Why India Isn't Safe from the Global Recession

Indian elections are democracy on an epic scale. Once every five years, over half a billion people get to choose their government. From the time the first vote goes into the ballot box to the last takes four weeks. It's by a long way the world's biggest poll – and each time it gets larger as India's electorate grows.

With this year's election kicking off in mid-April, the ruling Congress coalition is doing its best to talk up India's prospects and secure its re-election. The economy will grow by 7.1% in the year to April, says the government. Next year, it should manage 6%.

Those are pretty impressive numbers in the middle of a global economic crisis. Unfortunately, they're total fiction. After last quarter's 5.3% year-on-year growth, there's no chance that this year's target will be met. Meeting next year's is also highly unlikely. India is joining the rest of the world in a credit crunch and it will be remarkable if it can grow at half the government's target …

Investment is vital to India's economy

Investors often think India is a more self-contained economy than the rest of Asia. That's not true. It's certainly less-export dependent, though exports are a bigger part of GDP than many think. But it's heavily dependent on the rest of the world in another way.

A big part of India's economy is investment: it was around 39% of GDP last year, up from 25% five years ago. That's no surprise for a country at India's stage of development and it's certainly not bad. In fact, it's desperately needed given the state of the country's infrastructure.

Much of that investment is aimed at domestic demand rather than export capacity, which sounds as if it should hold up better than investment in more export-driven countries. But the snag is that around 30% of the funding for this comes from abroad, in the form of foreign institutional investment (FII) in equities and bonds, and foreign direct investment (FDI) in setting up local business and facilities.

Since the global economy melted down, those investment funds have gone into reverse. Investors in Indian equities have pulled out all the money they invested since 2006. And other flows of capital are also drying up. Take a look at the chart below, which compares the sources of new capital for companies in April-December 2007 and 2008.

You can see that while the overall amount raised is down only slightly, the source is very different. Increasingly, funding is coming through bank loans, with other sources of funding such as share placements and foreign borrowing down 25%-35%. Bear in mind that this covers the whole nine months, while markets only really froze in the summer, so this suggests a pretty severe drop in the last part of the year.

What's more, if you look at the lending detail more closely, you can see that the bank credit increase is solely down to an explosion in lending by public sector banks. Private and foreign-owned banks are also pulling back.

Banks can't fill the gap – and don't want to

That might not sound like too big a problem – as long as Indian banks can continue to increase lending, the gap can be filled. And at first glance, that looks perfectly possible. For example, the loan-to-deposit ratio is low at 73%, suggesting that banks have plenty of scope to increase lending.

But Indian banks are obliged to hold 25% of their assets in government bonds. Once that is taken into account, their ability to lend more is clearly limited. The government could remove that cap – but that reduces the market for its own debt. With a likely budget deficit of 9-10% next year - and ratings agency Standard & Poor's threatening to downgrade the country's debt to below investment grade - that probably isn't an attractive option.

What's more, all public sector and Indian-owned banks are supposed to direct 58% of lending towards agriculture and priority sectors. So while these areas may do okay, less favoured ones – such as real estate – will be left out in the cold.

All this may be moot, because the only banks that are interested in increasing lending now are the ones that can be strong-armed into it. When the economy slows and non-performing loans rise, banks everywhere get nervous about adding more risk to their balance sheets (if only they could be so prudent in the boom times).

The latest data suggests lending growth has dropped off a cliff in the last few months, as you can see in the chart below.

FDI is holding up for now

One of the few bright points is last year's strong pick-up in foreign direct investment, which you can see in the chart below. FDI is better than FII in equities and debt in many ways, because it's more long-term and less able to rush out of the country at the first sign of trouble.

The October-December quarter saw a sharp 25% y-o-y fall in FDI, but January flows are reported to have rebounded 59% y-o-y. Whether this is just a rush of deals going through together or the start of a new strong trend is unclear. However, the downside risks are clearly high in this climate – especially if India gets downgraded by the ratings agencies. And even if FDI flows remain strong, to put them into context, they were only 11% of flows in April-September 2008, so they can't fill the gap by themselves.

India is going to slow – and markets will be hit

All this means that India is likely to grow much, much more slowly than people expect this year. Back in the 2001-2002 slump, it grew by less than 4%, and while the economy has changed substantially, global conditions are far worse. Looking for a similar result this time strikes me as optimistic rather than pessimistic.

None of this undermines the long-term case for India – although an inability to invest in infrastructure now will be a bottleneck in years to come. But it makes Indian stocks look very vulnerable as this sinks in.

