Policy Fallacy in Indian Microfinance

A snippet on State Intervention and the resultant Mockery

Financial inclusion and access to finance has been one of the large failure stories of the Indian state intervention. India’s policy thrust for financial inclusion has always been well intentioned with the apex bank pushing for easy capital availability through a slew of policy initiatives; however capital delivery has consistently evaded the target segments. While the Regional Rural Banks have failed to grow without sponsorship of large state owned banks, priority sector lending initiatives have largely been conducted as a top down policy-fulfillment objective rather than a need based bottom up approach. This effectively fuelled the rise of informal sources of finance at costs that have had the exactly opposite effect of achieving financial security, low cost of credit and inclusion.

The Indian private sector after a much wait and watch approach and buoyed by the global success of micro credit loans in the rest of the world stepped in to full fill the role of financial inclusion at an institutional level. Today, India has around 200 million bank account holders and far fewer numbers who access other formal financial services like credit and insurance. A study conducted by the Centre for Microfinance in Andhra Pradesh in 2009-2010 revealed that 93% of the surveyed households were indebted. 75 % of these households were indebted to moneylenders and other informal sources of finance in-spite of fairly high penetration of banking among these households. Micro finance Institutions accounted for 11% of the indebtedness. (Source: Access to Finance in AP, Doug Johnson, Sushmita Meka)

The Indian Microfinance industry (MFI) represented the middle ground between formal financial services provided by banks and informal financial services provided by moneylenders. The industry grew rapidly in the period 2004-2009, with an average increase in number of clients year-on-year being 91%, while the size of micro credit outstanding grew by almost 100% Y-o-Y indicating the massive levels of under penetration to a large part of the Indian population (source: ‘Inverting the Pyramid’, Third Edition, Intellecap Publication). The business models of microfinance also evolved in this period to become businesses which seek capital from the formal sources and lend to the poor at a margin as opposed to the non-profit model earlier.

This period of high growth was accompanied by a barrage of private equity investments chasing established as well as start up microfinance operations. One of the pit falls of the break neck speed at which micro credit grew, was an inherent oversight in capping credit to customer who have borrowed credit from multiple sources. This resulted in multiple refinancing to the same customer resulting in repayment stress and leading to a few cases of personal extremities; an apt calling card for political intervention. Accompanying these events was a two pronged media coverage highlighting (a) the new and seemingly limitless investment & profit opportunity keeping in perspective India’s unbanked population and (b) the anti-thesis to such investments – financial strangulation of the poor. While both arguments had its merits, the second parameter was again an opportune moment for a bit of political mediation. Only, it did not remain confined to a bit.

This period of high growth came to a halt in Oct 2010 with the passing of the Andhra Pradesh Microfinance regulation act. Spurred on by allegations of unfair lending practices and exploitative debt recovery, the AP government, without adherence to what may have been sporadic cases of poor lending, clamped down on the entire microfinance industry in the State. Borrowers across the State sensing social and political sympathy sensed an opportune moment to default thus throwing the entire industry in a tizzy – among others, micro credit leaders SKS Microfinance and Spandana saw serious depletion of their networth and ability to continue. This opened the floodgates of regulation – the Microfinance Institutions (Development and Regulation) Bill 2011 - which was provisionally approved by the cabinet. The bill seeks to handle regulation of MFI's to the RBI and address multiple issues like prudential regulation and registration of MFI's . As per the draft, it would be mandatory for micro finance institutions (MFI) to be registered with the Reserve Bank and have a minimum net-owned funds of Rs 5 lakh. In addition, a Micro-Finance Development Council will be set up to advice the government on formulation of policies, schemes and other measures required in the interest of orderly growth and development of the sector with a view to promote financial inclusion. 

The bill is a classic example of "well intentioned" government intervention in a sector where a market failure has not been conclusively demonstrated. While it provides for certain broad controls and regulation, it fails to answer the question that led to the industry in the first place: what is the policy stance on ensuring credit delivery to the rural and urban poor?

Vinod Kothari, a micro credit securitization expert writes: The word “micro credit” itself is not defined. First of all, there is no monetary limit to the definition of micro credit provided in the law – that is, loans of what amount are “micro credit”, and beyond what amount they cease to be micro credit. Neither is there a definition by reference to who the borrower is - that is, whether loans to rural or urban or both borrowers would be micro credit. It is a surprise how the regulator skipped defining a parameter as rudimentary as this. The cause effect of this will now be regulatory stringency in determining who is a Microfinance NBFC and who is not a Microfinance NBFC – creating another set of regulatory confusion without addressing the core question of how do we deliver cheap credit to the poor.

On another note, the applicability of prudential norms to micro finance institutions also gives away the poor understanding law makers have of MFI's as a business. MFI's unlike thrifts or banks do not incur asset liability mismatches which are very large. The institutions they borrow from are already prudentially regulated and by increasing level of prudential regulation of MFI's the government is increasing the cost of MFI business adversely impacting their capacity to raise credit.

The MFI industry has shown a 20% decline since the AP ordinance. The impact on large MFI's is much more as they have not been able to access credit and they have shrunk in size. As a result, the broader policy questions remain to be asked: What has the regulator done to reign in larger unorganized money lending industry targeting the rural and urban?

