are paralyzing the global financial institutions’ ability to deliver
risk capital. Cost of capital continues to remain at higher levels
even while GDP growth has decelerated sharply. The vicious
loop of rising credit defaults, shrinking risk capital pool, slowing
growth and rising unemployment is unveiling. Our economics
team has revised its global GDP growth forecast to 1.7% in
2009 from 2.5% previously. In this environment, global capital
inflows into emerging markets are unlikely to revive soon.
While India is perceived to be relatively insulated in an
environment where the global economy is slowing, investors
have underestimated the dependence of its domestic demand
on global capital inflows. Risk aversion in the global financial
markets has resulted in a sharp reversal in capital flows into
India. With duration of risk aversion in global financial markets
likely to be longer than what we estimated earlier, we are
cutting our India GDP growth estimate for 2009 to 5.8% from
6.4% previously. On a financial year basis, we are forecasting
F2010 GDP of 5.7%, compared with our previous estimate of
6.5%.
Capital Inflows – Critical Macro Link
We believe that over the last few years, India’s GDP growth
accelerated much higher than the potential growth due to large
capital inflows — an argument that we have belabored for a
long time now. India’s GDP growth accelerated to an average
of 9.3% during the three years ended March 2008 compared
with an average of 6.6% and 6.0% in the preceding three and
five years, respectively. Capital inflows have risen dramatically
over the last five years. India received an average of US$10
billion per annum between 2000 and 2002. During 2003-2005,
capital inflows jumped more than two times to an average of
US$21.3 billion, followed by an increase to US$38.5 billion in
2006 and to US$98.3 billion in 2007. We believe capital flows
have been the anchor of the self-fulfilling virtuous cycle of
higher capital flows — an appreciating exchange rate — lower
interest rates — strong domestic demand growth.
Unfortunately, capital inflows into India have less to do with
India’s long-term fundamentals, in our view. Capital inflows into
India have trended in line with overall EM capital inflows. Trend
for capital inflows into EMs has been dependent on global risk
appetite, which, in turn, has been driven by liquidity and growth
environment in the developed world. As per IIF estimates,
capital inflows into EM increased to US$782 billion in 2007
from US$113 billion in 2002. The trend in India has been very
similar. Indeed, during F2008 (12 months ended March 2008),
Exhibit 1
Real GDP Growth Forecasts
(YoY% Change) 2007 2008E 2009O 2009R 2010E
Global Economy 5.0 3.7 2.5 1.7 3.6
US 2.0 1.3 -0.2 -1.3 2.1
Europe 2.7 0.9 0.2 -0.6 1.2
Japan 2.1 0.4 -1.0 -1.1 1.1
AXJ 9.5 7.7 6.4 5.5 6.9
--India 9.3 7.6 6.4 5.8 6.5
E = Morgan Stanley Research estimates, O = Old estimates, R = Revised estimates
Source: Morgan Stanley Research
Exhibit 2
Capital Flows to Emerging Markets and India
0
100
200
300
400
500
600
700
800
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007e
0
14
28
42
56
70
84
98
112
Private flows to Emerging market economies, net (LS)
India* Capital flows, net (RS)
US$ bn
e = IIF estimates, Note: *India data is from CEIC
Source: IIF, CEIC, Morgan Stanley Research
Exhibit 3
Three-month Trailing FX Reserves (US$ bn)
-60
-40
-20
0
20
40
Jan-97
Sep-97
May-98
Jan-99
Sep-99
May-00
Jan-01
Sep-01
May-02
Jan-03
Sep-03
May-04
Jan-05
Sep-05
May-06
Jan-07
Sep-07
May-08
Source: RBI, Morgan Stanley Research
India received US$108 billion in capital inflows. There are
several key components to this capital inflow: US$29 billion
were portfolio equity inflows, US$42 billion were debt
borrowings, US$15.5 billion were net FDI, and the balance was
other inflows. Over the last few months, with the reversal in
global risk appetite, we are seeing a sharp fall in capital inflows
into India and EMs. Our approximate estimates based on FX
reserves trend indicates that over the last five months, India
has actually seen net capital outflows of ~US$5-10 billion.
FX Outflows and Tightening Domestic Liquidity
Capital outflows at a time when the country runs a current
account deficit has meant a large balance of payments deficit.
We estimate that India’s balance of payments deficit was
US$35-40 billion over the last five months. With the domestic
banking system already witnessing tight liquidity conditions,
foreign exchange outflows at the same time have resulted in a
disruptive spike in the cost of capital. Policy rate cut and
liquidity measures cannot prevent a sharp growth slowdown in
domestic demand. We believe that measures initiated by the
central bank will likely help to keep the cost of borrowing for the
consumers and corporate sector from rising further
dramatically. However, these measures are unlikely to help
bring down the cost of capital in a meaningful manner before
domestic demand and underlying credit demand decelerate
sharply.
We believe the balance of payments deficit as reflected in the
decline in foreign exchange reserves will continue to weigh on
RBI’s ability to bring down the cost of borrowing. Even as the
RBI has announced liquidity measures, the three-month AAA
commercial paper rate at 13-14% has continued to be about
400-500 basis points higher than its level during the quarter
ended June 2008. Similarly, while public sector banks have
recently announced 50-75 basis points reductions in lending
rates for mortgage loans, they have tightened lending
standards, reducing accessibility for borrowers. Private sector
banks have not cut their lending rates so far and even if they
were to cut their prime lending rates, we do not expect the
banking system to cut the effective borrowing costs for
consumers and corporate sector until the credit demand
decelerates sharply and/or capital inflows revive meaningfully.
