Our overvalued currency big risk to growth: Ridham Desai

Interview with MD & Head of India Research, Morgan Stanley

Foreigners can't seem to get enough of Indian equities, as the rest of the world continues to grapple with rising debt levels and an ageing population. Ridham Desai, managing director and head of research at Morgan Stanley India, tells Malini Bhupta growth and earnings would definitely revive in FY16, provided the Reserve bank cuts rates and the currency depreciates. Edited excerpts:

Where do we stand a year after the hope rally started in equities and a new government is close to completing a year in office?

In May 2014, the new government inherited two cyclical problems, high inflation and a plethora of stalled projects. Inflation has been attacked very severely and government expenditure has been cut. Government expenditure has grown six per cent in 10 months, the lowest in 12 years. It has also taken care of the supply-side issues. The central bank has assisted by keeping real rates positive.

Is the battle against inflation won or is it largely because of the sharp fall in commodity prices, especially oil?

The inflation problem is in the bag. We believe it will surprise negatively and the Consumer Price Index will likely be below five per cent. There is a one in three chance of it going below four per cent. Most people think inflation is down because of oil but that's not true. Some of the benefit of low oil has not been passed on in the past two-three months. Instead the government has used the savings to curtail fiscal deficit and make investments.

Are Indian markets overvalued and do you see a near-term correction?

Valuations are not stretched because earnings are depressed. The key call is whether earnings are going to normalise. We recently surveyed our global investors and 76 per cent of them are overweight on India. The consensus is bullish and that, at times, acts as an overhang. Valuations are no longer at a level where it is the only criteria to invest. This is not December 2007, when valuations were at 30 times earnings.

Is there froth in the market?

If there is any froth, it is in the ownership. If you look at the markets over 20 years, in only a couple of years have domestic and foreign investors together put in money. If there is too much ownership, it acts as an overhang.

Why are global investors 'overweight' on India?

The world has been grappling with an ageing population. It is dealing with debt levels never seen in the past.  Global debt is approaching three times of gross domestic product, which is staggering. There is not much appetite left to borrow from future earnings, which is creating deflationary pressures. The world has these problems but India does not have any of these. It still looks like one of the brightest stars in the universe.

How much of a risk is the currency (value) to corporate earnings?

The currency is a big risk to corporate earnings and growth. The rupee is up against trading partners by 10 per cent and, we think, it is overvalued by seven per cent. Our exports were down by 25 per cent last month and it isn't only because of weak demand. If the Reserve Bank of India (RBI) cuts rates, the rupee would stop appreciating but if it delays these, earnings will be impacted. The dollar has risen six to seven per cent but the rupee has fallen only 1.5 per cent, making it among the best performing in the world.

The bottom-line is that inflation is under control and we need to cut nominal interest rates. Declining inflation and capital inflows are feeding into the currency, thereby creating risk.

Does this mean RBI will cut rates more aggressively?

We believe interest rates will collapse by 150 basis points cumulatively this year, of which 50 bps have been cut already. RBI will track inflation data to make its call, though what the US Federal Reserve does is a factor.

What if the US Fed raises rates this year?

We expect the Fed to increase rates next year. A revival in the economy has been pushed back by a few quarters.

What gives you the confidence that earnings will grow in double digits in FY16?

The past two quarters have been terrible for growth as the government went after inflation, which is why earnings went down. But this is set to change from April, as the government's expenditure is set to rise by 15 per cent instead of six per cent. And, the bulk of this spending is going to be in infrastructure. Second, RBI is cutting rates and, we believe, they will continue to do so. I think a couple of quarters down the line, corporate earnings will go into a major recovery. Revenue growth is set to turn from the tepid levels in the December quarter. The September quarter this year could be a good quarter, we believe, for earnings.

What are the risks to this turnaround story?

This is not a straight line story and there are risks. The world is a big problem and India's exports are declining. Last month's print was very disturbing. While this has something to do with global demand, it mostly is to do with an overvalued currency. India does not have the productivity to overcome such an overvalued currency and still drive exports. We need to see the currency weaken on a real effective and nominal basis, which in part has to do with real rates. The real rates are now on the higher side of RBI's target, which is why an interest rate cut is imperative. If there is a delay in these, recovery in growth might be delayed.

How much of a risk are the impaired assets of public sector banks?  

The one thing the government has not attempted to address is the recapitalisation of state-owned banks. If a new credit cycle has to start and a third of your banking system (if you exclude the bigger PSBs like State Bank of India, Punjab National Bank and Band of Baroda) does not participate, it can either be a drag or it might not allow a bigger credit cycle to emerge.

What sectors will drive earnings?

Earnings will be driven by information technology (IT), private banks, industrials and discretionary consumption. But, less so by materials, energy and utilities. We believe the real earnings picture for IT is changing, as demand is strong.  

What is your earnings forecast for FY16?

For the broad market, we expect earnings to grow by 18 per cent. It is not impossible to get there.
 

What about the other cyclical problem the NDA inherited -- stalled projects. What is the progress on that?

At the time NDA came to power, project completion was running at minus 30% and now it is running at plus 15%. Anil Swarup was running the department and he continued in office and got a free hand and has helped situation on the ground. 

But is this enough to kick-start the economy? 

Some structural issues too are getting addressed. Fiscal deficit is down from 6% to 4%. There is some effort to liberalise labour laws. We have been waiting nine years for GST (Goods and Services Tax) and now it is on the floor of the House. I believe it will be a law in the next 12 months. The Finance Minister has also promised a new tax regime, which will not be under the Direct Tax Code but something that was planned a few years ago. There is a promise for better business conditions and the government is doing things in that area too. 

People often talk of wave of reforms. What kind of reforms is the government focusing on? 

If you go back to the 1980s, the government controlled supply, demand and resources. Earlier, the government decided capacity, price and place where the plant would come up. Then we got supply-side reforms where enterprises could set up capacities that they wanted. That led to a glut as demand was not there and growth fell, which led to a massive build-up of non-performing loans for banks. Eventually, demand shifted to the private sector as India's per capita income went up. 

In the last decade, the only thing that the government controlled was resources -- be it spectrum, land, coal and iron ore. Now, the government is focused on liberalising the resources sector and with the new Bills focusing on privatisation of resources. This is the third phase of reforms. 

What is the government doing to revive infrastructure investments? 

There is some serious work being done in the infrastructure space. They have remodeled the private-public partnership (PPP) for roads as the original PPP was not working. The other area they are focusing on is railways. These two sectors have the maximum multiplier effect on GDP. 

How will decentralisation impact development? 

Globally, decentralisation has been a major activity driver. The results are hard to forecast and there may be doubt that all states will not behave properly and may misuse new-found resources. But the electorate has changed and, therefore, politicians' agenda has changed. Without development, elections will not be won and politicians realise that.