While the Central Government’s Credit Guarantee Fund Trust for Micro and Small enterprises (they essentially provide collateral free lending for small sums of money – from zero to Rs.10 Lakhs) is a strong initiative in enabling formal credit to small and tiny enterprises, the Government needs to replicate a similar initiative one step below the tiny enterprises to ensure delivery of affordable credit to the unbanked population – a crucial step in ensuring the delivery of the great Indian demographic dividend.

Bibliography:

(Funding to the microfinance sector: Review of options Guest Article by : Jayshree Venkatesan, CEO, IFMR Mezzanine and Vineet Sukumar, Head, Treasury and Origination, IFMR Capital)

http://articles.economictimes.indiatimes.com/2011-08-13/news/29884306_1_mfis-microfinance-institutions-rbi-deputy-governor 
http://www.moneylife.in/article/experts-concerned-over-new-draft-law-on-microfinance-sector/17968.html
http://www.firstpost.com/business/microfinance-bill-will-do-little-to-help-sks-heres-why-306038.html
http://www.indianexpress.com/news/micromismatch/814369/
http://microfinanceafrica.net/microfinance-around-the-world/india-microfinance-sector-may-decline-20-40-this-year/
http://ajayshahblog.blogspot.in/2011/10/policy-and-legal-review-of-micro.html
http://www.centre-for-microfinance.com/wp-content/uploads/attachments/csy/1602/IIM%20Regulation%20V11.pdf
http://www.microfinancefocus.com/microfinance-institutions-bill-%E2%80%93-bunch-conceptual-and-drafting-problems

Safe Haven Asset Behavior

Modern portfolio theory assumes that the relation between risk and return is a linear line and investors increase their required rates of return as perceived risk increases.  During periods of slackening economic activity i.e. recessions, rational investors’ expectations of return per unit of risk increases.   There is a preference for low risk assets during these times as investor risk appetite falls and flow of funds is skewed towards low risk assets such as USD, gold and treasury bills.  This long term faith of rewarding investors with higher risk appetite with risk premium is put to test in recent times. 

Traditionally, gold, US dollar, commodities and treasury bills were/are considered to be safe haven assets, meaning their volatility was lesser compared to equities.  Hence a person investing in gold for example, will have to be compensated less when compared to an investor investing in equities. In other words, the risk premium for gold should ideally be lesser than the risk premium for equities.

A study of various asset class performances over the last five years, while offering support to the above intuition, provides other counter intuitive results.  Results in favor of the theory are - USD has been the worst underperformer among assets such as Gold, Crude, commodities, and emerging markets over the past ten years. Counter intuitive results are as follows - Over the last 10 years, gold has been offering positive returns irrespective of the economic activity.  Returns from the asset ranged from 5% to 30%.  Considering real interest rates of 1% (rate of return of short term government bonds in U.S. markets which are considered to be really risk free), the risk premiums for gold have been between four percentage points to 29 percentage points. Another result has been that emerging market equities have performed in line with traditionally low risk assets such as commodities and crude oil. In other words, the risk premiums for crude and commodities have been in line with those of emerging market equities.

New norms in safe haven asset behavior

Possible explanations to this behavior can be two sided (paradoxical though) – one, equities have become less risky, or that assets once considered safe are no longer so.  Volatility, a measure of riskiness of an asset shows that emerging market equities have continued to be risky compared to commodities and gold. The rate of increase of volatility of commodities and gold compared to emerging market equities is lesser.   The annualized standard deviation of commodities (as measured by Thompson CRB Index) over 25 year time span has increased from 6.52%, to 9.82% over the last 5 years, gold from 17.69% to 21.27% over similar time periods, while equities have increased from 18.53% to 26.06%, indicating that equities continue to remain risky above commodities and gold.

Central banks have three key tools – one, stimulate demand in the economy through government borrowing and spending and two, monetary easing, lowering interest rates to near zero levels, three, printing or electronically creating currency and increasing liquidity in the economy.

The recent bailout of Greece by Euro nations, AIG by U.S. government, have created a trust among global investors that central banks and governments will not let assets fall in value.  This means that investors with such risky bets will keep the gain while losses will be covered by the central bank.

Performances and valuations of assets such as gold, commodities and recent IPOs such as Facebook indicate that cash flows are towards speculation and away from traditional assets.  In addition, analogs of money such as derivatives, mortgage backed securities and tulip bulbs add to the speculative chaos.

These new norms have resulted in money flow into assets such as crude, commodities and emerging markets.

MARKET COMMENTARY

Cautious Movement

Equity markets worldwide continued their upward trend in February driven by buoyant economic data from U.S. and renewed hopes of a workable solution to Euro Zone Crisis. Indian Markets too kept up their pace with the global rally for most part of the month but gave up some gains during the last week on concerns over soaring crude price and its effect on the domestic economy. On the whole, the benchmark Sensex moved up by 3.25% during the month and closed at 17753 points. MSCI India recorded a gain of 4.78% as against MSCI EM’s rise of 5.89%. The mid and small cap indices continued their outperformance over the large caps by moving up 8.8% and 6.1% respectively. FIIs emphatically displayed their current risk appetite and liquidity by buying equities worth USD 5.12bn in February, their fourth highest monthly net-inflow since their entry into India. Meanwhile, domestic mutual funds continued to be aggressive net sellers in the equity segment taking out about USD 421 mn.

