'Interest rates won't rise for two quarters'

There won’t be any earnings upgrades for India Inc till it starts investing; and firms aren’t going to invest until they see firm signs of a global recovery, perhaps when fourth quarter US numbers are out. This, in a nutshell, is the view of JPMorgan’s head of economic research. Prior to this, Jahangir Aziz has done a stint as principal economic advisor in the ministry of finance — he’s also headed the China desk at the IMF. Excerpts from a conversation with Shobhana Subramanian:

The US grew 3.5 per cent in September. Is the global economy firmly on the road to recovery?
There’s more to it than just the base effect; there’s the stimulus impact too; and the inventory restocking. But confidence in some sections is back and apart from that, I think there is a change taking place in the behaviour of firms and ourselves, away from this complete and total withdrawing into the shell. The risk aversion is slowly coming off but the situation is still far from normal. Again, since 1975, this is the first time that US, Europe and emerging markets are going to recover exactly at the same time. Typically, when something like this happens, the sum of the parts is much bigger than the parts themselves.

How do you read the Indian economy?
In India, almost every demand indicator has turned very sharply especially if you consider the numbers sequentially. Except for the most critical variable, which is capital expansion — private capital expansion just hasn’t picked up. That’s probably due to a lack of confidence because companies have raised significant money, not from banks but from other sources. I would say about $8-$9 billion has come in from private equity and a fair amount from external commercial borrowing (ECBs) and all of it has been used to deleverage so companies have been doing the right thing. So far, though there has been very little topline growth, it’s all bottomline growth and almost all of that is because firms have saved on inputs and interest.

So how would you rate the September quarter earnings?
I would say it’s essentially what you would like to see coming out of a recession. You want to see firms having cut costs and strengthen, you don’t want them to be expanding when you’re not even certain whether this is a recovery or not in the first place, forget about whether it’s going to sustain. So I think earnings have beaten expectations in several sectors and, as you would expect in a recession, you see weak toplines but improved bottomlines. That simply goes to show that Indian firms, in their first business cycle encounter, have behaved the way they should.

Will the topline catch up in subsequent quarters?
No, that is the big weak link in the Indian economy. The question is whether topline will catch up or not and whether capital expansion will resume. My guess is that capital expansion will depend on the return of confidence and that depends on whether Indian firms get some evidence of a global recovery. So far, we’ve heard there’s a recovery and there are some tangible signs. But you may have to wait till fourth quarter US numbers are out, in which case the expansion could happen in the second quarter of 2010. Indian firms were badly hit during the crisis — they believed they were decoupled and they were rudely reminded that they weren’t. And I don’t think they are willing to go into capital expansion before they’re convinced about the recovery.

So are you seeing earnings upgrades yet?
Until companies start capital expansion, people will not gain confidence about topline growth. Firms need to come up with business plans that are bankable and financed, till then I don’t think you’re going to see a spate of upgrades. I don’ think India can grow at 8-9 per cent GDP without credit growing at 25 per cent and without the investment rate growing at the old rate. That should happen in about a year and then earnings could grow at 20-25 per cent. As long as the cost of money doesn’t skyrocket, you could get back to the kind of earnings growth that you had before. After all, India and China are very small economies, we are a $1,500 per capita economy and China is a $3,000 economy, so there’s massive space for us to grow. The equity markets could turn red hot on the expectations of this happening and that we’ll probably see once firms start announcing capex plans even if they don’t start implementing them.

Surely, retail credit growth will pick up now?
My guess is that RBI, like the Bank of Korea and People’s Bank of China, will be extremely concerned with not just retail lending but any lending which they consider would fuel asset price inflation. The global crisis has brought about a big change in the monetary policy framework of emerging market banks and one of the lessons you find in their statements is the interpretation that they have of what caused the financial crisis. They will be not be worried about retail credit per se but they will be worried about retail credit fuelling commodity, real estate and asset price inflation. The reason you see RBI cracking down on provisioning of real estate is its concern that money would not remain in the banking system but will seep out into real estate, equities and commodities. The easiest way this happens is if credit card lending goes up and I’m using that to punch the equity market.

So how will consumption spending go up?
Consumption will take place now with much lower loan-to-valuations ratios and anyway I don’t think consumption is going to drive growth. Consumption has never been a driver of growth in India and, as a share of GDP, it has fallen every year since 2002. In China, it has fallen every year since 1997. It is investment that is going to be the driver of growth.

Now that the RBI has signalled the end of an easy money regime, where will rates go?
When the RBI Governor said he was going to exit before others, rates had already tightened. I don’t think you actually need to see an increase in policy rates, the hardening has already happened because people are building up the view that the Governor will exit before the US Fed. When policy rates change, some of it is passed on, but I think interest rates will harden less than what people expect because lending rates have already picked up. Look at any of the non-bank rates, which drive the cost of capital; the overnight swap rate was pricing in almost 180 basis points increase in call money rates by the end of the year though that has come down after the monetary policy didn’t deliver any rate hikes. The threat of tightening is far more important and he has threatened to tighten so the market is not going to wait.

How much will rates rise by?
I don’t see them increasing very much from current levels in the next two quarters because for that to happen you will need to see genuine credit growth, the way it was expanding before the crisis. I don’t see that happening at all because for that to happen you need capital expansion to take place. Also, if you look at the last three quarters of a recession and the first three quarters of a recovery, and if I give the rates of credit growth for each, you wouldn’t be able to tell one from the other. Firms don’t need credit in the first few months of a recovery because the bottomline hasn’t fallen apart and they have some internal savings . Moreover, alternate sources of financing have become very cheap with the equity markets running ahead of the recovery. I can’t imagine why, when their own debt is trading 100-150 basis points above the 10-year rate, any firm would want to borrow from the bank at 300-400 basis points above the 10-year rate, which is the PLR.

Where will 10-year rates go?
The 10-year benchmark yield will get anchored by three things . First, the government has a lean borrowing programme for the rest of the year. Second, there is no private sector credit growth, so what will you do with your money? And third, RBI will not let the 10- year rate breach 8 per cent. It will come in with open market operations or, if needed, increase the hold-to-market (HTM), but it will keep the 10-year rate below 8 per cent. So there won’t be any action on the 10-year benchmark.

Are the overseas debt markets cheaper to access now?
Spreads have eased from the peaks of last October and so blue chip AAA firms would not pay more than 400-500 basis points above Libor, which is cheaper than what SBI is giving them, and cheaper than what they would have paid late last year. And that’s a perennial problem that we’re going to face. Of course, the era of loans at 200 basis points over Libor is over because the risk premium or the risk aversion has gone up and I don’t think risk aversion will go down that much. But spreads today are lower than they were even in April.