Are the ghosts of 2008 back to spook investors?

Recent events may well seem like a flashback for investors who watched the 2008 crisis unfold — with the US debt downgrade, much of Europe slipping into a sovereign debt crisis and worries about US and Europe sliding into recession. So, are we going to see repeat of the 2008 crisis in India? In some respects, yes.

Developments over the last few months suggest a moderation in GDP growth, problems for debt-laden companies and FCCB holders, and volatility in FII flows. Unlike 2008, the government also seems to have little room for another round of fiscal and monetary stimulus, given that the fiscal deficit is already high.

However, investors can take comfort from much lower (and therefore less vulnerable) valuations. Here are some answers to key questions that are probably preying on the minds of investors.

What happened in 2008? How did India emerge from the crisis?

In 2008, despite the recession in the developed markets, India got away with a slowdown in its GDP growth. Low exposure to global derivatives or credit problems due to an insulated banking system helped Indian markets. Given that India was largely a domestic driven economy, the fall in exports did not have a major impact on its overall output.

The country was, however, affected considerably on the capital flow front. High FII outflow and lower external borrowings led to a liquidity crunch. Apart from stimulus measures (Rs 1.86 lakh crore of fiscal stimulus), payments under the Sixth Pay commission, debt waiver for agriculture and higher outlays on NREGS (National Rural Employment Guarantee scheme) allowed the country to reduce the impact on of the slowdown on GDP growth.

Though the government was forced to step up spending substantially, it prevented its borrowings from crowding out private debt by using the Market Stabilisation Scheme bonds.

If there is a 2008-like crisis, is a stimulus possible now?

It would be very difficult. On the fiscal side, the government has very little room to revive the economy from another slowdown. India's consolidated fiscal deficit, which was 4.1 per cent of the GDP in 2007-08, has risen to 7.3 per cent in 2010-11 (2010-11 benefited from one-offs such as 3G).

The situation looks likely to worsen this fiscal as the government in the first quarter (Q1FY12) incurred a Rs 1.62 lakh crore deficit, against the Rs 4.12 lakh crore budgeted for the whole of this fiscal. It has also foregone revenue by cutting taxes on oil. With weak equity market conditions, the disinvestment target of Rs 40,000 crore may also not be achievable. This puts India in a far more vulnerable position fiscally in 2011 than in 2008. If the Government borrows to fund this deficit, it may crowd out the private borrowings, and thus investments, which are yet to pick up.

Who will be vulnerable to round two of the credit crisis?

Companies with high levels of overseas borrowings, that are coming up for repayment over the next year or two, may be the most vulnerable. With global financial conditions turning hostile, companies with external debt obligations may find it a problem to re-finance their existing debt.

Raising fresh debt too will be a problem for companies that have major expansion plans or overseas acquisitions to fund. Relying on domestic sources for borrowings can increase India Inc's borrowing costs, as companies have been raising external debt quite aggressively in recent months. External debt that is due within the next year (March 2011) is 42 per cent of the total external debt.

For companies, ECBs (external commercial borrowings)and FCCBs (foreign currency convertible borrowings) debt service payments (interest and principal) are estimated to the tune of $18.6 billion (more than Rs 83,000 crore) in the current fiscal.

The debt service outgo for ECB and FCCBs in 2008-09 was estimated to be $10.7 billion. Rupee depreciation, if caused by any capital outflows, also would mean their borrowing obligations could increase.

Investors can, therefore, stay away from companies which have FCCBs maturing within this fiscal. Reliance Communication, Educomp Solutions, Financial Technologies, Assam Co and KEI Industries are a few companies that have FCCBs coming up for maturity in the current fiscal.

What will happen to domestic interest rates?

One respect in which 2011 is quite different from 2008 is the direction of domestic interest rates. When the 2008 crisis broke, rates were already at their peak and the RBI was able to reduce them to stimulate growth. Now, the RBI is categorical about reining in inflation, even if comes at the cost of growth.

In the last 17 months, the central bank has raised repo rates by 475 basis points to 8 per cent. Fixed income managers and economists are expecting another 25-basis-point hike. This would mean lending rates may rise further.

