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Down, down but not out


I have, over the last few weeks, been frequently asked to comment on the nature of the crisis in the financial sector and its consequent impact on the economy at large. With a view to gathering a broader perspective, I interviewed approximately 25 individuals, responsible for managing businesses across a spectrum from shipping to consumer products, engineering, BPO, automotives, travel and building products, amongst many others. This paper will seek to provide a view on the origins and nature of the problems facing India’s economy and how things may play out in the coming months. The deterioration, from an era of boom and buoyancy, has seldom before occurred so quickly and by so much. Some businessmen are predictably shocked as the world around them appears to have changed and in some instances quite beyond recognition. Most would argue it all began with the collapse of Lehman Brothers. As it happens, the problems actually started much earlier, but few were able or willing to acknowledge the signs.


In September 2007, in a note to our clients entitled “Downside Risks’, I issued words of caution arguing that the growth cycle was likely to turn in 1H 2008. This was based on the fact that credit was growing at about 40% per annum for two years, housing loans by 54% and commercial ones by 100%, despite a hardening in interest rates. Asset price bubbles had formed in the financial markets and in property. Consumers were highly leveraged as were businesses, which had over the recent past gone berserk on an acquisition spree, purchasing assets at values which would seem unthinkable in a sane set of circumstances. The consequences of such exuberance, when liquidity eventually tightens, are usually a hard landing. Subsequently, I argued in my editorial in IMA’s quarterly update “The Operating Environment Assessment Paper” in January 2008 and then again in March 2008 that the first tangible signs of a shift were now increasingly visible. Capital goods producers had reported falling order backlogs and banks were soft peddling on personal loans. We warned that a correction in asset prices was now overdue and perhaps to an extent that it could affect retail consumption and the economy at large.

The government too, under political compulsions, went ahead on a spending binge casting aside all norms of prudence. Rural employment guarantee schemes, oil, food and fertiliser subsidies, farmer loan write-offs, pay commission settlements comprised a long list of wretched initiatives that added some 400 basis points to India’s fiscal deficit – although cleverly the Finance Ministry has kept these off balance sheet. Such programmes soak money out of the system making it scarce and expensive for private borrowers. Most importantly they damage the balance sheets of PSU Banks and the oil marketing companies with grave longer term consequences. In summary the financial architecture was precariously balanced and all that was needed was a trigger that would create an avalanche incredibly hard to reign in.


That trigger was the collapse of Lehman Brothers and the liquidity and banking crises that followed. Global banks began failing as they ran out of cash. They refused to lend to each other, becoming progressively more suspicious of the quality of the collaterals offered. Several American institutions went cap in hand to the US Federal Reserve seeking to be bailed out and were effectively nationalised. European banks faced similar dilemmas and were either acquired by others or were rescued by taxpayer wealth. Liquidity in the global markets dried out.
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The inter-linkages in the global economy work in strange ways. Cash was so scarce that foreign Institutional Investors began pulling out of emerging markets even at high expense. Sale orders were placed on brokerage houses, not on the basis of number of shares but amounts of money, regardless of the prices obtained. FII withdrawals from India’s capital markets touched USD 13 billion within the space of a few months. With limited local investment appetite the markets now faced ruin. Effectively this constituted the trigger for a bear hammering in the currency markets and the Rupee fell by 25%.

To add to the misery, external commercial borrowings dried up totally. The situation was worsened by some USD 49 billion being soaked out of the system in short term credit. Importers and exporters were unable to roll over their funding requirements as offshore funding ceased. They had little choice but to take recourse to local borrowing in rupees, effectively soaking large sums out of India’s financial economy. To add a double whammy, this created downward pressures on the currency as they bought dollars from the foreign exchange markets. Foreign branches of Indian banks too added to the woes of limited local resource. They had in the course of their business, borrowed short and lent long, creating an asset liability mismatch in their balance sheets. When the time came to roll over their liabilities, the money simply ran out – because of the global liquidity troubles – and in order to avoid a default, they had to raise resource in Indian rupees for dollar lending overseas. These borrowings, which are to the tune of approximately USD 10 billion have further depressed the currency markets as well as drained local liquidity. Coupled with the short term credit demands of corporations and foreign branches of Indian banks, has been an absence of ECBs. The latest data suggests that ECBs are USD 10 billion in the negative – that is, there has been more going out through redemptions than inflows through new borrowings. All of these add up to USD 70 billion.

