Strategic privatisation can fund fiscal needs for 15-20 yrs: Chhaochharia

Even as there are signs of the economy bottoming out, Gautam Chhaochharia, head of India research, UBS Securities, says investors should not expect a sharp recovery. It is crucial to revive the non-banking financial companies (NBFC) sector, and there is limited upside for markets in the short term, he tells Vishal Chhabria in an interview. Edited experts:

Indian macros have turned for the worse, with some negative surprises also indicating that growth has been much lower than expected. Will it get worse before it gets better?

There are signs of bottoming out if we look at data on the auto and consumer sides, and also in the light of our recent channel checks and field trips with investors. But the data points worrying investors are slightly dated. In such a sharp slowdown, the first improvement in data points will not come from the supply/production side. Production data will respond to an acceleration in last-mile consumer activity.

The early signs of auto sales bottoming out will gradually feed back into the supply chain in terms of manufacturing coming back and increased inventory. Therefore, power, oil & gas, and all such data should gradually come back with a lag of one to three months.

However, the recovery is likely to be gradual. We have yet to see policy measures with the potential to drive a sharper recovery.

When you speak to companies against this backdrop, how do they respond?

In general, corporate sentiment remains muted. Companies have detected signs of bottoming out but their outlook is based on the hope that this will build up, and be accompanied by more policy support to get the situation to normalise. But it is too early for them to go back to the drawing board and set up new capacity.

Moody's recently downgraded the outlook for India. What are its implications for markets and investment?

It has limited significance, as the rating remains investment-grade. Indeed, the Moody’s rating was higher than those of other agencies. It is also important to remember that India is not a major component of key global bond indices, so there is no immediate mechanical impact. In any case, investor action is not based solely on ratings, rather they act on their assessment and understanding of fundamentals. If they were worried about fundamentals, which underpinned the downgrade, they would probably already have acted. The downgrade would have had more significance if it had represented a fall below investment grade. In any case, equity investors pay little attention to ratings.

In one of your reports, you mentioned that there's a huge potential in privatisation of public-sector undertakings (PSUs) vis-à-vis disinvestment. Now that the government has announced a list of PSUs for strategic disinvestment/privatisation, how much value-unlocking potential do you see?

In general, if the sale of a PSU is piecemeal, that is in the form of disinvestment, not strategic. There are two issues. One is how much you can sell. If the government wants to maintain control, the scale will be limited. And second, when you sell piecemeal, the realised value tends to be low. The value of a strategic privatisation could easily be two to three times these companies’ typical valuation.

Historically, disinvestment has been a key element of Budget revenues in India. However, if the government continues with piecemeal disinvestment beyond five years — the estimate is Rs 1 trillion for this year — there may not be anything left to sell. Strategic privatisation, on the other hand, has the potential to meet the government's fiscal needs and even support capital expenditure on infrastructure for the next 15 to 20 years.

How do you expect the government’s Rs 25,000-crore realty package to play out, and how soon will the benefits accrue?

The real estate sector has generated a broad stress in the economy, not only for property developers but also for the banking system, even households. A large amount of capital is trapped in incomplete projects.

Secondly, one must look at the property cycle. Today, urban property sales are lower than those in 2012. For a growing economy, India has low levels of ownership and poor-quality housing. If the housing cycle remains strong, it has a multiplier impact on the rest of the economic landscape — on credit, cement, steel, etc. We have seen that happening in US and China. After the global financial crisis, property prices corrected, but these countries made sure, from a policy perspective, that the property cycle remained robust and steady, facilitating rising property prices annually. Today, we all know what's happening to property prices in India.

By our estimates, the value of urban household residential stock in India is roughly $2.8 trillion. This value of assets has been stagnating because prices are not increasing in line with inflation even. In fact, prices are declining in real terms, and in absolute terms in Mumbai and Delhi. So, it has a multiplier effect on sentiment, ability to leverage, etc.

Property has an important role in the growth cycle. In India, it has been a drag on growth in the past seven to eight years, largely because policy environment has raised real interest rates for developers and the general public, despite affordability being at its best in the past 15 years.

The narrative has become weak. People are not buying property, not because they cannot afford it as in the case in 2009 or 2010, but because many believe property prices will not go up, even go down. So they are asking ‘why buy now’? It is a narrative that policymakers need to change through policy measures, if they want a quicker recovery in macro growth.

With regard to the Rs 25,000-crore package, it is a positive step because many projects have been stalled in the absence of last-mile financing. A great deal of currently-blocked household capital will get unlocked. NBFC lending to these assets will become performing loans and construction activity will resume, so there is a significant multiplier impact.

The cost of construction in the value of property is small, so Rs 25,000 crore will have a significant multiple in terms of value unlocked. The package has the potential to help the supply side by easing stress for developers, financial companies, and households. But, in itself, it does not revive or drive a property cycle in terms of sales/price growth. Only policy intervention will change the narrative for households.

Given the liquidity situation at NBFCs and low bank credit growth, how and when will economic growth revive?

