India Strategy | Economics

23 August 2011

Macroeconomics
Capex downcycle: End on the horizon
Capex downcycle to bottom out in Q3FY12: The current crisis of capex is a product of domestic uncertainties and increased cost of borrowing. An analytical and predictive model of capex becomes very pertinent in the current context. The key question for the markets is when will the current capex cycle hit a trough and how low will it be. We have taken a thorough look at the two Cs, namely capex and consumption in tandem. As per our model and scenarios, the capex cycle will bottom out in Q3FY12 but the recovery will be languid in the initial quarters. It will primarily be driven by increased government spending in the initial phase after which private investors will likely take over. Our historical business cycle analysis of the GFCF data confirms our findings. The analysis finds the peak-to-trough time-period to average 5.5 quarters. With the last peak in Q2FY11, this suggests a trough in Q3FY12. Uniformity of the cyclical patterns lends credence to our view. How did we get to such a sorry state? Industries have been hit by the contractionary monetary policy of the central bank. We believe that the current slowdown in capex is largely a result of government policies. On one hand, the governments spending on infrastructure projects has fallen steeply while several policy bottlenecks are not helping the cause of private investors either. The policy inaction in government circles is a further deterrent to the growth outlook of the economy. Majority of investment activities are long-term projects. Sentiments about the future play a big role in private investment decision. Though the current rhetoric from New Delhi is being toyed as the second wave of reforms, the government will need to show concrete action before the markets take a cue. Once this happens, we expect to see flurry in private investment activity. Consumption will initiate the bend at the end of the trend: The silver lining however is that domestic consumption will not experience a steep fall. Although a little moderation is imminent, the overall trend is expected to remain elevated for next 4-5 quarters. But capacity utilization is at an all-time high. The economy clearly needs new capacity addition to clear supply side bottlenecks, which is stoking inflation. We view this phenomenon as the catalyst for future investment activities in the economy. Meanwhile, inflation is expected to start moderating by Dec-2011. Taking a cue from this, the central bank is expected to reverse the monetary policy stance from Q4FY12. All these factors build the case of a revival in capex activities.
Exhibit 1: Domestic consumption will keep rising
10 yoy growth 2 4 6 8

Global Markets Research

2000

2002

2004

2006

2008

2010

Source: CSO & Elara Securities Research

Exhibit 2: Capacity utilization remains elevated

78 76

74
(%)

72

70

68
2008-09-Q1 2008-09-Q2 2008-09-Q3 2008-09-Q4 2009-10-Q1 2009-10-Q2 2009-10-Q3 2009-10-Q4 2010-11-Q1 2010-11-Q2 2010-11-Q3
2012

Capacity Utilisation

Source: RBI & Elara Securities Research

Exhibit 3: Capex cycle will bottom in Q3FY12

(0.03) (0.02) (0.01) 0.00 0.01 0.02 0.03

(Cyclical component of GFCF)

2008

2009

2010

2011

Source: CSO & Elara Securities Research

Exhibit 4: History supports our view

20

(yoy growth of GFCF)

(5)

10

15

2000

2002

2004

2006

2008

2010

Source: CSO & Elara Securities Research

Ashish Kumar ashish.kumar@elaracapital.com +91 224062 6836

Elara Securities (India) Private Limited

2010-11-Q4

Macroeconomics

The story so far

The current moderation in the overall economic growth is largely driven by slowdown in capex activities. Meanwhile, sticky inflation has forced a hawkish central bank to pursue monetary tightening. The resulting rise in The present downturn is a result of ad hoc policies of the government that focus on growth without paying much attention to the productivity cycle. The fiscal and monetary policies have failed to move in tandem. On many occasions, the two have been diametrically opposite. As a result of this, the economy has seen inflation emerging as the key challenge. the cost of capital is cause for concern for investments. The policy inaction in government circles is a further deterrent to the growth outlook of the economy. Majority of investment activities are long-term projects. Sentiments about the future play a big role in private investment decision. Though the current rhetoric from New Delhi is being toyed as the second wave of reforms, the government will need to show concrete action before the markets take a cue. Once this happens, we expect to see flurry in private investment activity. We expect the economy to grow at a moderate rate of 7.5% in FY12E and a downward revision to this estimate looks possible in due course. The revival of the economy in FY13E depends a lot on the resurgence in capex activities, creating new capacities given that the economy is working at full capacity now. Most are looking for the answer to the question as to when the capex will start expanding again. But first more compelling issues need to be addressed. The key question for the markets remains - when will the current capex cycle hit a trough and how low will it be.

