Reforms – Why it is so very Important to moot for it.

For India to try to get back on the growth path the following may need to happen

1) Inflation moderates
2) Interest rates soften
3) Growth picks up

For this to happen, the reform process needs to be re-kindled. People are talking about renewing reforms but why are reforms vital?

Let's say there is a small factory that is manufacturing goods and services.
The population of the town buys everything from this factory. As the population grows, the demand for goods also grows. Naturally, the factory raised prices because of the excess demand. This is how inflation steps in.
So how does one fight inflation and bring prices down?
One way may be to reduce the amount of money people have so that they buy less.
To make this happen the Central Bank will increase interest rates.
This way, money is less and prices are controlled.
But people may not be satisfied because they cannot buy much.
But if money is supplied cheaply, prices could go up and inflation could be back.
So what does the government do?
The government may need to make it easy for people to set up more factories and increase supply.
To set up more factories, entrepreneurs would need
1)Land
2)Good quality people
3)Reasonably cheap capital
4)Good infrastructure
In order to make the above available the government has to initiate reforms as explained:-
•Land: To get land, the government has to make policies so that both buyer and seller of land are happy.
•Labour: To get good people, the government has to make policies that will encourage entrepreneurs to set up educational and vocational colleges. This would also include FDI in the Education sector. Since we need to be efficient and competitive with the rest of the world, our labour needs to be productive. For this to happen, we need Labour Reforms.
•Capital: To get reasonably cheap capital the government can do one of the following:-

1. Frame policies to encourage people to invest so that capital is formed. However, people will invest if they have sufficient funds and if they are optimistic about the future. To have adequate funds, money should be available cheaply which means interest rates should be low. But if interest rates are low without commensurate economic production, inflation is likely to step in. Nevertheless reducing interest rates can spur investments.
2. Frame policies that attract foreigners to invest in India. When foreign capital comes in, the value of the rupee goes up and inflation is kept at bay. With inflation at bay, the government can take measures to reduce interest rates. However, the profits arising out of foreign investments have to be shared with them. Either people share and move forward or stay standstill. Hence the need of reforms in the retail sector such as FDI in retail.

•Infrastructure
To be competitive, the manufacturer may need to be efficient; gets supplies in time and can deliver finished goods in time and needs to hold minimum inventory. This is possible on the back of good infrastructure like roads and railways, storehouses, refrigerated vans etc. For infrastructure to come up, we need land reforms so that people are clear what they will get when they hand over their land for infrastructure projects.

So when we have reforms in place, more factories will come up. When more factories come up, the country will produce more goods. When more goods are produced, more money can be printed without losing value.

When more money is printed, the interest rates can be reduced. When interest rates are reduced more entrepreneurs jump into the fray creating more production and more jobs. With more jobs, people have more money and are in a good position to consume the additional production. This gives rise to more investment and thereby a virtuous cycle kicks in.

With adequate supply, inflation is kept at bay even as people have cheap money for investment and for consumption. With interest rates low, inflation low, value of rupee stable, high production, the GDP of the country improves. With higher GDP, more jobs and prosperity in place, the tax collection increases. With higher taxes from higher GDP the situation turns win – win.

People don't mind paying more taxes because they are earning more. Higher taxes help the government keep its fiscal deficit in check. In the meanwhile, the government is in a good position to invest in bigger infrastructure projects and improve the productivity of the nation.

The moot point of the above explanation is that if the country wants to get a glimpse of utopia, it must reform its policies to infuse efficiency and productivity in the system.

