An update on B, R, C and India

About a couple of months ago, I wrote how wrong the consensus is on where within the BRIC universe lies the best potential for change driven by lowering of economic risk premium, and I hope it is not too early for me to declare that markets have delivered as per expectations. The commodity focused markets along with China have and are continuing to see a torrid time. While there is still the feeling that the current market moves are just technical, it is clear that the back of commodity market speculation (including commodity EM) is broken; in fact the whole "QE-driving-prices-buy-commodities-gold" theme looks to be unravelling rapidly even as Japan has announced a fairly open ended (and in some sense a much more aggressive than the US) QE program (joined by renewed easy monetary policy in Europe). In fact there is a severe lack of inflation in developed markets (it's the developing world that is plagued by it). The only thing to tweak is the view on China, which has come out with economic data that is worse than expected and bodes ill for the future - it is mind-boggling to see credit creation at that scale delivering a GDP figure so underwhelming. Combine that with the fact that house price rises in China are not letting up. However, things may not go topsy turvy there yet, though when they do, we are in for a rough ride globally.

It is quite evident that nearly all strategists and market gurus, whatever organisation they belong to, have been caught wrong footed recommending to clients where in the BRICs should they put their capital. We expect future events to prove that they are even more in the wrong. I assume it is either the flawed framework that they have been working with, or the lack of understanding what is really happening in India beyond the aggregates that show up on their screens or, to borrow an ice-hockey phrase, they are too focused on where the puck is rather than where it's going. What's happening with commodity prices is another example of failure of strategists and sell side economists to understand Central Bank action. In my opinion most economists have not understood the impact of QE and its linkage with global markets especially in an environment where banking channels are broken due to financial crises. I expect most strategists are just using whatever analysis they can find to suit their biases to show support from economic theory. And I expect them to be sloppy, or lie.

Brazil's economic situation has continued to deteriorate both in higher frequency releases as well as annual statistics. For 2012 IBGE calculates that share of household and government consumption expenditure has risen even further, making overall consumption expenditure account for nearly 84% of GDP, with capital formation falling further and net exports negative. Inflation data worsened further and for March hit 6.59%.
Russia is in a quandary. With oil prices dropping fast and and the economy struggling to achieve any growth, it is looking towards more spending to revive the economy despite a poor fiscal situation. Some commentators fear the return to Soviet economics, now that Putin has effectively made sure he can last in power as long if not longer than his Soviet predecessors. Gazprom is facing pushback from Europe on expanding its gas supplies and the consumer story in the country, which has till now been a strong support for the economy looks shaky if the extraction and mining sectors start contracting.

How often have we heard that India is pursuing just incremental reform and that its economy is suffering because there is no 'big-bang' reform or liberalisation push? It pays to put in perspective that the 'reform push' in Brazil and Russia is non-existent. Even in China, there is no plan to liberalise industries or welcome more competition. In fact foreign investors in China are forced to come to the conclusion that State actors will dominate the business scene (which is primarily the reason why the globalisation efforts of Chinese companies have and will continue to receive push back from other states). It is tough to see China escape the middle income trap, now that state action through investment spend has brought it to the edge of it. India is acting slowly, but surely, to increase private and foreign investor access in pension, insurance, banking, retail, mining, power and defence sectors. In most other sectors, majority or 100% foreign investment is already allowed. Nowhere else does foreign business have access to such a wide variety of opportunities and an openly competitive environment in a market that is truly of scale! If foreign businesses are still hesitant about India, they should read this.

We continue to be in a low interest, positive liquidity environment and risk assets should do well. It is possible, in the short term even commodity prices will stabilise and EM will get some tailwind from the growing differential in valuations. However, expectations of global growth priced in Commodity EM markets are still too optimistic and that as the sole driver of EM returns is not the future. Improving marginal efficiency of businesses and reducing marginal cost of production is. This is where India should succeed, despite near term political or economic headwinds.