That's especially true of the kind of firms that I favour as a way to play its growth. While most people get excited about India's IT and business services industry, I think that its enormous infrastructure needs mean that firms in those sectors have to be a big part of an India portfolio (as do the kind of firms that will tap into the huge, unskilled, rural workforce as they move off the land).

But these firms such as Grasim Industries, which makes cement, will be hit hard by the credit crunch as the money to fund these projects dries up. Yet their share prices have bounced recently, as you can see below (Grasim is the white line, shown against the Sensex benchmark index in orange).

One big worry is the real estate industry – which is obviously a major customer for the construction and building materials groups - because this sector looks like it's heading for a very hard landing. There are no full property indices for India, but many areas are said to have seen residential prices rise by 200%-plus in the 2005-2008 period.

But with credit drying up, speculators pulling out and prospective buyers losing confidence, the bottom is falling out of the market. Developers are reported to be slashing prices by 30-50% in former hotspots such as Mumbai. The commercial sector is also being hit, with capital values and rentals for office space dropping 10-20% in some cities, according to consultants CB Richard Ellis.

Given the scale of the boom, the fallout is likely to be substantial. Regulators seem worried: the Reserve Bank of India is reported to be examining the books of ten major real estate firms to check their solvency and see whether default on their loans would pose any risk to the banking system.

Comments

[Manohar Men...:]

1) The problem with the govt is that they want to win election. So they just gave away the FREE AGRICULTURAL defaults to farmers (just like the govt here).
2) The prime minister when he sees that the nation needs lots of power & freeways, he should have set about 20 billion for power to generate additional 25000 MW of power (800,000$/MW). Because without power the industry can't run & without proper roads the transport is defeated as it takes more labor & truck time & more wear & tear on trucks.
3) They have reduced the interest rates from 13% (to curb inflation of 12.6%) to about 9% today. The real estate has started to pick up & the market has started to move.

Mar 26 12:18 PM

[argie:]

Although author has tried his level best to analyse Indian economy, I don't think he had omplete understanding of India. But still, it is a good effort on part of author...thanks,

Mar 26 11:55 PM

[andyn1:]

Good article on the Indian economy as of today. But where is it going tomorrow?

Growth rates of the economy above 5% would be something to die for in this day and age and if India can sustain that, it bodes well for the future. Sure, it's not as high as before, but the key thing to note is "stability of growth", not a fluctuating or fictitious growth number like the Chinese put out with their penchant for the number 8. (Have you not wondered how it is that they always grow at that magic rate??)

Anyway, a point to note is that the Indian elections itself would be a big boost to the economy. It is estimated that there is about $20B in direct spending for the election and an indirect (read undocumented, black market) boost 2.5x times that. So $50B is being pumped into every corner of the country within 3 months.
That's about 6% of India's GDP, nothing to snicker about.

Of course, much depends on who comes to power after the election. It will be mostly a coalition again, but the key difference might be that its a coalition without the communists. If so, India's growth rate should be sustained because both the Congress and the BJP have common economic agendas, even though they are politically at loggerheads.

So for the average investor, I would buy BEFORE the elections when the market is down and risk is low. Good candidates are those who do business within India and NOT the outsourcing giants. So buy banks (IBN, HDB), commodity stocks (SLT) and stock market in general (EPI, PIN) and time an exit around May when the election results are announced.

Mar 27 11:20 AM

[HaavBline:]

You are not talking facts about China at all. China's growth rate has not been as LOW as 8% for quite a few years now. They had to adjust the actual 2007 growth rate to 13% in late 2008 from originally reported 11% in early 2008.

On Mar 27 11:20 AM andyn1 wrote:

> Good article on the Indian economy as of today. But where is it going
> tomorrow?
>
> Growth rates of the economy above 5% would be something to die for
> in this day and age and if India can sustain that, it bodes well
> for the future. Sure, it's not as high as before, but the key thing
> to note is "stability of growth", not a fluctuating or fictitious
> growth number like the Chinese put out with their penchant for the
> number 8. (Have you not wondered how it is that they always grow
> at that magic rate??)
>
> Anyway, a point to note is that the Indian elections itself would
> be a big boost to the economy. It is estimated that there is about
> $20B in direct spending for the election and an indirect (read undocumented,
> black market) boost 2.5x times that. So $50B is being pumped into
> every corner of the country within 3 months.
> That's about 6% of India's GDP, nothing to snicker about.
>
> Of course, much depends on who comes to power after the election.
> It will be mostly a coalition again, but the key difference might
> be that its a coalition without the communists. If so, India's growth
> rate should be sustained because both the Congress and the BJP have
> common economic agendas, even though they are politically at loggerheads.
>
>
> So for the average investor, I would buy BEFORE the elections when
> the market is down and risk is low. Good candidates are those who
> do business within India and NOT the outsourcing giants. So buy banks
> (IBN, HDB), commodity stocks (seekingalpha.com/symbo...)
> and stock market in general (EPI, PIN) and time an exit around May
> when the election results are announced.

