‘We can support our growth from our own capital’

In an exclusive interview with Moneylife, Nilesh Shah, deputy managing director, ICICI Prudential AMC, gives his perspective on the current market rally and where the markets are headed. Moneylife presents the second in a three-part series of the interview.

ML: What are the key factors you would watch out for signs of significant reversal?
Nilesh Shah:
At the end of the day if 8% growth happens, notwithstanding small corrections, we can be reasonably sure that markets will continue to move up. At 8% growth rate even interest rates need not move up. We can have a virtuous cycle which can support us or we could have a vicious cycle which could derail us. The optimism is basically driven from the fact that we are generating about 25% savings and putting similar amount in investments. With that savings and investments we are able to generate just around 5%-6% kind of growth. If we can increase our productivity, it could easily become 8%-9% growth. The productivity is not going to increase overnight. For that infrastructure needs to be developed, deficit needs to be cured. For that certain real reforms have to happen in the real economy. I think all of that will follow, but at a slow and steady pace. The second shortcut is that we get money from overseas investors and convert that into capital. My feeling is that the world can give us that capital. People are talking about China and India virtually in the same breath, but the allocation is far more tilted towards China. We can bridge that gap. With that capital coming in, we can accelerate growth, which will accelerate government revenue, narrow down deficit problem, reduce interest rate pressure and reasonable liquidity becomes available. With that jobs and employment will be created, more consumption will happen, optimism will prevail, corporate earnings will go up.

The entire virtuous cycle will prevail for us, in which scenario equity markets will continue to move up. The vicious cycle could come is essentially because of two things. One, the real reforms don’t happen in the economy and hence the absorption capacity does not increase. Capital flows go towards asset price inflation, building up of bubbles, rather then building up of real assets. If that happens then we are back to the old story where eventually the bubble burst. So there have to be some real reforms in terms of improving the absorption capacity. We are seeing some improvements happening but it is not sufficient. We can do better. Like the ultra mega power projects announced some time back. None of these are moving at the speed they should. Same is the case with coal allocations. Bank credit growth has definitely slowed down in response to falling raw material prices, oil companies are not borrowing as much as before. But this slack of bank credit should have been absorbed either by the planned capex or infrastructure development. The slowdown in bank credit probably signifies that the real economy’s absorption capacity is not as high, so that we can be sure of that 8% growth on a sustained basis. 
 
ML: Is there too much of complacency not only about global growth but also about the domestic growth situation?
NS:
I think what we are seeing is the difference in the return expectation of investors. The Japanese investors investing in India will probably be happy with 5%-10% return because he is comparing with a 0.1% return on his deposits. An Indian investor on the other hand is looking for 30-40% return because he is comparing with previous experience. So we are seeing participation from different sets of investors with different return expectations, time horizons and hence the shrugging off of certain short term economic issues.
 
ML: Domestic investors have poured more funds into the markets. Have we finally shrugged off our huge dependence on FIIs? If so, what are the long-term implications?
NS:
I think while we suffer from the limitation of long term investment on the equity side by pension funds and retirement funds, we are seeing the emergence of insurance companies and mutual funds as a major force. They are acting as a stabilising factor for the Indian equity market. Very recently Goldman Sachs came up with a research report that said that India can actually fund the entire $7 trillion worth of infrastructure investment from its own savings. We don’t need foreign capital. This is based on certain assumptions and projections, but it shows the enormous power of Indian savings. For us savings comes naturally. We still don’t have the American lifestyle of living on credit cards. We live within our means. So we have this ability to support our own growth from our own capital.
 
ML: At what stage would inflation and higher interest rates be worrying factors given the higher high liquidity in the system, rising prices and huge government borrowing?
NS:
Somewhere between 1997-2003, our fiscal deficit remained at an elevated level, which is why stock markets fluctuated. It went up because of certain reasons other than fundamentals. Overall it didn’t go anywhere. From 2002, fiscal deficit started contracting. Fiscal responsibility and budget management reduced the deficit from around 7% levels to 3%. This created the brand value of India. Our equity markets expanded almost 7 times in those four-five years. Then in 2008-09 again we saw an exceptional response from the government. It resulted in higher deficit and the market valuation corrected. Now there is hope, that though deficits are high, they are cyclical in nature, they will come down.

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CRISIL says investor interest revived in debt mutual funds

The strong recovery by the mutual fund industry is reflected in the growth in assets under management (AUM) of debt schemes which have more than doubled within a year to Rs5.68 trillion.

Ratings agency CRISIL said improvement in liquidity conditions in the Indian financial market along with revival in investor confidence has helped the Indian mutual fund industry tide over the aftermath of the liquidity crisis faced by the financial market during the third quarter of 2008-09.

“CRISIL has also witnessed an increased preference by mutual funds for lower credit risk with a preference towards government securities and AAA or P1+ rated instruments,” said Pawan Agrawal, director, CRISIL Ratings.

The strong recovery by the industry is reflected in the growth in assets under management (AUM) of debt schemes which have more than doubled over the past year to Rs5.68 trillion as on 31 October 2009. CRISIL said it has also observed a shift in investor preference towards relatively shorter-term schemes, increased investment in higher-rated credits and high demand for debt instruments issued by banks.

