RBI governor's words of wisdom for India Inc.

Jan 31, 2014

In this issue:
» Delhi's load shedding woes.
» China's private sector debt to GDP stands at a whopping 230%!
» Should one cheer the 3.2% YoY growth in US GDP?
» RBI's road map to deal with bad loans.
» ...and more!

That India is well placed to benefit from its favourable demographic dividend is well known to all. The young population, the increasing work force and the rising salaries are just some of the many factors in favour of the 'Indian consumption theme'. However, with slowing volumes in recent times, doubts of whether the theme remains intact have been raised. And the key reason behind these slowing volumes is rising prices a.k.a. inflation.

Inflation has been an issue troubling the Indian economy for quite a few years now. Especially retail inflation, the one that actually impacts peoples' wallets! Putting money in a bank and earning an interest rate lower than the pace at which costs are rising simply erodes one's purchasing power. Multiply this over a longer period and the impact gets worse. This simple fact is what RBI Governor Raghuram Rajan believes is denting growth levels in India. Which is why taming retail inflation is very high on Dr Rajan's agenda. He made this pretty clear recently, setting clear targets for the new benchmark - the consumer price index - over a longer period.

In recent interviews with business dailies (Mint and Business Line), Dr. Rajan went on to say that there is no in between when it comes to growth and inflation. In other words, there is no trade off between the two. Inflation is simply hurting growth is his view. And only when the former is brought down, will the latter expand. The declining buying power of consumers, as expenses of essential items such as food and vegetables are moving up in their high single digits to the lower teen rates, has been hurting consumer demand.

Despite many pressures to lower interest rates, the governor is of the view that the changes made through monetary policies will not make much of a difference in terms of final lending rates from banks to customers. Given that deposit rates are set in line with inflation, it is the latter that needs to be reduced for banks to lower interest rates. His message to one section of people - India Inc. to be specific - demanding rate cuts is 'To put your house in order'. He opines that even if the central bank cuts rates, the likelihood of banks passing on the benefits to customers are very low given the high prevailing inflation rates.

With all this mess about inflation going around what is it that long term equity investors can do? Well investing in gold is one option, we believe. But the price of the same is dependent on many other factors as well and not simply inflation. Second option would be stocks. And within this asset class, the strategy would be to stay away from companies that have huge amounts of debt on their books. Rising interest rates would impact their interest and debt service coverage ratios.

We believe a good way to overcome the inflation monster would be to aim for companies that have an inbuilt inflation beating mechanism -pricing power. Combine that with return ratios well above the cost of funds and in all probability you have a winner. We believe having businesses with such characteristics does curb all inflation related risks. Buy them at good prices and you should very easily be able to earn returns to keep your purchasing power intact, or even improve the same.

Do you think investing in businesses possessing pricing powers are good bets to curb inflation risks? Let us know your comments or share your views in the Equitymaster Club.

Readers please note: Since The Equitymaster Conference 2014 is being conducted tomorrow i.e. February 1, 2014, there will be no weekend edition of the 5 Minute WrapUp.

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 Chart of the day
The Delhi government's attempt to slash power tariffs has had its side effects. The electricity distribution company BSES Yamuna Power (BYPL) has warned of 10-hour power cuts February onwards. It reasons that very low tariffs have left it with no money to pay the dues to generation companies like NTPC and NHPC. Today's chart of the day shows the difference in Delhi's power costs and tariffs over the years.

Delhi: Cost of buying and selling power
* includes cost of purchase from gencos and transmission cost.

In the absence of adequate power supply, the load shedding of 8-10 hours in Delhi will be inevitable. The discom has in the past threatened to stop power supply in the absence of a 'cost-reflective' tariff. With the current tariffs clearly making power generation and supply unviable, not just the distribution companies but even the generators will be under financial stress. At a time when politics has taken over economics in the power sector, the fundamentals of not just the PSU but even the private sector power utilities seem in doldrums. The impact will also be felt by banks and financial companies that have lent large amounts to these utilities.

The Empire of Debt. This title, which is also a book by the same name, was given by the noted financial market commentator Bill Bonner to the US economy. The allusion was of course made to the tremendous debt accumulation in the US economy over the years. These days though, the title may not look out of place on another economy. We are referring to China. As per Ruchir Sharma in his latest ET article, China's private sector debt to GDP stands at a colossal 230%! For the record, this is the largest number ever recorded in the emerging world. So, is this is a problem? It certainly is, argues Sharma. For historically, even in the most extreme credit booms, problems started appearing on the horizon when the debt to GDP ratio was just 42%. And in all such cases, without exception, the underlying economy suffered a major slowdown over the next five years. However, in spite of this strong evidence there is hardly any mainstream economist out there who's predicting doom for China. Almost all of them expect the Chinese juggernaut to roll along at 7.5% year after year. But to do so would mean taking a huge bet against history and that's not a very good bet to take we believe. As far as we are concerned, we've been bearish on the economy for quite some time now and expect trouble to show up sooner than later.

Higher borrowing costs and stalled projects have led to delays in payment cycles of corporates. Thereby exasperating the asset quality woes of the lenders. With economic growth at decade low and bad assets piling-up, the Reserve Bank of India has chalked out a road map to deal with the surge in bad loans. The total bad loans in the system amount to Rs 2 trillion. Not just that! Almost Rs 4 trillion accounts for restructured assets. According to the global credit rating agency Fitch, the stressed assets are expected to increase to 14% of the total loans by FY15. Stress assets comprise of bad loans and restructured assets.