How are B,R&C faring?

Once again on financial channels we see calls of India being the least preferred of the BRICs, at least economically (which leads inevitably to stock market calls) - it tends to happen every time the equity market fails to perform in tandem with the expectations of some expert or the other. This is despite the fact that the market had a good 2012 and despite a shaky start to the year, the Sensex is still outperforming China, Russia and Brazil in dollar terms at the time of this writing, though by a smaller margin. We are finding it hard to understand what's to dislike about an economy that is bottoming out and is heading into a cyclical upturn that can easily turn structural if the reform momentum continues relative to its peers (which the BRICs concept has bunched it in). All Emerging and growth countries have suffered cuts to their economic performance and growth outlooks. While India will recover from its self-inflicted wounds (and those that are collateral damage from slowing demand in the developed world), it helps to look whether the same can be said about the rest of the large EMs . Here is the big picture.

Brazil

For sometime, my thought was to define Brazil's current (and foreseeable) state of economy as 'being struck by the Indian malaise', however it is easy to overlook the fact that Brazil has been in a situation of no to low growth and very high inflation for most of its existence. In fact, it is India's current state that can more aptly be referred to as 'a touch of Brazil'. Brazil's latest annual GDP print was a meagre 0.87%.

A look at Brazil's net exports is telling. The country is known for - and to a significant extent, reliant on - its natural resource export prowess. However, the current account balance is widening and rapidly touching new lows. It is no surprise that it has toned down its rhetoric of 'currency manipulation' and is now wanting a stronger Real to counter its rising inflation. Something it is unlikely to get, despite the fact that 2012 was already a poor year for the BRL.

Brazil is in a bit of quandary trying to shore up its growth despite giving repeated stimulus which has led the fiscal balance turn to a deficit too (the budget still has a primary surplus). The link between the fiscal and current account deficits and inflation is well know. The problem is complicated by the low unemployment rate (despite its recent rise) which is one of the bright aspects of the economy. However, it is portending excessive demand leading to an even stronger inflation cycle. A further slowdown is imminent unless we see external support for the economy, especially from China for its exports. That may not be easy to expect, especially in the medium to longer term.

Brazil is an economy led by consumption. Household consumption accounts for over 60% of Brazil's GDP and government consumption adds in excess of 20%. With total consumption of over 81%, savings are minimal and capital formation stands at just over 19% (which is much better than the beginning of the century but nowhere close to the Asian savers). Just like we have seen in India, the rate of capital formation in now slowing down relative to consumption, which again is a negative for future growth.

Without the aid of demand from China, it is hard to see Brazil come out of its growth decline in any significant measure. There is possibility of continued stimulus, but it would need more focus from the government on creating infrastructure and work on moving Brazil away from its reliance on primary commodities (rather than just provide tax incentives to businesses) in order to create more sustainable growth and lower inflation environment.

Russia

Russia's political and economic environment stands in the way of many investors considering a longer term commitment to investing in the country. It's economy is even more one sided than Brazil, purely dependent on natural resource exports. Russia neither has the demographics nor the diversity of opportunity set that would attract continuing investor interest and thus becomes the most cyclical of economies and markets in this group. Such is Russia's vulnerability and GDP volatility, that for the quarter of June '09, the real GDP contracted a whopping 11.2% annualised (source: Bloomberg). Russia had the worst economic decline among BRICs during the recent crisis and it took far longer to recover. None of the other large EMs saw a contraction of this magnitude (Brazil suffered a 2.7% contraction in the March qtr of that year). With this context it is hard to see the overall economic structure of Russia as 'stable'.

