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Markets: Are we fundamentally secure? - Views on News from Equitymaster

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Markets: Are we fundamentally secure?

Jan 25, 2007

Forgive us dear reader for reviving the agony of the near meltdown that happened in May – June 2006 when the markets crashed, jolting investors’ confidence with the Sensex losing 826 points in just one trading session – May 18, 2006. During the same period, the Russian and Turkish stock markets trembled as well, losing some 30% of their gains. So it was not just the Indian markets that bled; all emerging markets saw shedding of gains as the ‘hot’ money that came in so easily, left just as easily. Emerging market bourses witnessed a flight of about US$ 20 bn that had taken some 20 months to come in. So much for business at the speed of thought, huh! The ‘foreign hand’
The money that flows into the markets comes mainly from the more developed and advanced Western economies, with Americans being one of the larger contributors. The interest rates have been low in the global markets for most of the last decade. In late nineties, economies like Japan maintained near zero interest rates and the US embarked upon interest rate cuts to boost employment and consumption levels. Investors in the western economies then explored other avenues in search of higher returns. Around the same time, the stronghold of Communism started to loosen and a lot of the Central Asian economies walked towards economic liberalisation from the fetters of a rigid ‘state-less’ economy. International monetary bodies were naturally applied to for help and they tried to usher in fiscal discipline into the emerging markets, unleashing their true potential for growth.

A combination of these and some other country specific factors saw a lot of money flowing into these economies from the west. The Foreign Institutional Investor (FII) investments touched unheard of figures in these markets. For instance, the assets in investment funds (for the US alone) aimed at emerging markets increased from a less than US$ 1 bn in the 1990s to US$ 90 bn in 2006. Would it surprise you then that the Russian market, albeit from a small base, has blazed ahead 3,000% over the past eight years? However a majority of foreign investors, who invest mostly through mutual funds, do not have a great appetite for risk, causing immense capital movements in and out of the emergent market economies that are potentially disrupting.

The India story is somewhat different. We have had stock markets long before most European countries had them, and the sheer size of the domestic economy keeps it comparatively well insulated from capital swings in the form of FII inflows. Total FII outstanding investments at US$ bn are 4.4% of our GDP. The markets anticipating the yields of liberalisation as also helped liberally with foreign inflows, have more than doubled in the last 24 months. At this dizzying level of 13,000 plus on the Sensex (the benchmark index), let us take a breather and take stock of the circumstances facing the Indian economy and markets.

Challenges in the days to come
As always the bug bear of our past indiscretions comes back to haunt us. The general dwindling of resources allocated for building roads and power stations along with a host of other necessary infrastructure is now in a position to put brakes on the growth. GDP in real terms has grown at 8% in the last two years. Increased demands on an already scarce infrastructure are inching costs upwards. It is a pity a service industry company like Infosys has to diversify into captive power generation just so that they can keep working. It is estimated by the Investment Commission appointed by the Finance Ministry that in order to support an annual growth target in GDP of over 8%, total investment of over US$ 1.5 trillion is required over a 5 year period, of which FDI should be US$ 72 bn. However, an analysis of Industrial Enterprise Memoranda (IEMs) between 1991 and 2004 showed that barely 14% of FDI approvals translated into investments.

Investment in the Indian Economy
Investment by source (US$ bn) FY02 FY03 FY04 FY05
Public Sector 27 32 45 61
Private Sector 27 29 41 57
Household sector 54 65 72 82
FDI 6 5 5 6
Total Investment 110 128 164 209
Investment as % of GDP 22.3 24.4 27.2 30.1
Source: Central Statistical Organization (CSO) Jan 31st 06 Press Release

Roads: Logistics and commutes continue to be the sore points for India, in part due to the lagging road infrastructure. To add to woes, growth rate in road sector has actually declined by 23.4% in FY06. The total length of highways upgraded / constructed during the year was 5,227 km as against 6,913 km during the previous year. Vehicles on roads have grown at an average of 10% per annum mounting further pressures on highways that though constituting 2% of the road network (3,34lkm), carry about 40% of the road traffic. Longer transportation times translate into increased costs, affecting margins. Just highways and urban roads need US$ 30 bn by FY10, and based on existing plans, an investment of US$ 20 bn seems likely.

Power: During FY06, the overall power availability was 578.9 bn units (BU) that was 9% (52.6 BU) short of the actual demand. Currently the peak hour power deficit in the country stands at 12.3%. FY06 saw the addition of just 3,469 MW of power or 22.5 BU - half the targeted capacity addition of 6,934 MW. Thankfully, the slow march towards allowing market forces to have a say in power economics has begun. Of about 90,000 MW of new generation capacity that is required by 2012, requiring an estimated investment of US$ 140 bn - only about US$ 54 bn worth of investment has been outlined yet, leaving a gap of about US$ 85 bn and an expected shortfall in generation of 35,000 MW.

