Why the worst is certainly not over...

Apr 21, 2014

In this issue:
» Why unemployment may become permanent in the US
» The Companies act has made life tough for real estate firms
» Should a CEO earn 300 times the average worker's pay?
» Only the power plants with clearances will get coal
» ...and more!

We have been hearing plenty of 'the worst is over' kind of predictions about the economy lately. As per the official announcements, India's GDP growth has already bottomed out. In addition to this, many believe that if we have a good monsoon, the inflation rate will fall and this will prompt the Reserve Bank of India (RBI) to bring down interest rates. Hopes that a new government will give a big push to reforms have sent the stock markets to new highs. Unfortunately most of the euphoria is backed by little proof of economic recovery. The only ray of hope is some relief on India's deficit problem. For, at least the expectation that the current account deficit (CAD) is set to go lower is backed by tangible data.

Now to what extent can a lower CAD underscore economic recovery? The CAD tells us that the country's imports are more than its exports. The difference has to be bridged by capital inflows like Foreign Investments (either direct or indirect) and remittances. If the CAD remains low then it is not too much of a problem. However a persistently high CAD can make the economy vulnerable to an external shock and put the currency under pressure. This is exactly what had happened in 2013 when the CAD had touched a record 6.5% of GDP. The government and the RBI had to take extraordinary steps to bring it under control. One year on, there appears to be good news. The CAD has fallen dramatically to just 0.9% of GDP in the March 2014 quarter. So the inevitable question is whether this can be sustained. Unfortunately, it cannot, at least not by the measures adopted by the government.

The sharp decline in the CAD has only been possible due to a massive fall in gold and capital goods imports. The curbs placed on gold imports have resulted in a sharp increase in smuggling and is clearly unsustainable. The fall in capital goods imports is not something to be proud of. It is merely a reflection of the poor state of the economy. These capital goods imports will pick up only as and when there is an improvement in economic growth and industrial activity.

Now the key to sustainable improvement in the CAD lies in higher savings and investments. If the total savings pool of a country (both public and private) is not enough for its investment needs, then money will have to be brought in from abroad to fill the gap. This is reflected in a rising CAD as has been the case with India over the last few years. The government has been providing subsidies for various schemes, including unnecessary ones for diesel and LPG. This reckless spending has adversely impacted the public savings rate. Meanwhile, thanks to high inflation, the negative real interest rates have hardly incentivized private savers. And as a result even the private saving rate has fallen to nearly a decade low! Thus the growth in savings has not been able to keep pace with the investments that the economy needs. The end result has been falling GDP growth and a ballooning CAD.

Let us not be fooled by the recent and temporary sharp fall in the CAD. It has come about only because of a huge decline in investments (especially corporate investments). This is a disaster for the country. Without private investment, productive assets like factories will not be created. This will only lead to higher unemployment. The solution to this problem is thus clear. The economy needs policies that will encourage private investment as well as a big reduction in government subsidies. These two measures will ensure that the CAD remains low and the currency remains strong. An improvement in savings rate and corporate investments must be a prioritized goal for the new government we believe.

Do you think that the low current account deficit can be sustained? Let us know in the Equitymaster Club or share your comments below.

By the way, Mark Ford, who is a very successful American publisher, entrepreneur and real estate investor, will be giving us a peek into his best wealth building ideas The Daily Reckoning.

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 Chart of the day
China is a lot in news these days. And not for good reasons unfortunately. Shadow banking, environmental pollution and fear of a property bubble in China are issues that are discussed now. This is unlike in the past when the economy was envied and hailed for its spectacular growth. Nonetheless, it seems like there is still a lot that India can learn from its neighbor.

As per a study by CRISIL Research, despite having a significant lead over China in 1980, the Indian economy now lags behind Chinese economy with regards to growth. In 1980, the size of Indian economy was 1.5 times that of China on a purchasing power parity basis. However, in a period little over three decades, China has beaten India by a huge margin. Over this period, Chinese economy has swelled to 2.7 times that of Indian economy. Some of the obvious implications for China have been faster reduction of poverty, higher per capita income and higher car sales.

While it may seem that we have missed the bus, it is not too late for India we believe. If the Government focuses on reforms, India can cover up the gap. After all, it has the leverage of huge youth population that China does not. Also, while getting inspired for higher growth, we need to be cautious about what not to learn from China. This will make sure we do not end up paying huge cost for the growth and will help us avoid the mess that the Chinese economy is facing today.

