Hard Times Ahead? - Sanjeev Pandiya

Interest rates have 'plateaued' said a headline in a pink paper. The chairman of one of the leading banks in India was quoted as assuring the public at large that interest rates had peaked. Even as he said this, his bank was putting out term sheets to corporates that quoted only a floating rate. Some time back the bank was happily writing fixed rate loans. So whom do we believe… the papers or the actual actions of the bank?

Don't believe what the banks say. Corporate demand for credit (i.e. projects already announced) stands at roughly $900 billion for an economy roughly $800 billion in size.Assuming a net savings rate (net of government and public sector dissavings) of 25 per cent, we can expect an inflow of roughly $200 billion per year growing at 8 to 10 per cent (assuming some increase in the savings rate because of higher interest rates).

Now add retail and government demand for credit to the demand side of equation and foreign supply of savings (FDI and portfolio investment into debt) to supply side of the equation, to get some idea of the balance between the demand and supply of money. This would mean that the current set of outstanding projects would need roughly 7-8 years to fund with domestic savings, on the assumption that half the domestic savings find their way into the hands of growing corporates.

I don't have data to give you the details, but consider the following: corporate demand comes from a large variety of projects. The actual investment into these projects would have different gestation periods - from one year in an FMCG project to six to seven years in a steel project (may be more in a core infrastructure project). The demand for credit, therefore, would have an average tenure, which I think is roughly four to five years because a large number of industrial greenfield projects would be executed over more than five years.

Sometime during all this, the equation will go out of whack. In the short run, demand for credit at the margins by corporates (that are looking to raise money for projects that are half executed), will trigger a liquidity crisis. The flow of savings will not match perfectly the needs of the project. From a “liquid” situation, we are moving towards a tight situation where any supply shock will create a spike in rates, similar to the steep hike in call rates that we just saw immediately after the CRR hike by the Reserve Bank of India (RBI). These actions by the RBI are like short jabs on the brakes when a driver seeks to tell the car behind him that he is slowing down. You don't want to surprise the guy behind you but you do want him to slow down.

This is the big point. For the last three years we have had high GDP growth in a high liquidity situation, very similar to the flood of fuel into an engine just prior to accelerating the car. What you will now see is the momentum of the fast moving car trying to pull out fuel from the carburettor, even as the fuel is drying up. In the analogy above, fuel is the equivalent of liquidity (supply of money) while acceleration and momentum relate to GDP growth (which in turn creates the momentum of credit growth).

Have I made my point? The average tenure of flows into the projects will rise above the average tenure of domestic savings flow (creating a large and widening) “savings gap” which will have to be funded by overseas inflows.

Up to a point, portfolio flows will be responsive to the rise in interest rates, especially if liquidity in the US dollar goes up. If we see a recessionary outlook in the US, followed by a few rate cuts we will see rising liquidity coming from the US. As the cost of capital drops, this might result in higher overseas flows of both portfolio investments and the foreign direct investment (FDI).

On balance we have to compare relative momentum.

Quite obviously, real interest rates (nominal interest rates minus inflation) in India have already risen above their long-term averages. The momentum of credit growth is not slowing down, although I am expecting to see first signs of credit growth cracking. There was a recent news item that home loan growth has already started falling off. The same should start happening to corporate demand for credit, shortly.

There are bigger risks on the supply side. The RBI with its repo/reverse repo and CRR rate hikes is doing its bit to slow down the expansion in liquidity. There is some drawing room talk of India's forex reserve being brought back in case of a crunch.

I don't see that happening, even as the central bank is going around tightening liquidity.

The prevailing bias would suggest higher interest rates. My colleagues in the CFOs' community have started to talk about the nightmarish Manmohan Liquidity Crunches of 1991 and 1996. The first was driven by the bankruptcy of India on external account and the second was a crunching, mind-numbing braking of the economy to fight inflationary fears, prior to a national election.

At the current juncture, circumstances are much better. For one, India has large forex reserves with a negative carry. This (negative carry) will increase as nominal interest rates rise in India and they fall in the US. At any point in time, these funds can be brought back to lessen the liquidity crunch.

That brings us to overseas capital flows coming from portfolio investments/FDIs. The big 'supply shock' from these flows will come from rising risk aversion in the middle of a global slowdown. The premium demanded for moving money to India will increase sharply, the moment the profit slowdown shows up in the bottom lines of the companies.

It is dangerous for me to put numbers behind each of the above factors but I am willing to bet on the direction.

There is a clear consensus among all large financial players that interest rates are hardening and the medium term view is that liquidity will stay tight. Banks that gave us 10 year fixed rate loans at roughly 7 per cent a couple of years back are today not willing to write.

similar loans even at 11 per cent. The message is clear - only floating rate loans, relatively lower tenures and no premature termination clauses. It is clearly turning into a sellers market reminiscent of 1996-1998. All this mumbo jumbo recounted above is meant for practicing CFOs (who might find most of the above to be obvious).

For you dear reader, I'll keep it very short. Start preparing for coupon rates to become perhaps one-and-a-half times current levels. As the base changes you can immediately expect a drop in the market PE ratio. Adjust this PE for, say, 15 per cent profit growth and re-calculate the level of the market. Do the same for the expectation of real estate returns (refer to my previous articles to understand the equivalence between equity, real estate and debt market returns).

In short, over the next 3-5 years, returns in the debt market (current yield) will rise but bond prices of existing issued paper will fall. Average PE in the stock market will also fall, so you will get less price appreciation for the same profit growth. And God forbid, if there is a profit dip, the stock will get crucified. Liquidity in the real estate market will dry up. In some overpriced markets, there may be bubble bursts but in most of India where houses have been bought without borrowings, there will merely be no buyers. A panic seller who is forced to liquidate for any reason will have to sell at a huge discount.

So where do you go? My answer is: there is a time to make money and there is a time to save money. We are entering that phase of the liquidity cycle where cash will be precious. This is the time to turn virtuous.