Sucheta Dalal

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March 9, 2009

COVER STORY (MoneyLIFE Issue, 26th March 09)


With no new sources of capital, few growth engines to generate jobs and no pragmatic leadership in sight, is the economic glass looking half-empty? Debashis Basu & Sucheta Dalal analyse


A lot of people say that India’s economic situation is not so bad. Personal debt is low, there is adequate domestic demand and the pain of unemployment has been, to a large extent, mitigated by government policies. Others say that the problems have not even begun. Corporate balance sheets are stuffed with massive debt that cannot be serviced. There is a lot of hidden and contingent debt due to reckless expansion during the boom times. As growth falters, a massive wave of de-leveraging has sent financial markets tumbling. Pessimists believe that worse is still to come. So, is the economic glass half-full or half-empty?
Glass Half-full
As head of India’s second largest bank and chairman of the Confederation of Indian Industry (CII), KV Kamath is probably most uniquely placed to observe the Indian business and economic environment and also look at things in the context of global economies and policy decisions. It is an added advantage that he is capable of seeing things with a sharp, macro perspective.
Mr Kamath took us through five key meetings of CII during the recent crisis – July 2008, October 2008, November 2008, January 2009 and 2 March 2009 – to get a perspective on the mood and reality at Indian companies.
July 2008: The mood was euphoric. It was a national council meeting of 55 people in Hyderabad and we were to take stock of what was happening. Each member spoke, including representatives of the small-scale industry and everyone was euphoric about growth. There was no sense of impending doom. After it ended, Naushad Forbes of Forbes Marshall said, I want to summarise the perception as follows: “Either we are in a state of delusion, or media is in the business of writing fiction.”
October 2008: By October, the global markets had crashed and so had oil prices. At that meeting, the mood was one of complete despondency. Nobody was willing to listen to anything or articulate anything thoughtfully.
November 2008: The same mood of despondency continued and I witnessed amazing psychology there. We didn’t spend hours discussing business because the mood was so bad. So, I asked a simple question: “All of you have possibly started implementing projects. How many of you have actually stopped the implementation process?” The din that followed was like a fish market – everybody was talking all at once about how someone else had a problem or had stopped production. Finally, when nobody gave a clear answer, I said, “If you have stopped your project, please put up your hand.” Only one-third of the hands went up. Clearly, there was severe pain, but there was also a disconnect between what was happening in one’s own organisation and the overall perception. There was a fear psychosis.
January 2009: Just before this meeting, I asked the SAIL (Steel Authority of India Limited) chairman, “Where are you in terms of your production?” He said he was back to the June (2008) level – which is 100% utilisation. Steel prices had gone down, so the margins were lower, but input costs were down too. Steel and cement companies had similar answers at the meeting. Then, I opened the discussion to the 50-odd members from other sectors and this is what we found. Motorcycles were back to 90% production level. Businesses that dealt with rural India said that they were growing at 10%-15% – not at 25% – 30% as before. FMCG was growing at 15%-20%. The knowledge industry (NIIT, Accenture and TCS were among those present) was growing at
10%-15% against 30% which was their earlier benchmark. But growth was still in positive territory.
There were a few negatives as well. Commercial vehicle sales had completely collapsed in January. Textiles continued to be in deep pain; companies had a litany of complaints against the government policy, which was hurting the business. In the small-scale sector, half of them said they were doing alright, while those in businesses such as auto-ancillary exports were hurt. The interesting message we got was that the Reserve Bank of India’s steps to ease liquidity had helped. For the first time, I heard industry saying that the money had reached them.
2nd March: This time, there were over 80 members. I again asked how they were doing. Steel was now growing at the same level as in January, which is around 5%. Motorcycles were back to 100% capacity utilisation; cars were also doing well. Commercial vehicles were not doing well, but production levels were higher than in January (when they were down 65%). Textiles continue to do very badly. Their main problem was that the government had procured cotton at 10% over international rates making export impossible.
I then said, if the third quarter was bad for everybody, how many of you think that the fourth quarter is going to be worse than the third? Only one hand went up – from the textiles sector. Interestingly, when I asked who was buying, we discovered that the market was rural India. I asked what they were buying. The answer was - corrugated sheets for roofing. From Jindal to SAIL everybody was selling corrugated sheets. So basically rural India is keeping us going now.
