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Macro Squeeze: Here Comes The Triple Punch

27 January, 2010
India’s nascent economic recovery is about to run into the triple punches of a fiscal squeeze (in the Union Budget), monetary tightening and soaring inflation. This will make life difficult for investors the further we venture into 2010. The three sectors most exposed to this triple punch are Banking, FMCG and Consumer Durables. The three sectors best placed are IT, Power and Infrastructure.
 
 A NASCENT ECONOMIC RECOVERY…
 
Contrary to popular perception, the economic recovery so far has been driven by a few sectors (mining and manufacturing, capital goods, intermediate goods, consumer durables) and by heavy public spending (accounts for 2.5% of the 7.5% GDP growth that India is expected to clock up in H2 FY10 ). At a fairly critical juncture of the recovery (when capex still hasn’t taken off and when credit offtake is still close to its 10-year lows), this recovery has run into a triple whammy of inflation, monetary tightening and fiscal tightening.

 ….WILL RUN INTO A MONETARY SQUEEZE….
 
Food and commodity inflation is becoming more generalised as it ripples through the supply chain and pushes up wages. We expect WPI inflation to be ~10% by the end of FY10 (currently 7.3%). With its fiscal firepower to absorb inflation limited, the Government has put the onus for fighting inflation on the RBI. We expect the RBI to raise the CRR by 50 bps on January 29, 2010 and then follow it up with 50 bps of repo rate and reverse repo rate hikes later in the year (possibly in April) when credit offtake reaches healthier levels.
 
….AND A FISCAL CORRECTION
 
Over the past six months, as tax collections have stayed weak and as the government has become acutely conscious of the need to meet the 6.8% budget deficit target, we have seen a sharp decline in all forms of public expenditure. We expect these cuts to continue in the Union Budget to be presented in February. We also expect to see the rollback of the indirect tax cuts implemented during the credit crisis.
 
SECTORAL IMPACTS
 
The sectors which are adversely exposed to this triple squeeze are FMCG (input cost pressure), Consumer Durables (top line and input cost pressure) and Banking (MTM hits). The sectors that stand to benefit from this environment (largely due to Govermental largesse in the budget) are IT (STPI extension), Power (tax breaks), Infrastructure (tax breaks), and, to a much lesser extent Stock broking (STT reduction).
 
FMCG: This sector will suffer from EBITDA margin pressure due to rising input costs. Furthermore, the public expenditure cuts could adversely impact the FMCG spend of low income and rural customers (who now make up half of the FMCG customer base).
 
Consumer durables: Over and above the pressure exerted by rising input costs, for big ticket items such as white goods and auto, the rise in indirect taxes will exert a meaningful drag due to the size of the absolute price rises now faced by consumers. Finally, rising interest rates will make it more expensive for consumers to borrow and buy.
 
While the economic recovery should help banks (both from a credit growth and from a credit quality perspective), the rising long term bond yields (driven by inflationary fears) are likely to generate MTM concerns (particularly for the PSBs). We have shown in our previous notes that not only are banks’ ROEs negatively correlated with the interest rate cycle but also that Public Sector Banks’ stocks are very strongly negatively correlated with long term bond yields .
 
IT: Every year this sector petitions the Government to have the STPI tax exemption scheme extended (the current scheme expires in FY11). These extensions are almost always granted since the STPI tax break is a potent source of extra profits for the IT firms (thanks to STPI, the IT firm’s effective tax rate is around 15-25% rather than the normal corporate tax rate of 34%).
 
Power: We expect the sunset clause for availing the tax holiday available to power companies to be extended to March 2012 from March 2011. We also expect exemption of import duty on power equipment for power projects of size between 500-1,000 MW (presently available to > 1,000 MW size) and private merchant players to get a credit/offset on the tax paid on input costs (both on the capital side and on the operational side).
 
Infrastructure: While the political imperative to build infrastructure might lead to specific fiscal incentives being offered, powerful political lobbying means that airports could be particularly favoured by this budget by being offered the same 10-year tax holiday that other infra projects in India get. Moreover, if the airports are allowed to extend this tax holiday to the profits they will make from the enormous swathes of real estate around the airports, airport-related stocks (GMR and to a much greater extent, GVK) will rally strongly.
 
Stockbrokers: The removal/reduction of STT can be a major positive for the arbitrage desks of the stock brokers because it could increase the arbitrage yield by 300-400 bps. (Edelweiss earns 30% of its revenues from arbitrage and will benefit if such a tax reduction comes through.)
 
Inflation – What can the RBI do now?
 
Given that we believe that the inflation fighting role has currently been delegated almost entirely to the RBI, we retain the forecasts made in our October policy squeeze note of a 50 bps increase in CRR in January 2010 followed by a 50 bps increase in April 2010 of the repo rate and the reverse repo rate.
 
We do not expect the RBI to raise the short term rates for liquidity management (repo rate and reverse repo rate) in January 2010. An increase in repo rate would be ineffective as the market is in reverse repo mode with Rs 800 billion parked with RBI.
 
On the other hand, an increase in the reverse repo rate would be rewarding the banks for their idle reserves with the RBI at a time when weak credit growth has emerged as a major source of concern. Hence we expect the repo and reverse repo rate rises to be held off until later in the year.

 


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Macro Squeeze: Here Comes The Triple Punch

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