Policy concerns

SMARTSHARE

At first or even second glance, the macro-economic numbers are fabulous. GDP has grown at 8 per cent in the first half of 2005-06. The upper-end RBI estimates of 7.5 per cent GDP growth in 2005-06 appear conservative.

Worries centre on deficits and currency pressures. The fiscal deficit is increasing. The current account deficit is likely to hit the $20-25 billion mark for the full fiscal. The trade deficit is also going to be large "" though softening crude prices may keep this below earlier projections.

The forex warchest is large enough to maintain balance at projected current account deficit levels. However, rising external deficits imply that any pullouts by FIIs would put the rupee under serious pressure. We will certainly see some devaluation and we will, in all probability, see interest rates rising.

Growth is being driven by manufacturing and services. The latter hit 9.9 per cent. Manufacturing, which rose 11 per cent in Q1, 2005-06, slowed down to a still-respectable 9.2 per cent.

The service growth is driven largely by easy credit and a wealth effect arising from large salary hikes and the housing/ stockmarket boom. If rates rise and demand tapers off, there could be a knockdown effect. If manufacturing fails to keep pace with consumer demand, this could fuel already-rising inflation.

Slowdowns in core areas like power generation, mining, gas and water supply carry another warning sign. This is the impact of halted reforms and it will cause larger bottlenecks in future.

Financial assets often respond better to low interest-relatively low growth regimes than to higher interest-higher growth regimes. Asset prices are driven by liquidity and comparative returns from debt.

The second half of 2005-6 and the whole of 2006-07 may evolve into bottom-up stockmarket scenarios. Only specific businesses with specific strengths will outperform in terms of stock prices if liquidity hardens. Oddly enough, one of those businesses with specific strengths may be in the finance sector, which is always the hardest hit by interest hikes.

Look at IDFC. The stock has outperformed handsomely since listing at Rs 60 in August 2005 (discounting the IPO lottery, which yielded large, instantaneous gains to the lucky winners). Since August, it's moved up around 25 per cent to Rs 75. In the same period, the market has moved up around 14 per cent.

IDFC's business lies in infrastructure lending where growth is assured for years. In 2004-05, it managed close to 25 per cent of total sector disbursals and it could hold most of its marketshare despite competition. One possible growth area is aviation.

IDFC has a magnificent balance-sheet in terms of zero net NPAs and near-zero gross NPAs. It has great operating and net margins on the order of 45 per cent and 42 per cent respectively It's delivered excellent Q1 and Q2 results with a consolidated growth of 69 per cent in net profits and 72 per cent in total income. But there has been a Q2 slowdown. And spreads from lending have got smaller. It has reasonable valuations "" the current price is perhaps 13 times the expected full-year price-earnings.

Rather than rate changes, my concerns would arise from policy. There has been stasis in reforms and that may directly affect the flow of funding into infrastructure projects. If the slowdown continues, it would inevitably lead to lower growth for the corporation. Contrariwise, if policy-making doesn't get slower, a long-term investor may just be picking up the stock at the bottom of a cycle.