India L/S letter- King’s Gambit

(i)India’s bold ‘demonetisation’ move – regime change 

Events over the last week have overtaken us, compelling us to put out this special report. Our title of this piece alludes not so much to the event in New York (the Chess World Championship currently underway and not the King of New York routing bond markets) but to Narendra Modi’s appearance on prime time television last week to announce the ban on 500 and 1000 Rupee currency notes. These highest denomination notes lost their currency status overnight, are to be exchanged by the end of this calendar year, deposited in bank accounts, or spent at government run enterprises, all of which will require identity proofs. While the decision came as a shock to many, prior readers will recall the financialisation of Indian savings and the attack on hard assets such as Gold and Property has been an ongoing theme in our prior commentaries. There are several dimensions to this, across sectors and over time, rural and urban. 

First, let’s start with some basics by way of framing the debate:

-India’s cash economy is estimated to be roughly between 23-38% of the economy (source World Bank and various).

-The black economy, which includes most of the cash economy as well as black money invested into other asset classes such as Property, Gold and Stocks, is significantly bigger than this. As high as 50% of GDP by some estimates.

-The so called ‘unorganised sectors’ (out of the tax ambit) employ roughly 90% of India’s workforce and are almost entirely cash run. These are sectors that run parallel to their formal counterparts. In Consumer, Retail and allied services such as wholesale, distribution and supply chains, Real estate and allied services such as Construction and Building Materials, Agriculture, Fisheries and Household services, to name a few. These especially are concentrated on rural areas and the vast majority of India’s unbanked poor.

-By most standard banking access metrics, such as live bank accounts, bank branches and ATMs per person per sq km, India is behind developed and developing world norms. Avoiding serious collateral damage on the common man, by way of inconvenience and the opportunity cost of lost wages, is impossible.

-The banned notes reflect roughly 86% of the value of currency in money supply circulation and nearly 12% of GDP (RBI, CRISIL). As a proportion to GDP India is still behind Japan, and marginally behind China. But Japan has been in deflation for years so hoarding cash makes sense as its purchasing power increases, whereas India’s inflation rates have consistently been higher than global averages. Adjusting for inflation would actually put India right at the top of the list. This explains why such a move had to happen sooner or later.

-Final consumption expenditure is around 71% of GDP (World Bank, 2014). 

Clearly, the proverbial elephant in the room is the consumer. India is not an export or investment led economy, but a consumer led one. Out of the cash economy, if we estimate roughly 50% to be black, and out of this cash pile if we assume another 30% can been laundered back into the banking system or invested into other assets (disclosure requirments have significantly gone up for making purchases in Gold but never underestimate their ingenuity), then that still leaves roughly a tenth of the economy liable to capital wealth transfer or destruction, either through punitive fines and back taxes or through destroyed/unexchanged old currency. This is only the impact on the stock of wealth. Flows will be severely disrupted. As the flow from the unorganised sectors and black economy dry up, the money velocity of circulation will fall depressing the money multiplier and temporarily crushing consumption. As we write, the ground reality is one of chaos, although the response has been stoic so far. We are witness to a complete stalling of trade and wholesale supply chains, collapse in cash transactions, and shortage of currency supply witnessed by lengthy queues at ATMs and banks nationwide. The latter should be temporary as new currency notes come back into circulation, estimated at 3 weeks (assume a couple of months). But the real damage is to animal spirits, consumer sentiment and business risk taking, which may be much longer lasting.

Now, the benefits. Firstly, it should now be clear that the latest move is but part of a series of steps to financialise savings, something we have extensively covered in our prior letters. Beginning with the opening of Aadhar and Jan Dhan bank accounts for the rural unbanked after Modi’s triumph, the move away from subsidies to direct benefit transfers, the govt’s unified payment interphase (UIDAI), the squeeze on hard assets through both monetary measures (real positive rates and inflation targeting under Rajan) and policy measures (identity proof for higher value Gold transactions). Nevertheless, the latest measures are nothing short of sensational. 

As we write, a whopping approx Rs 3 lakh crore ($45b) has been deposited into the banking system! Banks’ CASA deposits have ballooned. While the rest of EM sovereign bond yields have savagely sold off, Indian 10 year govt bond yields have fallen from just over 6.9% to 6.74%. Banking analysts were quick to point out the benefits. As banks’ costs of capital fall and especially the govt owned PSU banks see increased deposits, net interest margins widen. Furthermore, it was suggested that the destroyed and unaccounted currency notes will extinguish RBI’s liability on the same, allowing a surplus that can be transferred to the govt. But this argument has since been debunked by former RBI governor Rangarajan and Usha Thorat. All the same, what is clear is that the liability side of bank’s balance sheets have received a windfall gain. What about the asset side? This is where most of the commentary falls short.

