Wednesday, March 31, 2010

>The Sustainability of China’s Recovery from the Global Recession

China’s policy response to the global financial and economic crisis was early, large, and well-designed. Although Chinese financial institutions had little exposure to the toxic financial assets that brought down many large Western investment banks and other financial firms, China’s leadership recognized that its dependence on exports meant that it was acutely vulnerable to a global recession. Thus they did not subscribe to the view sometimes described as “decoupling,” the idea that Asian countries could passively weather the financial storm that originated in the United States and other advanced industrial economies. They understood that absent a vigorous policy response China inevitably would suffer from the backwash of a sharp economic slowdown in its largest export markets—the United States and Europe.

While it is now widely understood that China was the first globally significant economy to begin to recover from the crisis, critics nonetheless increasingly charge that the stimulus program has substantial flaws and that China’s early economic recovery cannot be sustained. One prominent critic has gone so far as to suggest that the stimulus has created a debt-fueled bubble that will collapse, causing China’s growth to plunge to only 2 percent.1 But the analysis below suggests these criticisms are exaggerated.

China and the Crisis
In the fall of 2007, just before the global crisis, the Chinese authorities tightened monetary policy and took steps to curtail an incipient property bubble. But when the global crisis intensified in the fall of 2008 the authorities reversed economic course by launching a policy of monetary easing in order to offset the additional drag on China’s growth caused by the sharp slowdown in global trade. First, they cancelled the lending quotas that had previously restricted the ability of
banks to fully meet the demand for loans from their customers. Second, to ensure that a sufficient supply of funds would be available to meet this demand, the government repeatedly
reduced the share of deposits that banks had to place with the central bank. Banks were not necessarily forced to expand their lending in 2009, as has often been asserted. It was in their economic self-interest to do so since the interest rate that they could charge on loans was several times what they earned either on funds they were required to place with the central bank or on funds lent in the interbank market.3 Thus, the government’s first step in monetary easing was to increase the supply of loanable funds.

Shortcomings of the Stimulus?
China’s growth in 2009 was impressive compared with the absolute downturns in economic output in the United States, Europe, Japan, and many other developed economies and was the fastest growth of any emerging market. But 2009 was the second consecutive year of slowing Chinese growth and 8.7 percent was the slowest pace of expansion recorded since 2001. Moreover, critics, both in China and abroad, argue that growth recovery in 2009 was unsustainable since it relied on a burst of investment financed largely by an unprecedented increase in bank lending.11 According to the critics, the massive stimulus program would have several adverse consequences.

First, in the short run it created bubbles in the property and equity markets as funds lent for investment leaked into these markets. Second, in the medium term the massive investment program financed with the expanded supply of credit would inevitably lead to excess industrial capacity and thus, with a slight lag, would put downward pressure on prices and firm profits.12 That, in turn, would impair the ability of firms to amortize their bank debt and thus likely lead to a large increase in nonperforming loans. Potentially this would require the state to recapitalize the banks once again, with adverse consequences for the government’s fiscal position.

Third, the critics argue that the stimulus undermines China’s strong fiscal position. China’s budget deficit barely topped 2 percent in 2009, a small fraction of the deficits recorded in the United States and some other advanced industrial countries. This meant China’s outstanding government debt remained stable at only 20 percent of GDP, again a small fraction of most high-income economies. But, the critics charge, this obscures a massive increase in hidden government debt.

Finally, the critics charge that the stimulus program exacerbated China’s structural imbalances and set back the effort to transition to growth that would rely more on the expansion of private consumption expenditure rather than the growth of investment and exports.

Excessive Lending and a Property Bubble?
The charge of excessive lending growth, for example, fails to take into account that the authorities initiated steps to slow lending growth as early as mid-2009. Increased window guidance and other initiatives slowed lending dramatically in the second half of the year. Although lending spiked upward in January 2010, the China Banking Regulatory Commission (CBRC) announced that month that it would take tougher measures to moderate the pace of lending over the balance of 2010. It reinstated mandatory lending quotas on individual banks and imposed tougher regulations to prevent banks from disbursing most of their lending quota in the first quarter or two of the year.14 It also raised the required reserve ratio by 50 basis points in both January and February, cutting banks’ excess reserves and further signaling the transition away from the “moderately loose monetary policy” of 2009 to the “moderately loose monetary policy implemented flexibly” policy of 2010.

