Sucheta Dalal :Markets issue reforms wake-up call
Sucheta Dalal

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Markets issue reforms wake-up call  

Oct 31, 2005

Markets, as is their wont, go up and down. But even the most sceptical of stock watchers would have hesitated to predict the savage correction of over 1,012 points in the benchmark Sensex in just a month.


At the end of September, Finance Minister P. Chidambaram was under pressure to defend the run-away boom in stock prices. He told the media that soaring indices reflected India’s ‘‘strong economic fundamentals’’ and the expectation of excellent second quarter results. A month later, analysts are choking over their words when asked to call the bottom of the price correction. Some TV pundits are even talking about the beginning of a bear market, albeit a short-term one.


The rapid change in market sentiment and investment outlook is also evident in recent research reports by leading Foreign Institutional Investors (FIIs). Foreign investors may have been overly optimistic and even indiscriminate while pumping in $8.5 billion into Indian stocks this year, but leading FIIs are now pausing to take stock and reassess the India investment story while others are waiting to commit their funds.


The FII view is important, because it moves the market. Two days after the Finance Minister asserted that FIIs will continue to invest, they responded with the largest single-day net sales in six years, which dragged the index down. The irony is that the FM’s own officials continue to underestimate the influence of FII investment on price trends. Internal reports of the ministry repeatedly harp on the fact that FII investment in the cash segment accounts for a mere 10 to 14 per cent of trading. For starters, it is a mistake to look at cash trading alone instead of analysing the overall investment in cash and derivatives markets. The combined impact provides a clearer picture of FII trades.


Secondly, retail investors blindly follow FII actions. This has been evident in the last few weeks when stock prices tumbled relentlessly even though cash-rich Indian mutual funds took a contrarian view and were big buyers (they bought over Rs 2,000 crore of equity while FIIs sold).


Thirdly, access to all the FII trading numbers also does not allow a proper analysis of their actions, because the Finance Ministry and its regulator have no clear knowledge about the beneficial ownership behind their investment. The difference between what one fund manager sarcastically calls ‘‘domestic FII’’ (Indian money routed through FIIs) and Foreign FIIs becomes important when portfolio money is flowing out of the country in a rush. While ‘‘domestic FIIs’’ are willing to find opportunities to make quick money, genuine institutional investors are questioning the sustainability of economic fundamentals and corporate growth in the absence of continuing reforms and infrastructure development.


In the past few weeks, McKinsey Quarterly, Fortune, UBS and CLSA have all asked tough questions about the sustainability of India’s economic reforms. UBS has even said the ‘‘downside pressure might be just getting underway’’.


As UBS points out, the fall in India stock prices is ‘‘by far the largest drop in Asia’’. The India rupee has suddenly turned weak after remaining rock steady for over a year and the country’s balance of payments position has deteriorated sharply as a current account surplus has veered into a deficit of 4 per cent to GDP. ‘‘Indian growth is overheated’’ and capacity utilisation in India companies is uniformly at or above optimal levels, says UBS. Thus the 8.1 per cent growth and good second quarter results (which have themselves turned out to be a mixed bag) are no indicator of future trends. UBS also expresses surprise at the central bank’s failure to intervene and ‘‘cool down the domestic cycle’’ much earlier.


Interestingly, the FM’s advisors have issued an equally sharp warning about the economy in note titled ‘‘Industrial Growth Pickp: How Sustainable Is It’’ (by Dr Ajay Shah, Consultant at the Finance Ministry, dated October 17, 2005).


Dr Shah says although monthly industrial production data for June 2005 reached a nine-year high at 10.8 per cent, ‘‘Industrial growth will retrace down to 5-6 per cent over the next four to six months’’. That is because, a ‘‘significant part of the acceleration in growth has been premised on support from unsustainable drivers’’ — namely a low real interest rate sponsored consumption boom. ‘‘Rising interest rates, slowing exports and a sharp rise in global oil prices are likely to trigger a significant slowdown in industrial growth,’’ he says.


Dr Shah also warns that a continued push towards consumption-driven growth will only escalate macro risks. The consumption-led boom has pushed the credit-deposit ratio to a 19-year high of 63 per cent. And government debt level is also very high. Consequently any attempt to pursue an aggressive manufacturing capacity expansion at this stage will only raise the risk of an interest rate shock.


The Finance Ministry’s banking sector research team believes that there is a ‘‘rising credit risk building in the system’’ as Indian households have leveraged significantly above the fair level supported by current per capital incomes. And consumption-led growth with a weak investment cycle has pushed the trade deficit to an all-time high of $11.5 billion, increasing the country’s dependence on less stable portfolio investment and external commercial borrowing.


Moreover, the decision to subsidise oil prices has resulted in a $8.3 billion off-budget burden in Fiscal 2006 and the Employment Guarantee Scheme will lead to an annual burden to of 0.7 per cent of GDP on the government, says the paper. At the same time, long pending reforms necessary for a structural correction in the fiscal deficit have been deferred. These include privatisation, labour reforms, reduction in subsidies and expenditure reforms. Dr Shah concludes that there are signs of emerging risk due to consumption-led growth and increased vulnerability from a potentially significant rise in interest rates, slow of exports and rise in global oil prices, but there is unlikely to be a crisis. The deceleration in industrial growth will however weigh on operating profit growth and corporate revenue.


Clearly, the Congress version of the India Shining story, as reflected by a surging Sensex is temporarily over. It is now time to initiate corrective action by kick-starting reforms. These are the very concerns raised by international investors.


The tragedy is that government shows no signs of breaking free from the restrictions imposed by the Left Parties. Disinvestment is on the back burner, and labour reforms have been kept out even from Special Economic Zones (SEZ); instead, labour issues seem set to haunt the booming Information Technology industry. Unless the government signals some change, the capital market is headed for more turbulence.


-- Sucheta Dalal