Monetary policy – it’s a turn for sure, BUT no U turn as yet!

RBI governor would be announcing the outcome of quarterly monetary policy review this week. Street is in a fix and so are the policy makers as whether the time for the reversal of the easy monetary policy has come or not. Early reversal could impact the economic growth while prolonged easy policy has its consequences in form of inflation, and could be enabling asset price bubble formation. We are certainly out of the woods and see the path to higher growth; though the concern remains as an early withdrawal could send us back to where we were earlier. On one hand we are still way below our potential economic growth, exporting sector still in doll drums, manufacturing recovering but well below their full capacity utilization; in sum output gap is still wide open. On the other side of coin is the high and increasing inflation; CPI never saw single digit growth number for more than 18 months now; WPI is out in green from a short statistical negative zone. Year to date inflation in 2009 is far above than those in 2008; and the gap is expected to be widening every week, with the expectation of well above 7% by end of fiscal if easy policy continues.

Given the backdrop I expect RBI to take actions to contain inflationary expectations while continue to enable continuation of economic growth. Ideal move, but how would they do it? To contain inflationary expectation they would be reducing the excess liquidity from the system for sure (through increase in CRR, to begin with 50 bps). Let me remind you that the reversal of the monetary policy accommodation would be in big steps and not in small bits, remember the large steps they took while loosening the policy.

Step 1- Increase CRR by 50 bps, to continue until inflationary expectations fueled by the excess liquidity is contained. In my view, this would take about 150 bps increase in CRR rates over next 9 months.

Okay, but if you do that wouldn’t the recovery story suffer? Well may not be so, as they would also be reducing the repo and reverse repo rates to the magnitude of another 25 bps. Which will enable RBI to single continuation of low rate environment; and to incase credit flow in the system rather than parking funds with RBI under LAF. This would also help in taking the pressure off the G-Sec yield curve due to high government borrowing requirements.

Step 2- Reduce repo & reverse repo rates by 25 bps. Lower rates environment to continue until Feb next year; further course would be dependent on the Budgeted fiscal deficit for FY11.

That should work in containing inflationary expectations, while not choking the economic growth per se!!! If the rates were the concerns you had, you may stop reading further. No change in SLR requirements is expected as of now; though one percent reduction allowed may be rolled out. We are also expecting the withdrawal/non continuation of some of the temporary liquidity measures announce over the course of last one year, as they are no longer needed/utilized, e.g. liquidity facility for mutual funds etc.

This is not all what we are expecting from the monetary policy, we also expect some change in securitizations rules for the banking sector, banks may be asked to keep the securitized assets on their book for six months, and may not allowed to sell down entire bucket, to help in retaining credit balance. RBI wouldn’t want to make the mistakes of the developed world by creating junk securitized assets.

Step 3- Restrictions on securitization of assets in full & immediately, this would mean banking sectors fee income growth may see some decline.

Other policy measures would be in form of introducing the new Base rate system, some time away from now. We may also see some announcement in view of financial sector reforms by allowing foreign banks to enter Indian market freely. However, we are not expecting any significant change in the course of capital account convertibility or shall I say dual listing?

Economic Impact Analysis: Union Budget 2009-2010

We expect a sick but recovering patient (Indian economy) to begin by climbing hills, and not mountains.

Are we past mid-night?

Borrow to pay interest….

On July 6^th, Mr. Pranab Mukherjee unveiled the budget with biggest expenditure of 10 lakh crore in Indian history, against earnings of 6 lakh crore with fiscal deficit at 4 lakh crore (6.8% of GDP). Of this 4 lakh crore, 2 lakh crore would be used to pay the interest!!! Add off-balance sheet items (i.e. specific bonds on fertilizer and oil) + state level fiscal deficit (now allowed up to 4% of GSDP) … we are talking about funding gap of 7 lakh crore (overall deficit at 11-12% of GDP).

…but where is the money

As on June 19, bank credit stood at 30 lakh crore and investments by banks in G-sec at 14 lakh crore. Incremental deposit growth to banking sector is about 7 lakh crore (22% growth rate annually), and the money supply growth is at 8 lakh crore (20% growth rate).

In such scenario, almost every additional rupee added to the system would get sucked by the government borrowing. What would be then left for the corporate sector borrowing? NIL! That is why we are concerned over the rising fiscal deficit!!!

