but the necessary reforms have been blocked by vested interests.
Rebalancing may cause slower growth for a long period but in its absence there may be a larger, more gradual and deep decline. If Chinese leaders don’t act on needed reforms, imbalances may continue to rise. But this cannot go on indefinitely. At some point, the ticking time bomb will explode, and the growth rate will crash.

Published in Investors Blog

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