CLSA: Rupee Depreciation The Biggest Risk That May Force An FII Sell-Off!

It would be tempting to conclude that, if foreigners have not sold now, then they are never going to sell. But with GREED & fear's base case still being a "euroquake", that is too complacent a conclusion. Meanwhile, it may be the case that a currency-triggered market panic is what the Congress-led government needs to wake up and address the challenge to India's growth in a more proactive fashion.

 

The bad news is a lack of action so far in what is probably the biggest infrastructure issue in India right now. That is the lack of progress on energy. Thus, as one speaker told Forum attendees this week, energy consumption is growing at a rate of 6-7% annualised whereas domestic sources of energy are growing at a rate of only 2.5-3%, resulting in a continued reliance on imported energy.

 

The main explanation for this deficiency is the lack of the necessary incentives for private capital given that the cost of coal and natural gas within India is still about half world prices. The power issue is, therefore, a growing constraint on growth.

GREED & fear assumes, as is traditionally the case in India, that the more media noise generated on this issue the more likely action will be forthcoming. Still for now it is not really possible to point to dramatic concrete action taken.

Indeed the most effective GREED & fear has been made aware of this week has again been an initiative by the RBI, which in September told the banking sector to stop lending to loss-making state electricity boards (SEBs) unless they raised tariffs. The purpose of this move is to put pressure on the state governments either to provide more funding for the SEBs out of their own budget – remember India is a federal system – or to raise prices. 

If the above are the issues, they are also largely reflected in the stock market. Consumption stocks have performed dramatically better than the likes of bank stocks or infrastructure plays during the course of the 20-month-long monetary tightening cycle. Thus, the BSE Consumer Durables Index and the BSE FMCG Index have risen by 46% and 48% respectively since the end of March 2010 following the first interest rate hike, while the BSE Bankex Index and the CNX Infrastructure Index are down 2% and 27% over the same period. This reflects both the buoyant rural economy, courtesy of rising income growth, as well as the weakness in investment and related concerns about NPL risk in the infrastructure lending area, most particularly again in the energy sector.

 

For the reason that much of this is by now discounted.

  

GREED & fear would advise against becoming too bearish. Indeed the more the investment data weakens from here the more will the political pressures grow to do something about it. Still GREED & fear would recommend a barbell strategy where positions are maintained in the highly rated consumption sector while building investments in the relatively depressed banking and infrastructure area. The reason to build positions rather than jump in aggressively is two fold. First, there is the likelihood of rising asset quality problems in the banking sector. Second, there is the probability, sooner or later, of renewed Euroland risk aversion.

 

That same external risk issue also raises the issue of the rupee which so far in 2011 has been Asia's weakest currency. Thus, the rupee has depreciated against the US dollar so far this year to Rs52.73/US$.

GREED & fear was interested to hear from CLSA's India economist Rajeev Malik that the RBI has been running a predominately hands-off policy towards the currency since 2010. Still this raises the risk of a sudden drop significantly beyond the 50 level should a renewed wave of Eurozone-triggered risk aversion lead to a deleveraging driven US dollar surge.

The point to be aware of here is that Indian corporates have increased their borrowing of dollars during the recent monetary tightening cycle because it has meant cheaper funding, as well as because some of them have had foreign acquisitions to finance.

Thus, total external commercial borrowings have risen by 48% over the past two years from US$63bn at the end of 2Q09 to US$93bn at the end of 2Q11. Still a reassuring point is that accounting rules now require companies to take currency-related losses through their profit and loss accounts on a quarterly basis.

 

The potential for rupee weakness is also clearly driven by India's perennial current account deficit. Thus, India's current account deficit rose from 0.4% of GDP in FY05 to 2.6% in FY11 and is expected by Malik to rise to 3% this fiscal year. This is not an issue when growth is robust and risk tolerance is high. But with renewed external risk aversion likely sooner or later, at a time when there is a question mark on Indian growth for domestic reasons, there is clearly every reason for renewed currency weakness.