Second, the CBRC has taken other steps to curtail the expansion of bank credit. In October 2009, in what he described as a “historic decision,” Chairman Liu Mingkang ruled that banks would no longer be able to count subordinateddebt and hybrid capital as part of their tier-two capital.

Contrary to repeated criticisms,
this stimulus had a substantial
consumption component and focused
on investment in infrastructure
rather than expanding capacity in
traditional industries such as steel.

Creation of Excess Capacity?
What about the assertion that the investment boom in 2009 created excess capacity that will lead to downward pressure on prices and thus on firm profits, perhaps leading to defaults on the loans that financed the capacity expansion? This argument too seems not well founded. In a high-growth, high investment economy, such as China’s, some product sectors inevitably have at least temporary excess capacity. The issue, however, is whether this excess capacity is so widespread and enduring that it could contribute to deflation, putting downward pressure on the profits of a large number of firms across many sectors. Such a situation would not only impair the ability of individual firms to repay their loans but also potentially lead to large-scale losses in the banking system.

To read the full report: CHINA'S RECOVERY


With strong demand and capacity utilisation of over 90%, Exide has increased its capex plans and expects to grow sales volume at a cagr of 17-18%. While after market demand in autos is strong, telecom replacement demand is likely to kick in from 2HFY11. Exposure to lead prices has steadily declined as 40% of requirement is now being sourced from in-house recycling smelters. Given the strong volume growth we are upgrading our forecasts by 19-23% over FY10-12. With lead prices moving up and strong demand in the OE segment limiting supplies to the after market, we believe that Exide’s margins in the next few quarters will decline to 20-22% as against the 24% achieved in the first nine-months of FY10. While we continue to like Exide’s long term potential and steady growth story, valuations are no longer compelling.

■ Demand growth remains strong
Exide believes that going forward replacement market in autos and telcos will drive demand and is targeting a 17-18% cagr volume growth. Exide also believes that unorganized players share will drop to 25% in 5-6 years from 42% presently as vehicle qualities improve and customers gravitate more towards well known reliable brands. With its facilities operating at 90%+ capacity utilization, Exide intends to spend Rs1.75-Rs2.0bn on capex per annum over FY10-12. Any greenfield venture will likely result in additional capex. On submarine batteries, the company has orders till March-11.

■ Customer reach being increased; in-house lead sourcing
Exide has a reach into 38,500 retailers through 12,500 dealers and 202 area offices in different cities and towns. By Mar-12, Exide expects to have a presence in over 400 cities. While improving customer reach, the network is also helping Exide to source more used batteries for its recycling smelter, which help the company to meet 41% of its total lead requirements. Recycling smelters will meet 70% of Exide’s lead requirements by March-12 at an investment of Rs1bn.

■ Investments, capital raising and valuations
Exide has 50% stake in ING Life Insurance and expects to invest about Rs1.25-1.5bn per annum in the venture. While ING Life is a marginal player at the national level, according to Exide, ING Life is among the top 4/ 5 players in south and western regions. Exide estimates that renewal premium/ new premium should be 2.5x for the business to break even and they are at 1.5x now. Operating expenses to premium and AUM have come down significantly in the last 3 years (66% to 40% and 28% to 18%), giving a sense that things are moving in the right direction. To meet its capex and investment requirements, Exide recently raised Rs5bn through QIP; however, Exide’s cash accruals are sufficient to meet its funds requirement. The stock is trading at 17.7xFY11 and we believe that while the long term story is very strong, valuations are no longer compelling.

To read the full report: EXIDE INDUSTRIES


Recycling waste into wealth
We spoke to the CFO Mr Gopal Agarwal of Ganesh Polytex Ltd (GPL) for an outlook on the Business and Strategy of the company. Following are the key takeaways from the meet.

Investment Highlights
Commissioning of new RPSF facility
GPL is set to become the largest player in RPSF in the country with the commissioning of its 18,000 TPA plant by the end of this month at its Rudrapur facility at an estimated cost of INR 250 mn. This will take the total RPSF capacity of GPL to 57,600 TPA beyond the current market leader Reliance Industries’ capacity of 42,000 TPA. The commissioning of this facility is expected to improve the operating margins by around 250 basis points making.

