All asset classes to rally if Germany gives in: Uday Kotak

Uday Kotak, Executive Vice Chairman & MD, Kotak Mahindra sees Germany's Angela Merkel as the last woman standing as far as the future of Eurozone goes. Germany's stance on European issues in June is going to be critical to the world economy.

Speaking at the Kotak Mahindra BFSI Conference 2012 today, Uday Kotak ruled out the possibility of a Greexit (newly coined word) and believes at some level Germany will give in to save the Eurozone from breaking up.  He says the bets are more in favor of a solution which is to kick the can, open up the flood gates of Eurobonds, print money and Germany paying the price as a significant player for solving the problem of Greek, Spain, Ireland, Italy and Portugal. "My instinct tells me that the political class in the world today is not ready to take immediate pain and there could be a big capitulation by ECB or Germany and France. They may do a little now and postpone the problem. If it’s the first, I think we will see a significant rally in all asset classes and if it is a second, we’ll move on between risk on and risk off for a long period of time." Later, speaking exclusively to CNBC-TV18, Kotak spoke at length on issues relating to India's fiscal deficit, depreciating rupee and the role of RBI. Below is the edited transcript of his interview with CNBC-TV18's Udayan Mukherjee. Also watch the accompanying videos. Q: What is the global outcome in June? How it affects us? Do you think this time around we’ll be able to avert a global crisis since global politicians and policy makers are going into this problem with their eyes open, unlike in 2008? A: I think the last person standing in the world today is Angela Merkel of Germany. She is the one who is still committed to fiscal discipline. I think the rest of the world is moving more in the direction of looser fiscal and monetary policy including printing more money. The world is a little different because it has gone through the Lehman experience in 2008 and therefore the systemic outcomes of a Greek disaster are certainly on leaders’ minds. The key event to watch is does Germany capitulate and agree to some sort of quantitative easing (QE) or Eurobonds, a different way of printing money? Q: So far, she has appeared quite inflexible. And that has got the market worried in the near-term. But do you think it’s a matter of time before she gives in and says, ‘I cannot afford a Greexit led financial meltdown, so much that I dislike it, I have to go along with what the market wants?’ A: Everyone is watching the Greek Elections on June 17. I think June is a very critical month for the future of Europe in many ways as September 2008 was a critical month for the world. So, watch out for June. If there is some sort of opening up or printing of money in some form, we will see a risk on trade. If it is some half hearted measure, which is kicking the can into the future, in that case, you will continue these bouts of risk-on and risk-off. I would say the probability of a disaster is low, though not zero. These are the three situations, I would put the overall global finance in. The most important challenge today is what is good for intended economic outcomes is leading to unintended market outcomes. India is caught on these two aspects. When you see loose monetary policy and a lot of money printing, which brings the risk on trade, you are seeing all assets go up including commodities. Therefore, that hurts India fundamentally, though you see bouts of short-term money supporting us. If you don't see loose money while asset prices decline, which is good for India fundamentally, the market outcomes are short-term and will not make India happy. So, the domestic markets face the challenge that is between a fundamental and market outcome.
_PAGEBREAK_ Q: Which one is a more desirable scenario? Crude has come down to USD 107 per barrel. The hope is that because of global weakness, it now gets into double digits. But a global liquidity event will come in the way almost inevitably and we may see a January- February kind of rally, but crude going back to USD 115-120 per barrel again. That creates macro issues. Which one is the lesser of the evils in your eyes? A: In my view, fundamental improvement of economic outcomes is better than short-term market outcomes. Q: So, if you had to assign probabilities to the three outcomes that you mentioned, would you say that the chance of a big global liquidity rally is higher or the highest probability outcome? A: My view is the highest probability outcome is kick the can into the future, do a little bit now, keep it going. The outcome of Euro zone is long and painful. That’s how I would see as the highest probability outcome. Long and painful end of it could be positive or a break-up. There is a fundamental issue on Euro zone structure. Unless you can get fiscal union, which is unlikely, the long and painful outcome may be painful at the end as well. Q: Can you just clarify or illustrate a little bit more on what this half hearted scenario is that you are talking about? How markets might react in June to that, if that were to come about, your base case scenario? A: My base case is half hearted for some sort of Eurobond, giving some more support to the Southern European countries, postponing the current challenges; throwing some money at the problem, but not going whole hog. If that happens, you will see bouts of risk-on and risk-off. Through that actually it may lead to less upward pressure on commodities, if it is not a clear outcome of throwing money whole hog and oil can keep on coming down. The issue in my mind is that oil coming down is good for India. It improves our current account. With the improvement in gold imports coming down, our current account will look better in 2012-13 compared to 2012. But we are depending too much on external events to help us. What are we doing? That is the question we have to ask. Q: A lot of people would be very concerned about what the Indian currency has done. Do you think it’s overdone or could these fundamental issues that you alluded to keep the currency under continuing pressure? A: A weaker rupee is good news