Once again we see a similar trend of falling current account and worsening of the external balance. Russia's export composition of natural resources and defence equipment is not suited to a world lacking demand and lacking spending capacity on new arms. With net exports falling, household consumption has been the one taking up the slack. Stagnating exports are being met by a steep rise in imports of consumption goods even gross capital formation has been stagnant for many years. It is not surprising to see the comeback of inflation, which the latest figures suggest reached 7.3% for February. Russia is being hard pushed to find sustainable avenues for growth in a weak global economy. It lacks policy impetus, has lopsided distribution of wealth and ownership of businesses and constantly struggles with providing an environment for entrepreneurship to thrive (in fact entrepreneurship, despite the show of government efforts, appears to be consistently discouraged). With our expectations for commodity prices to weaken over the coming years and Russia's continued struggle with capital flight, it might soon find itself struggling for attention in global space.

China

China always poses a conundrum. It is an economy that in investors' mindset occupies a large space in between two extremities - one that says it is a massive investment bubble about to collapse (see this viral 60 Minutes clip on China's ghost cities and many other that have been done before) and the other that relies on an enlightened government guiding the economy to the path of continuing high growth. That high growth has come in doubt and is no longer sustainable is true. Even the outgoing Premier of China issued a warning with the declared 7.5% growth target that this number will be difficult to achieve. Add to that the desire of the government to rebalance the economy and help growth through spending leading to a rising fiscal deficit (targeted at 2% for this year). Inflation is rising (but fed by food costs than manufacturing), but remains below the target that the government has set for the year.

The reality is always somewhere in between these extremities  The past 3 years have seen China grow robustly, but growth dropping from the 11% to 12% range it was averaging before the crisis to 7.9% as of 4Q 2012. The drop is definitely less worse than India but not by much for a country that is consistently being considered as one to emulate. China significantly increased its investment rate post crisis to aid this growth even as contribution from the external sector declined (India's capital formation rate actually fell post the financial crisis).


China remains the most robust as to its external situation but the worsening of this balance is not insignificant. It is largely because it was one of the biggest beneficiaries of the pre-crisis consumption booms and the CA/GDP ratio seems to show a return to a more 'sustainable' pace. The word sustainable here is used with caution; China continues to follow largely mercantilist policies, but it is no longer guaranteed that it will stay this way - the need to rebalance the economy, the rising cost of production and currency appreciation pressures (though lessened) will continue to put pressure on the current account. It will also continue to face demand pressures from Europe, which is a very significant export market. The wildcard is imports - if the rebalancing towards consumption is pursued, imports will rise significantly. This, though desirable, will also require a rethink from investors on how to invest in China. In the near term, a stabilising globe is good for exports.

Most announcements by the Chinese government and their analysis leads me to conclude that economic growth may trend higher, but not on the basis of rising consumption but an even further rise in investment, which can still be funded easily because the savings rate is higher than the investment rate. The expectation is that the stimulus will be more targeted to avoid the excesses of the previous stimulus raises doubts as to how much lift can come from here. Undoubtedly this spend will come from the SoEs, which have shown rising savings so questions as to the efficiency of this spend and the benefits to the wider economy will remain. Ultimately, how sustainable can a continuous rise in investment spend and its contribution to GDP be? An investment spend to increase capacity, overcome supply constraints and increase efficiency should lead to higher consumption, but such a change has not taken place in the last decade and a half. China represses household savings and now with a clamp down on Real Estate speculation, it is possible to see some of those savings go to a depressed equity market. The longer term reorganisation of the economy may take more than a generation - an ageing China risks turning into a nation of perpetual savers and exporters of capital, like Japan.That, as mentioned, is for the longer term.

In conclusion, in the shorter term the economic outlook looks much clearer for China than Russia or Brazil.

How is this relevant to investing? The above is not an exercise to point to out attractive or unattractive growth opportunities for equity investors, rather at understanding the economic risk premium - something that will factor into the discount rate projections of global investors in Emerging (or Growth) markets. In the near term, China appears to offer the lowest forecast economic risk premium. Growth in China is unlikely to pull growth substantially in Brazil or Russia and the quantum of investment spend is unlikely to have a substantial pull on commodities. However, the risks in Russia and Brazil are relatively high. India offers the largest reduction in economic risk premium as the CAD and fiscal deficit come down, growth rebounds and rates fall further. This should provide stronger support to valuations than in B, R & C.

