• OCTOBER 1, 2004

Too hot to handle...

The GDP growth numbers for 1QFY05 were declared yesterday. The headline number i.e. the Gross Domestic Product (GDP) has grown at 7.4% YoY in 1QFY05. While this is indicates that the broader numbers are impressive, the key questions whether this growth rate will continue?

First a brief snapshot of the 1QFY05 performance. Of all the three sectors of the economy, agriculture has recorded the lowest growth (3% YoY in 1QFY05). On the other hand, led by a strong 11% growth in 'trade, hotels, transport and communication' sector and 9% growth in 'community, social and personal services', the services sector has managed to grow the highest (10% YoY). The industrial sector has not done badly either (7% YoY).

In short...
Sector (% YoY growth)1QFY041QFY05
Electricity, gas, water supply4.8%6.3%
Trade, hotels, transport7.3%11.0%
Financing, real estate etc5.7%7.0%
Source: CSO

While there are many reasons to be optimistic about the country's long-term growth potential, for the next one year, the government is faced with a number of challenges. Lets take one at a time.

  • Monsoons:  As per the latest data available from the Ministry of Finance, almost 25% of meteorological divisions have received deficit rainfall for the period between June to September 2004. This is the third highest in the last six years, which is one of the reasons why the agricultural sector growth is lower. One will not be surprised if this sector posts a negative growth for FY05.

  • Crude prices:  While much has been discussed and debated about the impact of crude prices on the Indian economy, the numbers below says it all. Petroleum and oil imports have increased at 61.9% in dollar terms between April and July 2005. If one gets positive vibes from the 7.4% headline growth, the country's demand for inputs (largely crude and related items) is likely to increase. While the impact of higher crude prices on wholesale inflation is apparent, the implications on the finances of the government is concerning as well.

    In the union budget, the Finance Minister had accounted for Rs 35.5 bn towards petroleum subsidy (the figure last year was Rs 65.7 bn). Though the government has cut its share of the subsidy in LPG cylinders this year, with crude prices having risen so sharply, there is every chance that the petroleum subsidy bill is likely to be much higher than what has been budgeted. Every one-dollar increase in crude prices increases the crude bill by an estimated US$ 70 m to US$ 80 m. Given the fact the petroleum subsidy accounted for as high as 5.0% of the fiscal deficit and 14.7% of overall subsidy, the fiscal deficit target of 4.4% is unlikely to be met. As a matter of fact, the fiscal deficit in 1QFY05 had already crossed the 30% mark!

    Petroleum subsidy - What is budgeted?
     FY03FY04FY05 (BE)
    % of total subsidy12.0%14.7%8.2%
    % of total expenditure1.3%1.4%0.7%
    % of fiscal deficit3.6%5.0%2.6%
    (Source: Ministry of Finance, Our estimate)

  • Impact on corporate profits:  Since most of the commodities and manufacturing sectors depend on crude and related products as a source of energy, we believe that operating margins are likely to come under significant pressure. While some effect was witnessed in 1QFY05, we believe that the 2QFY05 and 3QFY05 results may reflect the full impact of higher crude prices on demand and on margins.

  • The impact on interest rates:  Given the fact that fiscal deficit is more likely to overshoot the budgeted estimate, the government's appetite for money (to bridge the gap between revenue and expenditure) is likely to increase. If one puts this along a 25% growth in non-food credit with the possibility of investment cycle recovering (i.e. corporate investment gaining pace), there is every possibility that the RBI may be forced to raise interest rates. More importantly, the RBI need not wait for the Monetary Policy to do that, if need be!

What is the impact on stock markets?

When interest rates rise, valuations of equities tend to suffer because at the end of the day, equities are a part of the overall asset allocation. While we are not trying to be doomsayers, the point we are emphasising on is that the headline numbers may be misleading. We continue to believe that the case for investing in equities still remains strong with a three-year view.

But if risks arising from very high crude prices on economic growth, corporate performance and valuations of stocks are overlooked, equities may be too hot to handle for investors at a latter stage.

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