So in conclusion, if industry is right and this quarter is better than the last quarter, we have a reasonable hope of growing at 7%, despite all the challenges.
Other Challenges
But that is only one part of the picture. Mr Kamath points out that there are several other issues to worry about, such as job losses of unskilled workers, worries about fresh employment for the eight million plus people coming into the job market and the continued disconnect and disagreement between perception about the extent of economic pain and apparent reality.
Job losses in the construction sector have been severe and unskilled workers were forced to go back to their villages. This had the potential to turn into a social problem but, according to Mr Kamath, “the National Rural Employment Guarantee Scheme is providing a safety net. One hears that over a million construction workers have gone back to their villages, but no pain has surfaced because of the NREG Scheme.” The NREG was largely seen as populist largess that would not reach the target groups but, apparently, a good chunk of the money has gone into employment generation. This is evident from reports about shortage of migrant labour in Kerala and Punjab because labour is finding local employment. 
Glass Half-empty
While businessmen must work from the latest set of data – and that data shows improvement – there is no way to tell whether the recent anecdotal evidence can be extrapolated. A bounce back, immediately after a massive crisis, can hardly tell us much about the durability of the bounce. There are three key factors to watch here.
Markets as indicators: If the evidence narrated above provides a glimmer of hope, crashing stock prices around the world are sending a completely different signal. In fact, one that is also at odds with ground reality. Are markets more accurate because they discount the future? Or have they got it wrong? We have had a few bankruptcies for sure but the domino effect of large companies going under has been staved off by big injection of State aid. Added to this, there has been a massive simultaneous global stimulus and cut in interest rates. But the markets seem to have seen through the ineffectiveness of such band-aid. Markets are supposed to signal booms and busts months in advance. If this is so, we are headed for far tougher times. Indices all around the world are crashing to new lows. The Sensex has just hit its lowest weekly close in three years. If last month’s corporate data suggests that the economy is recovering, the markets are certainly not signalling this. As a wealthy private investor puts it, “When global markets are hitting 10-year and 20-year lows, we are still at 3-year lows. One can take comfort from that; but we don’t. It suggests there is a lot of downside left.”
Leveraged businesses: While toxic mortgages are not the problem in India, we certainly have a case of over-leveraged balance sheets and over-leveraged promoters who have pledged their shareholding to fund purchase of warrants or new businesses. As a genuine recovery gets postponed, stocks prices will drop further making things worse for those who are leveraged. Debt destruction through a fresh wave of stock selling is inevitable; this, in turn, will make economic recovery more difficult.
Global situation is unclear: What about the international situation, which the media paints as grim? On a recent visit to three countries, Mr Kamath noticed that domestic flights in the US were over-booked in three segments. There was normal traffic at the airport, although the media was full of bad news. Canada’s auto industry had lost 150,000 jobs as against 600,000 jobs lost in the US, but a recession was not visible on the streets. “Everybody I talked to expected that it will hit them with a lag and so everyone was preparing for it,” says Mr Kamath. One of ICICI Bank’s partners there, Prem Watsa, who has been bearish for 4-5 years and made his biggest profit last year, thinks that the problems of the US are over. He told Mr Kamath, that while housing start-ups are down from 2.5 million to 1 million, housing inventory is also down to half a million. So when there is talk about a one-year inventory, it is only half a million. Even a marginal increase in purchases will create a shortage and get prices to move. Even in the UK, things seemed busier than normal, although the mood of the locals was glum. On the other hand, anecdotal reports from Singapore and Dubai are extremely grim and little is known about the ground reality in China, where the social security net has virtually been disbanded.
A perceptive market observer says that anecdotal evidence may be misleading because businesses often refuse to accept signals. He narrated several examples, including those of hotels and restaurants which have, in fact, increased prices even when occupancy and customer footfalls had shrunk drastically.
He asks: what happens when government bailouts and fiscal stimulus fail to work and nations themselves face bankruptcy? When third-world countries such as Mexico or Argentina or even Russia went bankrupt, it wasn’t a source of global worry. But when there are solvency questions about West European countries such as UK or Italy and Spain, the situation is radically different.
In short, it is hard to conclude at this stage, whether we are headed for worse times or whether economies will find solutions to power their way out of the mess.