Interest costs of CNX-500 companies (banks and financials, for instance) for 2010-11went up by 28 per cent, year on year. The interest costs rose as much 43 per cent for the quarter ended June 2011.

While India Inc posted a robust profit growth in the March quarter, in spite of a rise in interest costs, the impact of high raw material prices and interest costs are already taking a toll on profits of companies. CNX-500 companies' (inclusive of banks and financial companies) profits grew by a modest 9 per cent for the quarter ended June 2011.

That the rising rates are beginning to hurt the highly leveraged companies is evident. The number of credit rating downgrades has been on the rise for Indian corporates. According to CRISIL, in the first quarter of 2011-12, the number of companies downgraded was at 105. It downgraded 269 companies for the whole of last fiscal.

Companies have already been postponing their capital investments due to higher interest rates. Downgrades may increase the cost of funds for the affected sectors. However, the silver lining for investors from the recent chain of events is that a global slowdown or even a recession may cause an easing off in commodity prices. If that feeds into domestic inflation, it could, in turn, prompt RBI to end its tight money policy earlier than expected.

For now though, investors can stay away from sectors which are highly leveraged. Companies predominantly from sectors such as infrastructure, construction, sugar and small and mid-sized steel companies are highly leveraged. Interest costs will also affect the demand-side companies, for instance in the auto and realty sectors.

How will the economy and corporate earnings be affected if there is any crisis?

The RBI recently revised India's GDP growth estimates from 8.5 per cent to 8 per cent. However, this also seems to be a more optimistic projection as more and more economists are revising the projections downward. With growth already moderating due to domestic issues, a global crisis would further hit growth.

With GDP growth moderating, the earnings growth of corporates may suffer too. Evidence of Indian companies not being able to deliver to market expectations is already available. Market estimates for the Sensex companies' earnings for instance, stood at anywhere between Rs 1,270 and Rs 1,300 a few months ago.

This has since been steadily revised downwards to Rs 1,200 according to Bloomberg consensus estimates. The estimated FY12 earnings per share indicates a modest 7.5 per cent growth in profits this year.

If the global market crisis spills over, downward revisions in profits for commodity companies, IT majors and export-oriented sectors such as textiles and gems and jewellery. India Inc's return on equity at 19 per cent in 2010-11, is well below 2007-08 highs of 23 per cent. While the debt-equity ratio for India Inc as a whole (290 companies) ruled at 0.66 per cent for 2010-11, small- and mid-cap companies had much higher ratios of 1.04:1.

The interest coverage for small and medium companies is down from 7 times in 2007-08 to 4.9 times for the fiscal year ended March 2011. While this is not alarming, for the first quarter of this fiscal, the coverage has fallen to 3.5 times.

Are valuations attractive?

The earnings of BSE-500 companies have risen 41 per cent over their levels in January 2008. Yet the index is 28 per cent down from its peak in 2008.

The valuations of companies (BSE-500 trades at 13 times trailing earnings) are at a steep discount to January 2008 high of 26 times. The BSE Small-cap and Mid-cap indices are trading at 10 times and 13 times respectively which is far lower than their January 2008 highs of 21 times and 26 times.

While the valuations are almost double that of March 2009, there are a few stocks in these spaces (small and medium capitalisation) which are below the March 2009 lows. This gives an opportunity to selectively invest in small and mid-cap stocks.

Among the BSE-500 companies, more than 102 are below their March 2009 valuations. Stocks of companies such as NTPC, REC, United Phosphorous, IRB Infrastructure, Balarampur Chini, Shree Renuka Sugars, On Mobile, NMDC and Mphasis are currently trading at valuations lower than in March 2009 (when the market hit rock bottom). Fresh investments can be considered in these companies.

Low valuations this time around gives investors some comfort in terms of lower downside risk in spite of concerns of global slowdown. Looking at the sector-wise picture, BSE FMCG is the only sectoral index trading at higher than January 2008 valuation.

Banks and technology came close to peak valuations in November 2010 but have since corrected significantly. BSE Realty index is the only one that has not yet reached levels witnessed during the October lows.

In spite of low valuations Indian stocks continue to be expensive compared to other emerging markets; however, the premium has been shrinking, which also increases their attractiveness.

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