ECONOMY

LTRO 2 - Harbinger of hope and liquidity
Global markets have seen a resounding rally since ECB’s first liquidity injection of EUR489bn during Dec 2011, somewhat similar to QE1 driven emerging markets rally in late 2010. However, market performance during QE2 phase was subdued. It remains to be seen how the second phase of ECB’s Long-Term Refinancing Option (LTRO) program involving 530 billion euros (higher than expectations) announced during end of February impacts the global risk assets going forward this year besides the real economy of EU in the mid-term. The Greek package – Voluntary Private Sector Initiative (PSI), second bailout package and extended fiscal austerity – that has been agreed recently has cut down the risks of immediate default and disorderly exit from European Union. However, the upcoming elections in Greece and France besides a range of important countries like USA, China, Russia and Egypt could magnify policy uncertainties in respective regions with corresponding global effects. In the Indian context, FII inflows would be a key derivative of global risk appetite and liquidity funnel. Meanwhile, Oil prices have been creeping up, partly on recovery hopes but also reflecting political tensions in Iran and Middle East. The Brent prices have so far not broken out of the USD 95- USD 125 per barrel range seen since early 2011. But, if Iran nuclear issue escalates and triggers a spike up to USD 150 per barrel then economies worldwide may again shift back to a mood of caution.

Q3FY12 Domestic GDP growth – Bottoming out

India’s Real GDP growth fell to a 3-year low of 6.1% yoy in Q3FY12 (against 6.9% in Q2FY12), slightly lower than consensus expectation of about 6.3%. The data clearly shows that economy is undergoing an industry led slowdown. Industrial growth remains weak at 2.6% yoy, primarily due to contraction in mining (3.2% yoy) and puny manufacturing activity (0.4% yoy). However, on the positive side, construction activity (including construction of roads, bridges, ports and housing) has shown healthy pickup (7.2% yoy), auguring well for investment activity. Despite healthy construction growth, investments – as seen from expenditure side of GDP – posted quiet weak growth (1.2% yoy) which possibly reflects dull capex activity in the economy. In recent years, the economic growth has been driven more by consumption than by investment. Continuous slow-down in investment activity will affect the consumption with lag, which is a worry.

Fig 1- GDP at a 3-year low                                                   

  Fig 2- Industrial activity to see improvement ahead 

Meanwhile, services sector continued to post healthy growth (8.9% yoy vs 9.3% last quarter), providing the much needed support to the economy. Continued resilience of the services sector could be due to the fact that majority of its sub-sectors such as trade, transport, government spending etc are largely immune to the adverse business cycle conditions, a phenomenon observed during 2008-09 downturn as well. Going into Q4FY12, industrial growth should improve, as suggested by pick up in manufacturing momentum in Nov-Dec period (refer fig-2), improvement in mining activity and jump in forward looking PMI data. Besides, base effect will also be supportive in Q4. Overall, we believe Q3 marks the bottom of the ongoing economic downturn, although pick up is likely to be very gradual. We expect GDP growth for FY12 to be about 6.9-7.0%.


Inflation and IIP review
January inflation came in at 6.55% as against 7.5% a month ago, marginally surprising on the down side. The decline was mainly on account of base effect in the primary articles side rather than any meaningful drop in prices. Core inflation (non-food manufactured products) dropped sharply to 6.68% from 7.7% in December. Considering the seasonality in the food prices segment (mainly vegetables) that is currently pulling down the inflation and hardening of crude oil prices, RBI may not cut rates in its review meeting on March 15. The central bank has also signaled that it will be difficult to contain inflation without a proper support from fiscal side. Hence, we expect that it would wait and review the fiscal proposals in the union budget to be presented on March 16 before starting to ease policy interest rates.

The Index of Industrial Production (IIP) grew 1.8% yoy during Dec 2011, considerably lower than the consensus estimate of 3.4%. While the monthly numbers seem weak, it could partly be due to the de-stocking effect post the stronger than expected growth in Nov 2011 (5.9% yoy vs 2.1%). Capital goods production continues to remain weak, confirming the slow-down in investment activity. Though the PMI in manufacturing indicates that the worst is over for IIP, it will take time to recover significantly considering the global and domestic headwinds.


MARKETS
Pausing for Breath

At the beginning of the year, it was widely expected that the Indian Markets would turn around gradually in 2012 with major upside expected towards the latter half. However, the remarkable change in global investor risk and liquidity climate combined with change in RBI policy stance has fast tracked the market rally much to the surprise of the domestic investors. While the large caps have risen about 15%, the mid and small caps have moved up about 24% with certain beaten down sectors and stocks even seeing a 100% increase. Considering the sharp rally in such a short span, we expect the markets to switch into review mode in the near-term with important domestic economic and political events like state election results, RBI policy review and FY2013 Union budget lined up in March. Also, the oil price movement and development in EU (Elections in Greece & France and the impact on bail-out package) would keep the markets cautious.

