>BAER INSIGHT

India: Slowing economy, political uncertainty

■ Recent exuberance on the Indian bourses leaves us more puzzled – after deleveraging, risk aversion and synchronised global recession saw investors flee.

■ Political uncertainty poses risk of prolonged slowdown in reforms and focus on short-term populist and regional priorities.

■ Domestic economic slowdown and ebbing foreign investor interest seem unlikely to reverse with a big bang and corporate profits likely to follow suit.

After a drop of about 58% in 2008, MSCI India (in local currency terms) has pared back some of its losses in a spectacular rally since mid-March 2009 providing a return of approximately 15%, YTD. We look for a plausible justification:

• Political stability as seen in Indonesia;
• Revitalisation of growth as in China;
• Resilience in corporate profits.

The answer is none of the above, but simply based on hope that the stars will align. In order for India’s rally to be justified, the following would be necessary:

• Global growth to be re-instated faster than it turned down;

• India to re-emerge as a source of goods and services and destination for investment even faster than risk aversion hit all geographies and asset classes;
  

• India Inc. to witness a V-shape recovery in profits with FY03/10 estimates almost at thesame levels as before;
  

• India’s ongoing parliamentary election to have minimal impact on Indian economy and foreign investor interest.

To us, none of these are believable outcomes. In fact, pandemic of swine flu and geopolitical risks in Pakistan and elsewhere seem to increase the threat to global growth even further. India’s attractiveness as an investment destination depends on how quickly and effectively her political stability is restored after the elections. India Inc’s performance is linked to several macro factors, which have turned negative and how soon their impact dwindles is a matter of concern for now.

So the recent Indian equity rally seems like a classic case of - wishes being horses for Indian equity investors to ride. That said we analyse further the major hurdles faced by Indian equity investors at this point in time.

Political uncertainty

India is in the process of conducting her 15th general elections in a staggered manner with an estimated electorate of 714 million voters and 546 parliament seats. The polling was scheduled in five phases on 16 April, 22 April, 23 April, 30 April, 7 May and 13 May 2009. The results of the election will be announced all in one shot on 16 May 2009. The 2009 general election will see three main national pre-poll alliances take on each other.

At the 2004 elections the two largest national parties Congress and BJP managed to bag only 145 (26.7%) and 138 (22.2%) seats respectively. A government was put in place by forming a working coalition with outside support and by trading ministerial representation for support on the floor of the parliament. We do not expect things to be very different this time around. Given the volatile nature of coalition politics in India, alliances may change over time - before and after the polls.

Revitalisation of global growth and risk appetite is necessary, though not mandatory

India’s stock market performance over the last 2½ years has been concurrent with high global growth. As seen from the historical GDP growth chart above, the world experienced it highest growth of >5% and that too for a prolonged period of time of two years as against the short peaks earlier. This was accompanied by an accentuated investor risk-appetite. Foreign fund inflows into India were at historical highs. Total capital inflows during FY03/08 totalled to USD108bn. This propelled markets further.

Also Indian IT, textile and diamond exports saw geometrical growth in the last five years. Industrial production witnessed a sharp upward trend, peaking at a growth rate of 13.7% y/y in the quarter ended January 2007. Rise in prices of commodities and end-products added to the growth and wealth effect of developing and exporting nations like India and the top-line growth of their corporates. Things have changed now.

In contrast to the capital inflows in FY03/08, the quarter ended 31 December 2008, saw a capital outflow of USD3.7bn. Industrial production too has come off with the three months ended February 2009 recording deceleration of 0.5% y/y. All told, we find it hard to believe that the setback reversal will be over so quickly.

Corporate profit recovery likely to be slow

Recent easing action of the Reserve Bank of India (RBI) and the accompanying acknowledgement of slower growth expectations in FY03/10, lend additional support to our skepticism in the near term. Although RBI has made an estimate of 6% growth in FY03/10, analysts’ estimates are coming at even lower levels (JP Morgan 5.5%, Citibank 5.2% and Credit Suisse 4.9%).

India Inc.’s growth was on the back of strong topline growth due to increased volume and pricing
on exports and domestic sales. These trends have certainly reversed for now. It was also attributable to a strong investment cycle, partially funded by foreign capital inflows and partially by leveraging promoters’ balance sheets against personal holdings of listed stocks, which have lost about 75% from the peak in January 2008.

Further downside risk to equities

While Indian demographics remain attractive and domestic demand should be more resilient as compared with aging economies, the slowdown in the investment cycle is severe and domestic demand has pulled back.

For now, faster and stronger recovery in global growth and a clear verdict from the Indian electorate are necessary for a justified and sustainable recovery on the Indian bourses. Bothare not very probable in our view.

To see full report: BAER INSIGHT