All across..

In the last few weeks, I have been thinking about the e-commerce space and the impact on the economy. India for instance has developed in the last half-decade a US$3+ bn e-commerce market (excluding travel). This has replaced the typical brick and mortar retailing which means retailing space worth an equivalent amount has been taken out of business (assuming 10% rental cost and 10% cap rate). This has spawned a another industry on the other side of warehousing and logistics which may be taking almost an equivalent proportion of e-commerce cost but delivering customer through an alternate, more convenient, channel. Whether this has made the economy more productive is an altogether different question but it has surely reduced cost to the consumer which at least yet seems to be been paid for by VC firms and the vendors.

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This gets me the next aspect of how the current expected recovery in savings (despite reduced cost of ecommerce purchase which is very small) and form of savings will impact the Indian economy. The economic identity to remember in these discussions in savings (imported or domestic) is equal to investments. In the past decade while we saved at 30%+ rates our capital formation levels have been 200-400bps higher which meant we needed to import savings, a large part of this came through portfolio investments and NRI deposits both susceptible to short term movements. The last year Indian savings has dropped to below 30% levels to ~27%. Savings levels have been severely impacted by the incessantly high inflation levels in the last few years. This should recover as inflation comes off with a decline in food inflation.

But the bigger question is as the new government comes in in May 2014 and tries to push the overall growth levels in the economy for which recovery of investments is critical, Indian savings is woefully short. This will require a massive concerted effort to attract and manage foreign capital as the gap between investments and savings will become much wider in the initial timeframe. And, channelling of foreign capital into the infrastructure sector will enhance the long-term trend growth of the economy. The other aspect is that a large part of the savings in the last few years has gone towards real estate. This should change as real interest rate recovers providing more productive usage of capital.

While household savings have declined, income inequality levels have also risen. The rich do not consume the same in proportion to their income is a fairly well-known fact which means continued pressure on overall demand.

We will continue to have bright sparks in the economy (even Spain has its Zara clothing brand) but the macro needs some able management. In a savings glut world with easy money, problem of under-investment is relatively easy to solve than over-investment in case of China.

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It is almost that the centre part of Eurasian landmass has come to political life all at once…

Russia has annexed Crimea whether the west likes it or not and little it can do about it. NATO is a non-functional organization which leaves US alone to respond. US given its weariness of the last 15 years is finding it difficult to get its bearings but it has no choice but to build a new containment strategy for Russia before we see further capitulations across eastern Europe or Balkans.

Turkey continues to convulse under the factionalism in the Erdogan’s grand coalition with the Gulen movement turning away and multiple scandals breaking out. In the end, Turkey’s elections are about finally controlling the key city of Istanbul which is the economic life-blood (40-45% of Turkish economy).

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Finally, the BJP in continues to be among the favourite to win the election with >220 seats but not by itself (or its pre-election alliance) have enough seats to govern India. While this trend has held for the last few months parties which have been in power with the Congress in the last 2 governments are finding this prospect increasingly difficult and given their support base they will be unable to participate in the next government. This is resulting in the Congress and these parties making more and more acidic attacks (i.e. chop Modi etc). Second, UP and TN seems like the most likely states which will make the difference between a 220 and 240 BJP position. And, politics at the center can be very different based on the distance from the 272 mark. If the BJP misses the 220 mark by a margin then be prepared for a massive dent in investment sentiment.

This one said by Lincoln may sound familiar to Modi governance style, “I do the very best I know how, the very best I can, and I mean to keep doing so until the end. If the end brings me out all right, what is said against me won’t amount to nothing. If the end brings me out wrong, ten angels swearing I was right would make no difference.” So be prepared for the new style..no remorse no recourse..

Cycles are reality

The Indian economy has gone through a full cycle – the bust of the late 1990s, the benign period of early 2000s, the roaring period from 2005-2008, the near bust of 2008 which was rescued by global and local counter-cyclical measures and now the demand destruction of led by inflation of 2012 – 2014. This demand destruction has been led by the inflation bitten urban markets which resulted in high interest rates and slowdown in government tax buoyancy which in turn has resulted in government reducing the rural spends – MSP, volume of purchase and M-NAREGA. With urban demand already down and rural demand slowing in the next couple of years but is the counter balancers in place to address this situation.

