The recently released second quarter GDP number for India pertaining to the current financial year (i.e 2009-10) has been a clear surprise on the upside. A YoY growth of 7.87% takes the first half GDP growth to about 7%. This calls for an upward revision of my annual growth forecast. However, I am hesitant to do so before I see the Q3 GDP numbers. But, more of that later. First, The analysis.
As mentioned earlier, the recorded growth is a big surprise and the market reacted very positively to the news. While the growth of the industry at 9.21% was on the expected line, the growth of services at close to 9% was a surprise. Construction growth of about 6.5% was definitely above expectation given the high base effect. What is also surprising is that the segment ‘Financing, Insurance, Real Estate & Business Services’ showed a robust growth (about 7.7%). I was expecting a slower growth especially in light of faltering credit offtake scenario. The other surprise was a minor positive growth recorded by agriculture, which I expected to show a marginally negative growth. On the positive side, there has been some minor rebound in the GFCF (Gross Fixed Capital Formation) number. Although at 7.33%, it is lower than the average. However, what carried the day (as has been happening for the last few quarters) was the positive effect of the government stimulus package, especially aimed at rural and social sector. The GFCE (Government Fixed Consumption Expenditure) increased by as much as 26.91%. Not surprisingly, ‘Community, Social and Personal Services’ increased by as much as 12.66%, the highest increase amongst the various components of the service sector.
This takes me to my areas of concern. The extent of GDP growth rate is still crucially dependent on government consumption. While there has been some increase in the growth rate of PFCE (Private Final Consumption Expenditure) or domestic demand (5.63%), it still needs to grow faster and be more stable at the higher rate. So far, that has not been the case. As has been mentioned by me earlier, the lack of domestic demand is clearly evident from the financial performance of the Indian corporates during quarter ending September’09. While the growth in their bottomline has been quite robust (above 20%), the topline (sales revenue) hardly moved. On the other hand, if one factors in the effect on inflation on sales revenue, the volume growth will not be impressive at all. This clearly indicates lackluster demand. Also, the recent increase in domestic demand has a lot to do with the effect of the festival period, apart from the lingering effect of 6th pay commission payouts. This is also reflected in increased industrial activity.
Whether I would need to change my expectation of GDP growth for the full year would depend on how the Q3 data pans out. The existing data of the first half of the year cannot be extrapolated to arrive at the growth for the entire year. The next two quarters would see the real effect of poor monsoon and I expect the contribution of the agriculture sector to be negative during this period. Domestic demand might peter out again, if the faltering credit flow is any indication and also given that the festival period is behind us.
The other big unknown is how the global scenario pans out. I am amongst the pessimistic camp in this regard.
Hence, the crucial component with regard to the sustainability of high growth would be the role played by the government. If it continues to remain extravagant despite the rising fiscal concern, the growth might be stable, though at the cost of future growth. If the government looks forward to implementing the exit strategy during this fiscal, the growth will be impacted. The other crucial aspect would be how soon the RBI starts tightening the interest rates. The interest rates have already bottomed out. If it starts moving north in reaction to rising inflation, growth will be hit.
I also have a feeling that the initial growth estimates for Q2’10 might be revised downward, especially given some factors explained earlier.
As of now, I stick to my expected growth band of 5.8 to 6% for the full year.
A look at the US unemployment data trend indicates that the unemployment rate in US generally tends to peak a few months after the recession ends. In the last couple of recessions, however, unemployment remained high for an extended period even after the recessions ended.
Source: BLS, NBER
What explains this phenomenon?
When an economy enters into recession and demands slide, economic activity reduces. Manufacturers start to reduce production (resulting in falling capacity utilization), lay off workers (rising unemployment rate) and start drawing down on inventories.
Source: Fed, NBER
Source: BEA, NBER
What this means is that, the end of recession is signaled by the reduction in the pace of inventory drawdown and leading to inventory built up. This, however, does not mean that the employers would restart hiring, even when demand shows signs of bottoming up and maybe even rising. Only when they are convinced that the rising demand will be sustained will they start hiring. Till that time they would bank on productivity increases, hire part time workers and make the existing workers (the critical mass of people they want to hold onto) work more.
Source: BLS, NBER
The corporate sector performance in India, in terms of bottomline growth has been quite strong in the last couple of quarters. An analysis of the performance of a large number of non-financial and non-oil companies by the Economic Times showed that, while their topline has hardly moved, the bottomline has, on an average, increased by more than 20%. This has enthused the market no end, and save for a few corrections (due to both global and domestic cues), the undertone remains quite bullish.
The bullish undertone is evident from India’s VIX (Volatility Index) that was launched a couple of years back by the National Stock Exchange (NSE).
With the VIX hovering near its lowest level, it is clear that the risk perception of the market is quite low while the Nifty is now only about 20% adrift from its all time high, although the economic conditions were quite different during these periods. Is the market under pricing the risk? Quite so. Here, I will dwell with one of the three factors viz liquidity, corporate performance and government intervention.
Corporate performance – It’s important to note that non food credit growth in India has slowed down substantially. A tapering off of credit flow does not really make for a highly positive corporate outlook.
And with domestic demand remaining flat, corporate toplines have hardly moved during the last two quarters. Fact, however, is that the higher bottomline was on account of depressed commodity prices, low interest rates and low labour cost. Going forward, none of these would be able to boost the performance as these have, in the past.
Commodity prices: After the commodity prices peaked in 2008, they went on a tailspin.
