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.