The Placid Reform

Amidst the brouhaha over the upcoming GST reforms, and more recently around the demonetization move by the RBI and the Government, a prolific reform, brewing for over a decade lies ignored. The APMCs (Agricultural Produce Market Committee) as they function today will be replaced by a national e-market for agricultural produce. 

Why is this necessary?

In the 21st century, India has journeyed from a being a 476bn USD economy to a 2trn USD powerhouse (implying a CAGR of 9.3%). The largest sector (by employment) however missed out on this journey and have only registered a CAGR of 6.5% in the same time period. What is even more disheartening for over half of the nation's population employed in agriculture and allied services, is that the middlemen have eaten away from this sub-par growth leaving them declining real earnings at times over the last decade. The consumers on the other hand faced double (and at times triple) digit percentage point inflation in the prices of foodstuffs. This resulted in abnormal profits for the middlemen but excluded half of all Indian households from benefiting from the gains in pricing of their own product. 

59% of India's GDP relies on private consumption. For India to, therefore, become an economic growth engine participation of the masses is vital. Half of the households that are employed in farming and related activities can no longer be excluded from our growth story.

The Draconian Way

As the system stands today, the local APMC must be the first point of sale for the farmer. The limited number of licenses per APMC in such a system, gave a rise to a bandit of politically favored traders that colluded to lower the prices paid to the farmer while inflating the retail price by controlling the flow at times. 

To add to their horrors, each APMC had its own structure of levies and market fees that imposed on all participants. Additionally, they also had a menu card for any of the services that the farmers would have to avail from them. 

The Contemporary Way

Adopting the spirit of the Model APMC Act passed in 2002 and combining the same with the digital advancements the world has seen since, the Government of India will now replace this with a national e-market. 

The tenets of the Model APMC Act that this initiative will entail:

• Single license valid across the nation
• Uniform fee structure applicable for levy at a single point
• Consumers, Corporates and Contract farming sponsors to be able to purchase directly.

While this gives the farmers more autonomy over their produce, it is the tadka of the national e-market that really aids in redistribution of wealth and power from the middlemen to the producers. A preview of this move is on display in the state of Karnataka.

The e-market there enables the farmer to deposit their produce at any APMC in the state. The APMC then tests for quality and grades the produce and updates the detail of the same on a statewide online portal. Any registered bidder (trader, corporate, etc.) can place a bid for the produce and can up the bid at any point of time as well based on competitiveness of the bid. At the end of the day the farmer receives a SMS with the best bid and can accept or decline with a click of the button. If he/ she does accept the money gets transferred directly into their bank account. 

Why is this significant?

By March 2018, 585 of the 2000+ major Mandis in this country will be on the national e-portal. The software for the same will be provided by the Department of Agriculture and Cooperation in addition to an allowance of 30lakhs per Mandi to implement this platform. 

APMC is hardly an exciting topic that is absolutely incapable of inspiring an invigorating discussion but surely warrants one. It redistributes wealth and control by preventing its concentration in the hands of the traders/ middlemen. But more silently, a transparent nationwide price discovery mechanism enables an environment of structurally low inflation vs. the 100% rise in onion prices we see oh so frequently. In light of food and beverages constituting of 54% of India's CPI index, this move is monumental to say the least. 

Are they thinking again?

The recent launch of the NM App warrants the question, "Is the ruling party doubting their move?" or perhaps, "Are they now skeptical of their own estimation of the opposition's ability to turn this to their advantage post the by-poll results?"

The following graphic from Bloomberg Quint illustrates succinctly how the ruling party may have wrongly estimated people's willingness to "suffer" for the greater good.

In Lakhimpur, Assam, the BJP may have retained their vote share but demonetization has surely helped the INC to consolidate the opposing vote share and increase their share by eight percentage points! 

Political Maneuver? Think Again.

