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Conclusion: If you agree with our October call that EM assets will come under pressure and remain that way over the intermediate-term TREND, then you’re likely looking for short ideas. If so, we think Indian equities are among the top short ideas in this space, supported by the fundamental backdrop of slowing growth, accelerating inflation and interconnected risk compounding.


Position: Bearish on Indian equities and bonds.

When we last published on India (1/6 note titled: “India’s Two-Factor Squeeze”), we highlighted a two-pronged setup that leads us to be bearish on Indian equities: slowing growth and accelerating inflation. Over the last 48 hours, rhetorical, economic and price data are all contributing to that “squeeze” getting tighter.

India’s central bank, led by Governor Duvvuri Subbarao, hiked its benchmark interest rates by +25bps yesterday, increasing the Repo Rate to 6.5% and upping the Reverse Repo Rate to 5.5%. This is the first rate hike since their self-imposed moratorium starting in November.

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Despite inflation running twice the pace of the government’s target, the Reserve Bank of India (RBI) elected to purchase government securities from banks to ease a domestic liquidity shortage. Money Supply (M3) growth, though up sequentially in December and off its summer lows, remains near a five-year low. Moreover, the India National Stock Exchange Interbank Offer Rate, a measure of liquidity via interbank funding availability, averaged a full +90bps higher in 4Q10 vs. 3Q10. Relative to the 1H10, the rate averaged a full +250bps higher.

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The cash crunch was facilitated by an elongated trend of credit growth far outpacing deposit growth, as Indian citizens elected to protect their capital from inflation by shunning bank deposits. In 2010, loan expansion (+24.4% YoY) outpaced deposit expansion (+16.5% YoY) by 790bps!

Despite this demand-side inflationary pressure, the RBI felt it both prudent and necessary to help ease the cash crunch by repurchasing government bonds on the open market and stepping up its reverse repo operations. All told, Indian banks borrowed an average of 1.2T rupees per day in December, up from 854.8B in November. January is off to a hot start as well, with lenders borrowing an average of 909.4B rupees per day from the central bank in an effort to maintain the pace of credit expansion amid weak deposit growth.

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The aforementioned inflationary pressure has become such an issue in India, we’re even starting to see bankers and asset managers (people who get paid on inflation) come out against the RBI’s Quantitative Guessing scheme:

“For the time being, inflation takes the driver’s seat… I think the time has come to stop repurchases, as it is inflationary” – Manoj Swain, CEO at Morgan Stanley India

“Inflation is becoming an increasingly huge worry at this point in time and the RBI will need to do a major part of the firefighting in containing inflation… The monetary policy needs to be much tighter than it is now, given the building up of inflationary pressures.” – Sonal Varma, Economist at HSBC Holdings Plc.


“The RBI shouldn’t do anything more to add cash to the system… There was some logic for doing it earlier because the liquidity deficit had gotten excessive, but at that time inflation looked like it was moderating.” – Prasanna Ananthasubramaniam, Chief Economist at ICICI Securities

Unfortunately, this marginal backlash leaves the RBI between a rock and a hard place. If they continue the repurchases, they risk inflation getting out of control – even more so than it already is at ~400bps higher than the target (+8.4% YoY in Dec).  Should they elect to stop the repurchases, they risk exacerbating government borrowing costs, as Indian banks, the largest buyers of Indian sovereign debt, don’t have the excess cash to make purchases right now. In fact, Indian lenders sold 288.3B rupees ($6.4B) of Indian sovereign debt last quarter – the highest sales rate since 4Q05!

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The recent backup in yields hurts the central government’s efforts to narrow its budget deficit to 5.5% of GDP by the end of FY11 (March 31), after a near doubling in three-year’s time. Currently, interest payments alone consume almost one-fifth of government expenditures. That leaves little else for developing India’s woeful infrastructure after 10% is spent on food and fertilizer subsidies, 14% on defense and an additional 25% is divvied up amongst Indian States.

One area India can look to for cost savings is the subsidies it is currently paying to hold down the prices of certain foodstuffs and fertilizers. RBI governor Subbarao is calling for the central government to remove the subsidies and allow the prices to appreciate in an effort to reduce the demand-side inflationary pressure. This morning, he reiterated his call for fiscal conservatism, saying, “Monetary policy works most efficiently while dealing with an inflationary situation when the fiscal situation is under control”.

Unfortunately, fighting inflation with more inflation doesn’t work in a country where nearly 828 million people live on less than $2 per day.

