Changing lanes

To counter the possibility of slowing foreign inflows, the focus has to shift to boosting consumption to justify the rich equity valuations

By Mohan Sule
Is consumption going to replace liquidity-driven investment as the pivot for the economy to spin? Symptoms of the change in the mood of the market became noticeable after the equity market crash on 6 January 2014. Overriding the fears of the US Federal Reserve raising interest rates following the 5% growth of the US economy in the third quarter of last calendar was oil’s fall from grace. It pointed to the slowing of the world economy, particularly China, and triggered worries about what it meant for oil producing countries. Remittances from NRIs in the Gulf region form nearly 6% of India’s foreign exchange inflows. The contagion effect of the slowdown in consumption of oil could be as devastating as the 2008 meltdown of the financial markets, when credit dried up as lenders saddled with exotic derivatives, composed of home mortgages of varying degrees of default risks, were left with worthless securities on their balance sheets. The withdrawal of liquidity decelerated the growth engines around the world. The conclusion was that however attractive an economy, it needed inflow of cash to keep its wheels turning. Low interest rates in the US after the dotcom bubble bust at the turn of this century allowed investors to borrow cheap and stash the funds in high-interest rate emerging economies. Quantitative easing or the bond-buying program of the Fed following the collapse of some too-big-to-fail banks injected liquidity in the market when traditional avenues of borrowings had closed down.

The market did sulk after the announcement of the gradual phasing out of the QE programs. However, the Fed’s vow to keep rates near zero till the US economy was on an irreversible path of growth blunted concerns of credit turning scarce. Money poured into assets with the potential to beat inflation in the local economies and low interest rates in the developed world. In India and China, the flow was mainly into stocks and property. As a result, Shanghai and Mumbai were among the best performing markets in the emerging economies in 2014. Due to the Reserve Bank of India tightening lending norms to developers, the property market may not have a crash-landing like it is feared will happen in China, infamous for its financial institutions’ dodgy book keeping. The dangers of investment-led growth, without the backing of consumption, are now becoming evident in both the countries, which share the common trait of high savings rate. In India, manufacturing growth is lagging as reforms are yet to percolate to the grassroots. China is facing a slump as domestic consumption is unable to fill the gap created by the comatose exports markets. India’s wholesale inflation, majorly comprising the manufacturing sector, is down to zero, while retail inflation is sliding as the specter of drought and famine has receded despite deficient southwest and northeast monsoon.

Consumption falls when prices of goods and services increase at a pace faster than economic growth. Interest rates are hiked to cool inflation. The artificial barriers on supply results in underutilization of capacity, created during the boom period. Lowering of interest rates should indicate that the economy is not in a good shape and it needs liquidity injection. Instead, investors view the development favorably for stemming the outflow from equities. It is considered positive for sectors whose top line depends on borrowings by consumers. Hence, the beginning of the softening of interest rates sends a strong message that the central bank wants consumption to increase. Both China and India seem to be on the same page on this issue. After consistently ramping up interest rates, China’s central bank executed a U-turn in November. Another round of reduction is due anytime now. The RBI, too, has signaled its readiness to begin its cycle of rate cuts from this year. An important player in determining the cost of money is the government, which comes to the market to meet its expenditure needs. The success of the current phase of PSU divestment, therefore, is important as it will remove the presence of the elephant from the room. Even the forthcoming telecom spectrum auction is receiving attention for its ability to improve the country’s balance sheet. However, bagging licenses at reasonable rates is the key to ensure competition, so vital to increase usage. The government’s idea of allowing consumers to choose their power suppliers will be a step up the pyramid, the bottom being the unleashing of competition in the consumer staples and discretionary space. Improved consumption will moderate valuations of heated stocks, enabling more investors to enter and better price discovery. For all these reasons, investors should go out to eat, play and buy.