17th November 2016

Whether one hailed the Prime Minister's move to demonitise currency notes of Rs. 500 and Rs. 1000 or found themselves obloquious of the same, everyone seemed to agree that this move was timed well for UP and other upcoming local and state elections. We too gave into the notion and thought for a while that we were right; after all it did indeed claim a victim as well- AAP in BMC polls (or the timing of the same was fortuitous).

Alas, be it sheer altruism or mis-calculation of risk (in politics always believe the latter) it seems that this move could very well be BJP's undoing in the upcoming local and state elections. The evidence of this is seen in the front page ad of the newspapers today articulating and reiterating the difference between a bad loan write-off and waiver. The PSU banks are writing off 63,000 crores worth of bad loans as they are flushed with liquidity and have (finally!) the ability to provide for the same in their balance sheet. The sheer amount of financial jargon I have used in the previous sentence demonstrates the ease with which the opposition parties/ forces can convince people that a loan write-off constitutes as a waiver. The strain the farmers find themselves in today make them a vulnerable target for such disinformation; the strain for which the government cannot be blamed but can be held responsible for now, thanks to the multitude of its opposing forces.

District Co-op Banks are not allowed by the RBI to participate in the exchanging of demonitised currency notes. Customers are simply allowed to withdraw from these banks- the problem herein being, there are no new currency notes stocked with them. Time and again RBI studies have suggested money laundering activities being facilitated by such banks.  Reports of politicians using the technologically challenged co-op banks to issue back-dated FDs post the PMs announcement surfaced post which the RBI, in a statement dated 14th November 2016 excluded the banks from this process (opposition parties' officials at the helm of these banks could also be a motivator). The price of one another shall pay.

Of the 8 crore cultivator households in India, 7.5 crore take some form of loan for cultivation from a financial institution. 3 crore of these take it from these banks, though the share of these co-op banks in the credit flow is at a lower 29%. 66% of the loans made by such banks go to small and marginal farmers, a proportion higher than the 55% for commercial banks.These banks have an unsurpassed outreach at the grass root level and therefore crippling them, even for the right reasons, would agitate the farmers.

Loans against warehousing receipts by NABARD are not viable as well since the farmers are unable to move their produce. 50% of the country's truck drivers are currently idled- to an extent, possibly purposefully. The harvest is piled up at farms (a gross but not entirely incorrect generalization on our part) inhibiting income flow and co-op banks are disallowed from the currency exchange program hindering credit flow. We may face an issue of food price inflation before the promised wonder of structural disinflation kicks in.

In view of such a liquidity crunch faced by the farmers during the Rabi season preparation time, the local political forces  seem to be milking the situation to the greatest extent possible by claiming a PSU bank's write-off, to be a 63000 crore central government waiver to the industrialists.

Add to this potent mix, the local politicians giving away their accumulated unaccounted cash to farmers as a short term crop loan (interest- free!) and voila! not that smartly timed after all it seems. The government's intention were not in anyway misplaced, but they underestimated Indians' aptitude for engineering (financial included) and overestimated the nobility of their opposition/ peers (though when not in power they would have possibly done the same).

The Valuation Impediment

Since Budget Day 2016, the NIFTY has seen a massive rise of 27%. As a result newspapers, TV channels and other media outlets are awash with stories of how there is an impending crash ahead and how valuations indicate a bubble, etc. Undoubtedly the chart you have seen everywhere is the one below: 

It is true that the P/E multiple and most of the other relative multiples are above their long term average. Though these multiples in themselves are objective, as numbers always are; their interpretation is completely subjective. In eloquence, while price is objective, value is always subjective. The spurt in multiples is not a uniform phenomenon though- it is driven majorly by three sectors:  private financials, automobiles and consumer companies. While the complacency in some of the proclaimed “quality” stocks has resulted in frothy valuations for those companies in these sectors, a certain degree of the higher valuations in these companies as well as their peers will sustain. 

What are my options in India?