I.

Capex missing the props

The fiscal stimulus announced by the government to revive the economy during the financial crisis catalyzed investment activities sharply. GFCF growth recovered to 19.5% in Q4FY10 from negative growth of 2.3% in Q3FY09. Contrary to expectations, the cycle that was driven by government in the infrastructure sector was not quite replicated by the private sector even at a later stage. Since then, capex cycle has significantly slowed down, mainly on the back of macroeconomic concerns on the domestic front. GFCF grew at a dismal rate of 0.4% YoY in Q4FY11, down from 19.5% in Q4FY10. Growth has not only slowed but also turned volatile from the time of the crisis. Investor confidence in the domestic economy has been shaky as a result of concerns over inflation and governance issues. The headline inflation number has remained sticky in nine plus bracket since Feb-10. Monetary policy response to rising inflation has resulted in 425 bps rate tightening in the current cycle (See Exhibit 5). But the baby steps approach of the central bank has resulted in inflation outpacing nominal interest rates, thereby keeping real interest rate in the negative. Exhibit 6: Government share falls in infrastructure projects announcements
30 25 20 (%) 15 10 5 0 Jun/05 Jun/06 Jun/07 Jun/08 Jun/09 Jun/10 Dec/05 Dec/06 Dec/07 Dec/08 Dec/09 Dec/10 12.0 10.0 8.0 4.0 2.0 0.0 (2.0) (%) 6.0 Jun/11

Source: CMIE, Elara Securities Research

Exhibit 5: Hawkish monetary stance has slowed the investment cycle

10.0 9.0 8.0 (%) 7.0 6.0 5.0 4.0 Dec/07 Dec/08 Dec/09 Dec/10 Feb/08 Feb/09 Feb/10 Aug/07 Aug/08 Aug/09 Aug/10 Feb/11 Oct/07 Oct/08 Oct/09 Jun/07 Jun/08 Jun/09 Jun/10 Oct/10 Apr/07 Apr/08 Apr/09 Apr/10 Apr/11 Jun/11

Repo rate (LHS)

Source: RBI, CSO & Elara Securities Research

WPI (RHS)

Elara Securities (India) Private Limited

Macroeconomics
In this context, we believe that the private investment demand has only begun to shrink lately. So what explains the slowdown since mid-2010? The real culprits are policy inaction on the part of the government and sharp fall in government capex activities (See Exhibit 6). The period saw the government being caught in a spate of corruption charges thereby dividing its focus. In the key infrastructure sectors of power and roads, government share has plummeted to 12% in Q4FY11 compared to the 27% average during the financial crisis. II. The future outlook the back of rise in disposable income and various welfare programs continuing in the next plan. A significant portion of the domestic demand is expected to come from rural India. Exhibit 8: supported by government spending in welfare schemes in rural India
FY08 Mahatma Gandhi National Rural Employment Guarantee (NREGA) Swarnajayanti Gram Swarozgar Yojana (selfemployment for rural poor) DRDA (District Rural Development Agency) Administration Rural Housing Pradhan Mantri Gram Sadak Yojana (Rural roads) Grants to National Institute of Rural Development Council for Advancement of People's Action and Rural Technology PURA (Provision of Urban Amenities in Rural Areas) Management support to Rural Development Programmes BPL (Below Poverty Line) Census Non-Plan Total: Department of Rural Development FY09 FY10 FY11 BE 401 FY12 BE 400

163

375

391

17

23

24

30

29

We build our argument across the following scenario that will lead to the revival in capex activities in the economy. Steep fall unlikely in domestic consumption: The domestic consumption story remains strong. Though the rate tightening has led to slight moderation in key representatives of the consumption like passenger car sales, we dont foresee a steep fall from here. The overall demographics of the Indian population remain the catalyst for anchoring private consumption on a positive trend. Though a moderation in the sector is imminent, the overall trend will remain firm over the next 4-5 quarters.