Property Prices: The property prices across all metros and most tier-I and tier-II cities have soared over the past couple of years. This sudden surge is because the cities offer greater employment opportunities, higher disposable incomes and also due to lack of lucrative investment avenues besides the stock markets.

Extract of sectoral deployment of gross bank credit
(Rs bn) 19-Mar-04 18-Mar-05 31-Mar-06 CAGR
Gross Bank Credit 7,644 10,409 14,458 37.5%
Housing Loans NA 1,287 1,864 -
Real Estate Loans 56 133 267 118.7%
Source: RBI Annual Report        
Source: Annual Report – Reserve Bank of India

Besides, the quality of infrastructure beyond the existing boundaries of urban agglomeration is very poor, which has led to congestion and a subsequent upsurge in real estate prices. However, the question that looms is, are these prices sustainable and do they have a macro economic consequence? As supply of new houses catches up and with more correct behaviour from the banks under the eagle eye of the RBI, can see the prices stabilizing.

Talent Crunch: With the easing of various draconian laws coupled with globalisation in the last one decade, we have seen the evolution of the services industry in India. Its share in GDP increased to 53% in 2005 from 44% in FY96. Growth can be only upwards in the hitherto insignificant retail and logistics segments. While there is bound to be a churn as employees scout for better opportunities, there is also a shortage of skilled manpower, leading to high attrition rates across industries. This causes shortages and instability in the human capital, and it gets increasingly difficult to maintain high levels of productivity.

Services as a percentage of GDP – a cross-country comparison
(% of GDP) 2000 2001 2002 2003 2004 2005
China 39.3 40.7 41.7 41.5 40.7 -
India 50.0 51.2 52.6 52.5 53.2 53.8
Russian Federation 55.6 57.7 59.5 60.1 59.4 56.4
Source: World Bank Development Report

Going forward, why India is still attractive
India’s one billion plus population that was a stumbling block, is now her greatest asset. As incomes increase across the strata, Indians are demanding more of everything. The per capita private final consumption expenditure (at constant prices) has gone up 16%, from Rs 12,650 in FY00 to Rs 14,650 in FY05. Domestic growth spurs domestic investments and the gap in savings attracts foreign capital as the returns are higher here than most other countries. A more or less stable political environment is also an asset in a world divided by its own insecurities. The existence of laws (in some cases more than what is necessary), transparent accounting practices, and most important, the Indian spirit to maximize returns work in India’s favour despite the bottlenecks and imperfections of her super structures.

India is a very young nation in terms of the age composition of its population. The number of people in the “earning age” bracket (between 25-44 years) is expected to increase by 5.5 m each year taking its share in total population from 28% in 2005 to about 30.2% by 2025. Also the proportion of people with income in excess of Rs 90,000 per annum has increased from 20% in 1996 to 28% in 2002. Thus, as the people get richer coupled with an increase in the number of people in the “earning age” bracket, the consumption levels in India are expected to rise dramatically.

Households provide liquidity to the markets
As a nation, in FY06, Indian households invested just 5% of their total financial savings in shares and debentures. This figure was 12% in FY00 and 14% in FY95. Actual money into stocks has gone up nearly 6 times – from Rs 50 bn in FY05 to Rs 290 bn in FY06. Pension funds that garner money from a mere 13% of the population have collected Rs 570 bn in a year. Inability of the government to deliver the promised returns on existing pension accounts has spurred them into getting together a bill that allows employees to decide the fund they would like to invest in and be open to risks themselves, that is, the new monies collected will be allowed a freer hand in deciding the investment avenues, they will gravitate towards equity that has consistently given better returns, leading to increased liquidity into the stock markets.

The Indian markets have got a breadth that is paralleled by only a handful of other markets. However with almost 4,000 stocks out of about 7,000 stocks listed on BSE and the regional bourses being thinly traded, the Indian markets lack the requisite depth to be resilient to the volatile swings. With net outstanding FII investment of Rs 1,584 bn that forms 15% of the free float market capitalisation of BSE-500 (Rs 10,129 bn) we are still vulnerable to the ‘hot’ money.

Robust December quarter earnings and buoyant tax collections show the upswing continues despite the long continuing growth phase spanning almost 12 quarters. There is a complete shift of trajectory in the base economy. Demand for new services, newer technologies, improved productivity and the confidence of being competitive without the benefit of fiscal protection of high import duties, is here to stay. To help it along is the growth in domestic consumption that helps inculcate resilience to external factors. Minor blips owing to certain transitory issues like crude prices, government changes, or the effect of global factors like the weakening dollar, and the global market cycles are to be expected, but not to be worried about.

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