Light in the gloom

IFR Asia India Report 2013
11 min read

A Hindu devotee lights an earthen lamp on the steps of Sindhiya Ghat during the Karthik Purnima and Dev Diwali festival in Varanasi.

Source: Reuters/Jitendra Prakash

A Hindu devotee lights an earthen lamp on the steps of Sindhiya Ghat during the Karthik Purnima and Dev Diwali festival in Varanasi.

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While India is no longer a sure bet on rapid growth rates, the world’s second most populated country is still home to sector-specific investment opportunities that offer value during periods of currency depreciation or low points in the business cycle.

India’s recent macroeconomic woes are well documented. Since May, the rupee has slid 20% and political anxieties have festered, putting investors on watch and policymakers on crisis footing.

Although India’s economic fundamentals remain stronger than the rupee exchange rate suggests, the economy as a whole is unlikely to return to double-digit growth anytime soon.

Global investors had tentatively retained their confidence in India’s long-term economic prospects until Federal Reserve chairman Ben Bernanke began talking in May of tapering the US monetary stimulus, prompting a stampede out of emerging market assets.

Nonetheless, the future is not all doom and gloom for investors seeking returns in India’s growth trajectory. Some sectors will benefit from a depreciation of the rupee, while demand in other sectors may override cyclical variations.

“The market pendulum has clearly swung from greed to fear,” said Kunal Shroff, managing director at ChrysCapital, one of the largest India-focused funds with US$2.5bn in assets under management. “This will offer some great opportunities over the next one to two years to patient, long-term investors.”

“People think there’s been some massive structural deterioration when it’s mainly a cyclical phenomenon.”

Shroff said information technology, pharmaceuticals, consumer goods, and potentially, financial services were among the most attractive sectors. “Clearly export-orientated things work, especially IT and to some extent pharmaceuticals, which also works on the domestic side.”

Indian assets have taken a particularly hard hit from worries that the Syrian crisis will drive up the costs of oil imports – now paid for in more expensive US dollars – coupled with uncertainty over state elections later this year, and national elections expected in April 2014.

Markets are now fixated on a negative feedback loop between the plummeting rupee and worsening fundamentals – including higher inflation, a rising fiscal deficit and the need to service higher dollar-denominated external debt.

Although a few sectors, such as IT and pharmaceuticals, stand to benefit from these woes, hope may also come from unusual sources – such as Mother Nature herself.

“So, what can happen? Look up to the gods, they’ve been kind this year and we’ve had good rains,” said Dharmakirti Joshi, chief economist for Indian rating agency Crisil.

Strong monsoons should raise rural income, provide a mild push to rural demand, and, to some extent, moderate food price inflation. However, these trends would not be a cure-all for the Indian economy overall, Joshi warned.

“The outlook for the currency remains weak since agriculture alone cannot offset the headwinds coming from industry and the services sectors,” Joshi said.

Cyclical versus structural

In the face of a seemingly endless flow of negative news and data, analysts have slashed Indian growth forecasts to the 4% or even 3% range.

Yet, Robert Prior-Wandesforde, director of Asian economics research at Credit Suisse, is holding firm for the moment with a 6% forecast, citing exaggerations on both sides of the equation: neither was India a structural miracle during the good times, nor is the economy in a state of collapse now.

“When you get a country with two or three years of unusually strong growth, particularly combined with low inflation, you get people proclaiming a structural miracle, but what is actually happening is a cyclical improvement,” said Prior-Wandesforde.

He pointed out that such phenomena could be a function either of loose policy conditions, or of a market hitting the sweet spot of the economic cycle, with strong growth and low inflation.

“The opposite happens the other way around when growth is cyclically depressed for two or three years, as it has been in India,” Prior-Wandesforde said. “People think there’s been some massive structural deterioration when, again, it’s mainly a cyclical phenomenon.”

Prior-Wandesforde is not alone in seeing forecasts as being unusually vulnerable to distortion, especially in times of distress.

“Right now, there’s too much noise in the system – too many moving parts,” said Crisil’s Joshi. “The danger is, when you extrapolate too much noise into your forecast, you mess up on both sides, with pessimism, as well as optimism.”

Silver linings

While the troubled economic backdrop and currency weakness may cause Indian companies that rely on imported raw materials to suffer, other sectors may be set to outperform.

