Government Has Limited Scope To Stimulate The Economy: Neelkanth Mishra
There is a limit to the government’s capacity to spend, says Credit Suisse’s Neelkanth Mishra
This week on Thank God It’s Friday, Neelkanth Mishra, head of equity strategy for India at Credit Suisse says it’s a good time to start betting on information technology stocks despite looking fears of H-1B visa regulation changes, given that these stocks have been badly de-rated. In fact, Mishra would pefer to stay away from domestic-focused companies, with the exception of interest rate sensitives.
Here are edited excerpts from the interview.
Your Outlook 2017 report says, ‘The momentous changes of 2016, both local and global, have not played out fully yet, and there continue to be significant policy risks and uncertainty’. Based on this view, where are you placing your investment bets?
I think the uncertainty for India is far greater than for Indian sectors that are exposed globally. There is a lot of global uncertainty. If you ask some of the global investors, they think that their policy risk coming out of Trump and Brexit and what could happen in China is actually much greater than what could happen here, at least in the medium term. As an investor, I would rather be in sectors which are not focused on India. We had cut Indian IT to deep underweight in September and we have upgraded it back. I do think that it can actually do well. It’s been badly de-rated. We have been and continue to be very positive on metals. Within India, we would rather be invested in beneficiaries of lower interest rates. So we like some construction names and also think that housing finance companies can be beneficiaries.
You said you have increased your exposure to IT. The pharmaceutical sector is facing the heat of Trump’s comments. Your 2017 top picks include IT names such as HCL Technologies and Tech Mahindra. Are these purely a valuation call?
On pharma, the concerns are manifold. A lot of the froth that had developed in the sector in terms of price earnings multiples over the last two years has corrected. But I think there are still a lot of structural issues. There is still a lot of consolidation happening on their customers – pharmacy benefit managers, insurance companies, pharmacies. There is a lot of fragmentation happening on the supply side. When I used to track the pharma sector 6-7 years back, there used to be a huge backlog of ANDAs (drug applications) at the FDA (U.S. Food And Drug Administration). Now they have expanded capacity and the pace of approvals is picking up. Which means there will be more competition for existing drugs which means more pricing pressure. The fact that the Trump administration is openly going after pricing for branded drugs; they are not really talking about generic drugs...but if branded drug prices fall, for the customers, it would give companies more incentive to cut generic drug prices also. That is yet to play out. So you have to be very selective in pharma. On IT, I do think that some of these stocks are very badly de-rated and I think a global cyclical recovery, given that global growth in 2017 is expected to be the highest since 2011, that’s a reasonable sign that 6-7 months down the line we could see IT earnings start to get upgraded. There is the risk of H-1B visa regulation changes and changes in import tax, but with these kind of P/E multiples, it’s worth taking the risk.
Budget 2016 had an estimate of nearly 12 percent growth in gross tax revenue. From April to December of 2016, we have seen gross tax revenue grow 22 percent. What does this mean for the upcoming Union Budget? Where will allocations be made? What would be a good budget for you?
The last question is a very tough one but we’ll come to that. Let’s discuss the revenue growth number. I think the issue this year even when the budget came out, we did say that the revenue number from the tax side were underestimated. There was a lot of criticism for the government on the non-tax revenues that they were over estimating those revenues and that is played out exactly like that. As of now we are running a shortfall of Rs 60,000 crore on the non-tax side. If the tax revenue keeps growing at 18 percent for the full year, we are talking about an extra Rs 60,000 crore so we are more or less there. Can the tax revenue keep growing at this pace? If you see some of the sub-components, service tax revenue is up 44 percent in November. It was growing at 16 to 19 percent in the previous three months. I can imagine the formal economy did not slowdown in November but it accelerated to the extent that 19 percent became 44 percent. There are various distortions that emerged in the economy due to the demonetisation exercise therefore I would not extrapolate that as a trend growth number going forward. So I think this year’s number should be okay.