With the ruling party facing an election debacle in the key state of Uttar Pradesh, the penultimate budget to be presented by the current government in mid-March will be one of its last opportunities to do something constructive that will create a positive impact pan India. The finance minister has his task cut out in pruning the fiscal deficit by raising some indirect taxes, broaden the service tax net and simultaneously reduce the subsidy bill. This process is going to be extremely painful considering the current status of economy. High fiscal deficit leads to increased state borrowings for unproductive purposes thereby crowding out private sector fund needs for capex investments. Also, several key bills like the Lokpal Bill, the Food Securities Bill, the Companies Act Bill, GST (Amendment) Bill, Direct Tax Code and Mines and Minerals Regulation Bill that have been tabled a while ago have still not been able to obtain the parliamentary approval. With the state election results behind (and also unfavourable), markets would keep a close tab on how the congress government moves ahead with its long over-due reform process.

With GDP growth touching a 10 quarter low of 6.1% for the quarter ended December ’11, it is now widely acknowledged as a missed opportunity among the investment community largely reconciled to 6.5 to 7% growth. While investment trends remain lackluster, we hope that the recent announcement regarding ‘fast-tracking’ power and coal issues is not another false start. Despite good FII flows and consequent rally, it is difficult to confidently claim that this is a new bull market as it seems to have already factored in lot of expectations on improved governance and fiscal consolidation. Though capital flows can take markets higher in the immediate term, it is hard to imagine that the flows will off-set the problems on the current account side. Even if we assume that the worst phase of slower GDP growth is behind us, the earnings upgrade cycle is sometime away.

We believe in the secular long term growth potential of India’s consumption led economy, and reflect it in the way we build our portfolio. But we accept that we will be subjected time and again to the self-fulfilling inflation led interest rate cycle, and must bear its consequences upon Growth and Valuations. Our longing for better policy led measures to address the supply-side issues that lend inevitability to the inflation cycle, remains a hope today. Consequently, we accept the sub-optimal performance of India’s economy as the norm and focus upon the opportunities that arise from the volatility.

While the reversion to mean of mid and small cap valuations has commenced, there is still plenty of scope in this trade, and we expect small and midcaps to continue their out-performance over large caps. Sectorally, we continue to prefer financials and rate sensitive sectors in the expectation that RBI will cut rates soon. We expect Oil prices and currency risk to be led, in the near term, by the Iran situation. At this point, we are factoring in a prolonged negotiation between the world powers and Iran; not an all out war.

Extracts from Unifi's Monthly Newsletter

MARKET COMMENTARY

Springing Up

Global markets witnessed a remarkable bounce-back in January led by improved risk appetite and hopes of policy action driven growth momentum. Upbeat economic data from U.S and China lifted the sentiments worldwide and abetted equities to rally through the month. Copious FII inflows, shift in monetary policy stance and largely in-line domestic corporate results boosted the Indian markets performance further. The benchmark Sensex rose sharply by 11.2% during the month and closed at 17193 points. With about a 7% rise in rupee against the USD, MSCI India was among the best performers in Emerging Markets with a 20.8% rise. The mid and small cap indices outpaced the large caps by increasing 14.4% and 16.5% respectively. FIIs were aggressive net-buyers of about USD 2.03bn worth of stocks whereas domestic funds were on the selling side taking out USD 371.62 mn.

ECONOMY

Liquidity revives Sentiments; Can they ensure growth?

European Central Bank’s gargantuan refinancing effort (nearly half trillion Euros credit line to European Banks against their illiquid securities) is far greater than all forecasts and could turn out to be a game changer for the regional crisis if the banks utilize the funds to re-build their capital and core lending business instead of buying bonds. Further, the U.S Fed’s comments about maintaining interest rates at near zero levels until 2014 (earlier it was 2013) has minimized the possibility of liquidity crunch induced global slow-down. Meanwhile, IMF has reduced 2012 global growth forecasts to 3.3% from 4% citing increased downside risks – advanced economies to grow by 1.2% instead of 1.9% and emerging economies to grow by 5.4%. Given the revival in liquidity and sentiments, it will be interesting to wait and watch if the actual growth turns out to be better or not.

Domestic Macros – Upturn possibilities increase

The industrial production growth of November 2011 jumped to 5.9%, as against the street expectations of 2.1%, reversing the steep decline of 4.7% reported in October.  The sharp rebound was led by consumer goods that grew by 13.1%. Both the credit as well as deposit growth for December have accelerated to 17% levels. Headline WPI inflation for December eased sharply to 7.47% (a 2-year low) from 9.11% in November, reflecting both seasonal drop in food prices and favorable base effect. However manufactured inflation continued to remain sticky at elevated level of 7.41%, slightly lower than 7.7% recorded in November. We expect the headline inflation to trend below 7% in the coming months.

