India in Eye of GEM Currency Storm…

27th August 2013

Does history repeat itself, as if we learn nothing from one crisis to another?”

Duvvuri Subbarao, outgoing head of the Reserve Bank of India, speaking recently

Or rather another 1991 in India’s case. It’s remarkable how complacent GEM bond and equity investors have been regarding deteriorating external balances, a key factor which I’ve highlighted repeatedly over the past year as a driver of portfolio allocations. Korea or China might have had relentlessly negative earnings momentum, but no risk of a destabilizing margin call from global markets. We saw endless sound bites in recent years about how much stronger GEM solvency and fiscal dynamics were versus developed world, justifying the dramatic re-rating of EM debt. In fact, stripping out China and the Gulf oil exporters, the aggregate current account balance of emerging economies has slumped from a 2.3% of GDP surplus in 2006 to about a 0.75% deficit this year, the biggest since 1998. In recent months, that stark reality has begun to be reflected in divergent risk premia.

India has been a focus of that re-pricing; FX reserves now cover its CA deficit and short term debt (by residual maturity) by just over 100%, down from 400% in 2005. Coverage of total external debt plus the CA is down to just 60%. Only South Africa and Turkey are in such a weak funding position within major GEM economies; in contrast, Brazil’s reserves are double its gross financing needs.  Indonesia is in an ever weaker coverage position and saw the most savage selloff last week, with the IDR down 6% against the USD and the JSE down almost 9%. Policymakers in both India and Indonesia are flailing around with new policy initiatives to stem the panic. However, curbing the voracious local appetite for BMW imports in Jakarta with import tax hikes isn’t going to help much, and rates have to move positive to stem the rout, implying further hikes of at least 100-150bps and GDP growth slowing to sub 5% next year. As highlighted in several notes since last December, the country was a prime candidate for a panic like this.

About $22bn in private sector debt repayments are scheduled for H2 in Indonesia; the $119bn increase in total external debt position from 2006 to 2012 included private sector external debt rising by $48bn. The debt/export ratio stands at a current 120%, reflecting weak commodity export prices. Short-term Indonesian external debt by residual maturity stood at almost 59% of FX reserves as of end July. In other words, the panic is far from irrational as GEM portfolio inflows have reversed sharply since mid-May, and the question now is whether it feeds on itself or gradually calms. There are plenty of reasons to be relatively sanguine, not least the unseemly scramble by previously bullish but as ever momentum chasing IB analysts to slash FX and equity market targets.

Private sector debt as a ratio of exports was about 50% higher in Korea in 1997 than it is in India now; while India’s fiscal deficit is much bigger than those across Asia in the 1990s crisis, high nominal GDP growth means that India’s debt/GDP ratio has been declining even as deficits have remained high to about 66% now on IMF estimates. However, the debt situation is more ominous for the private sector should rates spike/funding dry up; many Indian companies have been on a borrowing binge. Since 2007, borrowing by the country’s 10 most indebted companies has risen from $20bn to about $120bn, with much of that denominated in foreign currencies as the offshore corporate bond market has boomed. Total short-term external debt has risen from $80bn to $170bn. Private firms that owe the bulk of India’s foreign debt will be under intense solvency pressure if the rupee stays below 60 for long. This makes the balance sheets of India’s state-owned banks ever more shot to pieces; they already have bad loans equivalent to 10-12% of their loan books, but in reality above 20% adjusting for ‘restructured loans’.  That second round impact of a weak rupee is one factor complicating the RBI’s task in focusing on growth.

The rupee’s fair value, taking into account India’s relative inflation and productivity is just under 60 versus the USD and after overshooting toward 70, we should eventually see the market stabilize at around that level by early 2014. Total FDI and portfolio investments amount to over 25% of GDP and sustaining foreign investor confidence will be key in coming months. The current account should start improving to sub 4% this FY on a belated export response and weaker gold imports (and gold prices in rupee terms are also at a record). The longer-term solution to the CA deficit has to be India’s domestic manufacturing sector, and industrial exports.