How RBI can find the money

At the risk of being innovative, one option is to utilize the gains on foreign assets (managed by RBI). For example, RBI holds US treasury in its foreign reserves, with yield falling off the cliff from sub 4% levels to near zero (0.25%). The value of those US treasury holding would have jumped by 13 times. However it doesn’t get reflected in our reserves since the MTM valuation is done only for the losses and not the gains. RBI could monetize such gains and pass it on to the government in form of dividend. Though there is no such precedence to back this argument and it’s more of theory!

Other option: RBI could indirectly purchase G-sec (since under FRBM Act RBI isn’t allowed to directly purchase G-sec, resulting in monetization of the debt) and leave the liquidity in the system for corporate borrowings. Negative side of such move would be the high rates of price increase. As system is already flush with liquidity (recently about 1.5 lakh crore is getting parked with RBI under LAF window), adding more money in the system would push up the prices of both consumables and assets. The government is placing higher importance on the growth than on the price levels, we expect government to live with high inflation levels and stay focused on growth. We believe future policy decision & rate changes would be increasingly determined by growth and not by inflation (as was the case before).

Under reporting of income…..

In our view, the government has under budgeted its revenue on both tax and non-tax revenue front.[1] Government has budgeted 35,000 crore for 3G spectrum and mere 1120 crore from disinvestments proceeds. We expect the non-tax revenue to be at much higher levels than budgeted on account of higher disinvestment proceeds and NELP-VIII auction. If the economy recovers as expected then we would also have higher tax-revenue resulting in lower deficit numbers than the budgeted one. Government has also not accounted for increase in tax revenue due to higher MAT.

…with huge subsidy bill

In FY09, subsidy burden was over 2 lakh crore amounting to 40% of net revenue receipt of the Government and 4.1% of GDP. Though the government is expecting the subsidy bill to come down in FY 10 by 14%, it is expected to remain over 1 lakh crore in current fiscal.

Subsidy Bill	RE 2008-09	BE 2009-10
Major Subsidies	122,352	105,579
Food	43,627	52,490
Indigenous (urea) fertilizers	16,516	9,780
Imported (urea) fertilizers	10,981	5,948
Sale of decontrolled fertiliser with concession to farmers	48,351	34,252
Total Fertiliser Subsidy	75,849	49,980
Petroleum Subsidy	2,876	3,109
Interest subsidies	4,063	2,601
Other subsidies	2,827	3,096
Total Subsidies	129,243	111,276
Does not include off-budget subsidies (Fertilizer bond: Rs. 20,000 Cr; Oil Bond: Rs. 75,942) in FY09

We do not expect India’s sovereign ratings to get downgraded

India enjoys sovereign rating of BBB- from Fitch and S&P and Baa3 by Moody’s. S&P had revised the rating outlook to Negative in Feb’09; Fitch retained the neutral outlook while affirming the rating in Nov’08; and Moody’s in Aug’08 affirmed the rating with stable outlook on local currency and with negative outlook on foreign currency rating.

Though all the rating agencies have raised their concerns on higher fiscal deficit, they maintain that it is within the expected level and unless corrective measures are not taken in medium term the ratings may be downgraded. In our view, the sovereign rating of India would not be downgraded until the Budget of FY11. Why? Because, rating agencies put higher emphasis on the stability of the rating and even more so for border line cases, as India’s rating is lowest in Investment grade, i.e. a downgrade would make India’s rating sub-investment grade (which has wide reaching ramifications). Rating agencies may re-look at the outlook of the rating after the recommendations of the 13th Finance Commission are submitted by October. However, if the government fails to provide a reasonable plan of action towards fiscal consolidation in the next budget then we are certainly at the risk of getting downgraded. Please note that the next budget is only 6-7 months away and not one year!!

Interest rate

We do not expected significant hardening in the rates in near term, as RBI is expected to maintain surplus liquidity in the system. We expect G-Sec yields to be ~7%, and rates to harden quickly post Oct/Nov. All said and done volatility in the interest rates are here to stay, which makes it much more difficult task for corporates to manage their borrowing requirements.

Crude Oil

In view of world economy contracting this year by 1.9% (first time since 1930), we retain our earlier forecast of the crude oil prices to remain in range of $60-$70/barrel.

Currency and BoP

We expect current A/C to be in surplus on account of relatively stable invisibles and fall in trade deficit (on account of both the contraction in export/import and fall in crude prices, coupled with new hydrocarbon discoveries in India). The overall currency movement would largely be dependent on capital flows in the economy.

