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.