The Key Challenges


Even if things are getting better in the current quarter, the economy will continue to face huge headwinds. Here are just a few of the challenges.


Where is the money? In the last burst of growth, investments were funded by accruals, domestic and foreign borrowings and equity markets. Now, cash accruals will be constrained, external commercial borrowings have dried up and the equity market is dormant. Domestic debt is becoming hard to get. Given the government’s massive borrowing programme, even if bank deposits grow at historic rates of 18%, there will be a shortfall of Rs100,000 crore. So, in the next two-three years, getting investment funds will be a challenge for industry and could hamper growth in 2010-11.


Where are the jobs? The biggest worry is about sustaining employment. In a few months, 8 million-10 million youngsters would come into the job market, at a time when every company has cut back on recruitment. The IT industry employs 600,000 and the indirect employment is 2.5 to 3 million. Will this industry be hiring in the coming year? Financial services, the retail industry and construction were employing millions and have now gone lean or have come under severe pressure. This would mean no employment prospects for all those who spent on expensive specialised courses that had guaranteed employment in the boom phase.


Where is the government pragmatism?

Indian businessmen are expected to compete with the best in the world, but how about the government competing with other governments to protect our interests? After the recent crisis, protectionism is in and each country is moving quickly to protect its businesses and employment opportunities. Global trading mechanisms, treaties and structures that have been built over the years are coming under threat. The next danger is curbs on the free flow of funds. For instance, many countries are openly expressing the view that if you have raised funds using a government guarantee, that money must be used domestically and capital cannot be exported. According to Mr Kamath, “To me the biggest fear is business and financial protectionism, which destabilises the basis on which you did business, since you will have to invent new structures to do business.”


Death of debt markets?

With credit ratings in complete disarray, the debt markets have gone into a freeze. Nobody knows how to trade paper that is still rated AA and A. In the past, a particular credit rating created its own price discovery mechanism; today, nobody trusts the ratings. Unless there is a functioning credit-rating mechanism and an active debt market, the credit flow that is critical for India’s growth will not happen because global institutions are not going to be able to lend. It is an issue that has yet to be addressed with so many global banks continuing to face a crisis.  – D.B.



