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Markets: Unfounded euphoria? - Views on News from Equitymaster
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  • Dec 29, 2006

    Markets: Unfounded euphoria?

    As 2006 culminates on a buoyant note on the Indian bourses, we look back at the mid year panic and the new found euphoria that caused the benchmark BSE-Sensex to oscillate within a range of nearly 6,000 points between the highs and the lows. While we do not disagree with the bright long-term prospects of the Indian economy, here we try to reason what could be the possible near-term perils.

    Unsustainable growth rate: India has achieved an average GDP growth of 8.2% over the past three years against 6.2% in the preceding ten years. This compares appreciably with the average economic growth of 10.3% for China and 5.3% for other emerging economies in the past three years. While it is warranted that we attribute most of the economic strength to structural factors, it must be acknowledged that a part of growth has also been a result of the sharp cyclical rise in capital flows in response to an increase in the global risk appetite.

    Cumulatively, over the past three years (2004-2006), India has received capital flows to the tune of US$ 72 bn versus US$ 28 bn in the preceding three years (2001-2003). Low real interest rates globally and the consequent rise in risk appetite have driven this disproportionate increase in capital inflows into India. Over the past five years, households and the government have lapped up this liquidity, increasing India's debt to GDP ratio by 26%. Versus this, the debt to GDP ratios of the US and China have increased by 25% and 8% respectively during this period. This debt has, in turn, been used either to bolster consumption or to fuel asset prices thus boosting growth beyond sustainable levels.

    Inflation pressure: With the domestic demand remaining strong, the Reserve Bank of India (RBI) has been especially concerned about potential inflationary pressures. The headline inflation barometer (WPI) has reaccelerated to 5.3% at the end of 9mFY07, close to the RBI's maximum tolerance level of 5% to 5.5%. The firmness in crude prices and possible cuts in crude production in the coming quarter dismiss all possibilities of softening in the inflation levels.

    Overstretched credit: The gap between credit and deposit growth has been a key concern in the current year. Although credit growth has moderated to 29% YoY in 2QFY07 from the peak of 33% in 1QFY07, it remains significantly higher than deposit growth of 21% YoY. The trailing one-year incremental credit-deposit ratio is also at a high of over 90%. With the banking sector's holding of GSecs already at 29.6% (close to the statutory SLR requirement of 25%), there is little scope for banks to continue with the current high credit disbursement rate. In addition to the strong growth in credit, the quality of credit being disbursed is also a legitimate concern. Banks have not only been lending more to riskier segments but have also been mis-pricing the credit. Although the RBI has initiated administrative measures to reduce the bias towards funding consumption and speculative sectors, there has not been a meaningful correction in this trend so far.

    Property market euphoria: It is well comprehended that excess liquidity without an adequate supply of assets results in bloating of asset prices. The inadequate supply of urban infrastructure and concentration of the same in certain areas led to property prices rising by 100% to 300% in major cities in the past two years. With the demand supply dynamics changing - the sustenance of the asset prices remains uncertain.

    Global re-pricing of risk: The wide disparity that was earlier prevalent between the global and domestic interest rates led to heavy global portfolio equity inflows (driven by a growing global risk appetite). With the said disparity now narrowing down, it is only a matter of time before the global investors choose to re-price their risk appetite and in the process pull back some of their assets to their domestic shores.

    Looking ahead...
    As opined by economists world over, investors should expect India's economic growth to get muted to an average of around 7% in the coming years, driven by the lagged impact on credit growth and inflationary pressures. In the event of the consumption-led growth remaining unabated, the risks of a sharp spike up in the cost of capital and an aggressive landing of the growth cycle looms large. To thwart this, the government needs to initiate an investment-led growth cycle, implement labor reforms, improve the management of government finances and execute the much-needed reforms. Accordingly, investors must judge their risk appetite and insulate their investments against the market euphoria.



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