This week on Thank God It’s Friday, we spoke to Rashesh Shah, chairman and chief executive officer of Edelweiss Financial Services on the trajectory for Indian equities in 2017, how he expects the impact of demonetisation to play out over the next few months, and when normalcy could return to the system.
Here are edited excerpts from the interview.
In the first few days of 2017, we’ve had a lot of data including automobile sales, Purchasing Managers’ Index among others. What have you made of all these data points considering demonetisation?
For a lot of industries, October was fortunately a good month. But in the 3-4 weeks after demonetisation, everybody was in a bit of a shock. Everybody was trying to adapt to that but in the last 3-4 weeks of the year, we saw things creep back to normal in a lot of industries. It’s very hard to say because one, there is a lot of anecdotal information and not real quantitative information. But it appears that about 85 percent of normalcy has been restored in December. There was a gap of 3-4 weeks when things slowed down. Our estimate is that remonetisation i.e. getting the currency back in circulation, should happen by the end of January or the middle of February and then another 4-6 weeks after that, by the end of March (2017), we should see normalcy return. The good news is after such a big change, such big disruption, people have adapted. Business has come back to normal. We have not seen huge price rises, shortages or big protests. People have accepted it, they have gone about their businesses. There has been pain and inconvenience. But for me, it is a very gratifying outcome. This is very good for the formal financial services, with banks cutting rates because there is a lot of liquidity which comes into the formal financial system. It has come into the banks and it will eventually go to mutual funds and insurance companies and that is all very good for the economy.
‘Normalcy Returned Quicker Than Expected’
So all of these data points have been more or less in line with your expectations. No positive or negative surprises?
Positive is how quickly normalcy has been restored. Initially a lot of people thought it will take 5-6 months or maybe even a year. And you know what happens to businesses like SMEs or even entrepreneurs if the disruption is for a couple of months, for two or three months, people can absorb it. They have enough cash flow cushion, they try and manage perhaps by cutting some discretionary expenses but they manage it. If it goes on for a year then the pain becomes very real. Then it starts going deep. People start making structural changes. And that is why we see people losing jobs. In a way, the fact that this has appeared to be very short lived is good news.
We don’t have official figures from the RBI yet but there are estimates that 95 percent of the demonetised currency has been deposited back into the banking system. What does this mean for the economy and the fruitfulness of exercise?
The moment the government introduced Income Declaration-2 (IDS-2) that is you pay 50 percent and declare it, it was more or less a given that the money will come back. Because if you have the money, even if it was accounted for, either you will declare it under IDS-2, and we will see that after all this is over, or you will deposit it and then there is a risk of an inquiry then you pay the price for it. But it was more or less certain to all of us that when the government announced the scheme, a lot of money was going to come back into the system.
I don’t call that a way to decide if demonetisation was effective because once you announce the scheme, it will come back. The impact will be judged based on whether the government’s tax revenues go up. That is important. Second, how much is the currency requirement for the economy? Earlier we had Rs 18 lakh crore of overall currency, out of which Rs 15 lakh crore got demonetised. The Rs 3-4 lakh crore which was lying in cash outside the system is now in the banking system and it should stay in the banking system which is very good thing. Even that would be effectiveness of demonetisation because you require much lower level of cash currency to keep the economy going. As I said, the government’s income tax revenues will go up. A lot of informal businesses will enter the formal sector. The third one would be the digital payment take-off or what we call the ‘cashless’ or ‘less cash’ part of the economy and how that is growing and that is also growing well. It will get a one-time bump and now it will start growing since a lot of people have got used to this. So overall, these are good outcomes. There are quantifiable costs like reprinting etc plus the pain and inconvenience and the loss of some output we lost for a couple of months but overall on cost and benefit analysis, the benefits should outweigh the costs for sure.
Demonetisation Impact On NBFCs
Financial services companies have taken the biggest hit as a result of the note ban. Edelweiss offers an entire gambit of financial services. In your assessment, how do you think the business of NBFCs have been impacted and has the recent correction in some listed NBFCs bought them to compelling valuations?