Huge fiscal deficit, contraction in export/import and flow of foreign money in the domestic economy provides support to our earlier estimate of rupee appreciation in medium term (9-12 months). However in the short term we may witness rupee depreciation. Though we expect the rate and magnitude of change to be muter than the ones witnessed in past.

Enough to eat if monsoon fails…

Wheat procurement in the current wheat season crossed 250 lakh tonne mark. This represents an increase of 23 lakh tonne over the procurement made in the season 2008-09 (226.89 lakh tonne). However, uncertainty over the monsoon (likelihood of drought), fall in sowing area and lower productivity could pose challenges. The budget has estimated the GDP deflator at 3.5% for FY10. In our view, with economy growth being the foremost target of the government, high WPI/CPI may be allowed to stay. Possibility of revision in the index itself and shift to longer reporting window (monthly from weekly) are on anvil.

Future Policy Direction

In light of the above, we expect quite a significant amount of policy announcements towards fiscal consolidation in form of divestments, and policy reforms to increase private investments.

Next Monetary policy review is due on July 28, 2009. We expect RBI to announce measures for smooth execution of government’s borrowing program and continue with expansionary monetary policy till Aug/Sep, government is also likely to front load its borrowing requirement. In view of the above we expect further reduction in CRR/SLR by 50bps, and no change in Repo/Reverse Repo rates.

The situation could get worrisome if the government’s borrowing program isn’t done with in time; and the economic growth remains subdued. As the inflation would start rising sharply post Sep’09 and could be in double digits by end of the CY 2009.

We expect:

· Currency to depreciate in near term (next 3 months), and appreciate in medium term (9-12 months)

· GDP growth to be subdued in 1H (Apr-Sep) and pick up in 2H, recording FY10 growth at 6%.

· Expansionary monetary policy to continue until large part of government borrowing is complete.

· Interest rate is likely to remain in lower territory for the near term, and to harden in CY2010.

· Low likelihood of sovereign downgrade in CY2009.

· Private investments to be subdued likely to be off-set by the public investments.

· Consumption growth to be the driving factor of the economic recovery.

· Government to try and push disinvestments wholeheartedly.

Risks:

· RBI to manage smooth execution of government borrowing.

· Global growth to pick-up post Sep, revival in trade and hence stability on Indian growth front.

· Monsoon to not play a spoil sport, delaying the recovery.

· Efficient execution of the proposed large government expenditure.

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[1] The Gross Tax Revenue as a percentage of GDP increased from 9.2% in 2003-04 to 13% in 2008-09. Estimated tax revenue is at 10.9% of GDP in 2009-10. Non-tax revenue increase is budgeted at Rs. 28,000 Cr.

A Pasoly in the eye is worth several in the shins…..

Expecting budget to take away all your pains??? Look no further and let’s not forget that the budget is just an accounting exercise of the government. Taking stock of income, expenditure and borrowing requirements. One must not have high expectations about the policy changes, reforms and big push etc. else you are bound to be disappointed!!!

CPI inflation has crossed double digits again (from 9.09% in April to 10.21% in May’09) even as WPI inflation is negative! High CPI inflation means savers face a negative real interest rate. Low WPI inflation means industry faces high positive real interest rates. That leaves very little maneuvering left on the monetary front. The entire onus of pushing the economy then falls on the government which might impact its already brittle investment grade rating due to the rising fiscal deficits. Having said that, we do expect government to adopt innovative steps in order to maintain economic growth and contain deficit.

The task at hands of the FM is by no means normal. The government has identified infrastructure as a key thrust area—both in its manifesto and in the President’s speech outlining the policy priorities for the new government.

General expectations from the budget are:

Ø Infrastructure push

Ø Supporting consumer expenditure

o Increased tax brackets (while targeting larger base), if not ‘helicopter money’ (read farm loan waiver)

o Push for higher rural employment

Ø Providing impetus to labor intensive sectors through tax sops and interest rate subventions.

To contain fiscal deficit in manageable labels, budget is likely to have provisions for divestment. We may also see new form of FRBM Act in light of changing economic scenario, outlining the path for the fiscal consolidation and shift from cash accounting to accrual based accounting system.

We would do well to be aware of the fact that what gets presented in the budget speech on July 6^th may not be what it would end up to be. As in past as well there have been significant changes from the budget speech to the final budget.

How plausible is Q3 recovery?

Everyone invariably wants to believe that the Indian economy would on the recovery stage by 3rd quarter for 2009-10. However, in the current economic and political scenario this optimism has its own downside risks. Everyone wants to believe that the word recession has had its impact on India but not many realize that the worse is yet to come! We are yet to see the bottom, which we may witness in another 3-6 months.