Understanding Depreciation of Rupee

Every country exports and imports for its survival. As long as this equation of imports versus exports is balanced, it is good for the nation but when imports become more than exports, the value of the currency starts declining. It means that the country needs more from other countries while it has little to offer to them. Indian goods are bought with Indian rupees. Hence if the demand for Indian goods falls, consequently the demand for Indian rupee also falls. India has dual challenges. While the demand for Indian goods seems to be waning, due to export slippage, India continues to import crude (petrol/diesel) and other imports vital for the economy at high international commodity prices and an inelastic demand for gold and silver. Therefore the demand for the dollars continues to be high. This situation puts further pressure on the Indian rupee widening the current account deficit. What is the immediate fallout of the rupee depreciation:- 1) The price of petrol has gone up substantially. Also the price of diesel and LPG could spike. When the price of fuel goes up, the cost of transportation goes up and when the cost of transportation goes up, the cost of goods goes up and thus inflation goes up. As we have a current account deficit, rupee depreciation has an inflationary impact. 2) Companies which are dependent on raw material imports or have imported components could see profitability and market capitalization take a beating. This is because its profitability may get hit by higher input costs. 3) Foreign travel is set to get costlier. One would have to keep more rupees on hand to purchase dollars to fund foreign travel. 4) Studying in foreign universities may get costly. This is the same in the case of foreign travel; more rupees would be needed to fund foreign education. 5) Several electronic goods which depend on imports and royalty payouts may get more expensive. 6) NRIs and exporters would be happy and can be expected to remit more dollars as they would get a higher price. Companies like IT software, Pharma and BPO would gain from the dollars that they earn by providing goods and service abroad. As seen above, devaluation of the rupee is inflationary in nature, as we are net importers. There is a need by the Government to devise policies and tools to stem the fall of the rupee. In this context it is important to examine the tools (short term and long term) that may be available:- 1) Government can buy Indian Rupees from the foreign exchange market by selling its dollars. This would however reduce the foreign exchange reserves which are needed to fund our imports. Hence this is not a sustainable solution. 2) Government can mandate banks to increase their Cash Reserve Ratio and Statutory Liquidity Ratio which means banks would have to deposit more rupees with the Reserve Bank. Alternately the central banks can issue bonds for the public. By these measures the central bank would reduce the liquidity in the system and try and make the rupee dearer. However, these measures have the effect of increasing interest rates which hurts profitability of companies and thus adversely affecting economic growth. When economic growth gets limited, the production of goods and services too gets unfavorably impacted giving rise to inflation. 3) The Government can ask companies who have dollar accounts to bring in the dollars back into the country and convert them into rupee accounts. This would increase demand for the rupee which in turn would stem the slide of the rupee. 4) The Government can make it easier for companies to borrow in dollars from abroad. Companies would get more rupees for every dollar borrowed. This would help them finance their working capital requirements. If the rupee regains its strength over a period of time, the borrower could have to return lesser rupees. However, if the rupee further slides then business would be at a disadvantage. Hence businesses would take this route based on their outlook of the rupee. 5) The Government can attract NRI dollar deposits by offering attractive interest rates 6) Government can reschedule / delay in paying off its dollar debts with the hope that the rupee would regain strength subsequently.Thus at a later day lesser rupees would have to be coughed up to repay the debts. 7) The Government can increase the limit of FII investment in debt papers. This would certainly bring hot money seeking quick gains. Some flow of hot money would be useful. 8) Government can liberalize foreign investments in insurance, aviation and retail, infrastructure sector, agro-based businesses as well as may reduce subsidy from various sectors. This would be one of the better moves as it would bring in serious long term money from abroad. 9) The Government could frame policies to restrict the import of gold by raising custom duty and thereby making investment in gold less attractive. 10) The Government could action some long standing economic reforms to induce both domestic and international investments. This would help in increasing production and productivity of the economy. Higher production along with productivity would help in increasing supply of goods and services and thereby reduce inflation. This would be a better and sustainable method for tackling both the rupee crisis as well as inflation. Economic reforms would bring in “Foreign Direct Investment”. Economic growth can improve investor confidence and this ultimately bringing back a higher trajectory of GDP growth. The depreciation of the rupee has an immediate impact on India in many ways, as discussed above. It is important to understand the macro-economic situation and the ways and means by which the Government can battle the challenges and try to steady the economy.

ITS TOMORROW THAT’S MATTER

Good returns are seldom made on investments made in good times.

Rather, good returns are typically made on investments made in adverse times.

There is a fair value for listed companies, just like for companies that are not listed.

In good times when the stock markets are doing well, companies typically trade above

fair values and in adverse times when markets are not doing well they tend to trade

below fair values. In the long run, markets do not sustain at either overvalued or

undervalued levels, rather move close to fair values. This is why investments made in

adverse times typically yield above average returns and vice versa.