There has been a lot of positive development for NBFCs out of this. On the positive side, the fall in interest rate, the increase in liquidity is good for NBFCs because they also borrow money. They also need liquidity. So I think that has been a good thing. On most of the asset side of NBFCs like housing, LAP (loan against property), and even SMEs (small and medium enterprises), have not seen much collection problems. The microfinance segment of NBFCs have had some shortfall in collection. They are at about 80-85 percent of normal. But housing and LAP have been normal. What you have seen over the years is housing, LAP, all the asset-collaterised part – which is largely our business – I think for the next 2-3 months people have cash flows to keep servicing their obligations. If it goes on for a long time, then it starts becoming a problem. So overall on the asset side, there has not been much deterioration in portfolio quality. On the growth side, disbursements have slowed down. So even in our case, in our retail book, disbursements in November and December would be about 70 percent of normal. Because some customers who wanted to borrow money said we will wait and watch. We also held back for some industries like real estate and construction. So given all of that, we will see the growth in the book size come down. What has also happened with NBFCs, especially housing finance companies, have corrected a lot because now there is a price war that has started after SBI introduced a new interest rate and all. So it is expected that there will be a price war in the housing finance segment, in the home loan segment. In a way, it will be good because it will help the segment grow but for some, yields will come down. I think broadly for NBFCs, even if yields come down on their asset side, their borrowing cost will also come down. So NBFCs will not be affected much on that part.
Challenges For ARCs
Yours is the largest asset reconstruction company in the country and Edelweiss has been betting big as far as the stressed assets business is concerned given the pile of debt that we have seen in the economy. What are the challenges in the asset reconstruction space that you are seeing right now?
I think one of the challenge in an ARC business is aggregating the debt. Because usually on a normal stressed case scenario, there are anywhere between 4-5 to14-15 banks involved and they all will sell their debt individually. You can’t really restructure and revive a company unless you control a large part of the debt because then you can restructure it comprehensively. So aggregating debt is a first problem. Second, expectations between the promoters and us as the ARC in terms of what is a good restructuring. Because everybody tries to optimise, everybody wants to maximise. The third larger problem is even when you work out the revival program, the companies need cash. They need banking facilities to come back and usually in India once you are in NPA, for 2-3 years after you are out of being in NPA, you don’t get any bank facilities easily. So how do you survive for those, so it becomes a chicken and egg situation. You were NPA, you got restructured, now there is scope for revival, there is a plan for that. But in order to execute that plan, you require some amount of cash from the banking system. Sometimes you need non-fund based limits like performance guarantees from the banking system, which are hard to get. So I think that is another challenge that we don’t feed companies which are on their revival path. Because once you have been tainted with NPA, it takes you 3 years of good performance before everybody will say you are a normal company again. But how do you survive for those 3 years? How do you execute? So that is a problem. There are ways around that and also expectations of the banks when you are buying assets from the bank. As an ARC, you want to buy it at a realistic price. So you and your investors can make returns.
The other key challenge has been on the funding side because now the amount of money required for acquiring stressed assets and reviving them is huge. Fortunately, we have this partnership with a Canadian pension fund called CDPQ which has allocated Rs 5,000 crore. So we have our own balance sheet, we have their money, we have couple of other funds also. So we have taken the funding part of it out of the equation. And I would say at this stage, over the next 3 years, we have about Rs 10,000-12,000 crore that we can allocate for cash for acquiring and reviving stressed situations. And the last thing you need in this business is patience. Everybody assumes that stressed or an NPA account can be revived and recovered in 18 months. That cannot happen. It takes 4-6 years. Because when you acquire, aggregate the debt, restructure, work on the revival, give the resources and when the company becomes normal you get it refinanced, or bring a strategic partner. It takes 4-6 years. And it requires a lot of patience and hard work.
Does India Need A Bad Bank?
Any thoughts on the idea of a bad bank?
I don’t personally think that the bad bank idea is a great one because what will happen is it will need a lot of funding. So either the government will have to give the funding or the banks themselves will have to give the funding. Historically, this has not been the most efficient model. Currently the problem is not of funding. We ourselves are about Rs 10,000-12,000 crore, a lot of other funds are looking at India; a lot of capital is available. But that capital needs to earn a return. To earn a return, it has to buy assets at the right price. Then it has to restructure them smartly. And then it has to provide enough resources for the company to grow again. And then it takes you 4-6 years. So you need money that will give a good return over 4-6 years. So if you have a bad bank, you will solve the problem of cleaning up the bank’s balance sheet. But it will come at a cost. Somebody has to fund it. If you do that in a hurry, then the onus on banks and ARCs to revive will go away. Because then it will become a parking place and you will just park them out there. Currently we are at a very good place in India where the banks are very focused on saying how do we recover money out of this – we sell to ARCs, we restructure, we do other things. So this onus on banks, ARCs is very important. If you create a bad bank and just park that you have cleaned this up but you have taken this and parked it somewhere else. It is not going to get revived automatically. The reason to do that is if all the bad assets are holding back the bank from their growth. But currently the credit growth is anyway very low. Banks are not short of liquidity, so it is not like these assets are not allowing them to provide more credit. Banks are flushed with liquidity. I would believe that with demonetisation and the kind of liquidity that the banks have, the need for a bad bank is gone away. The problem is not liquidity. The problem is the skill in restructuring and reviving which should stay as central as possible. Once you put it in a parking place, then that onus will go away.
