Indian Infrastructure - A decade in the making

The global investment landscape today looks quite unexciting. Consumers in developed countries have been maxed out for the better part of a decade. Notwithstanding the recent optimism in the US, it is highly unlikely that consumption growth will reaccelerate. The best scenario one can hope for is that consumption growth settles at a 1% to 2% rate and that fears of contraction subside.

Emerging markets face a completely different problem: China. China has been the engine of growth in emerging markets for the last two decades but the Chinese engine is now sputtering. China made a miraculous transformation of its economy by building infrastructure that is the envy of even the developed world. It fueled this growth with massive amounts of debt (most of it domestic, thankfully) and by borrowing growth from the future by conspicuous overbuilding. The problem with a capital or fixed hyper-investment model is that one cannot stop. If one stops then the entire economy stalls and crashes.  

China has been adding capacity in roads, railways, ports, power, steel, aluminum etc. Each of these sectors depends on the other sector’s “growth” to keep itself going. If one sector stops adding to capacity, the feedback loop stalls capacity addition in all other sectors. China has reached the point where the discourse has shifted from growth of capacities to utilization and shut down of capacities. For example, Chinese steel capacity exceeds 1 billion tonnes or about 50% of global installed steel capacity. China produces 825 million tonnes of steel. Chinese aluminum capacity exceeds 45 million tonnes which is once again more than 50% of global installed aluminum capacity. China produces about 30 million tonnes of aluminum a year. While steel capacity growth has completely stopped, China added 7 million tonnes of primary aluminum capacity last year. This year the discourse in aluminum has also shifted to capacity utilization and shut downs.  Chinese consumer spending is a sideshow compared to its fixed investment juggernaut. Discussing Chinese consumer spending as a driver of China’s economy is like discussing the restaurant industry in the Bay area as a driver of Silicon Valley.

I am not necessarily calling a bubble or a crash in China. The only point I am making is that the Chinese economy of the next decade is going to be very different from the Chinese economy of the previous two and that it will have major consequences for the world economy, especially for emerging markets. China will import a lot less of the primary commodities it had been importing during the previous decade.  The buoyancy in commodity prices since the China scare of Feb 2016 appears to have been driven more by speculative activity in China than by a meaningful resumption in fixed investment or capacity growth. A resumption of the global commodity meltdown experienced in early 2016 will be devastating for emerging markets. China will also dump a lot more of its manufactured goods on the world market despite protectionist safeguards and duties. This will keep a lid on global capital investment and capacity expansion.

This brings me to my main topic: India. I have always maintained that India is a bottom up economy and unlike China, it does not have the ability to execute state diktat while ignoring popular opinion. Therefore, it behaves a lot less like a focused corporation and a lot more like a feuding extended family. India is an emerging market and will get materially affected by the goings on in China. However, India is also emerging from a gut wrenching five-year slowdown and a clean-up of its banking and political systems. India will remain a bright spot (albeit a small one) in the global investment landscape during the next few years. What then is likely to do well in India and what is likely to not do well?

The financial services and financial inclusion story in India is a little long in the tooth. It has been so difficult to deploy money in the Indian real economy in the recent past that all investment dollars have gone to the easy business of leveraged lending. Anytime financials start trading at more than three times price to book value, the risk reward asymmetry becomes inverted. When the entire financial system starts to trade at valuations of more than three times price to book value, investors should be prepared for a very long period of underperformance. It is possible that the economy keeps growing but financials underperform as their economic realities catch up with expectations built into their stock prices.

The non-cyclical consumption story in India also looks a little over extended. The problem with consumption in India is that it is 100 small countries inside a large sub-continent. Purchasing power and consumer behavior and preferences are so heterogeneous that the addressable organized opportunity for individual players is relatively small. This has been anecdotally experienced by investors in Indian listed consumer stocks. Companies experience high double digit and even triple digit growth from small bases and their growth tends to taper off as they reach $250 - $300 million in revenues. Unfortunately for investors, valuations continue to climb and it is not uncommon to find non-cyclical consumer names trading at between five and ten times multiple of revenues. Often managements find themselves under tremendous pressure to grow to sustain market valuations and expectations.  This often results in sub-par decisions and diworsefications to capture unrelated and dissimilar lateral markets.