Fortunately, the Government’s initial response was decisive. The Reserve Bank eased liquidity by lowering cash reserve ratio requirements of banks by 1.5%, pumping Rs 60,000 crores into the financial system. The RBI has leverages to pump more money into the system through further cuts in the CRR or an unwinding of market stabilisation bonds that can infuse instant liquidity. Clearly, therefore, the challenges are not entirely insurmountable although such steps do come with an unpleasant flip side – price instability. The critical decision pegs on picking the lesser evil – inflation or illiquidity.


The liquidity crisis has now spilled over to industry which is now starved for cash. Banks have refused to disburse even allocated funding. Some businesses now face the most awkward state of affairs where the absence of capex money has stopped progress on partially completed projects, as bank loans are no longer forthcoming even on commitments previously made. In the property development sectors for instance companies were raising loans at 30-35% per annum and now that this too is no longer possible, have begun defaulting on commitments. The real-estate sector, specifically, which had ballooned on unsustainable prices is now on the verge of collapse. Private Equity investors are urging developers to cash out at what they can get, before the floor comes off and prices cave in totally.

Automotive is in trouble

These developments within the financial economy have begun to spill over on the manufacturing and services sectors although with lesser ferocity than on property and other asset based businesses. The automotive industry is badly off as car and motorcycle loans have nearly evaporated. Banks having previously aggressively targeted personal borrowings are lumped with questionable asset books and defaults are rising with hardening interest rates. Within the luxury segment, the consequences of a negative wealth effect phenomenon seem to be playing out as consumers have lost large sums in the value of their personal wealth.

Manufacturers who have to contend with large import contents in their products are worse off because of a decline in exchange rates. Margins have shrunk as cost increases cannot be passed on. As banks refuse to lend, capital expenditure, other than that previously committed, by OEMs is off the radar and vendors are even worse off.
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Most have been hit twice over through a reduction in volumes, together with a serious hike in working capital costs. The automotive sector will remain under considerable pressure for several years to come, as manufacturers are adding to capacity without the consequent increase in consumer demand. The situation is grim and will remain so.

FMCG is hanging in

In the FMCG sector, on the other hand, things are less affected. Consumer demand remains fairly buoyant, all things considered, although in recent weeks some producers have complained of de-stocking, as ‘the trade’ – channel partners – are under strain due to reduced liquidity. FMCG companies, which are usually less exposed to the vagaries of market conditions, have responded by reducing package sizes to sustain consumption. They have replaced high end brands by ‘price warriors’. Unlike in the previous downturn, however, it appears that this time they will not drop prices and compromise on margins. Growth may moderate somewhat but, in the least, it will come with profits.

All’s well in power

The best news yet is from the power and transportation industries. The order books for manufacturers are overflowing, as power producers such as NTPC, Reliance and the Tatas having previously raised funds are investing in new capacities. Over the next 5 years, approximately 50,000 MW should come up in India. The liquidity problems do not critically affect this industry as multilateral agencies – the Asian Development Bank and World Bank – have dedicated credit lines reserved for power generation. Other infrastructure suppliers, such as cement and engineering equipment manufacturers will continue to have their factories chugging along in the months and years ahead. The Government’s intention to improve the railway network, specifically by means of the dedicated freight corridor (USD 15 billion in investment) and a general modernisation programme (USD 6 billion), will sustain orders for engineering and infrastructure companies that service this segment.