 

This raises the issue of India's dependence on foreign capital, and the related large proportion of that foreign capital comprising potentially fickle foreign portfolio equity investment rather than FDI. Thus, the capital account surplus was US$60bn in FY11, with US$30bn in net portfolio investment and US$7bn in net FDI. On this point, foreign institutional investors bought a net US$24.3bn worth of India equities and US$7.9bn of Indian debt securities in FY11.

 

This is why one of the amazing features so far this calendar year has been the lack of net selling by foreign equity investors given the deteriorating external environment and the relative underperformance of India within the Asian ex-Japan context. Indeed foreigners have, remarkably, been net buyers of US$800m worth of Indian equities year to date, after having bought a net US$29bn in 2010.

Moody’s changes India banking system outlook to negative

Moody's Investors Service has changed its outlook for India's banking system to negative from stable due to concerns that an increasingly challenging operating environment will adversely affect asset quality, capitalization, and profitability. 

"India's economic momentum is slowing because of high inflation, monetary tightening, and rapidly rising interest rates. At the same time, concerns have emerged over the sustainability of the recovery in the US and Europe, and the rise in the borrowing program of the Indian government, which could drain funds away from the private credit market," says Vineet Gupta, a Moody's Vice President and Senior Analyst.

Gupta was speaking on the release of Moody's latest outlook for the Indian banking system, and which he authored along with other senior Moody's analysts. The outlook applies for the next 12-18 months.

 Moody's rates 15 commercial banks in India, which together account for about 66% of the system's total assets as of March 2011. The system is dominated by public-sector banks, which account for around 75% of the market in asset terms. The weighted average stand-alone banking financial strength rating (BFSR) is D+, and mapping to a Baseline Credit Assessment of Baa3. The average long-term deposit rating is Baa2/Prime-2. 

"With asset quality, given the tightening environment, we anticipate that it will deteriorate over the next 12-18 months, thereby causing an increase in provisioning needs for the banks in FY2012 and FY2013," says Gupta. 

"Meanwhile, with capitalization, we expect loan growth to be a strain on the banks' capital over the horizon of this outlook. As monetary conditions tighten and economic activities slow, we expect bank loan growth to fall to 16%-18% in FY2012 and FY2013, from 21% in FY2011," says Gupta.

Reliance KG-D6 output dips to yearly low

Natural gas production from Reliance Industries' showpiece KG-D6 fields off the East Coast has declined to a one-year low of less than 42 million standard cubic metres per day.

The Dhirubhai-1 and 3 gas fields and the MA oilfield in the KG-DWN-98/3, or KG-D6, block in the Bay of Bengal produced about 41.68 mmscmd of gas in the week ending October 30, according to a production report filed by the operator (Reliance) with the Oil Ministry here.

The current output is a far cry from the 61.5 mmscmd level achieved in March last year and the production plan of over 70 mmscmd for 2011-12.

The Dhirubhai-1 and 3, or D-1 & D-3, fields produced 34.71 mmscmd and the remaining 6.97 mmscmd came from the MA oilfield during the week under review.

Reliance, the report said, has shut four wells due to high water ingress and sanding issues. Current output is from 14 wells out of the 18 wells drilled and completed so far in the D-1 & D-3 fields.

The MA oilfield currently produces an average 13,071 barrels of crude oil per day.

The report said 14.06 mmscmd of the gas output is being sold to fertiliser plants and 24.29 mmscmd to power plants.

The remaining 3.3 mmscmd is consumed by other sectors, including gas transported through the East-West pipeline from the East Coast to consumption centres in the West.

Reliance had projected an output of 41.50 mmscmd of gas in the first week of November.

As per the status report, out of the 22 wells planned in in Phase-I of D-1 and D- field development, 18 wells have been drilled and completed so far. Of these, 14 wells were put on production, while four wells were kept closed due to high water cut and sanding issues.

Minister of State for Petroleum and Natural Gas RP N Singh had in August informed Parliament that output from KG-D6 was short of the 70.39 mmscmd level envisaged by now as per the field development plan approved in 2006.

While Reliance holds 60 per cent interest in KG-D6, UK's BP Plc holds 30 per cent and Niko Resources of Canada the remaining 10 per cent.

Reliance started natural gas production from the KG-D6 fields in April 1, 2009.