This is clear from the movement of the MGM Index. It is an index of base metals (aluminium, copper, zinc, lead, nickel and tin) developed by Metallgesellschaft (MG), the West German meatals, engineering and chemicals group. Off late, however, the commodity prices have picked up sharply. This is not only attributable to restokcing of commodities, mainly by China, but also to a large extent to the inflow of liquidity into commodities as asset class. Whatever some experts might want us to believe, the uptick in commdoty prices has nothing to do with perceived ability to have moved out of recession. Flow of liquidity in the commodities has been further exacerbated by the plethora of commodity Exchnge Traded Funds (ETFs), that are attracting the investors in drove. As per an estimate, the commodity ETFs have seen an investment of over USD 30 bn. The run-up in oil prices is another case in point. I read somewhere that the average daily trading volumes in key energy future contracts is at around 15 times the world demand. Phew. With commodity prices ratcheting up, this will lead to heightened cost pressures going forward.
Interest rates: The recent announcement by the RBI clearly indicating a tightening of monetary stance also implies that period of cheap liquidity is over for the Indian corporates. While I am not expecting the interest rates to rise soon, there are enough indications that as inflation picks up, interest rates will also go north. Agreed, the current bout of inflation has a lot to do with excessive food prices on the back of failed monsoon, but I expect the the food prices to moderate at a later stage as the Rabi output enters the market. However, with commodity prices moving up, it will start feeding into inflation. Also, with the monetary policy clearly in a tightening mode, pick up in credit demand will also lead to hardening of interest rates.
Labour cost: Anecdotal evidence also suggests that the thaw in the domestic job market is over. As companies come up with their hiring plans and retention of talent becoming paramount, reduction of work force or implementation of wage freeze is no longer an option now.
Clearly, as cost reduction ceases to be a feasible alternative for the corporates, sustenance of a 20% plus growth rate in corporate bototmline will not be possible, unless there’s a dramatic increase in their topline. This requires a substantial increase in domestic demand which does not seem likely. Added to that, likely increase in interest rates will act as dampener for leveraged consumption that many consumers have been used to during the last few years of cheap financing options that were available.
Hence the expectation of moderating corporate performance.
All talks about US economic recovery has been thrown to the wind with the latest release of the unemployment numbers today. The unemployment rate jumped by as much as 40 basis points in one month, up from 9.8% to 10.2%, while the general expectation was a level 9.9%.
Nonfarm payrolls declined by 190,000, more than the expected figure of 175,000. While this jump would have some technical component to it, the current unemployment rate is still a reality. More interestingly, the largest job losses have been in the construction, manufacturing and retail trade. The dip in construction is not surprising as there is a large scale fear that after the scheme of first time home buyer credit of USD 8,000 expires (slated for end of this month), demand will plummet.
Going through the numbers, there are quite a few interesting observations to be made:
· Unemployment among full time workers (i.e those desirous of working full time or are on lay off from full time job) has crossed 11% mark to reach 11.1%
· 156,000 additional people remained unemployed for more than 26 weeks, thereby making them ineligible for unemployment insurance
· In last one year, an additional 3.2 million people have stopped receiving unemployment allowance
· Of the total unemployed, currently 35.6% of them are not getting any allowance
· The average duration of unemployment has gone upto 26.9%, the highest ever recorded
What this means is that recovery (or some acceptable form of it) will only be possible if the stimulus package continues. Withdrawal of stimulus will affect likely nascent recovery.
Not surprisingly, yesterday the Senate passed the proposed extension of unemployment insurance benefit. Once this is okayed by the House and the president, the Emergency Unemployment Compensation Extension Act (HR 3548) will provide immediate assistance by extending relief to those workers whose benefits would or has already run out. The legislation will provide families in all states with 14 weeks of additional benefits, and six more weeks to the 27 states with the highest unemployment rate. Workers in these high unemployment states who have exhausted or will soon exhaust their benefits will be eligible for a total of 20 additional weeks of emergency unemployment compensation.
Now, the funny part. The bill would cost $2.4 billion, and will be paid for with an extension of the federal unemployment tax (FUTA). In essence, the government will force the companies to pay more tax for hiring employees, which would then be used to pay the allowance.
My fear is that, this will actually make the companies even more reluctant to hire full time workers. When the business is not sure about sustainability of demand, they would not prefer to hire full time workers as it will be even more costly (given the imposition of additional tax). They would prefer to increase productivity of the existing workers (as was evident from the rise in productivity numbers released yesterday), hire part time workers (as is evident from a dip in unemployment rate among part time workers, from 6.4% to 6.1%) and increase the work hours of part time workers.
Another point to be noted is that, the Senate yesterday also approved extension of the USD 8,000 first-time homebuyer tax credit through April 30, 2010 and provide for a USD 6,500 credit to new purchasers who have lived in their current residence for five years or more. This will, ofcourse, moderate the fall (may even see some increase) for some more months going forward. But this is more about postponing the inevitability and preponing the future demand (which will have even adverse impact on recovery).
Issue is, the basic problem stays. Consumers would need to contract and deleverage. Continuing the allowance for some more months will not lead to any sudden loosening of their purse strings, wiser as they are with recent experience of jobs hard to come by while bills (to be paid) being the reality. Companies would have been better off if they would have been incentivized by the government to hire people, which would have brought back some stability and confidence.
One event look increasingly (read ominously) possible. The double dip recession, the moment the government realizes that the fiscal burden is becoming too high and starts to exit. Brace for an even more difficult 2010.
Pasted below is the link to my article (on the above issue) that has been published by Financial times today