While improvement in liquidity contributed to increased demand for debt schemes, introduction of new guidelines issued by the Securities and Exchange Board of India (SEBI), capping the maturity of investments in liquid schemes, resulted in increased preference for ultra short-term funds. The share of liquid schemes has come down to 27% from 49% of AUM, the ratings agency said.

CRISIL, a unit of Standard & Poor's, said financial sector entities, especially banks, continue to dominate the portfolio constituting two-thirds of the AUM. However, within the financial sector, there is a clear shift towards investments in instruments issued by banks as compared to that of non-banking financial companies (NBFCs).

While the overall exposure to the financial sector remained stable, mutual funds’ exposure to banks has increased to over 50% from 43.3% as on 31 August 2008. On the other hand, exposure to NBFCs has come down to just above 8% from almost 18% as on August 2008, it said.

"Exposure to pass-through-certificates (PTCs) and real estate sector has also come down sharply because of the illiquid nature of the instruments and their increased credit risk” added Mr Agrawal.

Yogesh Sapkale [email protected]
 

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‘Industrial recovery was stronger than expected’

Moneylife presents the second part in a three-part series of the interview with Vetri Subramaniam, Equity Head, Religare AMC.

ML: Why has the market so quickly discounted the impact of the monsoon?
VS:
I think the monsoon is not a significant factor. When you look at data like monsoon is 20% less, how much does it affect the GDP growth? I am not an expert in this issue but it suggests to me that there is some kind of downside pressure on the economy coming through from agriculture. But I think the reason why the market has looked beyond is actually something else and that is essentially the fact that the industrial recovery has been far stronger then what we had anticipated. I mean six months ago our baseline view was that we would grow at a 6%-6.5% and while my baseline view has still not changed, that number frankly should be revised upwards given the strength in the industrial production. The only reason that it has not been revised upwards is only because of the weakness that we can eventually see from a poor monsoon. 
 
ML: Domestic investors have poured more funds into the markets. Have we finally shrugged off our huge dependence on FIIs? If so, what are the long-term implications?
VS:
Well, the rally was started more by foreign money. You can argue that the paper that was floating around was actually sucked out in the first place by domestic investors during late 2008 and early 2009. I think the bigger issue is that pretty much since 2007, the total domestic institutional buying—whether it is insurance, banks, mutual funds put together—has actually been more than what the foreigners have done. I think this is an important trend and it’s a trend that will at some level eventually sustain because at the end of the day the economy is growing in nominal terms at 10%-12% and incomes are growing and when incomes are growing investible surpluses are growing. They have to go somewhere. Obviously the asset class of choice much to our chagrin has been ULIPs over the last three-four years. Maybe it will be the New Pension Scheme in the next three-four years. Eventually this money has to find a home somewhere. If you say this money won’t go into the equities because the Indian investors are very risk-averse, I would argue it would equally end up creating an asset bubble, because the money would then flow into bank fixed deposits. Then we should not be discussing rate tightness; we should be discussing 5% rate for FDs. Eventually something has to balance out the equation and I think the pure fact that you are continuing to grow at nominal terms 12-14% GDP means that incomes are growing and disposable savings are growing and equities are bound to benefit.
 
ML: What are your expectations regarding corporate performance and which sectors do you see outperforming?
VS:
I think the resilience has been more on the economic numbers rather than necessarily in earnings and particularly balance sheets. A lot of the pain which was not felt in the economy was recorded in the earnings and lot of the pain that was not recorded on the earnings was recorded in the balance sheet. Companies have done all sorts of accounting jugglery; they used the rules to their advantage to not take into account what they should have had on their P&L and all of that. Maybe the true extent of non-performing loans has also not been recorded in the system because the RBI gave a time-window to the banks. I don’t think the true extent of earnings damage has been captured fully in all the reported numbers. Having said that, in terms of a trend, the June quarter numbers were clearly a little bit of a surprise, but more because of cost-related issue rather than top-line. My sense is that the second quarter will be more of the same. Maybe the top-line is still going to look uneven but the bottom line will look much better, but by the time you get to the end of the year, the cost pressures are going to start catching up again. We already started having pressure on most cost items whether raw materials, salaries, fixed overheads all of them have started to inch back up again. It’s interesting that you actually saw some of the best operating margins that companies have ever recorded in the last eight years being reported in the June quarter, when we were just coming out of a recovery. I think at some level they will have to give out some of their margins back either because of the pressure of raw materials or because of competitive pressures. Margins cannot stay at these elevated levels for so long.

But hopefully it may get replaced by some element of top-line growth by the time you get into the fourth quarter and that should be possible because on a year-on-year basis obviously your volume numbers should grow as per your expectations.

Our key preference remains for domestic consumption themes like consumer staples and consumer discretionary items. Not that they are absent of valuation issues but the valuation issues are across the market. Banking and finance companies too feel that credit growth is starting to recover. We are far more cautious about sectors that are more globally interconnected like the commodity space. We have been positive about IT but now valuations have gone up. But on a two-three year perspective, the IT business model will weather this downturn because the downturn in the western economy in this time is more consumer led rather than business led. The health of corporate balance sheets in the developed world is reasonably good. The financial system had a problem but that also has been largely put behind so I don’t think spending trends will really get badly affected. 
 
 

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