Figure 1-Industrial Production growth since Nov 2010         

                            

Figure 2 – Wholesale Price Inflation movement from March 2010 

Although the government is likely to overshoot its FY12 fiscal deficit targets, FY13 position could be a lot better with the emergence of two lifelines – 

1. The restitution of global risk appetite and liquidity would energize the proposed divestment of stakes in public sector companies, and 

2. The recent Supreme Court verdict cancelling the 2G licenses awarded in 2008 has thrown open the possibility of auctioning the restored spectrum at market driven ates (2010 3G auctions fetched USD 15 bn). 

Further, the steep 7% appreciation of Rupee against the dollar in January (highest monthly gain since 1980) and the continuing trend in early February would ease some pressure off the government’s crude oil imports amidst its forex reserves dropping to a 17-month low. Both IMF as well as RBI are of the opinion that FY13 GDP growth would be better than FY12 growth. In fact, IMF has pegged the FY13 growth at 7.3% while bringing down the FY12 number to 7%.

Q3FY12 Monetary Policy Review – Signaling a change

The central bank, in its recent review, surprised the markets with a CRR cut of 50bps while leaving the repo rate unchanged at 8.5%.  The Cash Reserve Ratio cut will inject primary liquidity of Rs.320bn into the system and would help in addressing the structural liquidity deficit seen in recent months (LAF deficit had gone up to Rs.150bn). However, RBI considers that rate cuts are not warranted at this juncture as upside risks to inflation persist. The policy document indicates that a reduction in the policy rate will depend upon ‘signs of sustainable moderation in inflation’.  In our opinion, RBI will wait for the FY 2013 Union Budget to be presented in parliament, (during mid-march) before making any decisive move on rate cuts. The RBI has reiterated its concerns about the rising fiscal deficit besides revising its FY12E GDP growth target downwards from 7.6% to 7%. RBI retained its inflation estimates for year-end March ’12 at 7%, considering the lagged impact of the rupee depreciation.  On the whole, it is clear that the growth-inflation balancing stance of the monetary policy stance has now decisively shifted towards supporting growth.  

MARKETS

Confident beginning - Downside risks muted but remain

After ending 2011 as the 2nd worst performing emerging market, Indian markets have rebounded sharply in the first month of 2012 aided by a host of positive global as well as domestic cues. The activity in bourses has also gained momentum with average cash volumes touching a 13-month high. Besides the CRR cut and EU developments, the Q3FY12 (Oct to Dec 2012) results of corporate India have also been supportive of market rally. At little more than the half way mark, the consolidated performance of BSE 200 companies that have declared their results so far have been marginally ahead of consensus expectations. Topline growth has been fairly robust at 25.6% yoy punctuated by shrinking EBIDTA margins (17.4% in Q3FY12 vs. 21.2% in Q3FY11) and earnings growth of 5.6% year-on-year. Most importantly, the overall downgrade cycle has been relatively benign with a 1% cut in FY13 Sensex EPS so far.

The upcoming central budget is going to be a very important event in the near term and would provide indicators as to how the government proposes to move ahead with policy reforms and fix problems in infrastructure, power and mining. Considering the fiscal deficit, the budget per se may not be corporate friendly as there is a possibility of increase in all taxes ranging from excise duty, service tax to surcharge on corporate tax. Nevertheless, a bullish view on India could emerge from better governance and policy reforms which would determine the sustainable long-term growth trajectory. The quick rebound from the 2008 crisis lulled the policymakers into believing that 9% growth was routine and double digit increases were round the corner. However, 2011 has provided a clear warning that poor governance would significantly jeopardize the India growth story. Going by the recent posture of the government in terms of fast tracking project approvals and resumption of concerted efforts to clear pending bills, it appears that introspection is on and amends would be made going forward.

Mid-Term Outlook for Metals

Contributed by: Sathyamurthy U, Unifi Research

Global political and economic events such as the sovereign debt crisis and the slowdown in recovery from the last crisis in economically sound countries have rendered the industrial metal prices directionless.   However, copper and aluminium prices have increased by 5.7% and 4.7%  since the beginning of the year.

China, the world’s second largest economy consumes significant share of primary raw materials such as iron ore -60% (of global iron ore trade) , copper – 41 percent, aluminium – 40 percent. Demand outlook for these industrial metals can be explained by import, export and value creation activity in China.

Copper

The metal is currently on an uptrend due to strong fundamentals – supply disruptions due to labor issues in some of the world’s largest copper mines, depleting stocks in LME warehouses, and potential demand supply mismatch.  The following chart shows the monthly import growth of China and Copper prices. (superimposed over one another with same time base). Copper prices have corrected along with the decline in import growth in China. 

Aluminium

A similar trend is seen in aluminium prices during the same time period.  

The impact of slowing imports on GDP is shown in the following chart. The current level of import growth and the corresponding GDP growth are exhibiting similarities to the crisis 2008-09.

The Chinese economy is buffeted by two forces - slow global growth is hurting exports to European union, which is the primary destination for Chinese  exports.  China’s exports have slowed down recently. The domestic consumption due to rise in wages in China might not be enough to make up for the shortfall in foreign orders. (Source – WSJ)

Another problem is the housing prices in China. Government is trying to control prices by making it difficult to finance development of luxury apartments and requiring 60% down payment from buyers.  The low cost housing is not progressing as planned.  These problems will likely have an impact on the GDP growth in China which has already slowed from 10.4% in 2010 to 9.2% in 2011.

