It's all about managing success

It's all about managing success
Bill Belchere, Asian Economist, Macquaire Securities for ECONOMIC TIMES

Sitting In Hong Kong, one misses a lot of the local colour that makes India such an exciting investment story. One also runs the risk of becoming so engrossed watching the Indian economy and equity market from afar and minimise the challenges that may spoil the story. However, Macquarie does have a reasonably large and growing local presence to help us balance our views of the economy.

We continue to be believers that India’s growth potential is in the 9-10% range against the market consensus of 8-8.5% . There is a reasonable chance that Indian growth will quicken over the course of FY08-09 after a modest slowdown this year. So, while we agree with the consensus that the real GDP growth will expand by 8.5-9% in FY07-08, we believe that it is more likely than not that the economic activity will pick up well above 9.0% in FY08-09 against consensus expectations of 8.2%.

We concur with the monthly data, which suggests that the growth trajectory is softening. From April through August, industrial production slowed slightly. The slowdown was concentrated in manufacturing (16% of GDP and 80% of industry), as gains in electricity and mining output actually accelerated. Industrial trends clearly confirm the slowdown in consumption while investment continues to accelerate.

Furthermore, the lagged effects of the RBI’s efforts to control demand appear to be working as envisioned. While overall domestic credit expansion remains steady at around 20% YoY, the rapid growth in commercial sector credit, particularly non-food, has slowed toward 20% after RBI increased risk weightings and provisioning requirements aimed at reining in consumer and property demand.

On October 31, the RBI left its policy rates unchanged as expected. Given the recent strength of the rupee, we are not surprised that it decided to raise the cash reserve ratio (CRR) by 50 bps to 7.5%. This will drain a mere $5 billion out of the banking system, which is far less than the $20 billion increase in India’s international reserves in September alone. As long as the US Fed keeps cutting rates while India remains on hold, capital inflows will continue. We don’t expect this to be the last hike in the CRR.

Why are we so certain that growth will re-accelerate in FY08-09? There are several reasons besides our differing view on India’s sustainable run rate. First, the current slowdown is concentrated in the high-end consumer and real estate sectors. But investment spending remains robust and this will provide the productive capacity for a rebound in economic activity in FY08-09.

Secondly, we believe elections will most likely be called after early next year providing the UPA government plenty of time to add stimulus with the announcement of the budget as well as accelerate project spending at all levels of government aimed at relieving infrastructure bottlenecks. Thirdly, bank interest rates are beginning to soften, which we expect will re-invigorate consumer and private construction spending. Private consumption accounts for 60% of the GDP and construction spending will boost investment into the 35-40% of GDP range.

Finally, the RBI’s demand management efforts by controlling liquidity will prove futile over the longer term. Luckily, inflation has dropped well below expectations. But the current measures are designed to deal with liquidity pressures that are interpreted to be temporary. We believe that India, like China, is a bullish structural growth story and the net capital inflows into India will only continue to mount. They are more structural than cyclical in nature. At the same time, this structural element renders an open capital account, a fixed exchange rate and an independent monetary policy well-nigh impossible over the longer term.