In-line with the new guidelines, the lenders now will have to carve out a special category of assets which would show early signs of stress. Currently, the loan repayments beyond 90 days overdue are recognized as non-performing assets. Under the new rules, payments exceeding 60 days due would immediately be brought under the notice of joint-lenders for early resolution. For cases where there would be disagreements amongst lenders, accelerated provisioning would be applicable. More importantly, high value restructured assets will undergo independent revaluation under the new framework. Leveraged buyouts would also be permitted for specialised entities for acquisition of stressed companies. Further, banks would have to establish a category of non-cooperative borrowers. These borrowers would be penalized with higher interest rates on borrowings in the event of non-cooperation. Lenders would require making higher provisioning for further loans extended to these borrowers.

The new framework is expected to help identify stressed assets at early stages. Given the current turmoil, the central bank's measures have come at the opportune time. Will the new measures incentivize repairing bad assets? Only time can tell...

Is the 3.2% GDP growth in the US economy in the fourth quarter something to cheer about? Not really. If one looks closely, there seem to be some signs of weakness. The data that suggests vulnerability of the economy are home sales and jobs. Let us consider home sales first. As reported in an article in Moneynews, new homes sales fell 7% in December led by rise in interest rates and cold weather in the country. Of course, this is just data for a month. But a steady rise in rates is bound to have some impact on demand in an economy which is struggling to come out of recession. The employment data remains weak as well. The economy added only 74,000 jobs in December. The labor force participation rate dipped to 62.8% last month. This rate measures the proportion of people who are employed or are looking for work. The situation is much worse when you consider the number of people who have been unemployed for long and have given up looking for work altogether. Obviously, the Fed's massive money printing exercise has not really worked wonders when it comes to facilitating job growth. But strangely, the government and the central bank do not seem convinced of finding an alternative and meaningful solution instead.

Just a few months before Dr Raghuram Rajan assumed the leadership role at the central bank, India had witnessed sharp depreciation of the Indian rupee against the US dollar. But his appointment saw a revival of market sentiment. Many market commentators then said that the worst was behind for the Indian economy. But in the months that followed, the economic situation hasn't shown any signs of revival. Inflation has persistently remained high. This has prompted the central banker to pursue a tight monetary policy.

What new challenges are in store for India economy now? In a recent interview, Dr Rajan hinted that the risk of capital flight is looming large as the US Fed taper kicks in. All this while, the emerging markets enjoyed riding on the wave of easy money printed by the central banks of developed economies. But now, there are growing signs that the easy money would flee back. As such, emerging economies that are running huge current account deficits are at big risk.

In the meanwhile, Indian stock markets hovered around the dotted line for most part of the day. At the time of writing, the benchmark BSE Sensex was up by 25 points (0.1%). The sectoral indices were trading firm with stocks from the realty and information technology sectors leading the pack of gainers. Most of the Asian stock markets ended the day on a firm note. European markets opened on a mixed note.

 Today's investing mantra
"Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid. - Warren Buffett

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5 Responses to "RBI governor's words of wisdom for India Inc."

Gunesh Apte

Feb 2, 2014

In my opinion, only way to curb rising inflation is to bridge the demand and supply gap, stop artificially increasing prices of certain food items, financial planning at central government and state government level and the most important is financial discipline. Also, it is necessary to have consistent policies at national level, and curb on subsidized items, such as diesel, LPG, food.

People should have 20 year vision for the state and nation, and have policies which are not designed to benefit in short term but which will benefit the nation in long term, say over a period of next 10-20-25 years. By cutting prices of electricity just before elections, may not lead to reduction in power prices over a prolonged period but will bring just short term relief, but how that will benefit us? People should ask such questions to themselves and believe in long term story, rather than fixing problems for short term. I feel that, people will learn this over a period of time, and then we will have better control over inflation, as many of the developed nations have today.



Feb 1, 2014

On the Delhi power cuts, the tariffs for power companies themselves have not been slashed !! The Delhi government will bear the cost til the CAG inquiry is complete. so I find it funny how the discoms suddenly find themselves in discomfort, when their tariffs have not even been slashed. Why were they resisting CAG audit for all this years ?

If you carefully scrutinize their accounts, they buy bulk power at a higher rate of 7+ and sell the excess power at 5+ to their own sister companies. Till today there has been no explanation from power companies on it. Not to mention fast meters or invoicing of equipments. This is a classic case of collusion at all levels between politicians, corporates, media houses which never address the questions raised but keep giving irrelevant explanations.


harjeet singh kalra

Feb 1, 2014

Yes I agree that Companies which have the power to increase prices without adversely affecting demand would be ideal for investment. The trouble is there are very few such companies in FMCG . One example ITC another HUL. Some companies in Capital goods sector ( high capacity DG sets ) could also have this ability.


harjeet singh kalra

Feb 1, 2014

Yes I agree that Companies which have the power to increase prices without adversely affecting demand would be ideal for investment. The trouble is there are very few such companies in FMCG . One example ITC another HUL. Some companies in Capital goods sector ( high capacity DG sets ) could also have this ability.



Jan 31, 2014

I disagree. The only way to control the inflation is to reduce the consumption, and the only solution is to control the population growth in India. Do India need such huge population? Strict measures are needed to control this like China did in the past and they are successful.

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