Large core industrials like steel, power, mining, chemicals and textiles are in unenviable positions. They are suffering from large domestic as well as global overcapacities in their respective sectors and the resulting absence of pricing power. This is unlikely to change even if the India economy grows dramatically. Global (Chinese) overcapacity is going to ensure that investors in these companies make sub-par returns on investment even in a growing economy. Manufacturing is therefore going to lag the economy and will not be a driver of economic activity in the first few years of the Indian growth rebound.

What will do very well in India then is anything that is cyclical but domestic and not influenced by global overcapacity. I believe that the Modi government’s thrust on infrastructure building and housing for all by 2022 is going to become the engine of the Indian economy. This will liquefy the market for land in India and will create a real estate boom. A boom in land and real estate both in transaction volumes and prices is essential to create a wealth effect in the economy and to rekindle animal spirits. The wealth effect will result in explosive cyclical consumption growth in durable goods. This imminent boom in infrastructure and real estate has been a decade in the making. These sectors are however prone to excessive leverage and systemic corruption.  They will eventually succumb to excesses like at the end of every economic expansion.  Hopefully these sectors will be able to put in a few years of high quality growth before they succumb to excesses.

Indian markets will therefore remain volatile and large sections of the market will suffer with contagion from other emerging markets. The markets will be a paradise for stock pickers who can stomach volatility and who can find idiosyncratic names that benefit from the growth in the Indian economy while remaining fundamentally insulated from global overcapacity.

Raghuram Rajan’s Exit and the Indian Economy

Raghuram Rajan at the Reserve Bank of India (RBI) has done a phenomenal job for India in the last three years. It’s no wonder that the entire country is upset at the government’s decision not to renew his term at the RBI which ends in September 2016. For the record, I think that Raghuram Rajan is one of the smartest people on the planet and his intellectual honesty is unquestionable. His unwavering belief in the free market and free market institutions resonates with me at a deep and fundamental level. I was a little taken aback by the Modi administration’s decision not to renew his contract. After the initial emotional reaction, I tried to objectively analyze what Rajan has accomplished during his time at the RBI and what he has struggled with or not succeeded at accomplishing. I then tried to think of objective reasons why the government might not have renewed his term.

Although Rajan has been credited with stabilizing the rupee, beyond the FCNR (B) deposit scheme that curbed volatility in the rupee at the start of his term, Rajan has not done anything exceptional for the rupee. The rupee has moved in line with other non-commodity currencies which have been relatively stable during Rajan’s tenure.

Where Rajan has made the biggest impact has been with encouraging competition in and reforming India’s banking system.  

  • The encouragement and support for the National Payments Corporation of India (NPCI) and its Unified Payments Interface (UPI) combined with the speed and the diversity in issuing Payments Bank Licenses will go down in history as Rajan’s biggest contribution to India and perhaps the world. India is likely to become a world leader in the digital payments space and maybe one of the first and largest countries in the world to go cashless.
  • The work done by Rajan on monetary transmission and the implementation of the Marginal Cost of Funds based Lending Rate (MCLR) regime will go a long way in bringing transparency and fairness into the business practices of the banking system.
  • The work done by the RBI in cooperation with the Finance Ministry in reforming the government owned banking system and the setting up of the Bank Board Bureau will also pay rich dividends over time.
Rajan has however had mixed success with his efforts in fixing the bad loans problem in the Indian banking system. If one were to believe rumors, the Asset Quality Review (AQR) done by the RBI and the resultant damage to powerful corporate vested interests are credited with the undoing of Rajan. However, I believe that the AQR and the manner in which it was conducted has been a failure on an objective basis. The AQR has debilitated the Indian banking system and frozen it into inaction. The cost of this to the economy is incalculable. Year on year credit growth has declined to sub- 10% levels and in April 2016 credit growth was at a 20 year low of 8.6%. Given India’s complex legal system, he has not been able to do much about distressed loan sales and asset reconstruction. Nor has he been able to do much to ensure that such debacles do not occur again in the future.