What ails India and why we should be optimistic

There has been in the past year (or more) a constant stream of commentary from many about whether India still belongs to the league of nations (rather, an acronym of nations) that defines the next set of investment opportunities for global investors after the developed markets, the next set of drivers of global growth. The fact is that India has always stood out among these countries as a very different beast, one that does not run consistent current account surpluses, one that does not grow by exporting commodities or by keeping an undervalued currency. It is time to stop questioning India's place in the investment universe and start looking broadly at the EM context, where things do not look as rosy and investors could do much worse. The point is not just that; rather that India is bound to do very well in the context of the rest of the EM universe slowing down because India is driven differently. There are growth issues globally, no less coming from the lack of demand in the developed economies, but it helps to understand why India's growth rate has come down and why optimism is warranted.

     India's problem is the CAD.

    A disproportionate amount of blame is put on the lack of investment and not enough on the current account deficit for the slowdown in the economic growth rate. It is clearly visible in the chart below:

India's foreign trade position has consistently gotten worse and so has it's contribution to the GDP (the blip in Q1, 2012 is what it is, a statistical blip). A corollary to this is the steep rise in domestic consumption and the rise in the fiscal deficit. A weak and unsustainable fiscal policy has led to high preference for consumption, consequently high inflation and then a preference for savings in Gold and Real estate compared to financial instruments. As the government consolidates its fiscal position and as inflation comes down, we could see a reversal in the current account position of the country, adding to GDP growth, without a disproportionate impact on consumption (thus consumption will slow, but not in direct proportion to the fall in the CAD). The reasons for this belief are:

    a. Fall in Gold imports: The RBI has recently said (and the Economic Survey reiterated) that if Gold imports grew at the same pace as in the rest of the world, the current account deficit's contribution to GDP would be 0.3% better. We feel this will be even higher as cooling of gold price and reducing inflation, plus increased attractiveness of financial instruments will lead to a below par growth in gold imports and we wouldn't be surprised by a long term de-growth in gold imports - accounting for 27% of gold consumption without holding proportionate income is not sustainable, despite India's love for Gold (this is happening in the current financial year). Gold is unproductive savings and cutting out Gold from the savings channels holds multiple benefits, especially to capital formation. The multiplier impact of not having large gold imports and wealth stored in gold are underestimated by economists. In my opinion, Indian's own too much of it and this maybe a risk to watch out for, especially for those who give some credence to wealth effects (though wealth effects, especially on consumption have been understood to be overrated).

    b. Slowdown in Oil Imports: India's dependence on global oil is well known and the rise in oil prices and domestic subsidisation has continuously detracted from growth. India has undertaken some measures to rationalise consumer pricing of oil products and this should have some impact on consumption, especially through imcreasing efficiency of usage. Already this is visible in surveys showing reduction in the growth of discretionary spend and even in auto data, people's preference for efficient cars is being seen again. There is need for a complete deregulation of diesel prices and this will be done slowly but surely. The price impact of oil should come down too as current indications are of higher output globally, not accompanied with as great a surge in demand. The boom years of oil has delivered significant investment in oil fields, even marginal ones, and that will keep a check on oil prices and commodity prices in general. In addition, there is good reason to assume that all those inflationistas buying commodities and gold should have at least started to learn their lessons. Mark Dow makes a good case here. Price stabilisation of imports is very important as a majority of rise in imports (non-gold) in 2011-12 was due to increase in unit value rather than quantity (Economic Survey 2012-13).

    c. Revival of exports: An interesting point made by the recent economic survey is that while India's export performance link to REER is not clear, it shows a remarkable correlation to global growth (Economic Survey 2012-13, Chapter 7, pp 150-152). India has been hard hit by the slowdown in Europe. In fact, the reduction in exports to Europe can account for a significant amount of export slowdown (followed by the slowing of activity in China). However, we see exports to other parts of the world rising. With some recovery seen in China and the US, the wild card remains Europe. We must reiterate that the US, long suffering from contraction in demand is now not doing that badly! The latest data is clearly showing an economy that is spending on capital goods, ready for incremental demand. That is all good news for exporters, including the software variety.