Key challenges facing the Indian economy

It is true that the economy is currently passing through a difficult phase. However, this is

neither the first nor will it be the last time the economy is facing challenges. Besides, the

problems facing the economy are such that should get resolved over time and through

some specific steps.

The following is a summary of the key concerns that the economy / stock markets are

faced with:

High Fiscal deficit: This has been the key concern in India over the last few years.

Fortunately at one level and unfortunately at another, this is an issue that is of our own

making and therefore the solution is in our reach too. Though some steps have been

taken in the last budget, the real solution lies in eliminating / sharply reducing the diesel

subsidies. Despite several disappointments on this front over last several years, there is

hope that this will be tackled on a priority basis as the dangers of not tackling this are

hidden from none.

High Current account deficit (CAD): The worsening of current account deficit over last

few years from 1.3% of GDP in FY08 to nearly 3.8% in FY12 (market estimates) is almost

entirely on account of increase in gold imports from 0.4% of GDP in FY08 to 2.3% (E) of

GDP in FY12. Looking at the sharp rally in gold prices over last several years, investor

behaviour that is so typical of such situations, significant moderation in USD gold prices

over last year and sharp moderation in recent gold import volumes, it appears that the

highest gold imports are behind us. If this is indeed the case, then as and when gold

imports revert closer to longer-term average of 0.5% of GDP, the CAD should get

addressed progressively in the current and over the next few years. The sharp INR

depreciation should also moderate CAD in FY13 and beyond by making exports more

competitive and imports costlier.

Depreciating INR: This is a result of high CAD and of poor investment sentiment leading

to weak capital flows. Though forecasting currencies is harder than stock markets, it has

been experienced that when there is a consensus in one direction, that is where the

turning point often is. A nearly 25% depreciation in less than one year of the currency

of a large economy like India is not a small movement and it appears to be excessive.

What could also come to the help of the INR is the expected improvement in CAD in

FY13, any policy steps that improve investment sentiment, notably reducing fuel

subsidies and / or any moderation in global crude oil prices.

European Crisis: Though the way forward of European crisis is hard to figure out, most

would agree that the impact of the European crisis on the Indian economy and

therefore on the equity markets over long periods should be much less than on other

countries. This is so because India’s exports / investments in the stressed economies of

Europe are miniscule.

Between April 2010 (when Greek Government debt was downgraded to junk status) and now,

other than the markets of countries that are stressed, Indian markets are one of the

worst performing globally across both developed and emerging markets. This indicates

that the Indian markets are probably impacted more by India specific issues and not by

the European crisis. It is interesting to note that DAX (German stock market index) is

marginally up in this period whereas India is down 10%.

GAAR : This appears to have been commented upon sufficiently to assume that this has

been discounted by the markets.

In the face of so many issues and adverse news flow almost on a daily basis, it is easy to

forget the several strengths of the Indian economy. These are large availability of

natural resources other than oil, favourable demographics, rising incomes, high

household savings rate, low penetration of consumer durables, rising competitiveness

of exports due to sharp depreciation of INR (particularly vs Yuan), slowly but steadily

improving infrastructure, etc. Though these strengths seldom make headlines, they are

intact and should lead to continued economic growth in future as they have in the past.

Global crude prices are correcting rapidly. OPEC and Saudi officials have openly

remarked that they are comfortable with Brent Crude at $100. Negotiations with Iran on

nuclear sanctions are also reportedly progressing. If oil prices stabilize at lower levels,

pressure on fiscal / current account deficits and INR will quickly ease. Lower interest

rates will then be a natural outcome and will support a much-needed revival in Capex.

The current problems facing the economy are not insurmountable. The solution lies in a

few difficult decisions. As difficult changes typically take place in difficult situations

when there are no easier options left, it is hoped that we will not have to wait for long.

With few such steps and over time, it should be possible to put the economy back on

the rails fairly quickly.

Difficult markets or bargain markets?