It will be gradual, and it is extremely dependent on confidence. The Reserve Bank of India (RBI) has tried to improve the availability of finance, but it cannot force anyone to lend to a mutual fund manager or an NBFC. So, it is more dependent on the risk appetite or lending standards for the bank/debt mutual fund manager concerned, rather than the regulatory environment. Confidence takes time to return, unless there is a strong policy intervention, such as the RBI increasing systemic liquidity or cutting rates aggressively, or enforcing measures to improve the transmission mechanism. Should the government become more relaxed about the fiscal deficit, confidence could improve and the recovery could accelerate, but, at the same time, it implies higher costs in the future. After all, there is no such thing as a free lunch.

We forecast that gross domestic product (GDP) growth will bottom out in the September quarter, and a gradual recovery will follow.

For banks, will the trouble at groups like DHFL, ADAG, etc, mean that the pain will resurface?

We track non-performing asset (NPA) numbers for bank, at aggregate and group levels. At an aggregate level, roughly 17 per cent of banking-system loans have been recognised in the past few years. If we look at incremental stress because of NBFCs, real estate, small businesses, retail, etc, incremental but so far unrecognised pain over the past year could be between 5.5 per cent and 6 per cent.

If the stress in the NBFC system is not resolved quickly, it has the potential to become a drag on growth for the next three to four quarters. At an aggregate level, capital in the banking system is enough to absorb this. The key is the introduction of a resolution, be it a hair-cut on bad loans or raising of capital. If it is not addressed, it can remain a drag on growth.

How do you view the deterioration in corporate governance?

I would not necessarily say that it is at a low. In general, corporate governance issues tend to become public when market cycles are weak. When you are in a growth phase, supported by leverage and sometimes insufficiently robust fundamentals, markets are prone to ignoring red flags. Contrastingly, in a slowing economy where funding may be scarce, markets exert greater scrutiny. So, I would say corporate governance today is not weaker than it has historically been. But, it reflects the economic and market cycle; and some of it is not necessarily corporate governance but over-leveraging. When the market cycle is weak it can create a vicious cycle.

On the contrary, as more of these cases have come out, there has also been increased scrutiny by policymakers, regulators and investors around these practices. The debate has centred on the role of auditors, credit-rating agencies, etc. In view of this, corporate governance practices in India should improve.

Are there events that investors could watch out for in the global or Indian context?

Global events, especially geopolitics, are difficult to predict. But we expect global growth — the US, China and the rest of the world — to decline in the next quarter or early next year, before we see a recovery. In our view, markets are underestimating the impact of the US-China trade war and the tariff issues on trade and global economic growth. Geopolitics is always closely tracked by markets. If it comes through around West Asia, specifically oil prices, it will matter to India.

On the Indian side, we will be looking for four things from the cyclical and structural perspectives. First, demand-side measures for the property sector, which can quicken cyclical recovery. Second, the broader reform agenda, including labour reforms, etc. Third, privatisation of PSUs, which could potentially surprise markets. And that's not well enough factored into the macros as well as markets. Last, the golden opportunity for India as manufacturing shifts away from China. The past year was dominated by elections, but now we are seeing a clear, focused government approach to tap into the opportunity, as seen in its move to reduce corporation tax rate. Further policy measures would be a signal for long-term growth in India.

Given the current circumstances, how will you play the market for the next six to 12 months or till the Budget?

We look at two things from the India perspective, the earnings cycle and the price-to-earnings (PE) multiple drivers, the latter being the hope around India from a growth perspective. So, the reforms and macro agenda matter — not quarterly data print per se — from a one-to-three-year point of view. Our base case is that the corporation tax rate cut, beyond the structural impact of attracting manufacturing and investments, will help headline earnings in the near term.

We are very positive on the reform agenda and expect both labour reform and the privatisation agenda to play out. So the narrative will remain supported. Keeping these two in mind, my target for June 2020 is 12,300 for Nifty. We were constructive in the past few months because markets had become over pessimistic around near-term growth challenges.

But, now that the market has rallied, the near-term risk-reward is getting less attractive when compared with three months ago. It's more balanced. I wouldn't be overly pessimistic, but, tactically, it is unlikely that much money will be made over the next six months. But otherwise, it is worthwhile to remain constructive beyond that period. I would also caveat that with a tail risk. When considering the build-up of financial services risks (NBFC, etc) and that things are bottoming out, there is a tendency to assume uninterrupted support from policymakers. It's about confidence. And confidence is very tricky to model for policymakers or for us. If that's not managed well, the vicious negative feedback loop as you have seen in the economy and markets in the past year is the tail risk.

Would you shift some money from top-rated stocks to smaller caps?

We remain underweight small- and mid-caps, and that hasn’t changed in the past couple of years. Among the large-caps, we see opportunities beyond the expensive high-quality names. We are overweight financials — both high-quality names and cyclicals, oil & gas as it could be the biggest beneficiary of International Maritime Organisation (IMO) regulations, and privatisation. That's a sector where we could see material re-rating. We remain overweight telecom. We are still not overweight small- and mid-caps because while relative valuations have come off, you need not just the macro or reform agenda driving multiples but real earnings visibility for these stocks to do well. For that, you need a real economic uptick. That visibility is not there for the next two-to-four quarters.

And the broader liquidity in the system and market is not really conducive, either. If you are asking for three to five years, maybe. But, in six months or one year, not yet.