Savings in India can be parked in gold, real estate or financial assets. 

Gold?

Purchases of Rs. 2 lakh or above from any jeweler require a PAN Card. The advantage of parking undisclosed income in gold is no longer a meaningful one given the 2 Lakh limit on it. Given that individuals would be forced to deploy only their disclosed income in gold for the most part- taxation becomes an important consideration. Except for indexation, there are no advantages from a taxation point of view as well should you chose to liquidate your savings in gold in the long run (note: long run in this case is defined as 36 months. 

These are the regulatory hinderances to investing more in gold. The key questions that we as Indians also have to answer is how much more can we invest in gold? An all India investment and debt survey done in 2012 (see table below) clearly demonstrates that except for the 99th percentile (or the “1%”) most people buy more of gold than consumer durables. This too has changed- with frequent technology upgrades and an heightened aspiration for consumption, the desire for consumer durables is only bound to increase and most likely going to eat into our consumption of gold. And gold prices are where they were 6 years ago, dissuading investors from gold. Consumption and investment in gold by Indians, therefore does not seem rational at this point. 

All India Investment and Debt Survey 2012 Findings 

Real Estate?

Real Estate is the largest parking lot of Indian household savings. It absorbs over 50% of savings and over 85% of Indians’ total investment and debt utilization. The investment appetite for this asset class, however, has completely evaporated. Rental yields in metros hover around 2% (annually!) making it an asset that may contribute to your net worth but does not do much for your income. With massive illiquidity being the classic feature of this asset class, even more so now at such high prices, investors are wary of real estate. 

With the looming implementation of state-wise regulators under RERA (Real Estate Regulation Act), builders are unwilling to do cash transactions. 70% of the payments collected from buyers is now escrowed, only to be used for contraction purposes. The appreciation of prices noted in the past, on account of increasing amounts of cash with people leading to a rise in demand for real estate, has finally come to rest. In the NCR region the asset class has deteriorated to the extent of builders now advertising discounts on their projects. 

Financial Assets?

With falling interest rates we have seen Fixed Deposit rates, PPF rates, etc. come down. Post tax return on fixed deposits hovers around 6% now, barely beating our rate of inflation. Suffice to say that, it hardly makes an interesting case for investors. 

All of the above asset classes and the conundrum in which their investors find themselves in, indicate that the flow should shift someplace else. India’s GDP is 2trillion USD. Over the course of the remainder four years of this decade we shall add a trillion USD more to our GDP. With a savings rate of 30%, thats 900bn USD of additional savings until FY20. Given the illiquidty in the real estate markets, especially now, assume that the 50% share of financial savings increases to 60%. Given the fall in interest rates, assume that of the new financial savings one-third comes to the equity market- that is a jaw dropping eleven lakh and seventy thousand crore of rupees. You can discount it a by a factor of ‘x’ whatever you may chose it to be, you still know that this is a significant amount. Juxtapose that with the highest domestic inflow we have seen in a year- 70,000 crore in 2015. The highest ever number seems measly now. 

Seen in the context of such a staggering imminent flow (it can take 6 years instead of 4 but that’s the extent of the deviation possible in my outlook), the prices today don’t seem overtly high. Higher multiples could very well be the norm going forward for investments are made not by looking at the past (no point comparing to historical averages) but with a vision of the future (underlined by an astonishing influx of money). 

What are my options globally?

Ray Dalio has talked about the corporate de-leveraging being on the cusp of commencement in the west (an idea discussed in my previous write-up). Industrial growth seems like a distant possibility in the west owing to such a phenomenon. To add to that we have negative rates and increasing amounts of self- inflicted destruction. 

Negative Rates?

Six nations, are in a negative interest rate territory today. Rates have been far too depressed for far too long that they have seized to be an effective tool for monetary policy, especially coupled with the corporate de-leveraging. Every couple of months a “new” Fed rate hike story floats around the markets putting equities in a temporary panic mode. Even if there is a rate hike, how much further up can we go from 0.5%! Even at 1.5% we are still well below the rates seen historically, when 18x was the long term average NIFTY P/E multiple (as seen below).  

