Sucheta Dalal :Why the Sensex needs a deep correction
Sucheta Dalal

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Why the Sensex needs a deep correction  

Oct 10, 2005

The Sensex has stumbled in its sprint towards the 9,000 mark, as it corrected in line with global market trends. Will it be a little blip, soon forgotten? Or, are we in for a serious correction?


Clearly, foreign institutional investors have been net sellers in the cash and derivatives segment for all of last week and there is a growing consensus that the Indian market is no longer inexpensive.


Yet, sentiment is strongly bullish, as growth indicators are still very attractive. And consumer goods, textiles and real estate, growing at about three times the economy, show no sign of slackening. Even the annual dip in sales during the inauspicious shraddh period last month was missing this time. Most blue-chip companies are expected to announce spectacular results in the second quarter.


Hence, corporate earnings’ expectations remain high for the third quarter, too. Yet, there is a gnawing worry among investors that most of the good news may have already been discounted when major company results begin to come out next week. The key then will be whether the earnings guidance by companies meets exaggerated market expectations.


A deep correction will be most beneficial all around. Apart from cooling raging bulls, it will knock some of the smug complacency out of the Congress government, evident in its satisfaction over soaring stock prices and the repeated assertion that there is no speculation or manipulation in Indian markets. Attention will also be directed to the fact that a mere slowing in capital inflows has weakened the rupee; a further correction will negatively impact FII returns and could trigger a further re-assessment of the India story.


The soaring Sensex sends a false signal that it is okay to put key reforms on hold, while focussing on “socially relevant” schemes that are set to guzzle scarce resources, with no accountability. A price correction could pressurise government to meet international expectations to maintain investment momentum.


Interestingly, the latest issue of the McKinsey Quart-erly—a special edition titled ‘Ful- filling India’s pro-mise’—contains a blunt but sympathetic assessment of India’s strengths and weakness.


• Sentiment remains strongly bullish as growth indicators are still attractive

• But there’s concern on most good news being discounted, with Q3 results due

• A price correction may pressurise government to meet global expectations


In one article, Raghuram Rajan, IMF’s chief economist sums up, “the vote of confidence that foreign investors are giving India should not induce complacency; they are betting on the potential, not the reality. It is up to India to realise that potential.”


Indian companies, he says, successfully rose to the challenge of foreign competition despite their initial fears and opposition. But one factor that continues to keep India relatively closed is the country’s politicians, aided and abetted by its bureaucrats. Rajan says foreign investors are less interested in tax concessions, than clear policy decisions based on consensus between business and political groups. Such decisions do not fail the market test or lead to fresh uncertainty caused by the need for change.


Most concerns outlined in the McKinsey Quarterly have been discussed ad nauseam, but implementation will require a willingness to take tough decisions and for government to free itself from the shackles imposed by the Left. For instance, the need to cut fiscal deficit, put India’s hoard of privately- owned gold to productive use and mobilise higher savings is well accepted.


The government also agrees that the tab for upgrading infrastructure will be $100 billion over the next decade, but there is little effort to address even cosmetic iss-ues. For instance, Mumbai is recognised as the true gateway of India. But the pot-holed, bone-jarring road leading up the so-called international airport is enough to persuade most first-time visitors to catch the next flight out. In fact, Mumbai’s infrastructure is crumbling so rapidly that it will soon drown out the positive signals emanating from its glittering malls, multiplexes, luxury apartments and fancy cars. If most nations know the importance of airports and the roads leading up to these are key to creating excellent first impressions, why can’t India do the same?


McKinsey estimates India’s black economy at 25%; Indian businessmen reckon it is significantly higher. Instead of creating disincentives to tax evasion and encouraging regulatory compliance, the government is busy hatching another amnesty scheme to reward law breakers. The difference this time is that the government officially denies any such plans.


Last week, Prime Minister Man-mohan Singh finally announced that there will be no disinvestment of the power utility, Bhel; this signals a complete halt to public sector disinvestment. McKinsey says India’s govern- ment could cut the deficit by 4% of GDP, thereby providing three-quarters of the $35 billion needed for additional investment, through PSU privatisation. Is there any chance of that happening?


Similarly, with bank unions turning more strident in their opposition to disinvestment of public sector banks (leave alone privatisation), there is little chance of forcing a dramatic improvement in productivity. The McKinsey Quarterly points out that the productivity of India’s public sector banks is 10% of US levels, while they control 75% of bank assets. Even the productivity of the more efficient private banks is just 55% of US levels.


Moving all Indian banks towards their productivity potential of 90% of US levels, an ambitious but achievable goal,would unleash $2.5 billion a year in savings. Interest rates could fall by 1%, say Diana Farell and Susan Lund of McKinsey Global Institute. But what is the chance of meeting even half that expectation in the foreseeable future?


Clearly, India has plenty of potential but lacks the political will to achieve it. That is one reason why Indian investors are always a little wary about sharing foreign bullishness and are constantly looking out for any change in perception that could see a flight of capital from India.


-- Sucheta Dalal