“This bout of heavy inflation in the US is perhaps best played through maybe Bangalore real estate, wherein a lot more of services get exported because the wage rates in the US are rising very rapidly and there is not a visible pipe but an indirect pipe which one can visualise where services there have a greater propensity for engineers in Bangalore,” says Neelkanth Mishra, Co-Head of Equity Strategy, Asia Pacific and India Equity Strategist, Securities Research, Credit Suisse.
Let us start with what has happened in the last few weeks and months. . You track the FII shareholding data pretty closely. What is happening with the FII side of the market? Markets are not falling much but FIIs are selling. Is it only because of primary market issuances?
The FII behaviour is more because of what is happening globally. There is elevated uncertainty in global financial markets. The Fed is trying to tighten aggressively as they are starting to realise that they are perhaps behind the curve. This is happening unfortunately at a time when global demand indicators are starting to weaken.
We have been tracking our proxy for global retail sales. They were significantly above trend for almost all of 2021 and then there was a very steep fall. It was protected by pre-buying in October-November but in the December sales in the US, the numbers were really weak and when one puts this together with consumption weakness in China, the expected weakness in real estate construction, etc, the global end demand situation is looking a lot weaker than what the supply constraints would suggest.
At this time, it is going to be very difficult for policymakers to stimulate the economy and this is a very new situation for global markets because over the past decade, we are used to a situation where whenever demand weakens and stock markets take a tumble, the monetary and fiscal taps get opened. This time the primary focus especially in the US seems to be inflation and therefore as growth weakens, we may not see that stimulus coming through. As that readjustment of expectations happens, the global markets are likely to stay quite volatile.
Emerging markets, in particular, have seen outflows and that is the usual trading pattern whereas as the US is tightening, you pull money out of emerging markets and the FIIs selling that we have seen is a reflection of that. For India per se, the cyclical rebound is doing very well and we expect it will continue to pick up in the next couple of quarters.
Whenever people think that the Fed will start tapering and raise rates, they believe we are back in 2013 when demand just collapsed across asset classes. Do you think this time around India and the overall world will be much better prepared?
The emerging markets are definitely better prepared. Their current account deficits are not really as high as they were in 2013. It is the case not just for India but for several other emerging markets as well. Many of the EMs have prepared themselves with much larger reserve positions. I do not think they are in a weaker position but at the same time, remember that even though inflation may be a primarily US phenomenon right now because in Japan, in China and large parts of Asia, inflation is not that big a policy headache right now. The reality is that most asset classes globally are benchmarked off the US 10-year treasury yield and that is why the volatility in global markets can be quite broad based.
This will be perhaps a time when the equity and bond markets both will see weak demand. So this is a readjustment process. I do not think the world has ever seen the US inflation being 1.5-2% points higher than India’s inflation for several months in a row. I am getting used to this and I think that uncertainty is going to be causing a lot of volatility across markets.
Last time around, Budget was a great event, markets had rallied overall and you as a strategist can also say that it coupled with what happened with the global rally. What to expect going into the Budget?
The challenge for policymakers in India at state and central level is shifting again. For most of the last decade, it was about fiscal consolidation and getting the fiscal deficits back in line. What is happening right now is that the markets are primed for higher deficits and so they are expecting that the Centre and the states will have high deficits. Tax collections are going up but the governments are unable to spend.
The biggest variable to track right now is the cash balance that governments have with RBI which is more than 2% of GDP right now. This is coming primarily as the government functioning was very badly impaired by the lockdowns and activity restrictions. As we get into the Budget and not just the central budget but the states budgets as well which will also get presented over February and March, the key variable to look out for would be what they are deciding to spend on, how much can they scale up spending because the fiscal, the tax revenues are good.
The temptation would be to consolidate aggressively but at the same time, the best way to get debt to GDP down is to grow the denominator, basically grow nominal GDP faster and especially when the markets are primed for higher deficits, it makes sense to spend a lot more. So, that would be the first focus area. At the same time, one of the key takeaways from the last year’s Budget was that it was very progressive; it showed clean accounts; it showed parts where the government was very focussed on growth, very reformed focus and announced privatisation of PSU banks and several other such steps.
Even if there are no concrete steps that affect the fiscal numbers, if the Budget speech comes up with some such announcements, say on the personal taxes or personal income taxes or some removal of exemptions, that will be taken very positively. I do not know if that will be enough to offset some of the global market turbulence but it will help India hold up better.
Last year, there was a higher expenditure. This year, the government may have some savings from vaccination, the Covid programmes. Do you think expenditure on such a high base cannot grow very strong and that is why the quality of expenditure would be the key?