There are multiple challenges for next year’s budget. It is going to be a very complex budget. There is going to be no plan, non-plan, railway budget is to be included, there is a likely mid-year start to GST so how are you going to present it? Are you going to assume excise and service tax for the full year or are you going to put a July1 estimate? Do you know if it’s going to be July 1? If you want to put GST, do you know the rates for each of the products? There is no idea. There is also likely to be some simplifications in the exemptions list. As the finance minister had mentioned a couple of budgets back that the headline tax rate is 30 percent but the challenge is that the overall tax paid is 23 percent. So they need to reduce exemptions and bring down the headline tax rate. So, some of those things are likely to happen.
I think the market focus will be on two things. First on what the headline fiscal deficit is, which given past experience and how the market responded, I don’t think the government will take too many liberties with it. There is an FRBM Committee review report which, as per newspaper reports, is going to be presented on Monday. It won’t be made public before it’s presented but the point is they may give suggestions which are to be incorporated in the budget and therefore we could see some tweaks. But in general, the deficit target could be between 3-3.5 percent of GDP. It cannot be less than 3 percent because it’s the target, it can’t be more than 3.5 percent because the markets may not like it. But the government has in the past relied on extra-budgetary resources so when you are talking specific expenditure i.e. national highways, railways, they could use a lot more of extra-budgetary resources wherever they have to give a stimulus. That is one on the fiscal deficit. The second one will be the revenue growth assumptions that the government makes. There is this belief in the government that there should be a lot of tax buoyancy because of demonetisation and expectation of GST. Now, do they go overboard with that? Some in the analyst community think that those things will happen but with a lag. That is the whole design intent of demonetisation and GST that is to improve tax buoyancy and compliance. But should that happen in the first year or in the first month? That is a bit hard to digest. Those are the two things which will matter the most for the markets. I think there is a lot of expectation of stimulus. Demand stimulus from the government and the budget.
My sense is that this whole process we’ve gone through in the last year or so and not just the last three months, I think there is a limit to the government’s capacity to spend. We all assume that we give them some money and things will happen. What we have seen on the road side for example is that all the Rs 70,000 crore that the NHAI had to borrow in terms of tax free bonds, not a single has been issued. So the fact that more roads are not getting built is not because of lack of money. The fact that the railways’ capex is not expanding is not because of lack of money. So there is a certain limit to which the government can stimulate the economy. That I think will be the critical factor in trying to assess what the government can do. And the government is aware of this and what the market expects.
Where are these challenges coming from? It can’t just be execution...
It is execution. The railways it seems, is struggling to scope out projects which are bigger than Rs 150-200 crore. Most of the projects are Rs 5-10 crore. You can move from Rs 50,000-1,00,000 crore annual capex with that kind of number but you have to double that number of projects. You have to move from 1 lakh crore to 2 lakh crore. You have to move to larger number of projects. With the same number of people you have to move to larger projects, you need to be able to outsource. If you can’t scope out more than Rs 150-200 crore projects, then how are you going to outsource? So beginning of the financial year, they expected to order at least 4-5 projects of Rs 400-500 crore. Middle of the year they said maybe that’s ambitious, let’s do 5-6 projects of Rs 200-250 crore. That is turning out to be very difficult. Over time it will happen. There are lots of structural changes being brought about in the bureaucracy, in the railways, and over the next couple of years you will see things change. But these are challenges which we cannot recover from quickly. There is a limit to how much land you can acquire. If you want to construct or if you want to order 25,000 km of projects, you have to acquire over 2.5 times the amount of land. Where are the people for that? So in terms of process maturity, in terms of availability of systems...like we discussed on the generics side, the FDA was designed to approve a certain number of ANDAs. And suddenly, the ANDAs started climbing. The FDA was short-staffed. They didn’t have the budgets. So they started using generic user fees. So generics companies started paying fees, they used that, they hired people, they trained them and five years later, the generic approval rates starts to pick up. Even in the U.S. it happened like that. How can you expect the Indian government to move any faster? Maybe they can. But as of now no.