Travellers are sulking

The travel trade has been visibly hit, specifically in the inbound segment. Some tour operators have reported cancellations as high as 40% during the peak Christmas season. European charters to Goa and other holiday destinations are being cancelled. Non resident Indian traffic, too, has visibly slowed considering the almost desperate situation in Europe and America. People are hesitant to move ten feet away from their desks lest it’s moved away. However, domestic travel is, as yet, not as badly off. The next 2 months are nonetheless critical, as they will provide a view on longer term trends.

Few new buildings

The building products industry is understandably concerned. Things seemed fine until September, largely as swings in the market place are cushioned by a six month lag. But the first signs of shifting trends are now progressively more noticeable. Building products usually complement the growth in residential and commercial properties, both of which remain adversely impacted. The BPO segment, which is typically an important customer for commercial real estate, has shelved all but the most critical expansion plans until the global economy begins to settle. Companies that produce commercial lighting, flooring, furniture, kitchenware, etc will be detrimentally affected.

And now choppy seas

The slowdown in the global economy is distressing for the shipping industry. Rates are falling rapidly and volumes have dropped by as much as 20% for cargo from the Far East and approximately 10% for outbound to Europe and America. The Baltic dry index which tracks rates for vessels carrying bulk commodities on the world’s busiest routes fell to its lowest level since 2006. From the looks of it, it is unlikely to recover anytime soon. Shipping is on track for a long overdue cyclical reversal after several good years of rising prices and declining capacity. Indicators have now reversed – rates are falling and new capacity is just about coming into the market place.

No new jobs too

Recruitment consultants who have had the best four years in all memory are now reconciling themselves to a shakedown.
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The fizz seems to have come out of the job markets as companies shelve expansion or new investment plans. Many businesses have retrenched highly paid staff only to take them back for a quarter of the salary. Median increments are likely to be more reasonable between 5-6% and some employers are even tempted to delay this by a quarter. Bonuses and other entitlements are likely to be slashed as companies try and get to grips with mounting HR costs.


Most analysts agree that US and European recovery will have to wait until 2010 as the chaos in the financial economy settles, banks start lending again and consumer and investment appetite returns. It is hard to say for sure how things will play out in India but my suspicion is that the turmoil will mend quicker as India’s banking system is undoubtedly more robust. Financial institutions have largely kept away from high risk structured instruments although some of them may eventually concede that they carry more than acceptable levels of bad loans. The problems of liquidity (having been drained out of the markets because of short terms credit, non availability of ECBs and FII withdrawals) can be fixed through expanding money supply as inflation begins to recede. The government too is seriously considering some pump-priming initiatives (inflation concerns notwithstanding) to generate demand and investment. With a bit of luck things will begin to settle down by 2H 2009. Asset based businesses such as real-estate will take a lot longer to recuperate. For them the worst is yet to come as correction in prices will continue well into the next twelve months. The capital markets too are unlikely to bounce back in a hurry. Whilst some reversals in the current slide should take place, asset valuation will remain more realistic over the coming few years.

But for now, industry needs to retain its focus on two important issues – cost and cash. The current situation provides an opening to renegotiate all vendor contracts and revisit employee salary structures and perquisites. Those affected will accept changes less grudgingly. Every aspect of the supply chain needs to be examined to identify and remove excesses. Businesses that are cash rich could shop around for cheap assets and acquisition opportunities. Such rock bottom prices will not come again in a hurry. For when the economy and markets rebound they would have put themselves in a position of advantage. Others who do not have this luxury, specifically those in the lending business would be better off consolidating their balance sheets in anticipation of greater defaults in their asset portfolios.

Hopefully, important lessons will be learnt in the aftermath of the crisis. Financial institutions will invest capital wisely and more efficiently. Greed will give way to prudence and regulators will closely look out for any over-heating that leads to the creation of asset price bubbles. Companies that have acted quickly will emerge fitter and stronger.


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