Size of China's economy trounces that of India's
*Purchasing power parity

The unemployment problem in the US may have been underplayed by the US Fed. However, the statistics hardly fail to reveal the magnitude of the crisis. As per Washington Post, for those who have been unemployed in the US for long, finding jobs has become nearly impossible! In fact as per economists, the long term unemployed may stay out of jobs forever. They argue that such workers have become part of a vicious cycle. Their skill sets have deteriorated during the long spell of joblessness. Hence they are unlikely to fetch jobs versus those who are newly skilled. Again, in their desperation to fetch jobs such workers are willing to accept lower and lower pay. Data revealed by White House shows that of the unemployed from 2008 to 2013, only 36% were in a job 15 months later. Hence a major portion of the population has remained unemployed for good. These unemployed workers have in most cases even ceased to become job seekers. While the US Fed may choose to call this 'less unemployment', the crisis in the economy is for real.

The debt to equity levels of many real estate companies has remained very high for several quarters now. And the one main reason behind this is that, these companies engage in various ways to raise debt. The company's directors or promoters or any related party injects cash in the form of loans in these companies. Thus, irrespective of a company's debt position, these related parties would infuse more cash thus putting pressure on the company's balance sheet. Thanks to loopholes in the Indian Companies Act, the promoters of the real estate companies have gotten away with huge debt on their books so far. And in doing so they have given away a huge portion of profits in the form of interest payments.

However, the recently enacted Companies Act 2013 seems to have put restrictions on fund raising by real estate companies. In our view, the new legislations will certainly hinder the fund raising capacity of these companies. This will impact the near term liquidity of the real estate companies. The companies will now have to go to financial institutions to raise loans and the funds cannot be procured internally and swiftly as was happening till date. More importantly, raising funds externally will require prudent financial management and good credit rating. Thus, real estate companies will have to brace for slower growth in the absence of debt funds. However, on the positive side, investors can look forward to leaner balance sheets in the sector.

One of the most perennial debates in the corporate world is how much should the top executives be paid? According to a report by the AFL-CIO, a federation of trade unions; CEOs are paid 331 times (based on companies in the Standard & Poor's 500-stock index) the average worker in an organization. Domestically too, the opaque salary structure of top executives compensation packages have come under scrutiny time and again by SEBI. Few years back, even India's prime minister had called for a cap on CEO salary in order to reduce the income inequality in the country.

As suggested by the U.S. Securities and Exchange Commission, disclosing the CEO-worker pay ratio may be a good way to keep a check on excessive compensation of executives. However, the transparency may not help much as investors and shareholders generally are oblivious to the income disparity between workers and top executives. Also, if the shareholders are involved in deciding pay packages for management, it will strip the company boards of one of their essential duties. One argument in favour of high salary for top management is that running a business is not an easy task. In fact, many CEOs are known to breathe new life into dying businesses. Therefore, they can justify the rich dividends in return for their efforts. The compensation disparity could be eliminated to a certain extent by adopting performance based salary structure. However, doing so entails a risk of adoption of malpractices by the managers which may include over stated revenues and profits. On the other hand, it encourages managers to strive hard to earn more.

We believe keeping a check on the gap between CEOs and workers salary is vital. A widening gap even in difficult times can alarm investors about the quality of management. Meanwhile, in cases where the management takes a pay cut in times of crisis speaks volumes about the ethical business practices.

Coal continues to remain the key input for most power plants across the country. But most power companies have been at the receiving end because Coal India has not been able to keep up its production with demand. Given that Coal India has a monopoly when it comes to coal supply and because of various problems plaguing the sector, power companies have no choice but to turn overseas for coal supplies. Meanwhile, Coal India has also decided to prioritize coal supplies. For instance, as per an article in Economic Times, at least 30 of the power plants that currently do not have an assured coal supply and are ready to be commissioned will be given coal first. Now there have been some plants from old projects which have been assured coal supplies. However, because they have either not been able to commission these plants or have been unable to sign power purchase agreements, the coal supplies would now be diverted towards the newer plants. It will significantly help in the longer run if Coal India sets and meets targets of higher coal production so that the gap between demand and supply narrows down. But it appears that would be hoping for too much in the medium term at least.

The Indian stock markets continued to trade firm in the post noon session. At the time of writing, the benchmark BSE-Sensex was up by 84 points (+0.4%). Majority of the sectoral indices were trading in the green led by capital goods and auto stocks. However, IT and FMCG stocks remained out of favour today. Asian stock markets are trading mixed with Malaysia and Hong Kong being among the best performers, whereas China is trading down sharply.

 Today's investing mantra
"There are no bonus points for complicated investments" - Warren Buffett

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1 Responses to "Why the worst is certainly not over..."


Apr 22, 2014

you say key to sustainable improvement in the CAD lies in higher savings and investments.What about increase in exports and controlling cheap but substandard goods imports.
Also help out business to export more instead of the customs impeding them.Encourage them to reduce margins and target the world and help them to do so.Follow chinese model to a great extent with some modications to suit Indian conditions

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