Financials are a close proxy to any economy. It’s almost impossible to see a scenario where the economy takes a knock while financials continue to benefit. In this particular case, while analysts are quick to see the benefits to banks via low cost deposits, most seem to be oblivious to the other half of their balance sheets. Namely the renewed stress on bank assets. As the (industrial led) bad loan crisis continues to wear on (and this season saw no light at the end of the tunnel no matter what managements said), one factor that has kept credit growth alive is the consumer. Retail lending, discretionary lending, lending to NBFCs, mortgages as well as loans against property, have all been the biggest sources of credit demand, and now account for a substantial portion of overall assets. Firstly, lower consumer spending itself will increase business stress. Secondly, now that the stock of money that was artificially propping up asset values is under attack, prepare for a correction. The most evident of these is Real estate, which is typically at least 40% financed by the black economy. At around 2-3% rental yields, it gives you an idea of how inflated realty is in India. Again, this is something we have written about a fair bit, so we shall not revisit this topic. Suffice to say that this event catalyses it. As the cash crunch bites, liquidations will finally begin, LTVs will increase and defaults soar. As non performing loans once again take off, this time led by retail, credit growth will completely stall leaving banks with acute Asset-Liability mismatches. The only winner we see out of this is the govt, which will again be flush with SDR deposits and enjoy lower sovereign bond yields, other factors permitting. This is important, as increased government spending may be required to prop up the economy in the likely probability of a short and sharp recession.

(ii)Sector winners and losers: 

Beyond the Consumer and Financial themes, there are significant ramifications for other sectors in the economy over the short and medium to long term. Notably, a shift from ‘unorganised’ to ‘organised’ sectors. While we don’t expect the creation of black money to vanish overnight, this shift to organised sectors will likely reflate the economy as inflation returns when ‘Menu costs’ in the old ‘unorganised sectors’ are marked up for indirect taxes.

(iii)Prognosis 

Our initial prognosis is for an odds-on sharp and (hopefully) short recession. By recession in India, we mean at least a 2 quarters of sub 3% GDP growth. It is pointless to look at our usual clutch of short leading indicators at this stage, or even wait for the impact of this currency move on the statistics. The ground reality and anecdotal evidence is more than enough. The move will likely overpower recent reflationary tailwinds, chiefly the latest pay commission awards for public sector workers and a good Monsoon.

While a sharp recovery is possible, the underlying theme is that the fundamental architecture is being redrawn in commercial India and this implies there may be more unpleasant surprises in store. We mentioned the amended Benami Properties Act targeting black money diverted into Real Estate. Authorities are also studying the diversion of black money into Small and Micro Cap stocks. So until the dust settles, it’s worth taking a step back. Be it setting up a new business, paying taxes (GST, another huge disruption but positive), bidding for infrastructure projects or mining assets, or conducting business through formal banking channels – these are all deep rooted reforms that will take time to take effect and for their benefits to accrue. There will be unforseen and unintended consequences, but the surfeit of analyses we have before us suggests it will be worth it in the long run. 

If this current demonetisation scheme is a success, and normalcy returns as planned within a few months, the Indian banking system will be much better capitalised and stronger as a result of it. Clearly Mr Modi has shown tremendous spine, especially telling given his support base of Gujarat based mercantilist communities. A true mark of leadership whatever his detractors may say. Many in opposition are clearly riled by the move just before the hugely important assembly polls in India’s biggest state, UP. While we cite the lack of universal banking access and financial infrastructure, especially the disproportionate impact on the rural economy, as a huge gamble (as the common man suffers disproportionately), whether the BJP is re-elected in 2019 or not is a bridge we don’t have to cross until we come to it. 

Beyond this policy move, the global macro picture is hostile to Emerging Markets as a whole. And although India has lost its beta versus EM, the latest divergence in yields being a case in point, we have to consider the effects of a Trump Presidency on long term EM bond spreads. The surge in the dollar index and US 10 year yields are both factors we have been highlighting since last year as likely sources of risk and the carry trade has been hugely disrupted already. Then there are sectoral impacts from protectionism, specifically in Tech and Pharma, which we annotated on the previous page. Too early to tell.

 Our last in depth letter (published end Feb) predicted a sharp market rally led by Financials and Metals. Now with 2 quarters of earnings under our belt, there is still no sign of an earnings recovery. And although the solvency and capital adequacy issue of PSU banks is off the table, there is clearly no growth to support existing valuations. With the economy battling a demand shock, global macro headwinds looming large, the commodity rally negating margin gains, Indian headline equities are still expensive at 22x historical with no real earnings growth and Mid and Small Cap indices in a bubble. Add to this India’s considerable overweight in EM portfolios and it’s easy to see why we recommend it’s time to head for the hills.