There are potentially 4 areas due to which India is likely to see a revival in the economic cycle:

•  Inflation, interest rates and investments – The lower MSP hikes (5.5% in FY14 vs CAGR of ~16% in 2008 – 2013) and rural spend will bring down the food component of inflation, which has the largest share in the CPI basket of ~40%, within a year or so. This reduction in inflation should result in a less than proportionate reduction in interest rates (given RBI’s clear stance on achieving positive interest rates) but a reduction nonetheless. The likely clearance of many delayed projects, replacement capex cycle and lower interest rates should revive the investment cycle within 15-18 months. Further, we have an unprecedented situation of almost no new project announcements in the last 6 months which is unlikely to sustain.
• Recovery in financial saving – The financial saving in the economy have declined to an all-time low with real assets like gold / real estate accounting for at least 70%. With the re-emergence of real interest rates, we will see an increase in investments in equity, bonds and bank deposits. This will allow for greater credit creation and risk capital to corporates.
• Reduction in external vulnerability – Current Account Deficit has come off massively over the last year. For the April-December period it was 2.3% of the GDP, down from 5.2% the same period earlier. This has significantly reduced the pressure on interest rates and the exchange rate. A large part of the reduction has been achieved by duties on gold loans. However, our significant dependence of FII flows, ~$40bn NRI deposits mobilized over the last year at very high interest rates and potential depreciation of the Chinese yuan will continue to maintain pressure on rupee and interest rates.
• Oil prices – Oil prices have been fairly stable over the last couple of years. It is surprising that they have not declined but given the likely reduction in the Chinese GDP growth and also the fuel propensity (better technology and environment consciousness) over the next few years we should expect to see oil prices continuing to remain benign.

While these factors would positively influence the Indian economic cycle, this will also coincide with the initial period of the new government. Unless we have a broken mandate, we should see decisions which would further aid this revival.

As we see the revival of the economy, the heady past and excessive leverage built both at the government and the corporate level needs to be unwound. The Reserve Bank needs to nudge the public sector banks to adopt an aggressive posture towards the NPA’s in the system – this capital needs to be released for productive usage – otherwise we will have a zombie banking system unable to support growth (PSU banks have ~75% market share).

The key economic risk remains a Chinese devaluation. The Chinese economy has grown since the financial crises through a massive expansion in leverage to its infrastructure and real estate markets. This engine no longer has wings and has the potential of triggering banking sector crises if pushed further, maybe already. The likely fall-back massive purging of excessive capacity and reduction in state government leverage through central government recaps or devaluation. The former is deflationary and can potential create political risks. We have seen a trailer recently of the devaluation possibility which caught all market participants off-guard. A Chinese devaluation will trigger an Indian currency devaluation and potential capital flight.

Having said this, India today looks almost like a ‘saint’ in the face of events in Turkey, Argentina, Russia and the commodity intensive nature of Brazil and South Africa.

Indian Prime Minister with a ‘Russian’ Cerebrum

The Russians control 11.5% of global landmass with the ninth largest population in the world. It has borders with over 16 independent countries including US, Japan and China. It has limited natural boundaries protecting the Russian core (Moscow region) except buffer states like Ukraine  or ‘caucus’ countries like Georgia or buffer regions like Siberia. Given the diverse population in such far flung areas, it manages to keep relative calm. It is fundamentally an ‘unstable’ kept in some form of stability by strategy including coercive force of energy or military. It would take great skill and heft to manage such a situation. It is a country prone to expansion as it seeks ‘geopolitical stability’ and then recoils in itself.

Viswanathan Anand was quoted saying, “The Soviets included a chessboard along with the bride's wedding trousseau to ensure that the children knew the rules of the game. For the Soviets, chess was in their DNA” and he was so intimidated by the chess prowess in the country that that he thought he could be “checkmated by every cab driver.” This is a result of nothing but their national psyche.

As I have written in my earlier articles, India’s abundance of agrarian produce, benign weather conditions, protection of the subcontinent by the mountain ranges in the north and the sea in the south have all given the country a sense of ‘protective camouflage’ until it is pried open as by the Mughals and then by the British. It is not my contention that a similar thing will happen but more to give a sense of history.

The last decade has seen a significant shift in status quo in our neighbourhood:

• Chinese economic growth, infrastructure and defence build-up;
• Disruption of the Afghan-Pakistan theatre and the convulsion likely post the American exit in 2014;
• Decline in relationships with Nepal, Bangladesh, Sri Lanka and Maldives;
• Then, the changes in the Middle-East driven by the underlying conflict between the Saudis and the Persians (manifesting in Syria, Iraq).

We have not only failed to manage this change, we have also let down our guard both in terms of economic strength and defense management. Our economic growth rate is now running sub-5% with a very weak banking system. Recent news reports of our defense preparedness, hardware procurement and border infra-management also point in the southerly direction.

The political capital of the state has been spent on managing the internal dynamics which broke down as the schisms with the state and regional parties increased and with it expanded the cost of political management. Unlike Russia which gives rise to dictators, managing India’s diversity requires a democratic set-up with credible institutions but what it dearly needs is the art of strategic management.

India's geography creates the sense of 'self-containment' leads it to exist with itself but we are no longer in 1,000 BC, we are part of the global economic system and technological advances have reduced the physical space in both the economic and militarily dimension..

One day everything will be well, that is our hope. Everything's fine today, that is our illusion” ― Voltaire