The other event we are looking at is the state elections. UP, Punjab, Uttarakhand will be most critical. Have you worked out any outcomes for the incumbents and perhaps any impact on political stability and consequential impact on the markets?
I don’t think elections matter too much for the market. Of course, I need to stay informed because investors want to know. UP is a four-way fight right now, it is expected to be a three-way fight with Congress and the SP possibly joining hands. There is a possibility, in the first past the post system, unlike many other economies where everyone contests, if no one gets more than 50 percent of the votes, then the top two have a fight. In India that does not happen. So the voter has to think through the first past the post system. The last two elections, despite a quadrangular fight, have given absolute majority. So what happens is, in a multi stage election, there are waves. Whether the exit poll results are published or not, people get a sense of which way…and they all want to vote for a victor. So if in western UP, a certain party has swing voters swing towards them, then the whole state starts to swing towards them. I am oversimplifying but those are dynamics which are impossible to predict. And therefore, I am staying away from any prediction on this election. All I can say is if the BJP does very badly, then there will be a chance of the Opposition starting to consolidate which can make things difficult in Delhi. If the BJP does very well, then the wind goes out of the Opposition’s sails, then possibly in Delhi, policymaking becomes a bit easier. Those are two extreme things. I don’t think that’s going to happen. It will be somewhere in the middle. I suspect there may not an absolute victor, that’s more than 200 seats. It will be interesting to watch.
What is your early assessment of the impact of demonetisation given that we have some solid data out now. Some experts say the recovery will be sooner than expected. Doesn’t seem like you hold that view because you are expecting 2017 to be very rocky.
India’s economy is very complex. I don’t claim to know it all. I am envious of people who can predict based on monthly data. We have been advising investors to look through this period of volatility. The question is once the currency situation is normalised, what is it that we are going to see. Is the economy going to be back to what it was on November 8? That is call that I can’t take right now. Because the data is very distorted. A lot of laundering seems to happened through service tax. There was perhaps some distortion in cement sales. December cement sales were very bad possibly because November sales were okay. Car sales were very good in December but that’s possibly because November sales were very bad. Some microfinance companies saw substantial recovery in recovery rates. But then they stalled at 91 percent. In one month they have not moved beyond that. So if they stop at 91 percent, that is terrible. Because a large part of their book value will have to be written down. So I think it is too early to take this call. And I would rather look beyond.
I think some of the recovery is already started. We are seeing factories are re-starting. Some of the reverse migration workers are starting to come back. In the perishable supply chain such as chicken, milk, vegetables, as also hosiery, stainless steel utensils, all the cash-based supply chains, end demand is not a question. People are not going to stop using stainless steel utensils or stop eating chicken. So point is that stays bound to recovery. Now what is the lasting implication. Lasting implications will come through the real estate market where things are still abysmally low. So all the data points are suggesting that registration rates have come down, people are in what you call a classic buyer strike, people expect prices to come down. If prices fall there is a negative wealth effect. If people don’t buy...a lot of money used to be parked in real estate. Even if someone is able to regenerate, and I think it will be a problem for next year. Suppose they have solved the problem, they will be able to get their bribes, they are not going to put a hit me sign on their head and say let me buy some real estate now. They know the government is scrutinising that. It is conspicuous consumption. So real estate demand in terms of volumes is going to be slow in the coming year. It is terrible because that means there is no construction. Who is going to build houses if there is no demand. So that’s bad for cement, steel, construction labour, downstream home improvement. If prices fall, it is bad for wealth effect, consumer discretionary. That is 13 percent of GDP. So that is what I am worried about. I haven’t heard any anecdote which says that real estate is starting to boom again. Then the banking system...