Socio-economic uncertainty? 

The BREXIT vote has marked what I believe will be the end of the European experiment. The parasitic leaching of German tax-payers cannot be sustained for eternity. Italian banks see a system wide NPA level of over 18%, Portugal over 12% and Spain over 10%. This problem seems further accentuated when only non-financial business loans are considered; 30% in Italy, 16.5% in Portugal and 13% in Spain. Combine this with the breaking away of their largest trading partner (UK) from their common market and we have a massive problem approaching. The western world is far away from any meaningful economic growth. 

China, the perennial alternative presented to India, is also brewing trouble. Real disposable income of urban consumers has slowed to 5.8% in Q1FY17 vs. north of 10%, a decade ago. Households are therefore leveraging to sustain consumption. Consequently, household debt as a percentage of bank deposits stands at 50%, double of its 2009 levels. Though this is nowhere near the excesses of the west, a quarter of all mortgages outstanding in China today has been taken out in the last 12 months. The NPAs there are not going to stay low forever. A slowdown and maybe a few shocks are inevitable there as well. 

In the light of deceleration of growth elsewhere, negative yields and rising bad debts globally- Indian stock prices may not be over-valued. 

What should we do?

There are pockets of over-valuation in the Indian markets. It would be foolish to deny that. IPO markets are a classic case of the same; but in face of the quantum of domestic inflows we are going to see in the Indian equity market- we should adjust to this new reality. While multiples are becoming difficult to grasp, if we stick to the approach of deciding the value based on the company’s market capitalization, decisions can be made. A 500cr company growing at 20% can command a 40 P/E multiple in today’s market. The question to be asked for your sanity is: Can this be a 1000cr company? Fail to change your viewing glass and you could lose out on a bull run of an enormous proportion. The choice is yours, the choice is ours. 

The argument that Congress should have made and the media should have covered

And once in a while everyone staying in a democracy has this urge of wanting out- witnessing the past week in the parliament was that moment for me.

Why a fugitive from justice governs the debate (or the lack of it) in our parliament-baffles me. Why a leading news reporter that wishes to place India above all, give importance to such a person by traveling ten thousand six hundred and twenty eight kilometers to interview him-confounds me. I guess it really does go to show that in India, cricket is a religion.

The discussion should have been focused on the contents of the GST bill. Unless they were auditioning for one of the many reality television shows in our country, the legislators should not have resorted to vicious personal attacks instead of talking about the appropriate rate of tax under GST? The economic participants it would impact? And the degree of that impact? The ruling party cites a benefit of two percentage points of GDP growth on successful implementation of the GST bill. If this was the case- why did they let India sacrifice six percentage points of GDP growth and raise opposition to the GST proposal in 2012. And why is the opposition currently succumbing to the same tactics that resulted in inefficiency during their years of governance. Why is no one asking for the basis of this two percentage point incremental growth estimation? Why are we not questioning if the supposedly proposed 25-27% GST rate is going to deliver additional growth?

Approximately half of the domestic indirect taxes are collected on goods (taxed at 30% roughly). The other half comes from services (taxed at 14%- raised from 12.5% in anticipation of GST). To impose a common tax-rate on goods and services such that the rate of inflation is not impacted by the same, 21.25% (based on 12.5% VAT)- 22% (based on 14% VAT) should be the ideal range to focus on. The government's proposal on 25-27% is significantly higher than the inflation neutral rate. It is therefore tough to imagine how tax induced higher prices for goods and services are going to result in additional two percentage points of growth for India. The proposal of 18-20% GST may not be revenue neutral but may have advantages in spurring growth. Why was this difference in approach not the focus of the debate? And why did the media not force the legislators to such a debate by ignoring the comments of a person who wants to assume importance by causing chaos.