Union Budget Expectations
What would you like to see in the upcoming Union Budget?
After this entire demonetisation move, there has been a lot of inconvenience, especially for rural India, and for the middle class. One of the most important things is some sops for them, and for rural India it is already expected after the prime minister’s address. For the urban middle class too, especially the salaried section earning between Rs 5-15 lakh, should get some income tax relief by increasing slabs and reducing tax rates. Reduction of tax rates for the urban middle class would be an important part. Third would be the government’s investment program, especially for infrastructure, because after this we need to kickstart the economy. We all know that private sector investment is not going to start in a hurry. Our expectation is that private sector investments are at least a year away. This year, the government will have to kickstart the investment cycle because that will release money in the hands of the people, which will start consumption. Lastly, the finance minister had announced that they’ll bring down corporate taxes by FY18-19 to 25 percent. This would be a good year to start that reduction, maybe remove the exemptions, but start cutting back the corporate rate. All these to me would be very important.
‘Select Infrastructure Stocks Look Attractive’
Is this the right time to turn bullish on infrastructure stocks?
After the government announced new arbitration guidelines on road projects, I think there were a lot of opportunities for the EPCs and the road construction companies. The new S4A is also a good opportunity to look at stressed companies which are going through some restructuring. All of these are good ways to revive these companies. A lot of these companies have positive cash flows, positive EBITDA, but they have unsustainable debt. So I would agree with you, I think that part is an interesting one to look at. Instead of going for the sector as a whole, being company specific is very important. Each company has their own balance sheets, management capabilities. We would be fairly bullish on infrastructure companies. Already the bad news is out there, they’ve all struggled, a lot of them have stressed assets, but all that is in the price. Now restructuring will happen, revival will happen, and new orders will come in. There should be more positive than negative news on these companies.
Prefer Domestic-Led Themes?
Is it fair to assume that there hasn’t been much change in your portfolio allocation after demonetisation? Does your preference for domestic-led themes still continues?
Absolutely. I think India’s growth is not under threat on a long-term basis. Growth may be hit for a quarter or so because of this disruption. That is now expected, and a lot of people have started building it into the price. On a long-term basis, consumption and the supply-demand equation that we have, with a thriving middle class, urbanisation, young population, people are buying cell phones and cars, and that will start again. By March, I expect all that to come back to normal. I would agree with you that a lot of India-related themes should continue to do well. The only caveat, or the only other thing I would add is that the U.S. economy is also coming back in a good way, and there will be some positive export-related opportunities coming about. Exports has not grown for the last 4-5 years. There could be time for that. Also, if you look globally, oil prices are up again, commodity prices have come back, cyclicals are making a good comeback. Some of the steel companies and other commodity-oriented companies are also not bad given a good price price. I think there’ll be good opportunities across the board – whether it is in cyclicals or infrastructure or stressed companies which are going through restructuring, financial services because of the growth of the formal economy, and maybe some of the export sector. After 3-4 months when this quietens down there should be a lot of opportunities for investors.
What is your view on the dollar, and how will it impact India?
The U.S. dollar hardening has been one big drag for emerging markets. This is because U.S. interest rates are going up, and as long as that happens, it is hard for the dollar to fall. The U.S. dollar will strengthen for sure. I think the rupee should weaken a little bit, which will be good for us because our exports will become more competitive. In fact I am of the view that rupee should be about 70 or 72 in a year’s time which will restore our export competitiveness as we go along. All the other emerging market currencies are also falling. So the countries competing with us in exports, their currencies will also fall. On the whole, I would think that the U.S. dollar will strengthen. Indian interest rates will come down a little bit, which will give an impetus for the rupee to weaken a little vis-a-vis the dollar because U.S. interest rates are going up and Indian interest rates are coming down.