In this period of uncertainty, where you have significant global uncertainty. You don’t know what Mr Trump will do. Many of his cabinet or appointees seem to be committing to things which he has opposed. So we don’t really know what this government is going to do. Brexit is going to get triggered. We don’t know what is going to happen to Chinese stimulus post the plenary elections. So there is tremendous global uncertainty. We don’t know what the real impact of demonetisation is. We don’t know what is going to happen when GST starts. We don’t know what rates of GST will apply to my sectors. Why would I invest? If that is the case, where is the loan growth going to come from? If you’re the banking system, and the banking system is a very large part of the market and of the economy, if you don’t see loan growth and here the largest competitor in the market is taking the battle on pricing because they clearly realise that there is not going to be loan growth in the coming year, it is already quite bad, it is going to be worse perhaps. And you can only compete in the retail market on price because you cannot compete on service. The private sector banks are doing better there. This is a race to the bottom. So your margins are getting squeezed, your loan growth is weak, your asset quality problems are not really behind you, you have recognised many of them but you have not provisioned for them adequately. A weak banking system, a weak real estate market and the unorganised to organised transition that people are talking about, which I think is likely to happen, will not be without pain. The guys whose supply chain gets shut down are going to take a few quarters to find new jobs. So this is an important transition. I compare it to the refurbishment of a house...it takes 3-4 months. And while it is getting done you are unsure whether the contractor is really going to deliver what he’s promised. If you are in the market, now I can tell you that this is all very great in the medium term and I do think for 12-18 month prospective this is going to be great. Because tax goes up, more formalisation, better competitiveness, better access to credit, more data to work with but who is going to tell that to the investor? Have patience. That is why it will be turbulent for the market. So I am not really focused too much on how soon the revival happens because it is bound to happen. If currency doesn’t normalise in January, it will normalise in February. And things will come back. The question is what happens on a 12-month basis. That is where the concerns are.
What are your thoughts on the entire bad loan resolution process?
It is not easy. The bad bank has been discussed for almost two years now. We haven’t seen the government make much progress on it. Maybe deliberately. I think the problem was much bigger a year ago in that the size of the problem kept growing. A steel company, and I will not name it, if the banks had taken a scalpel to it would’ve lost Rs 3,000 crore. If they’d taken the scalpel to it in 2016 by March-April, it would’ve lost Rs 25,000 crore. And they kept lending to renew loans. I almost had a hallucinatory conversation with the CFO in 2014 where I said ‘I think there is a problem with your cash flows, how will you pay interest?’. He said, ‘No, we get loans to pay interest’. I was stunned to see that I don’t know how my economy operates. So those things have stopped.
With the AQR (asset quality review) and the recognition of bad loans, at least the size of the problem has stopped growing. Some resolution is important because there is a lot of capital stuck here, there is a lot of banking attention that has been diverted to handling these issues on a daily basis, a lot of the large corporates are also stuck. They are unable to do capital expenditure because they are still resolving some old issues. The problem is any resolution will require taking some more political risk because you can’t solve this problem without making a judgement call on letting promoters retain control. If you force them to lose control then there is a bigger problem, you’ll suddenly be criticised that all these steel plants and power plants are being run by the bankers who don’t know how to do it. Crazy things can happen. What is the risk? Believe it or not, nominal GDP growth is in double digits and once this thing is done and the cash situation normalises, the economy would most likely not feel as pained and turbulent. Why would you want to do it? The political risk is perhaps too high. While as an analyst I may think it is important, it is just too uncertain. And who is going to resolve it? Do we have a set of people, like in the developed world, let’s say, where you put steel assets for grabs and auction and some professional raises capital and then comes and takes over control? Do we have them? We don’t. You can’t really auction these bad assets so you have to let them retain control and there’s a huge moral hazard there so why would the government want to dirty its hands? In terms of systemic risk, the fear can be that if you don’t do this then the banks can fail, because these are all PSU banks anyway. Some of them have been reporting huge losses. No one is afraid putting deposits there. So in a way, this is already nationalised. It’s a giant bad bank, it’s just that it’s an inefficiently run giant bad bank in the sense that there are too many entities and therefore the resolution of the problem is much more dragged down and protracted. But from a systemic risk perspective, I don’t think it’s that high. Therefore, and I don’t know what the government is thinking, but my sense is that there will not be too much active stuff on this.