The terms of trade vs. Europe have improved significantly because of the INR depreciation vs. the EUR. The ground is set for revival in growth to  Europe, whether Europe will respond to the lack of domestic demand there remains to be seen. We should also see a policy push from the government for revival of exports, whether in the form of tax breaks or cheaper credit as the problem with exports is well recognised in policy circles.

With the above in mind, there is very high probability for a lesser drag from exports in next year's GDP. However, it is quite difficult to imagine India running sustained CA surpluses (and a mercantilist India may not even be advisable).

    Investments relative to Consumption needs a lift

    The problem as defined by experts that India needs an investment boost is somewhat understating the reality. India needs a very significant boost to investment spend, enough so that it outpaces growth in domestic demand. Only then can it create all the conditions needed for a sustainable period of growth, without risking inflation and that includes a lot more of the population. Note that it does not require that consumption falls off a cliff or that government spend accelerate immensely. All it needs is the right incentives and policy framework and let market forces take care of the elimination of supply side constraints. The period from 2004 to 2008 is a reminder of what can be achieved if this happens.

India's return to high single digits of growth demands judicious investment spend; it needs infrastructure, power, new industry and revival of manufacturing. It needs lowering of artificial barriers to entry that prevent competition and let entrenched players exercise pricing power. On top of that it needs a rise in savings rate and consequently a rise in formation of productive capital (thus less savings stuck in Gold). India definitely cannot afford wasteful infrastructure spend the kind seen in China - it just doesn't have the capital for it - but there are many low hanging fruit to be had. This is not difficult to achieve. There are funded projects that are stuck because of land acquisition or clearance issues. These are definitely not insurmountable. Clearing them gives an immediate boost to the economy and also tells the world that India is ready for business.

It is difficult to emphasise it too much, but getting investment going is the only way to get India out of its low growth funk and get the benefits of development to wider segment of people, bringing poverty levels in India down.

    Efficiency Gains and other positive surprises
 
    There is a decent amount of realistic policy input that can drive efficiency and productivity gains in the economy, all of which can have dual impact on the economy, both in terms raising growth and reducing inflation. Recent efforts on resolving the impasse on much delayed implementation of goods and service tax are very welcome as implementation of GST can improve manufacturing and business efficiency very significantly. As infrastructure investment is prioritised, efficiency gains are inevitable, whether they come from transportation or better supply chains or lower turnaround times. Another positive surprise can come from established industry that is facing supply constraint of raw material. A clear example is the power sector, where installed capacity is running at sub par load factors because either coal or natural gas is not available to process. Similarly, the exploration and mining industry is facing hurdles to expanding capacity because of arcane government policy. This is changing incrementally and while it was a detractor in the past year, it should become a sharp positive contributor in the next.

For long (most of the decades after independence), India struggled with the so called Hindu rate of growth of 3% to 4% and this period was dominated by socialist and populist policy, insurmountable bureaucracy, absent entrepreneurship, high taxes and investor apathy. While there is always the chance of populism coming back (the last 4 years are a testimony to a partial return to such a state), most post liberalisation characteristics of India's growth are irreversible. As such, while the present state of GDP growth is dismal, it is hard to get lower in terms of growth rate for India. The long term growth of India is not in doubt and from here on, neither should the short term. How this will impact stock market returns requires another deeper introspection. Many studies have shown that growth and stock market returns are not that linked, but if there is a market where we have seen a higher correlation it is India.