Exporters in industries that source inputs locally, such as IT, pharmaceuticals, and ready-made garments, should benefit from the rupee’s devaluation, according to Joshi.

What is more, the depreciating rupee offers import substitution opportunities that target India’s large and growing market of middle-class consumers. Indian companies can step into the crease and manufacture more goods currently sourced from China and other parts of Asia to sell in the country.

“The manufacture of mobile handsets can help India in a big way over the long term, as can production of consumer goods, such as toys, sunglasses, and footwear. India can obviously make more of these,” said ChrysCapital’s Shroff.

Of course, there is also the longstanding tradition of buying into the down cycle of an emerging market when it is affordable, in anticipation of an eventual rebound.

“We’re not in the business of catching falling knives, but the unwinding creates a wonderful buying opportunity to invest in India, where valuations are cheap,” said David Cornell, chief investment officer for Ocean Dial Asset Management, which focuses on Indian equities.

Ocean Dial’s investment strategy rests on understanding the power of compounding. “You cross a certain income threshold, and the demand for certain products goes exponential,” said Cornell. “So, a 25% increase in real income can show up as a sevenfold increase in the demand for certain products.”

This phenomenon applies whether it is healthcare, consumer-related financial products – mortgages, loans, credit cards – or fast-moving consumer goods, especially those that cater to the rural consumer.

“These opportunities are not in the slightest affected by the current cyclical variations because they’re irreversible,” Cornell said.

Some of these opportunities may already be priced in, according to ChrysCapital’s Shroff. He describes India as a “bipolar” equity market, with “other sectors not doing so well, such as infrastructure, where there are a lot of negatives – leverage, execution – that aren’t easing anytime soon”.

Three macroeconomic concerns – currency volatility, lack of global export competitiveness, and high interest rates – trouble Shroff. “The chances of short-term easing are looking less likely every day,” he said.

Return of the rupee

If the rupee stabilises without the need for further rate hikes or more aggressive measures to defend the currency, some positive factors are likely kick in.

“Frankly, in any country where you see a 30% depreciation against the dollar, and large moves relative to regional currencies, you could see a bounce back,” said Shroff.

What is more, India’s current account deficit is narrowing, and the trade deficit has stabilised in recent months. A strong, stable source of support for its capital account has been a factor for India’s success in attracting substantial deposits from overseas citizens, or non-resident Indians (NRIs).

Held either in dollar or rupee accounts, these have climbed substantially, from US$200m in fiscal year 2008 to US14.8bn in fiscal year 2013, close to the amount of foreign direct investment the country attracts annually.

Unlike “hot money” portfolio investments, which Royal Bank of Scotland forecasts will plummet to US$12bn in the current 2014 fiscal year, NRI deposits are expected to increase to US$16bn over the same period, and can be read as a vote of confidence in India’s economic future.

Indian Finance Minister Palaniappan Chidambaram announced on August 26 the fast-tracking of US$28bn in stalled energy, infrastructure, and power projects, which should help to provide some stimulus to offset the currency-related slowdown.

“India wakes up when pushed to the wall,” said Crisil’s Joshi. “The government is serious. These projects need to be cleared and it’s likely that at least some of them will be.”

Investors can also look forward after the 2014 national election to the long-awaited adoption of a goods and services tax, although India’s constitution must first be changed.

“A [GST] system would create a single common market in the country, one which hasn’t existed so far, and would rationalise and reduce the burden of taxation across the supply chain,” said Gaurav Kapur, senior economist in India for RBS.

Implementing a GST would also have fiscal benefits, boosting compliance and tax revenue for states and the central government. The increase in transparency could even lure more foreign investment.

An investor like Ocean Dial’s Cornell believes the current woes may provide just the shock India needs. “The recent volatility is likely to be a good thing,” Cornell said, “because it will lead politicians to undertake long overdue structural reforms.”

However, in the end, government action is not required for individual Indian companies to succeed, and many will weather the current storm with or without it.

“Corporate India works, in spite of the government, not because of the government,” Cornell said. “India has huge managerial depth and skill, both onshore and offshore. Given the difficulties they have to put up with, it’s astonishing what they have managed to achieve.”

Light in the gloom