39

88

88

100

100

65

78

120

120

200

Exhibit 7: Domestic consumption will keep rising

10

yoy growth

288

569

627

661

741

Source: Various Budget documents, Elara Securities Research

2000 2002 2004 2006 2008 2010

Source: CSO & Elara Securities Research

We support our argument by the historical peak and trough analysis of the consumption cycle (See Exhibit 7). The last recessionary phase in the domestic consumption was seen from Q4FY08 to Q1FY10, a period of five quarters. This was preceded by a long expansion which lasted 12 quarters peaking in Q4FY08. Peak in the current expansion cycle is 4-5 quarters ahead. In the period ahead, the trend growth is expected to keep rising, mainly on

Capacity utilization remains high: The recent Order books, Inventories and Capacity utilization Survey (OBICUS) of the RBI indicates that the economy is at an all time high in terms of capacity utilization (See Exhibit 9). To that end Indian economy is very capacity constrained.

Economics
3

Capex cycle is a lead indicator of the overall economic activity. In a sense, it is driven by the investors confidence in the economy. Since most of the capital formation is an asset for a firm, a decision to invest means that the firm expects returns from the investment activity in the medium to long term.

Macroeconomics
Exhibit 9: Capacity utilization remains elevated
78 76

74
(%)
72

70
68

Capacity Utilisation
Source: RBI & Elara Securities Research

Apart from the abundance in labour, the economy is running at full capacity on all fronts. A major reason for the persistent inflation lies in supply side bottlenecks due to lack of new capacity creation. These bottlenecks have been accumulated in the system over years. The bottomline remains that the economy needs urgent capacity building failing which the supply side problems cant be tackled. Inflation to start moderating by Dec: The short term scenario of inflation is scary. Among other factors, the recent fuel price hikes will push the inflation into double digits during Jul-Sep through direct and indirect effects. Post the monsoon, we might see some cooling in food inflation, though the overall headline number will remain at elevated levels in near term. We assume that normal monsoon will pull down food prices while international commodities prices are also expected to stabilize at current levels. We foresee a moderation in inflation from Dec-2011 on the back of fall in food inflation and monetary tightening choking domestic demand. By March 2012, we expect the headline inflation to hover around 6.5%-7.0% levels.

Rate cycle to peak around Dec-2011: The central banks effort to weaken the demand-led push to the inflationary pressures will start showing result by Dec-11. Accordingly, we believe that the current interest rate cycle is expected to peak at 8.5% by end CY11 (from here on, we expect a further 50 bps hike in total from the Sep-11 and Oct-11 policy reviews, mainly on the back of a double digit inflation over Jul-Sep 2011). As we foresee moderation in inflation from Dec-2011, the policy stance of the central bank is expected to maintain status quo in early Q4FY12. Monetary policy will change stance once visible moderation in headline inflation numbers are seen. We also expect the government to not breach the fiscal deficit by impassable margins and help reduce further fillip in inflation figures. Policy bottlenecks will go: Instead of being proactive in the crisis time, the government has been lying low. The policy inaction from the government has been visible across major sectors of the economy. However, markets can take solace from the fact that many of the policy bills have been in pipeline for a while after several rounds of debate. We expect major bills to be passed in the ongoing monsoon session of the parliament. Once the government gears up to act, it will serve as a catalyst to turn the sentiments of corporate as well as foreign investors. The government will move quickly on FDI in multibrand retail, land acquisition bill and granting environment approvals. There is also urgent need for government to contain the fiscal deficit within budgeted limits. In the long run, it should aim to build an interest rate environment that gives enough room for investors in private sector to grow. From the current rhetoric of the government, we feel it will also move, albeit slowly on complete deregulation of diesel and other subsidized petroleum products. There is also a proposal for dual pricing of diesel to contain the unnecessary subsidies given out to consumers who have no need for it.