Mar 28 11:31 PM

[Zyx007:]

Good article, but needs to take into account the developments on the ground in the marketplace. As an example, the cement industry has been increasing the price in recent months, despite an excide duty cust that would have lowered the selling price. Q4 FY 2009 (Jan - Mar 2009) is expected to be the best in the current financial year ending in March 2009.

5.0 - 5.5% growth in 2009 calender year is the most pessimistic this year, which is outstanding in an environment the rest of the world is falling apart. Market could decline by 20% from the current level of 10,000 if elections produce a painful result, which would bring them back to where they were a couple of months ago.

The risk-reward trade-off seems well balanced in the near term, and outstanding in the medium term.

Mar 29 07:07 AM

[Alan Young:]

This sounds like a Catch-22. The economy can't grow without more foreign investment... but investors want to see a growing economy. Where do we start?

Mar 31 12:02 PM

[Carneades:]

Given that the Indian economy has performed so well (any growth at this point deserves accolades) despite the disruptions to the global financial system, we would posit that the greatest threat to India is none other than the instability in Pakistan. The potential for armed conflict can not be ignored when delivering an assessment of the near-term prospects for the Indian economy.

TheValueatRisk.blogspo...

Mar 31 12:55 PM

[User 378502:]

So your argument is that the domestic credit is drying up and foreign investments are winding down so growth will slow down.

Often overlooked is an important indicator in the Indian context: monsoon rains.

India's rural economy is so heavily dependent on agriculture and monsoon rains, irrespective of whether banks lend or not, is going to drive the growth rates. Lending might influence the growth rates by showing positive gains in the infrastructure and telecom sectors but the decisive influence is that of the agricultural sector.

Watch out how Hindustan Lever's stock performs. They are a much better indicator of India's growth prospects than anything published by any authority. HLL is the only consumer firm that has sunk itself deep to the eyeball in the rural Indian market.

Mar 31 03:20 PM

[dw57:]

they might renew the contracts, but don't have the need for the same amount of work. so the contracts will be a lot smaller. less work, less cost, smaller all the way around


On Mar 31 02:40 PM juan77 wrote:

> India is definitely interlinked with the global economy. If Wall
> st sneezes, India catches a cold. The boom in real estate and stocks
> in India is due to foreign investments. Price of plots of land shot
> up like 50-70 times(not 50-70% but 5000-7000%!) thanks to the "IT
> boom" and allotment of cheap/free land to IT companies. 1000's of
> apartment construction projects sprang up all over India in the past
> few years. They too were beneficiaries of Florida Condo like speculation.
> Now, the property boom has cooled and prices have fallen a bit but
> they are still over priced. Lots of big name developers are facing
> a cash crunch. There are no buyers for new housing and Banks are
> not willing to lend to the developers to complete these projects.
>
> Elections are a very expensive affair in India. Contestants to the
> legislative assembly spend over a million dollars for election expenses.
> They are in politics to make money, to earn maybe 5-10 million in
> their 5 year term. To earn that kind of money they need to take it
> from Industrialists, small businesses, civil contractors, etc.<br/>In
> return they have to hand out benefits like allotment of free land,
> business licenses, construction contracts, building permits, etc.
>
> Businesses do their best to curry favor with whichever party is in
> power but it's not an easy task to accomplish.
> So, one can imagine how the upcoming elections can be a big game
> changer.
> Most Indian IT companies earn money through contracts with overseas
> clients. There is a concern among the Indian IT companies that their
> overseas clients may not renew their IT contracts with them. But,
> the rupee's decline against the dollar will probably encourage clients
> to may be negotiate a lower dollar price and renew their contracts.
>
> That being said, facts are facts but the stock market is all about
> perception. Traders can make good money in the Indian stock market.
> Indian stocks have great volatility and you can make a neat bundle
> as they run up huge(without reason, but that's besides the point).
> Indian stocks also fall hard, so buyer beware!

Mar 31 04:01 PM

[DR.R.SRINIV...:]

The author has not given any comments about the global recession and its impact on cement units world wide. The serious consequences will face due to global financial crisis by other sectors were covered. Being cement is one of the important segment for the infrastructure development , financial appraisal of the cement units before and after meltdown is seriously considered as a debate. i am happy if the author highlights thesignificant aspects involved in growth of cement units after globalisation.

DR.R.SRINIVASAN

Jun 05 09:24 PM