Absolutely right and if you are going from 6.8% to a situation where you can theoretically consolidate to 5.8% or even a 5.5%. this would be faster than what you had guided to which is 4.5%. Again we are talking only about the central government by FY26. The fact is if you consolidate too fast, you are going to shrink expenditure and there is some natural expenditure shrinkage which should be expected and there should not be that much vaccination requirement next year. The foodgrain supply also should be lower. Fertiliser prices globally are starting to come off and so the fertiliser subsidy can come off as well. It is possible that some of the disinvestment proceeds may improve next year as well. So we will have more space and keeping up expenditure and finding avenues where one can spend a lot more is going to be the biggest challenge for the Centre.
For the states the revised headline deficit in FY21 was 4.7% for states. In reality, if one looks at how much they borrowed and how much cash they ended the year with, it will be lower than 3% which is not very different from what it was pre Covid. For FY22, the states are at 3.6% but the borrowing is again below what was expected and their cash balances have actually climbed further and which suggests that they will end this year also with a deficit lower than 3%.
So at a time when everyone expects India as an economy to have incurred the cost of higher fiscal deficit by pushing up yields, the term premium in India is at a ridiculous level. But the benefits from that in terms of higher government spending have actually not come through. Just to give you a number, in the September ‘21 quarter, the GDP in real terms was about 0.3% higher than September 2019 quarter, the pre Covid base quarter but the government spending was 17% lower. This is the government’s final consumption expenditure and comes at a time when the governments the world over are boosting expenditure to support aggregate demand so that their economy does not contract.
In India the GDP is growing despite the government spending shrinking and this is something that needs a lot of attention of the markets and as well as for policy makers because the markets just look at the headline deficit and then say oh, my God there is a problem! What they are not observing perhaps or not paying enough attention to is the fact that there is Rs 4.5-5 trillion cash that the governments are sitting on and how that gets spent is going to be very important. As you said, it should be spent productively; the quality of expenditure needs to be good so that the multiplier is good and that will I think be a good support for growth going forward.
In terms of fiscal deficit consolidation path, the oil tailwind with the excise duty is no longer there. How should one look at divestment programmes and the oil revenues which will now not be there?
Oil revenues will be lower. They are not going to be there. The total cut by the Centre and the states put together at an annualised level – and this happened in November so fourth months have already been seen in FY22 – we will see eight months of that reduction. The total was Rs 1-1.5 trillion which is large but in the context of government taxation, I do not think that is a very large number. This is coming at a time when because of formalisation and better compliance, the tax to GDP, excluding the oil revenue, is not doing that badly while corporate profits are doing well. So corporate tax growth will be strong and therefore the process of consolidation in theory can continue.
However, as I said earlier, the objective should shift from just managing the year to year fiscal deficit to looking at debt to GDP and seeing how fast can we bring it down because at 90% debt to GDP, we are in a very tricky position if the cost of borrowing goes up like it has. Then very quickly, one can get trapped into a trap where your interest costs start climbing and then the deficit starts climbing and that forces a reduction in the GDP and that sort of brings down ratings and a lot of other risks can emerge.
So one need to get that 90% down to 70% over the next decade and the best way to do that in my view is to grow the denominator and that must happen with the Centre and the states coordinating on how to spend productively in a way that once the economy really takes off, it can be withdrawn. The simplest way to spend and some states may be tempted to do that is to give salary hikes to state employees. I am not saying that that should be done or that will be done, but that is one way of increasing expenditure which will have some growth impact but it will then create a permanent liability which one cannot pull away from and that is what happened 10 years back. These are the most important issues as we go into the budgets for the centre and the states.
In terms of inflation, if the hyperinflation continues or the inflation goes ahead, what is the best way to play it as an investor?
The one nuance that I would like to bring is that this is not global inflation. In our financial markets globally, we need to worry about it because the US, which effectively sets the cost of capital for most asset classes, is going through a bout of very heavy inflation but this is not yet a global inflation problem. The debate in Europe as well has been whether this spike in inflation to 5% is something that will persist and as we are seeing US inflation go up, we have to see what are the goods and services that the US can import because then the differential starts to become a lot more attractive.
In conventional high inflation situations, one starts buying commodities but the Chinese inflation is less than 2%. The outlook on hard commodities like steel and iron ore is not that strong; the outlook on oil and gas is more geopolitical driven and depends on what is happening in Russia and Ukraine or what is happening in West Asia. So this bout of heavy inflation in the US is perhaps best played through maybe Bangalore real estate, wherein a lot more of services get exported because the wage rates in the US are rising very rapidly and there is not a visible pipe but an indirect pipe which one can visualise where services there have a greater propensity for engineers in Bangalore.