Nilesh Shah of Axis Direct believes India is at the cusp of losing its investment grade rating. India's sovereign credit is rated BBB-, the lowest level for investment grade bonds. The higher the level, the safer the debt, and the cheaper it is for India to borrow from abroad. India runs a current account deficit and sometimes needs foreign capital to meet government obligations. "We are in a scenario where there is a task cut out for the government and depending upon what actions can be taken as quickly as possible we will determine whether markets can continue to hold onto current levels or not," Shah says adding, the markets are still hopeful of a rate cut. However, he says, it is no longer a consensus view anymore.
"There will be some amount of money necessary to be spent over food grain release -- over drought related relief work. So these things will have an impact on the fiscal side and which probably will not give enough firepower or enough elbowroom to the RBI to cut rates in a hurry," he believes.
The rally so far witnessed in our markets is more of a liquidity-driven rally, essentially global risk-on trade has been helping India year to date, feels Shah.
Below is the edited transcript of his interview to CNBC-TV18.
Q: There is a wall of liquidity which has kept our market afloat, but do you think the macro underpinnings are getting weaker?
A: Definitely, India is the highest receiver of FII flows in the whole of Asia and that partly explains why the markets are holding up. The markets are today pricing in lot of optimism about actions from the government to control the macro environment, but the odds are quite challenging. Poor monsoon, consequent drought potentially and political compulsion on raising diesel prices could have an impact on fiscal deficit.
The rating agencies have also started sounding warning bells about a potential downgrade and we are right at the cusp of just above junk rating into the investment grade.
One more downgrade could potentially move India into the junk rating, even though there is no imminent danger of defaulting on any foreign obligation whatsoever. So we are in a scenario where there is a task cut out for the government and depending upon what actions can be taken as quickly as possible will determine whether markets can continue to hold onto current levels or not.
Q: We have heard some positive noises but we nothing concrete is seen on diesel prices and fiscal consolidation. Do you think FM comments will be enough to arrest the downward momentum that we seem to be seeing now in the economy?
A: In the last six months there has been a fair amount of disappointment from FDI in retail, diesel price hike or pushing through some of the actions on the GST or GAAR for both the markets as well as the economy. If we convert some of this into positive expectations, then clearly there will be some amount of momentum building up and one will buy some more time to push through the difficult things.
Probably, GAAR, retrospective amendment of taxation loss, divestment, all these are easily achievable targets. There will be hardly any opposition for the same and that gives you breathing space to push through FDI in retail or GST or diesel price hike. Market may give time for this type of difficult to push through reforms provided some of the lose hanging fruits are covered.
Q: Inflation number will be out tomorrow and a GDP reading at the end of this month. Do you think these numbers will give the central bank any room to move on interest rates or do you think that in the near term is no longer a trigger for the market?
A: A rate cut will be a positive trigger for the market. Markets are pricing in some amount of rate cut, not a very solid expectations. However, looking at the current fiscal situation an emphasis which RBI has put on in reduction in fiscal deficit before rate cut can happen, probably the inflation and the GDP number are not going to give sufficient firepower for RBI to cut the rates.
They will be focusing on fiscal consolidation which is not immediately on the horizon. Drought has also worsen the fiscal deficit situation. Some money will be necessary spent over food grain release, over drought related relief work which will impact the fiscal and not give enough firepower or elbowroom to the RBI to cut rates in a hurry.
Q: Do you think it is liquidity playing tricks with prices or is there any fundamental reason for the market to be where it is today?
A: A substantial portion of the current rally can be attributed to liquidity, there are two sets of liquidity, one is the domestic, second is international. Domestically, liquidity is not coming to our market because people are saying 'India is growing at 6-6.5% against potential of 8%, we don't want to invest in this market.'
Domestic liquidity is also saying that 'look I am making far more money in gold, real estate and bank deposits, why should I come and take the pain of equity market?' On the other side, global liquidity says that ‘the world is slowing down. Even mighty China with all the support of monetary and fiscal policy is coming down from 10% to 7.5% and under such scenario 6-6.5% of India doesn't look too bad, let me go and put some money over here.'
These are the two opposite views on the domestic liquidity versus global liquidity and that global liquidity of USD 11 billion plus have supported the market. One more important thing is that there is hardly any supply from the primary market and that also is helping to stabilize prices at current levels. Had there been a supply of IPO, QIP and rights issue which corporate India needs, then certainly prices would not have been able to stabilize at current level. This rally is liquidity driven.
Q: But could that change with the supply of paper which the government is lining up in terms of offerings from SAIL , BHEL in the coming weeks?
A: The buzz of divestment had begun in 2003-2004, and Maruti Udyog Ltd IPO acted as a catalyst in changing the sentiment towards the equity market. PSU divestment will kill two birds with one stone. One, it will help in reducing the fiscal deficit. Second, if the pricing is correct, it can attract domestic liquidity which then can compliment the global liquidity. So a lot will depend upon how correctly these divestments are done in terms of pricing and changing the sentiment.