2008-09-Q1

2008-09-Q2

2008-09-Q3

2008-09-Q4

2009-10-Q1

2009-10-Q2

2009-10-Q3

2009-10-Q4

2010-11-Q1

2010-11-Q2

2010-11-Q3

2010-11-Q4

Exhibit 10: Our view on inflation

12.0

10.0 (%) 8.0 6.0 4.0 Dec/10 Aug/10 Aug/11 Dec/11 Oct/10 Jun/10 Feb/11 Jun/11 Oct/11 Feb/12 Apr/10 Apr/11

FDI inflow to improve: In view of the global crisis coupled with US downgrade, the case for a revival of FDI inflows in FY12E remains strong. With the surge in global liquidity created by the quantitative easing and US losing its credibility, the Indian growth story will find many takers amidst expectations of a resilient performance by the Indian economy. Q1FY12 numbers already point to this phenomenon- FDI inflows rose by 133% YoY to USD13.4 billion.

Source: Bloomberg, Elara Securities Research

Elara Securities (India) Private Limited

Macroeconomics
Exhibit 11: FDI inflows set to rise in FY12
40 35 30 25 20 15 10 5 0 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Our analysis suggests that the capex cycle will hit a bottom in Q3FY12. Exhibit 14 Suggests that it will be a slow recovery in the initial phase and cycle will pick up considerably since Q2FY13. In the initial phase of the expansion, we believe the government will take the lead in announcing and executing new projects which will be supplemented by private investors later. The main drivers of the recovery will be projects in infrastructure and power sectors. Exhibit 14: Capex cycle will bottom in Q3FY12
(0.03) (0.02) (0.01) 0.00 0.01 0.02 0.03

(US $ million)

(Cyclical component of GFCF)

Source: CMIE & Elara Securities Research

CMIE quarterly surveys suggest revival: The Q1FY12 figures from the CMIE survey of capex activities are interesting. New projects announcements- an indicator of the investor's confidence in the economy, shows small recovery in project announcements in infrastructure sector (See exhibit 12). However, the private sector continues to shelve projects announced earlier, pointing to the distress among investors (See exhibit 13). While it might be early to conclude if the momentum will sustain in the short run, we believe that the recent fillip will act as benchmark for future investment strategies.

2008

2009

2010

2011

2012

Source: CSO & Elara Securities Research

III. History supports our view We analyze the cyclical patterns of the capital formation (GFCF) on a quarterly frequency from mid-1999. Using the standard methodology of the NBER cycle dating committee, we find historical peaks and troughs (See Exhibit 15) in the capex cycle. The exercise suggests that the historical average peak to trough duration in this cycle is 5.5 quarters. Exhibit 15: Historical investment cycles
(Cyclical component of GFCF) 0.02

Exhibit 12: New infrastructure projects have seen small recovery in Q1FY12
600 ('000 Crore) 500 400 300 200 100 0 Jun/05 Jun/06 Jun/07 Jun/08 Jun/09 Jun/10 Dec/05 Dec/06 Dec/07 Dec/08 Dec/09 Dec/10 Jun/11

Government
Source: CMIE, Elara Securities Research

Private sector

Exhibit 13: but projects announced earlier are still being shelved
80 70 60 50 40 30 20 10 0 Sep/08 Mar/09 Sep/09 Mar/10 Sep/10 Mar/11 Government
Source: CMIE, Elara Securities Research

-0.02 -0.01

0.00

0.01

2000

2002

2004

2006

2008

2010

Source: CSO, Elara Securities Research

('000 Crore)

Unlike most macro-series, capex exhibits cycles of similar length. We find four cycles starting mid-1999 with the latest starting in Q2FY11. Currently we are in the last leg of this cycle.