Where Rajan has completely failed has been in the handling of the macro-economy. By shifting the headline inflation number from the Wholesale Price Index (WPI) to the Consumer Price Index (CPI), Rajan has painted himself into a corner. The CPI in India is disproportionately weighted towards food. Food forms 50% of the weight of the All India CPI whereas it forms only 27% of the WPI. Food prices in India are constrained and completely determined by supply and demand dynamics and local inefficiencies. The sensitivity of food prices to interest rate changes is zero. By keeping liquidity tight, Rajan has impaired consumption, capacity utilization and as a consequence capital investment. This has become the ideological bone of contention between the government and the RBI.

Rajan’s contention has been that the short term pain and medicine of tight liquidity will structurally break the back of inflation and will put India on a fifteen year path of low inflation and high growth. Reality unfortunately has not been agreeing with Rajan’s theory and he has completely failed to understand the compulsions of democratically elected governments. The political cost of no growth and no employment creation for periods longer than a few years is simply unpalatable and unsustainable.

While conspiracy theorists will attribute Rajan’s dismissal to political compulsions and power mongering, my view is that it is driven by a fundamental disagreement on policy between the government and the RBI. While believers in central bank independence will shed many tears, the reality is that elected governments have to address the demands of the electorate.   

If my belief is true, then the exit of Raghuram Rajan will be followed by unprecedented monetary and fiscal stimulus, the kind India has never seen before. One can only hope and pray that this stimulus is directed at capacity creation and not at consumption and populist transfers. Supporters of Rajan’s policies will contend that stimulus will not create any real growth and whatever is achieved in the immediate term will be sacrificed to inflation and a weaker rupee in the medium term. Given that we are well into the fifth year of a gut wrenching economic slowdown, that there is unprecedented domestic slack in the system and that there is extreme overcapacity globally, I believe that there is a fair chance that Rajan is wrong and that the government’s plan to stimulate the economy might work without pushing up inflation too much. If the government manages to reignite animal spirits and stimulate growth, it just might result in an appreciating trend in the Indian Rupee.

Therefore, while I am sad to see Rajan go, it is important to recognize that he did not get everything right and that his successor (hopefully) might not get everything wrong.

A Train Wreck in Slow Motion

The Reserve Bank of India (RBI) recently concluded an Asset Quality Review (AQR) of large Indian (primarily) government owned banks.  The outcome of the review was appalling.  Two years into a Non Performing Loan (NPL) recognition cycle, banks had large ticket NPLs that had still not been provided for.  

The Chairman of State Bank of India Arundhati Bhattacharya has been vociferous in her opposition of the AQR and the manner in which the RBI has gone about it.  In the defense of her bank she has said that although the identified loans are not being serviced, they are backed by healthy collateral and that the borrowers have positive EBITDA. Unfortunately, her argument does not hold water. In a liquidity or debt crisis, the value of collateral is not its appraised value but rather its market clearing or transaction value.  When collateral needs to be enforced, arguments like thin markets, weak economic conditions, tight liquidity and buyers' strike don't count. The reality is that these accounts have become NPLs because it is unlikely the assets are saleable even at substantial haircuts from their appraised values.

The reason the US financial system has always rebounded is because of the ruthlessness with which problem assets have been culled by it during crises.  The Resolution Trust Corporation of the early nineties conducted fire sales of otherwise good assets and quickly restored health to the US financial system.  The $700 billion TARP program of the US government during the 2008 crisis did not lose a penny for the US taxpayer. However, the story was anything but happy for shareholders of AIG, Citigroup, Wachovia, WaMu, Merill Lynch etc.

I believe that among emerging markets India has one of the strongest and most well regulated financial and banking systems.  I believe that the Indian economy has been through a gut wrenching slowdown and consolidation over the previous five years and that it looks very healthy prospectively. While I am not a big fan of banking as a business in the current environment, I believe that most of the rot in the Indian banking system is out in the open.  Given the fact that India is a net importer of energy and commodities, the global commodity collapse is helping India's fiscal situation and India's macro indicators are on a sound footing. However, the scenario in India's emerging market brethren could not be more different. The picture there looks like that of a train wreck in slow motion.

