Inflation and change

BEATING THE STREET

Any long-term investor must be capable of handling change. Long-term investors must create contingency plans to deal with occasional catastrophe as well as continually cope with twitchy interest and forex rates.

Even in adversity, an intelligent investor can hope to make money. During a crisis, an investor can pick up assets while they are cheap; he can always search for sectors or individual companies that will grow faster than the norm.

So long as there's some growth, it's possible to cope with inflation, deflation and crises. The most painful situation is one of zero or negative growth.

India is unlikely to hit that nadir. But market expectations are based on an assumption that Indian GDP will grow at 5 per cent plus through the next decade.

To Indian investors, 5 per cent growth is stasis and anything less is negative growth.

At the bottom of the boom-bust cycle, the Indian economy (post-liberalisation) appears to put in at least one year of lower than 5 per cent growth in every five. The chances are, we'll see this dip inside the next two fiscals.

There are other basic assumptions investors don't articulate. Interest rate reductions over the past few years have triggered a consumer boom and created a widespread belief that rates will stay low.

This is true in that spreads between inflation and interest rates will not widen, meaning real rates will stay low.

But there is also widespread belief that inflation will stay low and this is debatable.

India has undergone several years of the lowest inflation in recorded history. There are signs of higher inflation in the rising wholesale price index. Sooner or later, those numbers will feed through to consumers.

At that stage, dramatic things might happen. In the last five years, the Indian consumer has got used to spending next month's salary. Demand has been driven by big-ticket hire-purchase of autos and white goods, plus an enormous number of new housing loans and generally expanding credit-card usage. Much of this borrowing has been done at floating rates.

I would suspect that, as a result, a large proportion of the Indian middle-class is over-leveraged. Indian salaries are not inflation-indexed in a meaningful sense and floating rate loans are.

A high-inflation situation where loan servicing becomes tough for the middle-class may mean gloom and doom.

When this happened in the US and UK in the 1980s, the negative effect was exacerbated by a sharp fall in real estate prices.

The demand for housing dropped as interest rates rose and defaults on previous loans also shot up; the twin effect led to lower real estate values.

Lenders then ended up repossessing properties worth less than the original mortgages that they had lent against. Many institutions with large housing loan portfolios went bust.

Could this happen here? Well, the screwed up legal system may actually insulate the economy. Lenders are always reluctant to repossess because the process takes decades.

Most would prefer to suffer through default. But how many consumer-finance institutions have the pockets to cope with an extended scenario of higher default and lower credit offtake?