Private sector

Economics
5

Macroeconomics
Exhibit 16: The bottom is near
20

Monetary tightening continues in Q4FY12 If the inflation refuses to subside, the central bank may be forced to move up on the tightening ladder. Economy might see policy rates peaking at 100 bps from now, taking it to mid-2008 levels. With the government endorsing the monetary policy of the central bank and reinstating the current governor for two more years, it might be some time before we see a change in the stance of central bank. Government fails to act

(yoy growth of GFCF)

(5)
2000

10

15

2002

2004

2006

2008

2010

Source: CSO, Elara Securities Research

Though we believe that this cycle is very different form previous cycles due to the involvement of global factors and the domestic policy response therein, the analysis serves as a benchmark for predicting the trough of current cycle and supports our model forecast. Exhibit 17: Capex cycle has been uniform
Peak P 1999 (Oct-Dec) 2002 (Jan-Mar) 2004 (Oct-Dec) 2007 (Oct-Dec) 2010 (Apr-Jun)
Source:CSO, Elara Securities Research

The markets are expecting the government to move quickly on the policy front. But with the government caught in a web of scams, it might shift governments focus on salvaging its image for some more time.

Appendix
Economic activity is often modeled as a function of a seasonal, cyclical and growth (trend) component. Yt = f (St , Gt , Ct , t ) Isolating the component of Yt relevant to the business cycle is controversial. There are debates around real versus nominal specifications, seasonal adjustment models, detrending techniques and issues arising while dealing with multiple measures of economic activity. Detrending series, or isolating and studying the cyclical component of economic activity is widely practiced. This models business cycles as a stochastic equilibrating process. The premise is that detrending seasonally adjusted series of aggregate economic activity produces a stochastic cyclical fluctuation, which is then analysed to find turning points. This is therefore a theory before measurement perspective on cyclical fluctuations. Detrending can be carried out via either deterministic (HP-filter) or standard band-pass filters like the Christiano and Fitzgerald, but isolating the cyclical component (Ct ) via detrending is a necessary prerequisite to studying business cycles. The variables are adjusted for seasonality and then transformed to log terms. The cyclical component is derived through the application of the Christiano-Fitzgerald filter. The standardized cyclical component is then subject to the rules of the dating algorithm by Harding and Pagan (2002). In addition to reporting the peak and trough dates, we also report the average duration of a phase from peak to trough and from trough to peak. Filters Typically, detrending is carried out by applying the Hodrick and Prescott (1997) filter or standard band-pass filters like the Christiano and Fitzgerald (2003). The

Trough T 2001 (Jan-Mar) 2003 (Apr-Jun) 2006 (Apr-Jun) 2009 (Jan-Mar)

Recession Expansion P/T 5 5 6 5 T/P 4 6 6 5

Exhibit 18: with similar expansion and recessionary phase

Average Duration (in quarters) Trough to Peak Peak to Trough Peak to Peak Trough to Trough
Source: CSO, Elara Securities Research

5.25 5.25 10.50 10.67

IV.

Key risks to our outlook:

The risk to our outlook flows from three key issues: Inflation may not fall down considerably, as a result the interest rate cycle may further peak in Q4FY12 and domestic policy making may continue to dampen the market sentiments. Inflation refuses to cool Structural risks from a bottlenecked supply with no steep fall in domestic demand may ruin our inflation outlook. While moderation in food prices post monsoon may be possible, further global shocks may force us to import inflation. Meanwhile, crude prices are yet to stabilize at fair levels. On the policy front, if the government acts swiftly on the food security bill, it might balloon out the fiscal deficit with impassable margins. Our estimates suggest that if the bill comes through in H2FY12, it will raise the fiscal deficit by 0.6% alone in this fiscal. A higher fiscal deficit is highly inflationary. This will further stoke the inflation in the short run.
6