Expansion plan to drive growth
The company’s ambitious growth targets include enhancing the recycling capacity to over 100,000 TPA in stages over the next 3-4 years, building up of yarn spinning capacity to integrate its operations forward, foraying into manufacturing of downstream products and entering into horizontal integration through producing more value added products like Partially Oriented Yarn (POY), packaging sheets, etc. from pet bottle waste.

These growth plans would help the topline and bottomline to grow at a healthy CAGR of 35-40% over the next few years.

Valuation & Outlook
At the CMP of INR 42, the stock trades at 4.8x its FY11e EPS of INR 8.8 (on weighted average capital). The company’s FY10e sales are 5x the current market capitalisation and the price to cash EPS is 3.1x. The stock looks attractive considering the expansion in capacity and the growth of the user industry. We applied a multiple of 4x on FY12e EPS to arrive at our target price of INR 64. We feel investors can buy the stock at current levels for a good upside within a year.

To read the full report: GANESH POLYTEX LIMITED


Adani Power is setting up 6,600MW power capacity which will make it one of the largest private sector players by FY13. It has 70% power tied up in Case 1 bids and the balance 30% will be sold on merchant basis. Additional merchant sales before the start of long term PPAs are contingent to timely commissioning of the projects. The fuel supply for its projects is a mix of Indonesian coal (sourced from AEL at US$36/t cif) and coal linkages from Coal India. The Budget proposal of imposing a duty on power imported from SEZs (has 70% capacity in Mundra SEZ) to DTA is a risk. Initiate with a U-PF and TP of Rs111/sh.

■ Strong capacity addition over next three years
Adani Power has 6,600MW capacity under development which is targeted to be full commissioned by FY13. This will make Adani one of the largest private sector players in power generation. 70% of this capacity is located in Mundra SEZ (Gujarat) while the balance 30% is in Tiroda, Maharashtra. The company has plans to add more capacity in Gujarat at Dahej (1,980MW) and in Rajasthan at Kawai (1,320MW) and expand its Tiroda project to 3,300MW.

■ High exposure to merchant power in initial years
~30% of its capacity is untied in any long term PPA which the company intends to sell on a merchant basis. Apart from that, the company has window to sell more power on a short term basis where its projects gets commissioned before the start of the PPA date. Thus the timely commissioning of its capacities is absolutely necessary to take advantage of this window when the merchant tariffs are also likely to be relatively higher.

■ Fuel supply to be a mix of Indonesian and linkage coal
The fuel supply for its projects is a mix of Indonesian coal (sourced from Adani Enterprises at US$36/t cif Mundra) and coal linkage from Coal India. The coal block allocation (Lohara) for part of its requirements for Tiroda project has been cancelled by the MoEF and the company has recently got a linkage (tapering) in lieu of that. We have assumed a coal linkage for the full requirements of Tiroda project in our numbers.

■ Project execution/merchant tariff – key to stock performance
Our DCF based target price for Adani Power is Rs111/sh. We believe the capacity ramp up/ risks associated with the coal supplies (mainly the pricing) from Indonesia/ merchant tariffs are going to be the key for the stock performance. We have given the company benefit of doubt regarding the budget proposal of imposing a duty on power imported from SEZs to DTA (domestic tariff area) however we have assumed a MAT rate for taxation for the company (similar to other mega power projects) even though the company’s assessment is that it will have zero tax liability for the initial 10 years under the SEZ Act. Initiate with an Underperform.

To read the full report: ADANI POWER


After witnessing low spot prices over the past four months, rates have bounced back in March'10. Spot rates touched a high of Rs 7.9/unit in March, indicating strong demand. Average rates for March '10, Rs 5.8/unit, were 67% higher over Q3 FY10. With the country entering the summer season and an improvement in the economic environment, we believe demand for power will remain high. The demand-supply gap is expected to remain high as the country witnesses slow capacity addition during the eleventh plan. Hence, we believe spot rates will continue to remain firm.

Lower capacity addition will keep deficit high
Spot prices regaining firmness
Expect average merchant rates to hover around Rs 5.5-6/unit.

To read the full report: UTILITIES SECTOR