We, the people of this nation deserve better. Our intelligence deserves more respect than what we were shown this past week. Our legislators need to be more in awe of the place they work in and the constitution that has given them this right. This may sound preachy and unlike the other posts on this blog- but the level of debate in our country needs to be raised.

Disclaimer: The IIP may not be what you think it is.

I wish I had written the following article a month ago. I, for some time, have been a believer that we are going to see an inflection in the business cycle of India. But every time I would utter such a view point I would be met with an onslaught of sell-side and media reports talking of how corporate India is bleeding. The key metric that traders await to affirm this negative view is the monthly Index of Industrial Production (IIP). Until Friday June 12^th, the numbers for this year have been disappointing and non-indicative of any real activity growth in the economy. (I am a non- believer of the index but do not intend to change your stand on it).

For a number that is quoted very often in leading financial newspapers and used frequently by traders to move markets in either direction, very little reporting is done on the method of arriving the number. Below is the disclaimer that any report judging the economy’s strength on the IIP, should contain.

“The all India IIP is a composite indicator that measures the short-term changes in the volume of production of a basket of industrial products during a given period with respect to that in a chosen base period.” So in other words, the IIP is an abstract number which represents the magnitude of the production in the industrial sector for a given reference period. The IIP index published in India by the Central Statistics Office (CSO), however, only deals with registered manufacturing units. By definition this includes those manufacturing units that employ 10 or more workers and use power; and 20 or more workers but use no power. On an average, the entire manufacturing sectors accounts for 16% of India’s GDP. 10 percentage points of that comes from registered manufacturing units but 6 percentage points of that comes from the non-registered manufacturing units, which get ignored in the IIP calculation. Therefore, the indicator the market uses to gauge the manufacturing strength in India in fact ignores 37.5% of the manufacturing in the country.

Also, the United Nations Statistics Division expanded the scope of the index to include Mining & Quarrying, Manufacturing, Electricity, Gas steam and Air-conditioning supply, Water supply, Sewerage, Waste management and Remediation activities. Due to constraints of the data availability and other resources, the present general index of industrial production compiled in India has in its scope limited to Mining, Manufacturing and Electricity sectors only. Thus of the 10 percentage points, a few registered manufacturing units are still not covered in the Index given the limited scope of the survey.

It is difficult for the CSO to standardize the data even within this limited scope. With 16 different sources contributing to the index, standardization of data collection across the nation becomes an even more of an impossible task.

This difference in data collection could result in the index portraying a different picture of the ‘ground reality’ than the true facts. For example the sample size for data collection for the different components is decided by the respective source agency. The only guideline stated in the CSO handbook says, “Generally, efforts are made to cover all the major units”. The definition of major is however left up to the source agency and it has changed with time depending on whether the department is understaffed or overstaffed.

“The basic data used for compilation of the index is the production in terms of quantity. However, there are certain items especially capital goods such as Machinery, Machine Tools, Ship Building etc. on which the production data is furnished in value terms. In order to remove the effect of price rise from the index, the production figures of such items are deflated on the basis of Wholesale Price Indices (Base 2004-05), compiled by the Office of Economic Adviser, Ministry of Commerce and Industry, before compilation of index.”  This is yet another example of how the different sources of data can lead to discrepancies owing to differing methods of data collection.

Given the size of the undertaking, and the varying sectors covered by the index, it would be nearly impossible to conduct the operation without different sources. It is however the lack of standardization across departments and the consequent lack of data validation checks that require this to be highlighted as a glaring drawback in the quality of the data point released every month.

Before releasing the data, the CSO confirms the accuracy of the data points with the source agencies if there is a significant deviation from the data point in the previous month.  The underlined word in the previous sentence demonstrates the peril of using such an index.