Elara Securities (India) Private Limited

Macroeconomics
Hodrick-Prescott filter is a time-domain filter that renders the resulting cyclical component stationary1. Band-pass filters, such as Baxter and King (1999) and Christiano and Fitzgerald (2003), have the advantage of extracting components of a specified frequency without producing a phase shift and hence are better suited for business cycle2. In view of the same, we have used the Christiano-Fitzgerald filter for our study. Turning point algorithms Algorithms for dating of business cycles were first proposed in Bry and Boschan (1971). The procedure was subsequently revised and quantified in a better way by Harding and Pagan (2002). The algorithm defines a rule to select peaks and troughs dates, identifying movement from peak to trough as a contraction and from trough to peak as an expansion. Bry and Boschan (1971) and Harding and Pagan (2002) algorithms are quite akin to each other, where the latter seeks to eliminate elements of subjectivity in the former. The Bry and Boschan (1971) algorithm finds the turning point as follows: The data is smoothed after outlier adjustment using short-term moving average. The preliminary set of turning points is selected for the smoothed series subject to the criterion described later. In the next stage, turning points in the raw series are identified taking results from smoothed series as the reference. Bibliography Hodrick RJ, Prescott EC (1997). Postwar U.S. Business Cycles: An Empirical Investigation." Journal of Money, Credit and Banking, 29(1), 1{16. URL http://ideas.repec.org/a/mcb/jmoncb/v29y1997i1p116.html. Christiano L, Fitzgerald T (2003). The band pass filter." International Economic Review, 44(2), 435{465. Baxter M, King R (1999). Measuring business cycles: approximate band-pass filters for economic time series." Review of Economics and Statistics, 81(4), 575{593. ISSN 0034-6535. Bry G, Boschan C (1971). Cyclical Analysis of Time Series: Selected Procedures and Computer Programs. National Bureau of Economic Research. URL http://www.nber.org/chapters/c2145. Harding D, Pagan A (2002). Dissecting the cycle: a methodological investigation* 1." Journal of monetary economics, 49(2), 365{381. ISSN 0304-3932. Fabio Canova. Detrending and business cycle facts. Journal of Monetary Economics, 41(3):475512, May 1998. A C Harvey and A Jaeger. Detrending, stylized facts and the business cycle. Journal of Applied Econometrics, 8(3):23147, July-Sept 1993.

The identification of turning point dates is done subject to the following constraint: Peaks and troughs must always occur alternately. Duration may lie between 15 months to 12 years. In case there is a flat line at any point, choose the latest point as the peak (or, trough). Avoid any turning point at extreme points. In case of many reference series, use a central tendency measure to determine final cycle.

The HP algorithm drops the last three of these constraints and modifies the second. It seeks cycles that have a minimum duration of 15 months and ensures that peaks and troughs alternate.

Criticisms of the HP filter include spurious cycles, phase shifts in the variables and a high level of sensitivity of results [Canova, 1998, Harvey and Jaeger, 1993].
2

In the business cycle analysis, the periodicity range of interest is 2 to 8 years.

Economics
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ananthanarayan.iyer@elaracapital.com +91 22 4062 6856 dharmesh.desai@elaracapital.com manoj.murarka@elaracapital.com vishal.thakker@elaracapital.com +91 22 4062 6852 +91 22 4062 6851 +91 22 4062 6857

Construction, Infrastructure Mid caps Oil & Gas Paints, Fertilizers FMCG, Hotels, Hospitals Media & Retail Derivative Strategist Information Technology, Strategy Metals & Cement Cement FMCG Pharmaceuticals, Real Estate Power ,Capital Goods Strategy, Information Technology Automobiles

abhinav.bhandari@elaracapital.com aliasgar.shakir@elaracapital.com alok.deshpande@elaracapital.com anand.shah@elaracapital.com ashish.kumar@elaracapital.com himani.singh@elaracapital.com mohan.lal@elaracapital.com pankaj.balani@elaracapital.com pralay.das@elaracapital.com ravi.sodah@elaracapital.com sumant.kumar@elaracapital.com surajit.pal@elaracapital.com rahul.modi@elaracapital.com mona.khetan@elaracapital.com pooja.sharma@elaracapital.com stuart.murray@elaracapital.com gurunath.parab@elaracapital.com

+91 22 4062 6807 +91 22 4062 6816 +91 22 4062 6804 +91 22 4062 6821 +91 22 4062 6836 +91 22 4062 6801 +91 22 4062 6802 +91 22 4062 6811 +91 22 4062 6808 +91 22 4062 6817 +91 22 4062 6803 +91 22 4062 6810 +91 22 4062 6859 +91 22 4062 6814 +91 22 4062 6819 +91 22 4062 6898 +91 22 4062 6815

ravindra.deshpande@elaracapital.com +91 22 4062 6805

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