Risk of a hung parliament in the next election (schedule of which could be announced within a week) leading to the political uncertainty and delays in policy responses could very well entrench the time to recovery path. The pre-poll survey by CNN-IBN predicts a Hung parliament in the coming Lok Sabha elections. The governing UPA is projected to get between 215 and 235 seats and the NDA to get 165 to 185 seats. Something which we witnessed last decade, in 1989, and 1996 elections when we saw 5 governments in 5 years (1989-1991: 2; 1996-1998:3), general elections being held at interval of one year rather than the five years (1989, 1991, 1992 and 1998, 1999).

Just the visualization of such a scenario sends jitters across the spine! No meaningful policy actions to counter the worsening economic scenario; coupled with political uncertainly; another round of elections could push us in long de-growth phase which we are yet to price in be it in the equity markets or other asset markets.

On the fiscal front, the deficit figure would be hovering in double digits for this and in the next fiscal. Recently, S&P changed it rating outlook on India from stable to negative in light of the worsening fiscal situation and reverting all the consolidation benefits of past several years. FRBM act have been kept on the book self for the time gathering dust and may not see the light of the day until the economy recovers from the doldrums!

On monetary policy front, market participants are betting at 100-150 bps rate cut by RBI। The recent GDP slowdown from earlier 9% to 5.3% in Dec quarter with expectation of further slowdown to below 4% in next two quarters could force to cut rates drastically, may be by over 200 bps in near term. We all believe that the monetary policy actions are more likely to bring India back on the growth trajectory faster than the fiscal stimulus packages being announced by the government straining its fiscal position severally. An estimate suggests that a 100 bps policy rate cut is better than the 200 bps indirect-tax rate cut. However, huge borrowing requirements of both the central and state governments would keep the pressure on the interest rates, despite monetary easing.

Corporate borrowing costs are unlikely to come off significantly under this scenario, straining both their BS and P&L। Dropping sales and increased cost has caught all the corporate on their wrong foot of expansionary mode. We are yet to witness large corporate defaults due to financial strains even in the highly strained sectors like automobiles, real estate, and metals. Recent downgrades of some of the major players in the sector by the rating agencies point towards the increased likelihood of such event in near future.

Just how much money is at stake in shares pledged by promoters?

SEBI in its recent directive in January mandated disclosures regarding pledge of shares by the promoter and persons forming part of the promoter group to the company and by the company to the stock exchanges where shares of the company are listed, post Satyam fiasco.

Ever since the companies started disclosing this information, market learned the degree of this financial engineering, which looks like and Indian version of western word’s CDO/MBS.

Majority of Indian companies have been pledging shares for more than two decades, if not longer. There are 114 companies where promoters have pledged more than 50% of their stake, and about 22 companies (about 5% of disclosing companies) have pledged more than 50% of their paid up shares. Promoters of 467 companies have pledged with lenders an average 23% of their holdings so far. At current market prices, the total value of pledged stocks is over Rs 62,000 crore. This is over 2% of Indian stock market’s market-cap of Rs 30.33 lakh crore.

Promoter’s pledged shares represents, on average 17.07% of paid up shares. As per the data available for 3,483 listed companies, Indian promoters hold 49.85% of paid-up shares of these companies as on Dec’08. Generalization of this to all listed entities, suggests whopping 258,107 crore[1]. Assuming 50% margin, the bank credit to these promoters could be pegged at Rs. 129,000 crore (about 5% of credit by entire banking system in the economy)!

What would happen if the equity prices continue in its downward trend, eventually forcing promoters (those who have pledged their almost entire stake in the company) to default leaving financial institutions no other choice than to off-load all the equity in the market? And if they choose to off-load these pledged shares in the market, its bound to cause havoc on the equity prices, set to crash by at least 20-30%, and eventually the losses financial institutions may have to bear could be well about 100,000 crore (about 25% of Scheduled commercial banks capital, reserves and surplus as on March’08).

The question in every investor’s mind is whether it is just a corporate governance issue or a much deeper financial problem looming its head? Is our banking system strong enough, as argued by almost everyone in past, to whether out such blow on their balance sheets? Are they capitalized well to survive?

[1] SEBI directive doesn’t ask mutual funds to disclose their pledged shareholding. Mutual funds are also expected to have pledged shares to the tune of Rs. 3,000 crore.