The intention of this article is not to convince people to ignore the IIP numbers altogether but rather to provide a disclaimer for those ‘consuming’ this index. Put in a cliché manner, the intention is to provide one with the grain of salt to ‘consume’ this data with. 

Maybe there is still some lustre in gold

Given the performance of the equity markets in India, most financial newspapers are gung ho about how retail investors should invest in mutual funds or SIP's and not even consider real estate or the eternal global currency, gold, as a form of investment any more. But maybe there are a few gains to be made by investing in Aurum.

Overall thoughts on the commodity

Fundamentally speaking the gold markets seems to be in balance. The degree of imbalance in the short term would at most be demand falling by 1% causing a temporary imbalance but otherwise I do not believe that there is an imbalance in the physical market. With capacity additions now tapering off into H215, as per the new mine addition schedule, I think there could also be a slight tightening in the market. In terms of flows- currency uncertainty, the fall in Chinese markets witnessed last week and the risks of a Greece default and delays of a fed rate hike given US GDP shrinkage numbers being released last week- all lead me to believe that gold is positioned to correct upwards soon.

I don’t know if we will see the 40%+ recovery we have seen in oil prices since they have bottomed but I would not be surprised. I have realized that in the most traded commodity markets- oil and gold- the market imbalances don’t have to be great for there to be an immense pressure on prices induced by financial liquidation. Even with oil the imbalance was of just over a percentage point that precipitated into a 55%+ decline.

Risks to my view

There are two fundamental risks to my view. One would be rising retail domestic investor involvement in the stock markets in India. Jewelry demand in China fell by 10% in Q115. Though this was in comparison to a historic high in first quarter demand in China in 2014 and though the demand was still 27% above the 5 year demand average in Q1, a part of this decline can be attributed to rapid rise in the domestic equity markets. Gold is looked at as an alternative investment by many retail investors. If domestic participation by retail investors in the local stock market rises, some demand for gold would be lost. 8 million new accounts (DMAT) were opened in China in Q115; a 433% increase y-o-y. Given the rising involvement of retail investors in the domestic market in India, jewelry demand supported by need for alternative investment could take a hit.

Another risk to my view is the surge in recycling of gold in Turkey. Given the slowing economic growth, rising unemployment and growing political risk in Turkey, we witnessed the Turkish Lira plunging in Q1. This propelled the price of gold locally to 100 Lira/ kg with gold. This caused a lot of people to cash in their gold for currency and led to a rise in recycling supply for the metal.

How the flows work in Gold’s favor now?

Investors turn to gold, the eternal global currency, when paper currency markets register volatility or in cases of geo-political instability. The world seems to be ripe for both of those to occur now. Currency volatility has dominated 2015. The one popular trade- long dollar- is also lightening up now with people unwinding their long positions owing to uncertainty of a fed rate hike.

Movements in real rates are inversely related to movements in price of gold. With the shrinkage in US GDP noted last week it seems even more unlikely that the Fed will raise rates in their June meeting. This coupled with the rising risk of default in Greece as well as the uncertainty of the future of Chinese markets given the over 9% drop in the Chinese A Shares within two days last week- will force some retail investors into gold.

Moreover the relative strength of the underlying commodity to its miners’ stock price seems to be at a historic high. My guess would be that should there be a correction we would see miners correct a lot more than the commodity price itself.

How do the fundamentals hold up?

Globally, Q1 demand was only slightly weaker than last years’ with most of the fall caused by the increased domestic participation in the equity markets in China. Given the move last week, some of the fringe investors will be drawn back to gold. Moreover growth in demand in India, SE Asia and the US should offset the fall in demand in China.

The key fundamental factor supporting my view on gold is the supply curve. Not only are the mine capacity additions tapering off in H215 but we also see the cost curves adjusting to the lower gold prices having faced lower prices since mid-2013. A correction in gold prices will therefore create increased cash flows per ton for miners who have devoted a lot of the operational energy on lowering costs and adjusting to the new price levels over the past few quarters.