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Hard times

Rajiv Bhuva | Print Edition: Dec 25, 2011

If a final confirmation of India's worsening economic situation was needed after a string of disparate signals over the past months, it came on the last day of November. Data put out by the Central Statistical Office showed a significant pullback in growth during the July to September quarter.

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The 6.9 per cent growth in the gross domestic product, or GDP, during the period was the slowest in more than eight quarters, pulled down chiefly by the mining and manufacturing sectors.

Although the slowdown was evident across all sectors of the economy, what really raised the hackles was the dip in gross fixed capital formation, a harbinger of growth slowing down further.

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How has the corporate sector fared amid all this? An analysis of the performance of BT500 companies over the past two quarters tells its own tale of woe. These companies recorded a healthy top line growth of 25 per cent, but their operating profit fell to 11.70 per cent while their net profits declined by 18 per cent over the same period last year.

David Bloom, Global Head of Forex Strategy, HSBC Bank
The rupee has room to fall further, and if global growth expectations continue to decline and dollar liquidity pressures intensify... we believe the dollarrupee rate could reach the 58 level: David Bloom
A 30.59 per cent growth in raw material costs proved to be the biggest profit margin pincher for companies. "Companies are not in a position to pass on the higher raw material prices through price hikes," says Dipen Shah, Head of Fundamental Research at Kotak Securities. While the rally in commodity prices during the first half of the year has cooled off to an extent, the sticky inflation in the economy remains a source of constraint.

'Rising input costs hit business confidence'

Says Nick Paulson-Ellis, India Head of Espirito Santo Securities: "The inability to pass on higher input costs was more evident among smaller companies." He says that the operating profit margins of Espirito Santo's small cap universe of companies with market capitalisation of less than $250 million contracted by 460 basis points compared to a 100 basis points contraction for large caps that market capitalisation above $5 billion.

According to Paulson-Ellis, larger companies with strong brands are in a better position to cope with higher input costs, as they enjoy better pricing power and are able to exploit inflationary conditions to push through price rises. But if higher prices run into lower demand, after a point the consumption story will hit a roadblock. The companies' profit margins also came under pressure due to the rise in the prices of power and fuel, and salary costs, which grew over 28 per cent and 15 per cent, respectively, during the period.

Also, for 423 non-banking and non-financial services companies from the 2011 list of BT500 companies, interest costs rose by 33.56 per cent during the first two quarters compared to the same period last year, thanks to the 375-basis point hike in policy rates over the past 20 months by the Reserve Bank of India.

Rupee fall: Moody's sees moderate impact

"Most companies are debtheavy, but some have seen over 50 per cent annual growth in interest outgo in recent quarters," says Shah of Kotak Securities.

Adds Espirito Santo's Paulson-Ellis: "Input cost inflation and higher interest expenses have been margin squeezers over the last three quarters."

And now there is the added uncertainty of the rupee. While the rupee has traded at an average of Rs 46.06 to a dollar in January-November 2011, it strengthened to Rs 43.95 on July 27 before weakening to Rs 52.70 on November 22, a fall of nearly 20 per cent since July 27.

"The companies that are hedging their exposure would not have hedged for the current levels of surprise," says Paulson-Ellis.

According to David Bloom, HSBC Bank's Global Head of Foreign Exchange Strategy, the cataclysmic changes in the Euro zone are not leaving any economy untouched and in that respect, currency has to be seen in a relative context. "In last three months, the long-term prospects of India have not changed a bit," says Bloom. "But that of the US and Europe have changed."

There are worries about foreign institutional investor, or FII, inflows, too. Even though there have been no significant FIIs outflows - just $354 million - this year, this has been due to the relative immunity showed by India in 2008, when global markets were seized by a slowdown, and the widely-held perception that it would be a hedge to a global slowdown, according to a mid-October equity research report by Credit Suisse.

"We, however, feel that this optimism is misplaced, and FII inflows are likely to stay muted over the next six to 12 months," say the co-authors of the report, Neelkanth Mishra and Karthik Visvanathan.

This is not just because of the disproportionately high inflows over the last several years, but also because the earnings growth is likely to remain muted for sometime. "FII inflows in the past have been driven by earnings growth expectations," the report adds.

"Investors are in the mood of surviving and not thriving," says HSBC Bank's Bloom. "The rupee has room to fall further, and if global growth expectations continue to decline and dollar liquidity pressures intensify… we believe the dollar-rupee rate could reach the 58 level," he adds.

Further weakening of the rupee could spell more trouble for Corporate India. Oil marketing and metals and mining companies will be the biggest losers as imports will become costlier. On the other hand, companies in the pharmaceutical and information technology, or IT, sectors will stand to gain from it. "For every one per cent of rupee depreciation in the average exchange rate in the period, IT companies have a 30 basis points' positive impact on their margins," says Paulson-Ellis.

But, in general, a weaker rupee will start impacting companies on their external commercial borrowing, or ECB, repayments, when companies will have to book mark-tomarket losses in their profit and loss accounts.

In 2011, Indian companies have raised over $30 billion debt abroad to take advantage of lower interest rates. New Delhi-based SMC Global Securities estimates that the additional burden on companies on account of ECBs will be around $5.4 billion, or over Rs 28,000 crore.

So, are we going back to 2008?

The Sensex has lost 21.95 per cent in 2011, up to November 29, but in dollar terms the decline is more than 32 per cent. But Paulson-Ellis thinks otherwise.

The current valuation of the Indian market at 13.1 times one year forward price to earnings, or P/E, is below the 10 year average of 14.3 times, but not yet at the capitulation levels of sub 10 times we saw in 2008. "India is trading below historic averages, but is not cheap enough to be sure it has found a floor given the level of domestic and global uncertainties".

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