Does History Risk Repeating for Indonesia?

I’ve been cautious on Indonesia since late 2012, terming the country a ‘macro accident waiting to happen’ and moving underweight local equities in late Q1, but a late 1990s style capital flight crisis looks very unlikely unless local policymakers again display remarkable incompetence. So far, despite several missteps, they have retained credibility. Back in the 11th December weekly looking at Indonesia’s generous minimum wage hikes, I noted that: In 2013, there is a growing risk that either inflation lets rip or the trade deficit turns ugly. In either case, BI would be forced to hike rates to defend the IDR. Brazil offers a cautionary tale of excessive domestic consumption growth gone horribly wrong, in the absence of structural reform and infrastructure investment, with a crashing currency as the solution.’ 

And that just about sums up the past few months; the country’s GDP growth fell to 5.8% in Q2, and with a surge in inflation to 8.6% last month, sustained IDR weakness and overall a broad stagflation trend, echoing the pattern from India to Brazil in recent years. This is partly the result of the ‘terms of trade shock’ for commodity exporters, a key macro investment theme which is the flipside of China’s new lower trend growth rate.

Rising consumer spending has been a key pillar of Indonesia’s growth acceleration in recent years, alongside burgeoning natural resource exports, but the latter has been badly affected by the slowdown in China. The impact of this slump alongside the recent 75bps BI rate hikes is beginning to damage broader confidence in the economy and will dampen growth in domestic private consumption, the crux of the bull case. The IMF has recently estimated that each percentage point fall in Chinese trend GDP growth could cut as much as half a percentage points from Indonesian growth, via the commodity export impact.

International financing costs for local corporates are rising as markets anticipate a tightening of US monetary policy reflected in 10-year sovereign yields breaking 8%, a level at which as highlighted in recent notes inflation risks are fully priced in and which has attracted opportunistic foreign buying. Import costs, notably for capital goods, have been pushed up by the rupiah’s depreciation of nearly 9% against the dollar over the past year while business leaders also fear growing political interference in the economy ahead of the presidential election next year. Both factors are capping investment growth, critical to avoid an Indian stagflation style outcome.

Private consumption is still strong, boosted by those minimum wage hikes, expanding 5.1% y/y in Q2. However, investment growth slowed to 4.7% y/y from 5.8% in Q1, accounting for most of the overall slowdown and has now fallen for four consecutive quarters in an echo of India’s structural growth slowdown/supply side inflation crisis. Base-year effects skewed investment, which slowed in y/y terms to 4.7%, but bounced 3.1% q/q seasonally adjusted following a flat quarter in Q1. Policy makers have indeed now given up on supporting the IDR, which has broken decisively through 10,000 versus the USD and saw its worst monthly performance since 2009 in July, adding to inflation upside risks.

Are there echoes of the 1997/8 backdrop in Indonesia’s current outlook? Yes, to the extent there are also echoes of that period across much of Emerging Asia, after a period of rapid credit/GDP, real estate and wage growth with record carry trade driven foreign capital inflows across the region and wider GEM starting to reverse. Global funds pulled $3.6 billion from Indonesian stocks and bonds in the three months through July, amid a general GEM rout on USD strength; globally, this has been a year for a ‘barbell’ strategy of developed and frontier equity markets, with the BRICs a horror story and ASEAN markets turning volatile, with the JSE struggling to rebound from the Q2 selloff.

Longer term, like say Mexico, Indonesia offers a compelling secular consumer income EM growth story, but while Mexico has begun radical structural reforms and an ambitious multiyear investment program under its new government and is attracting a surge in manufacturing FDI, any sustained equity re-rating seems unlikely until the commodity/China growth cycle bottoms out and we have clarity on whether post-election policy making will continue along the recent haphazard but on-going reformist path. A 15x current year forward JSE multiple looks full until at least some of the macro uncertainties clear.