Further slowdown in consumption of industrial metals (lower imports) either through slower growth in EU or domestic weakening in the Chinese economy appears likely and will have an impact on metal prices especially copper and aluminium.

Hence my outlook for copper and aluminium is negative.  

Steel

Steel consumption in India has slowed considerably from 14.5% to 2.9% in 1H12, with project offtake slowing down and other macroeconomic challenges cropping up. According to ICRA, 25 MT of new capacity are coming up in the next 18-24 months (30% of current production capacity) and keep the realizations under check despite the weakening currency scenario.

The higher interest payments arising out of the capacity expansions will also decrease margins for steel makers and raise working capital requirements, thereby affecting the liquidity profile of steel companies.  Companies with better capital structures such as Tata Steel  will be able to withstand the competitive pressures.

The major steel consuming sectors in India – construction (65%), capital goods (15%) and automobiles (8%) are witnessing slowdown.  Project offtakes  are affected by land acquisition issues and interest rate scenario.  The near term outlook for steel is weak.  India’s GDP growth rate for Q1 and Q2 FY12 was 7.7% and 6.9% while steel consumption growth for the same period was 2.9%. (Typically steel growth rate is 1.2-1.5 x GDP growth). According to GoI projections of 7.5% growth rate for India in FY12, this will be ahead of steel consumption growth.

Hence the mid-term outlook for steel sector is negative.

Views expressed are personal and do not constitute to the market outlook towards commodities at Unifi. 
Email: sathya@unificap.com

Market Commentary for the month of December

Grinding Down

Indian markets slipped further during this month, which was choppy for most parts, disappointed by falling industrial output, worsening fiscal deficit position and government’s rollback of its proposal to allow Foreign Direct Investments in Multi Brand Retail segment. Despite decent advance tax numbers, marginal moderation in inflation and RBI’s hint about reversal of hard money stance going forward, the domestic sentiments remained subdued pulling the benchmark Sensex down by about 4.14% in December.  MSCI India was among the worst performers for the month as well as for the calendar year with a decline of 6% and 37.97% respectively as compared to MSCI EM (Emerging Markets) which dropped 1.29% and 20.41% respectively. The Rupee depreciation of over 16% against the US dollar in 2011 accentuated the adverse impact for India. The domestic mid and small cap indices continued to underperform the large caps by falling 8.75% and 8.97% respectively. Although FII’s were marginal net buyers of about USD 31.79 mn worth of equities in December, they have withdrawn about USD3.81 bn for the year as a whole. Alternatively, the domestic mutual funds have been net buyers in 2011 bringing in about USD 1.2 bn to the equities segment with USD 112 mn coming in during the month.

Snapshot Review of the ‘Chaotic’ Year 2011

Year 2011 is best characterized as an eventful year but mostly for the wrong reasons. Global Asset Markets squirmed as the sovereign debt issues in peripheral Europe snowballed into a full-blown crisis scuttling the global economic recovery process besides raising the specter of a double dip recession. Indian economy and consequently its markets were further hit by persisting inflation, multiple rate hikes and inertia in government policy making amidst a background entangled with periodical news of grafts and scams. Interestingly, all seemed well for the Indian Markets in the beginning of the year 2011. The indicator of Indian corporate performance, BSE Sensex, was near its peak levels of 20,000. Output of six core infrastructure industries such as finished steel, cement, crude petroleum, petroleum refinery, coal and power had recovered sharply after a moderate quarter. RBI had forecasted WPI inflation to drop to 5.5 percent by March 2011. Current account deficit as percentage of GDP was a manageable 3.6 percent.

To top it all, India’s growth rate was projected to grow at an annual rate of 9+ percent overtaking China as the world’s fastest growing economy. With the benefit of hindsight, one would note that whatever could have gone wrong at the start of the year indeed went wrong in Year 2011.  WPI Inflation remained at elevated levels of 9 to 10+ percent levels through the year on account of rising food, fuel and commodity prices despite RBI’s successive rate hikes (from 6.25% in January 2011 to 8.50% in December 2011) to curb demand. Slowdown in IIP, which was seen to be more of a short-term issue solvable by affirmative policy actions, turned out to be a long-run problem affecting national GDP growth and corporate earnings due to increase in input and borrowing costs besides government’s complete inaction on the reforms front.

The monetary tightening did have an impact on inflation which started cooling off in November, however at the cost of slowing industrial and economic activity.  Industrial performance deteriorated further during the end of the year and declined by 5.1% on yoy basis, due to contraction in manufacturing and mining activities, while capital goods witnessed a yoy decline of 25.5 percent. GDP growth for Q2 FY12 moderated to 6.9 percent from 7.7 percent in Q1 FY12.  On the expenditure side, investments also showed a significant slowdown.  Flow of foreign capital into the country which was in an uptrend during the first half of the year due to strong FDI inflows, rise in ECBs and trade credits, initially offset the sharp decline in FII inflows due to Euro zone debt crisis and concerns of double dip recession. However, as global risk aversion continued to build up and domestic markets continued to fall, flow of capital dried up considerably, widening the current account deficit further amid faster decline in exports than imports. Global concerns such as the European sovereign debt crisis, slow economic recovery in the U.S., political unrest in Middle East nations, and natural disaster in Japan were initially believed to have little impact on the Indian economy due to its domestically driven demand.   However, there were significant indirect effects - spike in oil prices led to increased current account deficits. Accommodative monetary policies in Europe and U.S. which were rolled back in June 2011 adversely affected the global trade and capital flows.