Vicious Loop of Risk Aversion Already Unveiled
India has had an unusually strong credit growth cycle over the
last few years premised on large capital inflows. Outstanding
bank credit stock increased from just US$186 billion as of
March 2003 to US$638 billion by end F2008 (Y/E March). RBI
has constantly been initiating prudent measures to build
protection in the banking system against a reversal in the
growth cycle. However, we believe that a sudden dramatic
reversal in capital inflows at a time when the banking system
had been in one of the strongest credit cycles in history, a
major rise in non-performing loans in the banking sector will be
inevitable. Industrial production has already decelerated
sharply to an average of 4.7% during the three months ended
August 2008 from the peak of 13.6% during the three months
ended January 2007.
The risks are particularly high in real estate loans, unsecured
personal loans and small-and-medium enterprise loans. Our
conversations with real estate market players indicate that
many developers are facing serious financial management
challenges. Some are borrowing at 30%-plus to complete their
projects. Private sector banks already face a significant rise in
also have exposure to non-banking financial companies, which
in turn are also likely to face higher NPLs.
One of the areas that concerns us the most is the performance
of the SME sector. Its profitability has been hit badly. Hundreds
of SMEs have raised external commercial borrowings over the
past few years when the cost of borrowing in the international
market was very low. Some had not hedged the foreign
exchange risk or had hedged under 'knock-in knock-out'
(KIKO) agreements. Many hedges made under these KIKO
contracts are lapsing due to the sharp movement in the rupee
in such a short time span. This has meant that many SMEs
have seen foreign losses on external liabilities increase
significantly. SMEs are also facing challenges on their export
income due to the global demand slowdown, and the recent
tight global liquidity has meant that trade credit has also
become difficult to access. Lastly, the borrowing cost of the
SME sector has risen sharply. With AAA rated companies
borrowing in the commercial paper market at 13.4%, the SME
sector is suffering even from higher borrowing costs for its
short-term funding needs.
Cutting 2009 Growth Estimates Again
We believe that despite the measures initiated by the RBI, cost
of capital will remain relatively high even if growth has
decelerated sharply. A vicious loop of a tight liquidity
environment and rise in non-performing loans has been
unveiled. We expect the fixed investment cycle to reverse
sharply. Tight lending standards are likely to restrict consumer
loan growth and private consumption spending. In addition,
weaker global growth will also reflect in the form of a slowdown
in external demand. We expect export growth to decelerate to
-1.8% in 2009 from 15.9% estimated in 2008. While lower oil
prices should help reduce the current account deficit, we
believe that lower exports and remittance from non-residents
should offset a large part of this gain. Moreover, as we have
been already arguing, for balance payment outlook, capital
inflows are more important than the current account balance.
Building in weaker domestic as well as external demand, we
are cutting our 2009 GDP growth forecast to 5.8% from 6.4%
previously. On a financial year basis, for F2010, we are
expecting GDP growth of 5.7%, down from 6.5% earlier.
Can The Government Initiate Aggressive Fiscal Policy
Measures Like China?
The Indian government has been running pro-cyclical fiscal
policies over the last few years. In F2009, we estimate that
fiscal deficit including off-budget liabilities will be 9.2% of GDP,
one of the highest amongst large economies in the world.
Public debt to GDP after including off-budget liabilities is
estimated to increase 95.1% as of March 2009. Moreover, with
domestic liquidity conditions already tight, there may not be
much room for further increases in public expenditure. Indeed,
the RBI recently decided to redeem banks’ holding of
government securities under the market stabilization scheme
to provide room for the government to pursue its normal
borrowing program without tightening in domestic liquidity. We
believe the government could however try to increase
infrastructure spending through bilateral investment
agreements with Japan and/or Middle East countries. However,
we suspect the implementation of such an investment program
is unlikely to be quick enough to get the growth support in 2009.
The End Game is that Earnings Suffer
Our Equity Strategist, Ridham Desai, believes the BSE Sensex
constituents, in aggregate, have grown earnings five fold in five
years from Rs247 billion to Rs1215 billion – it is not incorrect to
call this an earnings bubble, in our view. Broad market earnings
have grown six fold between F2003 and F2008. Corporate
India is sitting on record margins, record financial income and a
high base of earnings. To top this, financial leverage has risen,
operating leverage is turning negative and asset turn is
dropping. If earnings were to fall in the coming quarters, it
should surprise nobody, in our view. We expect broad market
earnings to fall 20% in F2010 and ROE to decline from 22% at
its peak to 16% in the coming 18 months. The consensus is
currently forecasting 13% and 15% growth in the Sensex EPS
for F2009 and F2010, respectively. We think that these
numbers are likely to be significantly lower at around 9% and
-7.5%, respectively. In our bear case, we think earnings for the
Sensex constituents could fall 15% in F2010. Financials,
materials and industrials should bear the brunt of the likely
earnings weakness, in our view.
Gradual Recovery in 2010
We expect GDP growth to recover in 2010 in line with our
global forecasts. Our economics team expects global GDP
growth to accelerate to 3.6% in 2010. US and Europe GDP
growth is expected to rise to 2.1% and 1.2%, respectively. We
believe the improvement in domestic demand in 2010 will be
restrained by the fact that the banking sector will likely remain
