Investors need not be pessimistic – current Indian economy

Investor confidence is low even though markets are emerging from their lows. Understandably, the recent step decline has left a deep impression on investors as have the US sub prime crisis and spiraling commodity prices, Besides, there’s burgeoning fiscal deficit on account of subsides. Investors are trying to interpret the impact that these factors will have on the markets. The question is: is it time to worry? Investors are better off not digging into economic glossaries. But the noise on the subject is bound to be deafening and statistics will be bandied about that rattle one’s equanimity.

At the outset, one must be clear that the economy and equities have a symbolic relationship. Still they are not conjoined wins. Indian economy has been growing at around 9% for few years, and fiscal deficit has declined from 9% of GDP. But crude oil prices at a mind-bogging $120 a barrel, coupled with the government’s stance of keeping retail prices of oil and allied products capped, have raised concerns again. The worry is that the new government measures, and populist measures already in play are adding to the deficit.

What are the subsidies our exchanger will have to bear? A major component is the oil deficit, which will swell to around Rs 70,000 crore at $120/barrel. Other key components – fertilizers and food subsidies loan waiver wage hikes – add up to Rs 69,000 crore. Together, this is staggering Rs 1.39 lakh crore, or 2.5% of GDP. This and the reported fiscal deficit of 6% of GDP, takes the overall fiscal deficit to 8.5% of GDP.

Sounds alarming but let’s look at it holistically. A developing country like India is bound to experience growing pains, Compare India’s 74% debt to GDP, with the accumulated debt of developed countries; US, 126%; Japan, 224%, UK; 422%. If we adjust for government holdings in listed public sector units, India’s debt to GDP is just 48%. Of course, developed countries reached these levels after becoming developed. India is going through this process, and has time to make amends. Let’s assume our fiscal guidance will remain committed to accentuating deficit by only 20 basis points (0.20%) annually. So, what happens a decade before the BRICS year 2050? By then accumulated debt, at a 10% nominal GDP growth would be a relatively comfortable at 45% of GDP, and the fiscal deficit would be down to 2.3% of GDP. By 2050 – when the BRICS Report envisages India as the world’s second largest economy – our fiscal deficit would be nearly wiped out. This should alleviate some of the alarm.

Drawing attention to the necessity of these subsidies in a competitive global landscape, all countries, especially developing ones, subsidies in one way or another China, for instance has pegged its currency to the US dollar, which is tantamount to subsidizing exports, which contributes 40% of GDP. In a free float, the Yuan would appreciate 10-12% against the dollar. India, which is targeting growth based on domestic factors subsidizes the expenditure of people who are the key drivers of growth. Every growing economy must subsidize key economic constituents to accelerate growth.

In fact, compared to its peers and despite fiscal deficit concerns India is well placed to tackle exigencies like flight of liquidity thanks to high domestic savings. These are 32% of GDP and can well support 8% real GDP growth. Further more, household financial savings of 10-12% of GDP will largely take are of the fiscal deficit and credit growth. Thus, India can continue to grow at a healthy pace without external support, and also be somewhat insulated from the impact of a flight of liquidity.

Should economic parameters be the main criteria for investing in equity? Look a Japan; even in a Zero growth economy where the interest rate is close to zero, equity is considered the best option, as it provides higher and better returns than other asset classes. This holds true for the US, too, where even after fears of a major slowdown at best, and recession at worst equities have relatively corrected less from their peak, implying that there’s more to understand than just plain economy.

Overall, valuation is a key consideration in equity investment. It’s also vital to consider earnings yields of markets compared to returns on risk free assets, such as government bonds. If earnings yields are higher, it’s a goodtime to invest in equity. An economy is a polymorphic field, full of dichotomies with supposedly worrying elements such as fiscal deficit, liquidity and money supply on the one hand, and optimistic signs, including rising financial savings, reduced dependency and lower median age on the other. The optimistic side of the economy will in inevitably outweigh its pessimistic partner and spawn a new generation of success and prosperity.