A combination of all the above problems discussed i.e. high inflation, burgeoning current account deficit, decline of capital inflows resulted in a massive 16+% fall in the value of rupee (from Rs.45 levels to Rs.53 levels) against the U.S. dollar. This in turn has considerably jeopardized the position of several Indian companies that have significant dollar denominated /linked debt in their books.  

2012- Transformational Year? - Focus to shift from Inflation to growth

The previous year turned out to be a nightmare with multiple domestic issues combined with slowing global environment.  What is worrying is the fact that the growth deceleration could spill over into 2012 and perhaps beyond.  As per reports, global growth is expected to slow from 4.2% in 2010 to 3% in 2011 and to 2.5% in 2012.  Considering the false start of FDI in retail and populist measures like Food Security Bill, the domestic policy prospects for 2012 don’t appear good.  Last year, we were discussing about double dip in US economy and possibility of India’s growth overtaking China.  Ironically, today the U.S. is doing satisfactorily and the hot topics are ‘Fiscal Integration in Europe’ and who will slow down more, between India and China!

Although USA may not recover significantly, the recession talk has vanished. European banks will continue to take a hit on their balance sheet owing to their exposure to sovereign debt.  Whether it is a ‘default’ or a ‘managed default’, credit shortage could become a handicap for growth in EU region.  In India, the government has to battle on many fronts.  The first half of 2012 will see concerns about a slowdown gaining prominence over peaking-off inflation.  Most of the leading economists have already revised down the GDP forecast for India to 6.7% for FY12 and 6.6% FY13, well below the government guidance of 7.25%.  This reflects the impact of higher interest rates resulting in slowing investment demand and global uncertainties affecting export demand.  We expect the growth rates to bottom out in middle 2012 on account of rate cuts and base effect.  We also expect the RBI to cut rates by around 200bps in Q2-Q3CY12. At this juncture, inflation is likely to peak off in early 2012.  However, with five states going in for elections in March ’12, we will not be surprised to see price hike in Kerosene, diesel and LPG post-elections.  Further, possible price increase in coal and power tariff cannot also be ruled out. These measures will once again stoke the inflation up, testing RBI’s policy stance. 

Any adverse global economic developments are obviously not in our control. What’s more disconcerting is the fact that Indian government has severely fallen short of expectations on the reforms agenda. The problems are well-documented starting from coal shortage to policy paralysis, fiscal slippages and multiple scams.  We don’t have any big hope on the reforms front as any related impact on the economy comes only with a lag.  However, we do hope and feel that the government would be able to manage the fiscal issues without disturbing the rates as slowing economy will pull down the loan demand. Prudent fiscal management coupled with some determined policy decision-making from the political class could help the economy bounce back with a growth rate of around 8% at least in FY 2014 if not earlier.

MARKETS

What lies ahead?

Cyclical deceleration in growth and policy inertia are the key drivers for the current slow-down in India.  Unlike 2008, the problems now are home grown and hence domestic market benchmark indices underperformed their developed as well as emerging counterparts. Mid and Small cap Indices witnessed a steeper sell-off compared to large caps. The sell-off was also broad-based with all the sectors except FMCG closing in the negative territory. Real Estate, Metals, Power and Capital Goods were the top losers amidst concerns of slowdown in investment activity and coal shortages. Trading volumes in equity market is presently at five year low and still declining.  The current bear market has sustained long enough and we have to look out for reasons that can cause a turnaround.  As explained earlier, consensus is also concerned about macro signs with fiscal, current account and rupee spiraling out of control.  Most of the domestic funds and insurance companies are a tired lot with no fresh inflow of funds. 

Although Indian markets look attractive based on P/E multiple, considering the amount of earnings downgrades the PEs may be higher than our current belief.  While markets could rally on rate cuts, the sustainability would depend on investment spending and policy reforms from capital.  As we go in 2012, though the macro picture looks weak, we will probably see raw material prices moderating on the back of a slow-down in China which in turn would help India Inc to improve their gross margins.  Interest cost will peak in next couple of quarters that would help driving below-the-line profits.  In other words, considering the below-expectation profits for December and March quarter, the base effect will provide some sense of optimism that earnings can surprise on the upside during the later part of 2012. Right now, “it’s so bad, it’s almost good”. 

Direct access for foreigners to the Indian stock market - Is the excitement for real??