“If we target to raise NRI deposits from the current $45 billion to $75 billion, then all our problems are solved”
The rupee has weakened drastically and the RBI seems disinclined to intervene, even though forex reserves are dwindling rapidly. At the same time, the 10-year bond yield has strengthened even while inflation is down to 3.5%. Meanwhile, the government’s borrowing programme for next year threatens to crowd out funds for corporate investment and lead to a rise in interest rates. The question that is perplexing bankers is the RBI’s continued reluctance to tap NRI deposits, which are a unique pool of resources available to just a few countries.
As Mr Kamath points out, freeing the interest rate cap on NRI deposits can solve three problems – it will provide a new source of funds for investment, strengthen the rupee and keep interest rates in check. Unfortunately, RBI seems unwilling to even experiment with the possibility of attracting higher NRI deposits. If you offer a good rate today, an Indian who has saved and has money in 20 different global banks will move money from at least one or two of them to India because he is getting 1% or 2% more and still believes in India. The constraint is that the interest rate cap is around 1% above Libor. Globally, if an NRI goes to a street-side branch and deposits money, he gets 0% interest; if he does it online through an Internet banking account, he can get 3.5%-4%. So there is a benchmark. A savvy person goes online and decides where to keep his money safely. Some countries have a deposit guarantee of $100,000, others have $200,000 so a net-savvy person can ensure government-guaranteed deposits. India has to compete to get a slice of those. The amount of deposits sitting in the system is $45 billion and it is earning marginal interest.
At one time, there was a view that NRI deposits are leveraged money, but those days are over. No global bank wants to risk leveraging today. The RBI can free interest rates a little and see what happens. For instance, it can offer 2% above Libor and check the effect; if it fails to attract investment, it can raise the interest rate. On the other hand, if there is a flood of overseas money, it can just as easily turn off the tap. All it needs is a little experimentation to figure out the rate at which NRI dollars would flow into India.
According to Mr Kamath, “If we target to raise NRI deposits from the current $45 billion to $75 billion, then all our problems are solved – the rupee-dollar parity can be controlled; the balance of payments issue is solved; and interest rates come under control. In any case, we are a controlled economy. It is not as if we will lose control only because we have opened it up.” He also points out that foreign remittances have not slowed down even in a recession and continue to grow at 30% on a year–on-year basis. With elections round the corner, this flow has increased.  
Through the Glass, Darkly
Our columnist R Balakrishnan is pessimistic about an economic recovery anytime soon
Everyone seems to be in a state of denial when it comes to forecasting the economy for
FY09-10. The government says that we will report a GDP growth of 7% this year and the next year should also be okay with growth hitting around 6%. Most economists and equity analysts are echoing this view. No one wants to read the street signs. My view is different. If things deteriorate at the current pace for another six months or so, then we could actually see a NEGATIVE number for GDP growth in FY09-10. Street signs indicate a definite slowdown in industry as well as in the services sector. Agriculture alone cannot lift the economy.
Industry is definitely on course for a serious decline. With the general elections due in May, policymaking would be on a holiday till June. The finances of the government are in a mess. Remittances from the Middle East are going to slow down. The only cheer is that oil may hold at current levels. This is also a bad sign in a way; it means that the world is using less oil due to poor economic conditions. The combined fiscal deficit of the states and the Centre will perhaps be in the range of 13% to 15% of GDP in 2008-09 and rise further in the next year. Virtually, every main street is lined with shuttered ‘high profile’ retail shops. All those who had put up their shingles on the expectation of the Indian consumer blowing up his money through credit cards, is now without money to even buy a lock. Rentals have crashed by 30%-60% in many cities. Real estate prices continue to sink and the bottom is far away from where they are today. Mere interest rate cuts are not going to help housing sales. The IT industry is in a bad shape. Hiring slowdown, wage cuts and freezes, longer working hours, lower margins, etc, are only the visible signs. Many large companies that had planned expansion and signed lease agreements for land and buildings are looking at exit options.
All analysts maintain that India will be the best performing economy in the next one year and foreign money will flow into India. I wish it were that simple. With a deteriorating rupee and a weakening economy, India is not going to be on the menu of most global investors. India has been a beneficiary of global greed (and the reckless leveraging) that led to dollar inflows. That tap is running dry. It will open only when the global economy recovers. Recovery holds the key. We are seeing double-digit dips in economic growth in many countries. This will hold back crossborder investing for some time. We will see private equity and venture capital flows being held back. Even commitments will be withdrawn.
At the same time, consumer spending is sliding. To boost demand, companies are reducing prices. This, in turn, means lower profits, if not losses. So, with a drop in earnings, the Indian markets can suddenly look very expensive without the equity indices going anywhere from here. My guess is that by September 2009, we will probably see earnings of Indian companies collapse. We will face the classic conflict of ‘value vs growth’ when it comes to equities. What look like value stocks will wilt as growth disappears.
One other fear is that of overworked government printing presses. With a dip in production and demand, increasing money supply can be extremely dangerous. The Indian government is resorting to foolish actions like reduction in tariffs and taxation. These will benefit only a small section of the populace. The key to arresting the slowdown is consumer spending. Only when the consumer has the confidence and the money to come back to the marketplace, will industry start to prosper. Instead of giving Rs100 crore to an industry, it would be better to distribute the money in cash at
Rs1 lakh to 10,000 families. They will spend it on a broad range of goods and services. Government sops and bailouts will not help anyone except that they might win favours for some politicians from certain lobbies. The reduction in tariffs and taxation will only lead to loss of revenue for the government and it will be politically tough to raise them again in future. We also have the paradox of government servants and armed forces getting a huge pay revision when the nation is going through an agonising phase and people are losing their jobs! After a long time, I am seeing people yearning for government jobs! These are just a few pointers.
The optimistic view is that the global economy will heal itself by the end of calendar year 2009 and 2010 will see recovery. This is the line that most stockbrokers will adopt, since they need your transactions to keep their shops open. The pessimistic view is that we may be in limbo for several years. Let us hope that the optimists are right.
For me, the signs of revival would be evident when we see consumers spending again, new jobs getting created and the emergence of new public issues in the Indian markets. Till then, we are likely to be bombarded with bad news. Our markets can lose another 50% from here. I am not convinced about the profitability of most Indian companies. I find that less than 100 companies enjoyed a return on capital employed of more than 20% over three successive years. Companies that qualify include Hindustan Unilever and Colgate, which have delivered decent returns to shareholders. I do not see a single Indian company with sustainable profitability over the next five years. Either the business model is flawed or the promoter takes away the cream. In this context, here is the thought process of many Indian promoters, especially among the small and mid-size companies:
“In a bull market, I do not mind converting my black money into white. The market rewards EPS increase handsomely. In today’s gloom, even if my EPS falls dramatically, it makes no impact because the share price is already down. So, in this market, let me siphon off the money. No one will bother.” So, as a shareholder you will be inflicted a double whammy.
With each passing day, the much-vaunted 10-year or 20-year return from equities as an asset class is sinking. Accepted theories about equities being the best asset class are going to be under stress. Stock-picking and timing your exit are going to be important techniques. Gold is having its day in the sun. To my mind, gold prices are perhaps a good signpost. Higher gold prices would mean a messy real economy. Perhaps a fall in gold prices would be the first sign of economic recovery. Brace yourself for a hard landing. Keep liquidity with you. Buy shares in very small doses. You have a long buying – and waiting – period ahead of you.
The views are purely personal. The author can be reached at [email protected]


-- Sucheta Dalal