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Stockmarkets: Chilly at the top!

Oct 19, 2006

The benchmark BSE-Sensex having re-done its gravity defying act for the second time this year, investors need to carefully analyse their portfolio and gauge its riskiness with respect to their own risk tolerance levels. While valuation of companies have seen a re-rating in the last couple of months (after the crash in May), there are several macro-economic factors that seem to contradict the sustainability of the same. Fiscal risks camouflaged by excess liquidity
Typically, the cost of a high fiscal deficit would have been higher real interest rates. However, India has witnessed an unusually low real interest rate environment at a time when its fiscal policy has been expansionary, as reflected in the rising public debt to GDP ratio (currently around 80%). To give a perspective on the magnitude of India's public debt problem, as per the IMF World Economic Outlook 2006, India has the highest public debt to GDP ratio among the developing countries, while the figure for country with the second-highest public debt, Turkey, stands at 69% of GDP.

The key to lower-than-warranted real interest rates is the supply of global liquidity in form of portfolio and debt inflows. As per the Reserve Bank of India (RBI) estimates, almost 83% of the total US$ 76 bn capital inflows into India (between FY03 to FY06) have been in the form of non-FDI flows. A pull back of these funds coupled with higher government borrowing (to meet the FRBM target) may see the interest rates charting a steep upward route.

Liquidity at the cost of growth?
One could argue that considering India's strong growth prospects, global capital inflows should continue unabated, thus thwarting the possibility of further rise in interest rates. However, it needs to be comprehended that the current high level of unproductive government expenditure and public debt is weighing on the long-term growth potential. The government's spending on productive areas such as infrastructure, education, health and welfare has been constrained by high levels of non-development expenditure and high interest cost on the public debt. The development expenditure has averaged at 15% of GDP over the last five years, declining from 17% at the commencement of the liberalisation process in FY91. On the other hand, non-development expenditure rose to 13% of GDP in FY06 from 11% in FY91. Not to mention that the oil subsidies and state electricity board losses have only worsened the position of the exchequer.

The easy liquidity condition in recent years has also encouraged a surge in the demand for consumer loans that has surpassed the credit to industry and infrastructure. The outstanding credit towards consumer loans has grown at a CAGR of 49% between FY03 to FY06 (Source: RBI Annual Report) as against 24% in the case of industry and infrastructure. Correspondingly, the share of personal loans in total bank credit increased from 15% in FY03 to 25% in FY06 while the share for industry and infrastructure dropped from 41% to 39% in the same period.

FRBM targets - so near yet so far!
As per the Fiscal Responsibility and Budget Management (FRBM) Act passed in 2004, the central government is required to eliminate its revenue deficit and reduce its fiscal deficit to 3% of GDP by FY09 (7.5% in FY06). While on paper the Act is expected to improve fiscal balances significantly, its implementation has been derisory.

Investors to take a call on interest rates and crude?
Amongst the BRICs, India is supposedly the best positioned to withstand the cyclicalities of the global business cycle. This is because of its resilience to slowdown in exports (which comprise merely 13% of its GDP) and little correlation to the slowdown in the global economy. The country also has an ample cushion of internal demand (private consumption was 61% of GDP in 2006). However, in the event of foreign investors embarking on a long-overdue shift to risk aversion, India's currency and interest-rate vulnerability cannot be minimised.

While it is certainly not feasible for investors to take a call on interest rates (domestic and global) and crude prices to determine the longevity of the foreign funds, a more rational approach would be to bet on more compelling long term growth themes.

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