If the whole approach is like what happened with the largest oil company's offer for sale then certainly that will not help the market. But if the issue is correctly priced and use that as a catalyst to bring the domestic liquidity to compliment international liquidity, then certainly this can be a turning point like Maruti IPO in 2003-04.
Q: Do you think the retail mood will change any time soon?
A: Retail mood will change towards equity either by default or some design. In terms of default, we have to hope and pray that after 10-12 years of continuous positive return in gold and real estate, at some point of time law of average will catch up with them. And then by definition some money will shift towards equity. Obviously, that's not the best approach.
The design will be to bring quality issues at right price to the market and give pleasant experience to investors. In 2003-04 Maruti IPO, where one good company at a great price turned around the sentiments of retail investors and laid the foundation for next four years bull run.
Now there were many other things which worked and sustained that bull run but one of the catalyst was certainly experience of Maruti Suzuki IPO which brought investors into the market. Now, can we line up couple of companies at right price which will give positive experience to retail investors and then other things will automatically start falling in place. Till such time we can create right quality of company and right pricing, it is unlikely that investors will come to the equity market on a sustained basis.
Q: Do you think it is possible for the government to do that because the list of divestment candidates that they are putting out are all listed companies so the Maruti IPO experience is not possible. They may do a follow on public offer. That too, with stocks which are trading at multi-year lows like SAIL and BHEL. Do you think it is possible that the government can give a huge discount to an existing market price on a beaten down valuation to excite the market?
A: The positive way to look at it is that if these companies were issued at the peak of their business cycle, then certainly there would not have been any scope for investor appreciation. Now they are coming at the beaten down valuation and at the bottom of the business cycle. SAIL has been suffering from drop in steel prices as well as iron ore demand and that is reflected into its prices. Probably, from here onwards can SAIL in terms of intrinsic value be far higher than what it is to the provided business cycle support? The answer is yes.
Now BHEL and SAIL will not be that kind of catalysts which can give immediate appreciation and which is why you need to give a discount to their fair value and that hopefully will give immediate return to the investors on listing and then the business cycle will take over. Both of these are blue-chip companies and over a period of time there will be sustained return. So unlike a Maruti IPO which gave immediate return to the investors on a sustained basis, here will have to probably depend upon little bit on the business cycle.
But if we can line up some other companies which are probably not listed to the stock market but where there could be potential of immediate gain on listing as well as sustaining them then this whole combination of things, couple of listed companies, the FPO, couple of unlisted companies IPO, consistent quality issues coming at right pricing will give confidence to the investors to come back to the primary market.
Q: There has been lot of disappointment and despair last week over asset quality of PSB; SBI did not have any great communication on asset quality last week. Would you buy into that space or do you think the NPL cycle will stretch out much longer?
A: If we see the result season which is coming to an end for the June quarter, in the large cap companies there is some amount of volume and profitability growth. But on the broad basket there is a huge amount of disappointment because raw material and interest costs have increased and that has impacted margins and profitability on a negative basis.
If we include the oil companies into the basket, the drop in profitability is fairly severe. All these things are reflected into the nonperforming assets for the banking system. The only positive side of this cycle is that, these are all liquidity issues rather than credit issues.
Certainly, some of the projects have been delayed in infrastructure, power, telecom side but a lot of it is liquidity related issues rather than credit related issues. The monetary policy has been tight since May 2010 and that is reflected into this. At some point of time if liquidity can come back into the economy, then some of these problems will start easing off.
Market was hoping that NPAs would have peaked out last quarter, that has not happened, and even in this quarter the level is rising especially in public sector banks and that is reflected into their prices. We should wait for liquidity to return back to the economy and then we will see a revival in PSU banks valuation.
Q: What about interest cost? You are correct that company after company over the last couple of weeks have reported big margin compression because of the way interest costs have gone up, do you see a way around that any time soon because cash flows are not great, equity capital seems to be constricted for now, access to the equity market and interest rates are not going to go down dramatically in a hurry. What is the way around this interest burden problem?
A: Some of the companies have accounted their FX loans at the depreciated currency into the P&L account, so interest cost has gone up. Many companies have accounted for the FX depreciation into the asset side of their balance sheet but couple of companies have debited their P&L account. So to some extent there is almost 70 bps expansion in interest cost as a percentage of sales, it is partly because of currency depreciation. This is not withstanding that overall interest costs have gone up. But the one positive thing is that overall debt levels have been jumped up as significantly. Bearing news print and road infrastructure companies, majority of sectors debts have more or less remained same over last three years. It is the cost of borrowing which has gone up rather than the quantum of borrowing.
Over next couple of quarters if we can allow currency to appreciate on back of slowdown in gold imports and softer oil prices and some amount of positive sentiment triggering FII and FDI flows, then one partial reduction in overall interest cost will happen because currency has appreciated.
Second, looking forward to the steepness in the yield curve. Right now, we are almost seeing a flat yield curve whether one is borrowing for three months or three years, it is virtually at the same rate. Now if by bringing in liquidity we can bring down the short end of the curve, then some amount of borrowing cost will come down albeit it will be difficult to bring down longer end of the curve.
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