The Emerging Market script today looks very different from that of the nineties when sequentially Mexico, the Asian tigers and Russia went bust.  Those crises were all driven by too much foreign debt, fiscal and monetary imprudence and insufficient foreign exchange reserves.  After 15 years of unprecedented fiscal and monetary expansion in emerging markets driven by China's insatiable demand for commodities, the situation looks different. Foreign exchange reserves are large, lead by the big daddy of them all, China with $3 trillion.  Sovereign debt in foreign currency does not seem to be as large and as much of a problem as earlier. And finally, stimulus seems to have become the name of the game with governments everywhere willing to step in all the time to support panics.  The bond vigilantes seem to have gone into hibernation.  

But that is where the differences end. Nothing has changed in the underlying economies of emerging markets. Government spending remains high, tax collections remain poor, corruption remains high, welfare has expanded at an unprecedented rate with the size of economies and education, skill and healthcare remain as bad as ever.  The one engine that had kept all these issues under the carpet for a long time, unprecedentedly high prices and insatiable demand of commodities by China, has come to an abrupt halt.

The sanguine camp loves to point to the absence of crisis triggers and the cushion of large foreign exchange reserves. This is why I refer to the crisis in emerging markets as a train wreck in slow motion.  A small breach can sink a very large ship, therefore the important thing to focus on is the underlying fundamentals of emerging markets and not the cushions and triggers. 

In a recent discussion on the Russian economy, I heard a very silly argument.  The commentator stated that the reason the Russian economy is not facing a crisis is because although the price of oil has fallen from $100 to $40, the rouble has depreciated an equivalent amount from 30 to 75, therefore in rouble terms the price of oil has not fallen and has not disrupted the domestic economy. The commentator further highlighted the absence of material foreign currency sovereign debt and $350 billion of foreign exchange reserves.  The above discussion completely misses the reality of the underlying fundamentals.  Russia produces 10 million barrels of oil per day.  A reduction in revenues from $90 per barrel to $45 per barrel has a direct impact of $162 billion per year.  There has been no change in the spending pattern of the Russian economy during the decline in oil prices.  In addition, due to the disproportionate impact of this reduction in revenues on some sections of the economy more than the others, there has been a rapid deterioration of credit worthiness in those sections.  

In a leveraged global financial system, confidence is everything.  A run on the system, whether a bank or an economy can quickly become self fulfilling. At that time, $350 billion of reserves in Russia and $3 trillion of reserves in China may not prove sufficient.  The only way a run can be stopped is by a lender of last resort. The Federal Reserve and the US treasury stopped the run on the US financial system in 2008.  Emerging markets cannot print dollars.  Multilateral agencies like the IMF have also almost all become irrelevant.  Sovereign wealth funds of countries like Abu Dhabhi and the People's Bank of China have tried to play the role of lender of last resort in controlled instances.  Whether these agencies will have the ability or the mandate to act as lenders of last resort in a full blown crisis is not clear.

That the train has derailed and a wreck is under way is plain for all to see.  Only a voluntary suspension of disbelief can make one think that the worst is behind and somehow everything will go back to being the way it was.  China and therefore the rest of the world does not need what emerging markets are producing and that is unlikely to change at least for the next five years (until China works through its excesses of the previous twenty five years). Emerging markets need more and more of what the rest of the world produces because they have not been prudent with their bounty from the previous fifteen years and have not invested in productive capacities of manufactured goods and services. That there will be a run on their currencies and foreign currency debt (mostly private and bank related this time) is therefore inevitable.  The deeper the cushion of foreign exchange reserves, the slower, longer and therefore more painful the train wreck will be.

As self serving as this statement sounds, I believe that India will emerge as a major economic engine over the next decade or two.  It will experience nowhere close to the meteoric rise that China did in the previous two decades but will hopefully also be spared a spectacular eventual collapse.  However, the seas are likely to be stormy as the crisis in other emerging markets plays out and both the Indian markets and the Indian currency are likely to be tested.  We have not seen the last of the headlines on emerging markets - stay tuned.