November 2017

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Nov
3

Globally, the world’s attention last month was focused on Beijing as Chinese premier kicked off the 19th Party Congress, and laid down the quality of growth as an over-arching objective of Chinese economy. The vision is to turn the Chinese economy into an innovation hub governed by the rule of law and accompanied with much cleaner environment, adequate public services and reduced inequality. This all fits in with the continuing macro theme of rebalancing. Xi Jinping’s grip on power has been getting stronger. The main achievement of Xi’s first five years in power has been to restore the credibility of the Party in the eyes of the Chinese people. Plenty of extra leverage has delivered a nice kick to the Chinese economy with growth almost scratching 7% over first half of 2017. Further, with expanding military footprint and large pile of FX reserves to back-up the ‘One Belt-One Road’ initiative, Xi is clearly showing the determination to lead China to become an economic and political superpower.

Back home, India made a bold move on 24th October as the government announced a big-bang recapitalization plan for the public sector banks.

Rewind to the decade back. While the Indian economy fairly withstood global shock emanating from the Lehman brother crisis, it embarked on an ill-appraised lending. On top of that, the policy paralysis and execution logjam added to the piling up of bad debt, which started to gradually show up in the banks’ balance-sheet starting early 2014. After toying with numerous alphanumeric soups such as 5/25, SDR (Strategic Debt Restructuring), CDR, S4A, IBC (Insolvency and Bankruptcy Code) and other measures such as Indradhanush, the government finally gave in to large scale capital infusion (worth Rs. 2.11 trillion) into the public sector banks (PSBs) last week.

As is widely known, of the Rs. 2.11 trillion (~1.3% of GDP), Rs. 1.35 trillion will come in the form of recapitalization bonds, Rs. 180 billion from the budgetary support (the amount left to be infused under the Indradhanush plan) and the remaining Rs. 560 billion is expected to be raised through market sources.

The modus operandi of issuing the recap bonds will require the Government infusing money (capital) into the banks, which will be utilized by banks to invest in government bonds. If the 1990’s model is followed, then the recap bonds could be issued as non-marketable securities with fixed coupons where subscription to them becomes cash flow neutral for the banks. That said, the exact modalities of recap bond issuance (SLR/HTM/repo treatment etc.) are awaited.

Infusing capital into the PSBs was the need of the hour and has been rightly addressed. It will help banks to improve their capital ratios at a time when the adoption of Insolvency and Bankruptcy Code (IBC) is accelerating the NPA resolution and also support in meeting Basel III requirements. Having a fresh equity of such large scale will not only help cleaning up the banks’ balance-sheet, but also gradually provide a booster to the languishing supply of credit.

While one may argue that India’s weak credit growth today faces challenges from both supply and demand side. Indian businesses have plenty of spare capacities and many are still over-indebted. However, despite this, there are still many areas such as affordable housing, infrastructure and SMEs which show potential to expand. For instance, Indian government also gave a renewed impetus to its BharatMala Project. BharatMala project is an umbrella scheme for highway development across the country. Overall the scheme is expected to cover 60,000kms with an investment of Rs. 8 trillion. Definitely, there is a want of funds for such large-scale infrastructure projects.

While the recognition of ropy loans and infusion of the adequate capital addresses the stock problem in the PSBs, there is still a pending need to address the flow issues of personnel management, technology and appropriate credit appraisal system in the public sector banks. Being a capital transaction, it does not account to a rise in fiscal deficit as per IMF standards. However, public debt will rise. If this plan is intended to be cash-flow neutral as well as deficit-neutral, it should not be disruptive for bond markets, especially as no additional government bond issuance is required now.

Thus far into 2017, apart from the PSB recapitalization, we have seen three major structural moves with long-term positive underpinnings. In May, we saw the implementation of Real Estate Regulation Act and empowerment of RBI to direct banks in recognition of stressed accounts. Then during the year, we saw the GST going live. We also saw some of the politically compelled actions such as commitment to waiving farm loan by select big states and reduction of taxes on petroleum products. These measures (i.e. farm loan waiver, fuel tax cuts, bank bail-out, higher revenue spending) come likely at the cost of raising fiscal concerns. The stability of Indian currency today can be explained by the relatively high real interest rates and reform-oriented government. But the possibilities of fiscal slippage may be a risk from currency point of view.

It has been four months since the GST went live. Implementation of GST remains very much a work-inprogress. The tax base has increased, but it is not clear if it has widened since services business will have to register in multiple states as against a single pan-India service tax registration before. The composition scheme, which was expected to ease compliance burden for many small businesses, has not found many takers yet. Invoice matching is one of the key features of the GST design in India and we are yet to go through one complete cycle of invoice matching and tax payment. There is anecdotal evidence of working capital stress on small firms selling to larger businesses. On the positive side, there is anecdotal evidence of ease in movement of goods across state borders.

The earnings outcome for Q2 FY18 thus far suggests some reversal in the profit growth (~5% growth for 30 NIFTY companies that have reported results) along with higher topline growth (9.8% y-o-y) and improved operating profit (10.2% EBITDA growth). That said, few companies (Tata Steel, HDFC Bank, IOCL, and Reliance) accounted for most of the earnings growth and broad based recovery is yet to be seen.

Improved earnings and economic data, relaxation in GST provisions and PSB recapitalization move helped NIFTY to deliver 5.6% returns during the month, making India the best-performing market among the emerging economies. YTD, NIFTY has delivered 33% returns in USD terms and 26% in rupee terms, relatively higher than 30% dollar returns delivered by MSCI Emerging market Index. Accordingly, valuations continued to remain elevated at ~21 times 1 year forward earnings. While policy reforms and robust liquidity have supported the market, as we get closer to some of the key state elections and 2019 general elections, one can expect political underpinnings to play a role from the headline perspectives. We continue to focus on bottom up stock picking for alpha generation.

Bond yields, on the other hand, have risen (10 year G-sec up by 20bps in October) on fiscal concerns leading to a possibility of increased bond supply rising global yields and market expecting an elongated pause from RBI. Further, the announcement of bank recapitalization also inched the yields upwards owing to the likely expansion of total government debt, and a slight boost to growth/inflation expectations.

Navneet Munot

CIO – SBI Funds management Private Limited

 

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