Conclusion: We are likely to shun long exposure to Indian rupee-denominated assets for the intermediate-term TREND as bad POLICY looks to erode the country’s future GROWTH/INFLATION dynamics.
On FEB 28, 2011 we published a note titled “India: Missing Where It Matters Most”. The summary conclusion of that note was as follows:
“Finance Minister Mukherjee’s budget failed to adequately address the #1 issue facing the Indian economy – inflation. As a result, our bearish stance on Indian equities continues unabated.”
Fast forward to 1Q12, we’re seeing a similarly-precarious setup develop post the unveiling of India’s FY13 budget (APR ’12 – MAR ’13), specifically in that it: A) fails to achieve much-needed fiscal consolidation; B) like last year’s proposal, relies on aggressive growth assumptions to drive tax revenues; and C) it proposes tax hikes, which have a direct impact on India’s elevated inflation statistics.
Regarding point “A”, the budget calls for India’s deficit-to-GDP ratio to narrow to 5.1% in FY13 from a revised estimate of 5.9% in FY12. The -80bps decline seems good at face value, but recall that India’s FY12 budget proposal actually called for a -30bps narrowing of the deficit-to-GDP ratio to 4.6%. Net-net, if all goes according to plan, India will wind up with a deficit that is +50bps higher as a percentage of GDP two years after the initial investor scrutiny of the country’s fiscal position began. Not good. Other metrics worth highlighting include:
- Total Receipts ex-Debt Issuance:+22.7% YoY in FY13E vs. +2.6% in FY12E
- In FY12A (through JAN), Total Receipts ex-Debt Issuance is tracking -5.7% relative to initial expectations and -3.3.% YoY
- Total Tax & Fee Revenue:+22% YoY in FY13E vs. +0.2% in FY12E
- In FY12A (through JAN), Total Tax & Fee Revenue is tracking -2.9% relative to initial expectations and -2.7% YoY
- Public Divestment Receipts:+93.6% YoY in FY13E vs. +75.1% in FY12E
- In FY12A (through JAN), Public Divestment Receipts are tracking -61.3% relative to initial expectations and -32.2% YoY
- Total Expenditures:+13.1% YoY in FY13E vs. +5% in FY12E
- In FY12A (through JAN), Total Expenditures are tracking +4.8% relative to initial expectations and +10.1% YoY
- Expenditures on Subsidies:-12.2% YoY in FY13E vs. -17.2% in FY12E
- In FY12A (through JAN), Expenditures on Subsidies are tracking +50.7% relative to initial expectations and +24.7% YoY
- Rising global food and emerging prices specifically pressure this line item, forcing the Finance Ministry to choose between passing through higher costs to producers and end-consumers (inflationary NOW) or allowing the budget deficit to widen (inflationary LATER)
- Sovereign Debt Issuance:Down just -1.6% YoY in FY13E (from an all-time high of 5.2 trillion rupees in FY12A) vs. +10.5% in FY12E
- In FY12A (through JAN), Sovereign Debt Issuance is actually tracking +26.4% relative to initial expectations and +39.7% YoY
Regarding point “B”, it’s easier to see the risk of the Finance Ministry’s expectations of a fairly dramatic acceleration in Total Receipts ex-Debt Issuance in the context of the GDP target of +7.9% in FY13E. While down from an initial estimate of +9.25% in FY12E (which we identified as laughable then) and at a more achievable level, a +80bps acceleration in India real GDP growth from +7.1% in CY11 seems fairly aggressive in an environment where inflation is poised to reaccelerate and slow growth incrementally from already-depressed levels.
Regarding point “C”, Finance Minister Pranab Mukherjee proposes increasing both service and excise tax rates +200bps to 12% – a hike that he admits will lead to “some inflationary pressures”. Still, he says that he doesn’t expect central bank policy to be influenced by his latest budget. Ironically, members of the RBI have been very outspoken in recent weeks regarding how the [then-pending] federal budget was their #1 factor in determining their intermediate-term monetary policy outlook. Refer to the MAR 5 publication of our “Triangulating Asia” series for more details.
On this metric alone, we expect the budget letdown to support the central bank adjusting its bias away from easing back towards neutral and perhaps even towards tightening later in the coming months (our baseline model suggests Indian inflation readings start to accelerate in 2Q). In fact, in its monetary policy statement on the eve of last Friday’s budget release, the RBI stated that “upside risks to inflation have increased from the recent surge in crude oil prices, fiscal slippage, and rupee depreciation”.
Specifically regarding the latter point, the tailwind of currency strength relative to global food and energy prices is beginning to exhibit signs of erosion. We expect that to accelerate as capital inflows – which are up dramatically in the YTD – slow and/or reverse over the intermediate term. Foreign debt investors already spot trouble ahead, with holdings of rupee-denominated debt falling -2% from a cyclical peak on FEB 29; 10yr sovereign yields are up +21bps over that duration.
As we’ve flagged in recent notes, Indian interest rate markets have been well-ahead of these developments, pricing in incrementally-less monetary easing since the start of the year. Even Indian banks, who were hopeful of broad-based easing as recently as the week of MAR 8 (day of -75bps CRR cut), continue to borrow near-record amounts of cash daily from the central bank.
Net-net, from our analytical vantage point, India is at risk of going from a country with a substantial amount of monetary policy leeway to being a country with a meaningful need to tighten policy in a couple quarters or so. Don’t overlook the ruling party’s awful showing in the recent regional elections as a critical factor for monetary policy. In the absence of credible fiscal consolidation, political pressure will likely be on the central bank to shield India’s ~840 million people living on less than $2/day from incremental inflation.
An outlook of monetary tightening poses a critical risk to Indian equities, which (per the SENSEX) are up +12% in the YTD and +14.1% since the index bottomed on DEC 20 – largely due to speculation around monetary easing amid a backdrop of accelerating economic growth expectations.
As we continue to see across the macro universe, POLICY (fiscal and monetary), which itself is a function of reported GROWTH/INFLATION figures, remains a leading indicator for future GROWTH/INFLATION readings (Soros would call this relationship “reflexive”). Absent a deflationary shock to global food and energy prices, a move back into Quadrant #3 on our GIP chart likely awaits India in 2H12, begging the question: “Does the rally in the SENSEX have legs?” Our answer is unequivocally “no”.
All told, when countries consistently print sizeable fiscal deficits and monetize debt amid a global backdrop of excess liquidity and food and energy price gains (as India is doing now), inflation accelerates. Don’t make it more complicated than that. We aren’t, and thus, are likely to shun long exposure to Indian rupee-denominated assets for the intermediate-term TREND. The Trifecta is back on the table.