Luckily for India’s citizenry, Prime Minster Manmohan Signh is learning from the mistakes of Tunisian and Egyptian politicians and is getting marginally serious about fighting inflation, as evidence by his recent cabinet reshuffle. In the move, he appointed K.V. Thomas to head the Ministrity for Food and Consumer Affairs, a position formerly held by now-departed Agriculture Minister Sharad Pawar. Facing elections in five States over the next five months, Singh’s coalition government cannot afford to lose the ~40-42 seats predicted by a recent poll published by the India Today news magazine.

Still, the move to put in place someone who’ll be directly responsible for reeling in India’s inflation rate may be more of an empty scapegoat than it appears. Keep in mind that the Food & Beverage component of India’s benchmark Wholesale Price Index is only 14%, one of the lowest in the world by our calculations/estimates. Given that, we’ll continue to take the other side of Governor Subbarao’s claims that inflation is currently being driven by “excessive food price increases, which look to subside in coming months”.

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Even Subbarao himself is backtracking on this stance, saying recently, “The rise in food inflation in India has not only persisted for more than two years now, the increase has been rather sharp in the recent period. This cannot but have some spillover effects on generalized inflation.”

Indeed it does; recent examples of the spillover effects from higher input costs include Hero Honda Motors Ltd. (the producer of roughly half the motorcycles sold in India) recent plans to raise wages. Godrej Consumer Products Ltd. (the second-largest producer of bath soap in India) plans to increase prices for the third time in three months, citing “reduced profits from higher input costs”.

Tactical Setup

Many equity investors cheer on inflation, particularly in economies with growth profiles as robust as India’s, as rising input costs can be passed through to consumers. By all means, India had an excellent year in 2010, growing at an average +8.85 YoY rate in the three quarters through 3Q10. An easy comp in 4Q suggests that growth rate could potentially be higher when it’s all said and done:

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The problem with that is that it’s in the rear view. Many investors, particularly emerging market portfolio managers point to lagging growth data points as justification for their long positions. Given, you need a go-forward outlook to be short India here and our call is for growth to top out in 4Q10. While we’re not calling for a significant draw-down in Indian growth, we do think the confluence of tough comps, accelerating inflation, tighter monetary policy and a general erosion of financial liquidity could cause Indian GDP growth to slow sequentially by a full (-100bps) in 1H11.

Since 11/9, when we called out the aforementioned setup and turned bearish on Indian equities in a note titled “India’s Two Big Problems”, India’s SENSEX Index has declined  (-9.4%). Further, the index is the second-worst performing global equity market (down (-7.5%) YTD), so one would assume much of the juice has been squeezed already.

Not so fast. India’s SENSEX’s long-term TAIL line of support lies some (-2.4%) below at 18,511. Should we choose to get involved, we’d likely wait for a rally up to the immediate-term TRADE line of resistance at 19,462. There’s more resistance to be found at the intermediate-term TREND line of 19,991. Shorting there would be most ideal.

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Analyzing India from a global risk management lens, we see that the US dollar remains comfortably broken, trading below its intermediate-term TREND line of $78.66 for nearly three weeks on weak promises of austerity and an upward surprise to the US federal budget deficit.  While the inverse correlations between the DXY and many commodities have come down in recent months, we do anticipate them to pick up should the dollar exhibit further weakness from here. Such an event would exacerbate India’s already “desperate” inflation situation (as termed by Subbarao himself).

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Make no mistake about it, India has a major inflation problem, and, as we’ve seen time and time again throughout the history of emerging markets, inflationary spells are typically a much larger headwind than initially predicted. Indian officials are aware of this, subtlety ratcheting up their inflation expectations over the last few months. Their target for YoY WPI growth by March 2011 has increased from +5% in early 4Q10, to 6% on December 14th, to 6.5% in early January, to 7% yesterday. A +200bps jump in inflation expectations over a ~3-month period is certainly cause for alarm.

The alarm bells have been met with foreign investor redemptions, pulling $1B from Indian stocks over the last three weeks. If such redemptions were to mean revert to flat on a two-year basis, there’s $28B more redemptions waiting to be accounted for in 2011. Keep in mind that the 2008-09 crash of the SENSEX was predicated by just $14.8B in foreign investor redemptions in 2008.

While we’re not calling for a crash right here and now, we do think Indian equities will continue to experience further downside in the face of slowing growth, accelerating inflation and interconnected risk compounding.

Darius Dale