India's Two-Factor Squeeze

Conclusion: We remain cautious on Indian equities as growth looks to slow due to a cash shortage and additional monetary policy tightening on the horizon. Further, we see inflation as a much larger headwind in India than we feel is currently priced into its equity market.


In 2010, we’ve seen India struggle with inflation, aggressively tighten monetary policy to the tune of six rate hikes and take measures to alleviate a shortage of cash in its financial system at the end of the year. In spite of all this, the Indian economy and Indian equities barely skipped a beat on the year as a whole: 

  • Indian GDP has averaged +8.8% YoY in the three quarters through 3Q10 vs. a +6.8% YoY quarterly average throughout 2009;
  • India’s BSE SENSEX Index finished 2010 up +17.4%; and
  • Indian banks borrowed 923 billion rupees per day from the Reserve Bank of India in 4Q10 – the most since 2000 – as they struggled to meet rising demand for loans. 

India's Two-Factor Squeeze - 1


Given this sequence of events, the question, “Where to now?” seems most fitting. India is struggling with inflation running ~300bps over the government’s 4-4.5% YoY target and accelerating food inflation currently at +18.32% YoY (there are 828 million Indians that live on less than $2 per day at PPP, so food inflation IS an addressable problem in India, contrary to our conflicted and compromised views of inflation domestically).


India's Two-Factor Squeeze - 2


Despite these inflationary concerns, the RBI has been keen on adding fuel to the speculative fire in an attempt to ease a cash shortage within its financial system by supplying Indian lenders with liquidity. This is likely because the RBI expects inflation to continue to soften from here on the heels of the aforementioned interest rate hikes in 2010.


India's Two-Factor Squeeze - 3


Currently Indian Finance Minister Pranab Mukherjee expects YoY WPI (India’s broadest measure of inflation) to decelerate to +6.5% YoY by March 31 – up from the government’s initial estimate of +5% YoY in early 4Q10 and +6% YoY as recently as December 14. This subtle ratcheting up of inflation expectations suggests the Indian government sees what we see: more inflation on the horizon.


India's Two-Factor Squeeze - 4


As it currently stands, the shortage of cash within India’s financial system has driven rates on short-term paper to two year highs: India’s one-year certificate of deposit is currently at 9.45%. The rise in rates has contributed to a doubling of AUM at Indian money-market funds in 2H10, finishing the year with 569 billion rupees ($12.6 billion). Heightening inflation expectations may also be a contributing factor to the increase, as the returns from such instruments are allowed to be adjusted for inflation before being taxed.


India's Two-Factor Squeeze - 5


Liquidity continues to remain tight within the Indian financial system, as deposit growth (+15.3% YoY) is being outpaced by credit growth (+21.1% YoY) – a recipe for accelerating, NOT decelerating, inflation in an economy with demand-side pressure as robust as India’s. To counter weak deposit growth, we’re seeing Indian lenders hike deposit rates: the State bank of India has raised one-year deposit rates +225bps since July 30 to a 22-month high of 8.25%; Housing Finance Corp., India’s largest mortgage lender, increased its deposit rates +75bps to 7.95%. India’s overnight interbank borrowing rate jumped +50bps since the end of last week to 6% - another sign of tightness within India’s cash market.


If this tightness persists, we could see the Indian economy run into a scenario whereby they simply can’t meet demand consumer and corporate demand for loans enough to sustain the current cycle’s robust growth trajectory. Interest rates likely have to continue to heighten across the Indian economy in order for Indian lenders to grow deposits enough to meet such demand. Sure, India could continue to pump liquidity into the system by accelerating its government bond purchases, but it does so at the risk of exacerbating inflationary concerns.


Adding to this confluence of stresses is the increasingly likelihood of additional tightening by the RBI to combat a potential acceleration in inflation. The RBI meets on January 25 and may resume hiking the repurchase rate, which currently stands at 6.25%.


All told, India’s 4Q10 GDP (which we think may surprise consensus estimates to the upside) may be wind up being a cyclical peak when look back 6-9 months from now. Given, we don’t think getting long Indian equities right here and now would be the most prudent investment to make. If anything, we prefer to be exposed to India on the short side absent a meaningful improvement in the data.


Darius Dale


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