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Indian market as a contrarian play
July, 12th 2010

The near-flat performance of Indian equities in 2010 till date is at marked variance with the performance of most other large markets with Europe down by nearly 20%, China down by some 20% and the US down by close to 5%. While it was Asian frugality that helped pay for Americans spending binge till the global financial meltdown in 2007, it is now the loose monetary policy in the west that is helping fund the Asian investment spree.

Robust growth prospects in the Indian economy, strong earnings momentum and signs of progress on the reforms front are some of the factors that have contributed to this capital inflow though the market has seen several bouts of volatility during the period.

Domestic institutional investors, however , seem unenthused by these factors and have continued to be marginal net sellers year-to-date . Given the prevailing unsettled conditions in Europe and the fast-paced unfolding events there, it is worth examining if the remarkable outperformance of the Indian equities is likely to continue over the coming months or if we are being lulled into an unwarranted sense of complacency.

India is seen as a domestic demand-led economy that is less dependent on exports to the west compared to many other emerging markets and, hence, less exposed to the ongoing economic turmoil in the western world. Indias exports are just about 16% of GDP and the bulk of its investment needs are financed by domestic savings. Given the robust growth momentum in India, the domestic market has served as a bulwark to the constant barrage of negative news coming out of the west. The old decoupling theme of 2007 a possible negative correlation between the fortunes of the Indian market and those in the developed world has started making the rounds in investment strategy themes once again.

While the arguments for decoupling appear valid, it is worth noting that Indias dependence on foreign inflows to sustain its growth momentum has been increasing at a rather brisk pace. The countrys current account deficit is at a near-twodecade high at 2.9% of GDP in fiscal 2010 vis--vis a current account surplus of 2.2% as recently as 2003-04 . This is despite modest crude oil prices during the year and continued strength in software exports and inward remittances.

Robust imports on the back of strong consumption and investment demand are likely to take the current account deficit higher by possibly around another couple of percentage points over the next two years. These deficits need to be financed by external capital flows whether in the form of non-debt-creating inflows like FDI or FII or by external borrowing.

This has brought about a higher degree of vulnerability to Indias potential economic growth from global factors like the economic turmoil faced by some European nations, a possible weakness in US growth and their implications on the risk appetite of global investors in addition to the obvious implications on Indias foreign trade.

With Indias high inflation rates proving to be a bit more sticky than earlier anticipated, partly on account of increased fuel and agricultural support prices , the inflation differentials between India and its international trading partners are continuing to be very high for quite some time now. This has inevitably made Indias exports less competitive, especially because the Indian rupee has not been depreciating commensurate with the loss of competitiveness on the back of sustained foreign inflows. This is likely to have a fairly significant negative impact on the trade account, thus accentuating the countrys dependence on foreign capital flows.

The countrys financial system has admirably weathered the sovereign credit crisis emanating from southern Europe under the watchful eyes of the money market regulator. With real interest rates offered to bank depositors being in the negative territory for more than a year now, bank deposit growth has started trailing the growth in demand for credit by a substantial margin now. Given that this situation is unlikely to change in a great hurry, a significant portion of the heavy lifting in financing Indias consumption and investment growth would need to be from external sources whether in the form of debt or equity. In addition, if the minimum 25% public float norm for listed companies is enforced strictly, the supply of paper in the form of new issuances would be at record levels and would require an unprecedented high level of support from foreign investors.

Against this reality, it is prudent to have policy action that actively encourages foreign capital inflows. Frequent noises about controls on capital flows emanating from diverse quarters would need moderation till domestic savings can fully finance our growth ambitions. Meanwhile , all is not well with the outlook on potential foreign inflows. With the credit rating agencies finally taking on board the economic reality facing several southern European countries, sovereign credit downgrades are happening at a quick pace. Soon enough, Europe would realise that pumping in short-term liquidity is not the appropriate medicine to treat what are essentially serious sovereign solvency problems.

Without some debt restructuring, it is difficult to see how countries like Greece, Spain and Germany can remain a part of the monetary union for long. Moreover, the ongoing Bank stress tests in Europe have the potential to bring out harsh facts about the near-insolvency of several Banks holding weak sovereign bonds. Even a mild repeat of a Lehman-like crisis with some European countries being unable to service their debts can cause the global financial markets to freeze with predictable consequences on risk appetite and potential capital flows into emerging markets like India.

The India growth story based, among other things, on high returns on equity and improving corporate governance standards is well captured at current market valuations. Only unprecedented levels of capital inflows to more than adequately absorb increasing equity issuance levels can help sustain the market at current or higher levels.

Given the fragility of the global recovery , the self-congratulatory tone of the decoupling discourse about India needs some serious tempering.

 
 
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