Glenn Roger Carr, Vice President, Unifi Capital

The Indian Government has made a strong bid to strengthen the domestic markets by proposing to allow Qualified Foreign Investors (“QFIs”) to invest directly into the Indian equity market vide press release dated January 1, 2012 issued by the Ministry of Finance. The proposed new investment route is aimed at providing the much needed stimulus and to improve the sentiment of our markets

Currently, investing through the FII route directly or by going through a sub account of an FII are the only means for foreign individuals or institutions to invest into India.  In August 2011, the Securities and Exchange Board of India (SEBI) had permitted QFIs to invest into mutual fund schemes, thereby providing an indirect way of making foreign investments into Indian equity markets, and that was the starting point of the current policy which we shall carefully analyse

Key Highlights of the Proposed New Regime as provided under the Press Release

1.    RBI to grant general permission (i.e. under the automatic route) to QFIs for investment under PIS route similar to FIIs.

2.    The investment by QFIs would be subject to an individual investment limit of 5% of the paid up capital of the Indian company and an aggregate investment limit of 10% of the paid up capital of the company. These limits are over and above the limits applicable in case of investment by FIIs or NRIs under PIS route.

3.    QFIs would be allowed to invest only through a SEBI registered qualified depository participant (“DP”) and all the transactions would have to be made through this DP only.

4.    DPs would be the ones who would be required to ensure that the QFIs comply with the KYC norms and the stipulated regulatory requirements.

Pros and Cons of the policy

1.      Under the current SEBI (Foreign Institutional Investors) Regulations, 1995 there are stringent conditions imposed on the registration of FIIs and sub-accounts such as if an asset management company or an investment advisor has to be registered as an FII, it has to indicate that it is proposing to make investments on behalf of broad based funds. Further, funds can be registered as sub-accounts only if they fulfill the broad based criteria. Similarly, if an individual wants to register as a sub-account, then inter alia he has to fulfill minimum net worth criteria of USD 50 million. With these conditions not being imposed on a QFI it makes it easy and gives the investor the incentive to register and invest directly as a QFI.

This would allow a large group of foreign investor’s direct access to the Indian equity market instead of investing through FIIs/sub-accounts and at the same time will provide wider opportunity to the Indian companies to raise funds.

2.    If we look carefully at the regulations, it states that the individual limit of 5% and the combined QFI limit of 10% of paid up capital per stock is over and above the FII and the NRI limits that are already in force. This could mean that QFI’s could now buy into stocks that were earlier blocked due to the FII or NRI limit being breached. I would actually think that some of these stocks would see substantial fresh investment into them thus pushing their prices up.

3.   There are questions about whether NRI would be classified as QFI’s? Even though there is no direct mention to the contrary, it is quite clear that the QFI   limits are over and above NRI limits, which could lead us to conclude that NRI’s do not qualify under the new QFI regulations.

4.  The tax treatment for the QFI investment will ultimately decide the success or otherwise of this regulation. While it is quite clear that these investors will not benefit from a zero tax regime( which the bigger players who invested through the FII sub-account route benefitted for many years and continue to do so)it remains to be seen what kind of  tax structure and the method of taxation that would apply to the QFI’s. I do believe that the larger investors would any day prefer their tax benefit to the ease of investing option.

It would only be the smaller foreign investor who invested through the non discretionary route of a sub-account (which is a complicated and costly route to take) who would probably consider this trade off worth taking. In that sense one may not see a rush of fresh investments coming in through the scheme but it could definitely bring in a new breed of investors and widen the base of the current investor profile.

5.    When a guru of the stock market was asked about this new regulation he said that opening just one market does not excite him too much, he went on to say that if one opens the stock market they should open up the commodity and currency market also then only will the big boys be interested to invest large amounts into India. This then clearly is another affirmation that the BIG investments may not line up under the QFI route.

6.    The pessimist may ask why an individual foreign investor should choose India, wont he put his money where his mouth is? And even if we assume that he is a diehard Indian market optimist one would think that he would prefer the easy route of an India ETF which is now available in choice especially in the American markets.  This argument I must confess does hold a lot of weight.

7.   SEBI has stated that one of the objectives of this regulation is to broad base investor bases, improve inflows and make the market less volatile. While the first two objectives are definitely achievable to some degree it is difficult to understand as to how QFI investments will reduce volatility. QFI’s are not lateral thinkers they will think and act like all investors who are driven by greed and fear and in market swings these investors will act like any other thus probably adding to the volatility and not reducing the same. Statistics from the American and British markets also tell us that 90% of the investors are day traders and if they now choose to invest into India there is no reason for these individuals to suddenly turn into long term players.

8.  It would be appropriate to conclude the analysis by looking at one big benefit that the QFI will finally have and that is true beneficial ownership. As a client who invested through the FII or through a sub account the client were merely holders of buy positions in a company and never enjoyed  voting rights and other benefits which they will now be able to exercise as “real shareholders”

It would also be very interesting to study the operative guidelines that SEBI is going to put in place. The qualified DP’s/ brokers  who believe that the QFI segment is a one worth servicing would have to ensure new systems and process( the kyc part of it would be a big challenge-unless simplified), beef up research by a huge margin and also gear up to build their brand, and after doing all this there is no assurance of success.

The QFI has thrown up a lot of debate and discussion and the proof of the pudding will be in its eating, so as we wait and watch for the happenings in the next few weeks like all investors I hope that more than anything this would improve the market sentiment more than anything else.

The author is Vice President at Unifi Capital. Views expressed are personal.

glenn@unificap.com