The stock markets are passing through a difficult phase. The values of the listed

businesses as indicated by the Sensex are down by 20% between 2008 – 2012 (presently

SENSEX level is 16000 compared to 21000 seen in early 2008). This is despite a nearly 60% growth

in the GDP (15% CAGR) and therefore a similar growth in the fair values of businesses over

the same time. Consequently, one year forward P/E multiples have come down sharply

from over 20 times in FY08 to below 13 times presently. These are nearly 20% below the

long term averages. Further, the P/E of the Sensex based on FY14 (E) EPS of 1475(source : BOFA ML) is nearly 11 times, which is close to the lowest multiples that Indian

markets have traded at in the past.

Bargains are available only in challenging environments / in markets characterized by

weak sentiment and seldom when the going is good / sentiment is strong. That’s why,

from an investor’s perspective, a more appropriate way to describe the current

markets would be bargain markets and not difficult markets.

God and Equities

The couplet by Saint Kabir, a much loved and revered saint of 15th century who lived near

Varanasi – which many believe is the oldest city in the world to have survived continuously.

This couplet reads as follows:

Dukh Mein Sumiran Sab Kare, Sukh Mein Kare Na Koye

Jo Sukh Mein Sumiran Kare, Toh Dukh Kahe Ko Hoye

It means the following:

[ In anguish everyone prays to Him, in joy does none

To One who prays in happiness, how sorrow can come ]

Stock markets and God do not have much in common. Probably, that’s why, the above

does apply to stock markets but in reverse.

An adapted version of the above for stock markets would be as follows:

[ In good times everyone invests, in adverse times does none

To the wise one who invests in bad times, wealth should come ]

The moral of this is that remember God in good times and equities in bad times. If this

is done, then chances are one will avoid both - bad times in life and poor returns on

investments.

Its tomorrow that matters

By the end of June or shortly thereafter, Greece will either be in Eurozone or it will not

be. Over the same timeframe, steps if any, that are undertaken by the government to

resolve some of the issues facing the economy will also be known. Irrespective of what

happens, markets should discount these outcomes fairly quickly.

It is true that the economy is currently battling twin deficits, but that is known to the

markets. What will determine markets of tomorrow, are the deficits of tomorrow and

expectations thereof, both of which chances are will be better and not worse than

today.

Times such as present, when the markets are not doing well should actually be looked

upon as a window of opportunity for savers to invest more into equities, so that when

the good times come, there are meaningful investments in equities to reap the

benefits from. The lower the markets are, the bigger is the opportunity and the longer

the markets remain depressed, better is the opportunity for savers. In a lifespan of

investing of say 30-40 years, it is unlikely that the markets will provide many such

windows. In the last 20 years there have been only 3-4 such windows.

Finally, what has taken several pages, Sir John Templeton conveyed more effectively in

one line:

“Bull markets are born on pessimism, grow on skepticism, mature on optimism and

die on euphoria.”

Needless to say, pessimism is all that one sees all around.

Prashant Jain, ED & CIO of HDFC Asset Management is bullish on Indian equities. Markets are currently undervalued - making these levels a good entry point for retail investors, Mr Jain said.
""I think investors should look at current market levels as an opportunity and not as a threat,"" Mr Jain said, adding, ""Instead of focusing on the news flow investors should focus on valuations - good valuations are available only when there are challenges.""
According to him, retail investors don't make money in equities because they enter stocks at high price-to-earnings multiples. Good returns on equity investments are typically made on investments made in bad times, he said.
Mr Jain is aware of the challenges faced by the country, but feels Indian economy is structurally very strong to wilt under macro-economic pressures. ""Our decadal growth rates, since 1960s, have been rising by nearly 1% each decade.. This is despite several issues and problems - both internal and external,"" Mr Jain said.
According to Mr Jain, Indian economy will recover in the months to come.
""The key thing for India is to reduce its subsidy on diesel. And to top it, if global crude prices come down, a lot of negative factors will be set right. Crisis situations have always lead to changes for better. We're going through a difficult situation currently; but I am optimistic that few years from now we would have emerged stronger from this,"" Mr Jain said.

Market Update

Global/Domestic economy looks gloomy - Right time to participate in market.