and bad news. It is good news for people who are in businesses where they are competing with imports and for exports. So, these two sectors have good news of the depreciating rupee. The problems are companies with high import intensity and companies who have a stock of un-hedged foreign exchange exposures. On the second one, I think it is back to risk management and governance. If your business is in India, you have no business to have an un-hedged dollar exposure just because you have got a nominally lower rate of interest. This is first principles of risk management. Some of the pain for corporate India is coming out of that. If I have to take a call, the monetary policy is now laser focused on rupee-dollar as its number one objective. That’s how I would look at it. Liquidity, interest rates and others are derivatives of a fundamental focus on the foreign currency situation as the number one objective of monetary policy at this stage. Q: If you were in the Reserve Bank’s shoes, what would you do? A: In the short run, I think all my monetary policy actions need to focus on the value of the rupee. On a fundamental basis, I think a lot of the pain is in the price. From here we need to see what are the policy actions? Second, on the current account, I am more positive than what most people are. I see a USD 10 delta on oil improving our current account by about USD 10 billion a year; a USD 15 billion delta on gold imports that is USD 25 billion. I see current account in 12-13 at 3% or lower. That is good for the value of the rupee, but it is still a fundamental correction. Markets tend to over react in the short run. Q: The problem is that we are not getting any flows to cover whatever deficit we have, whether it is 3% or 4%. Do you see that improving in the near-term, given the kind of sentiment that you are seeing in the conference and in your meetings with investors? A: On that, we have a fundamental business model challenge as a country. Over the last eight-nine years, we benefited by having a business model, which got our current account financed by short-term portfolio flows. That is a very dangerous assumption. Therefore, we need to go back to policies, which encourage exports, which focus on FDI as the key source of financing our current account. We just cannot get away from the fact that we do not have the luxury of large current account deficits. Depending on short-term portfolio flows in this scenario, in today’s world, is a very dangerous model. _PAGEBREAK_ Q: What’s the fix? How do we turn that around? A: The fix is happening. The fix is happening through the fact that the rupee is where it is, it is helping our current account. Finally, if there is a challenge to financing a current account, you got to bring the current account down. That is happening right in front of us. I believe we are going to see USD 25-30 billion delta in our current account this year over last year. That means we have a smaller amount to finance. From a stability point of view, we still have enough reserves to be able to manage a 2.5-3% current account deficit. The portfolio flows are fragile. They can change easily either way and then we are going to do stuff like long-term health fixing, which is going back to what we were doing in the late 1990s and early 2000s of encouraging foreign direct investment, making the domestic Indian sector competitive. We have had crazy increases in salaries, in real estate rentals, which has made India very uncompetitive in many areas. So, go back to the basics, we got to fix the basics. You have two issues. If you have a heart problem, in the short run, you do a massage. But in the long run, you must do long walks. Q: Do you some degree of reset, the way policy makers have approached the problem this time and therefore asset prices needs to happen before things can level out or do you think that is in the price, the reset has happened globally already across asset classes? A: I think a lot of reset has happened. My personal view is a lot of the pain is in the price, whether it is the price of rupee-dollar or Indian equities. Therefore, this is a good time for a long-term view. In the short run, if there is a Greexit or some event like that in the month of June, you will have to face the challenges of that attack. Q: On the domestic policy front, we have had a petrol price hike after a long wait. Do you think that is enough to convince the RBI that they can now get on with the business of cutting rates further as they said before the Budget or do you think we have had the rate cut that we were looking forward for the year and we won’t get too much more? A: I hope June will see some modest improvement in the price of diesel. Politicians understand the issue, they have their challenges. I hope they can come to a resolution on that, however modest it may be. On interest rates, I think rupee drives interest rate policy at this stage. We have had a close to 25% depreciation in the rupee. That is going to have its impact in terms of higher costs in rupee terms domestically, which is inflationary. Therefore, it’s difficult for the central bank to drop nominal rupee interest rates at this stage dramatically. Q: For how long? A: Till you get some clarity on global situations, our ability to improve our current account, our fiscal situation before you can go out and improve interest rates lower. On the fiscal situation also, keep one thing in mind, with the value of nominal rupee going down so much, custom duty and other corrections in rupee terms go up. Therefore, managing the fiscal deficit gets better than last year. If you are getting your customs duty with rupee-dollar at 56, it is more rupees compared to rupee-dollar at 46. Q: We spoke on the day of Budget and one of the first things you said was that the bond yield was headed to 8.5%. It got there and then it went way past that. As we speak, it is almost exactly at 8.5% again. Do you see it anchored around that for the rest of the year? A: A year is a long time, especially with all the changes in the world. But I feel that currently if I had to take a call on bond yields, it’s going to be around 8.5%, give or take 25 bps on either side. Q: You are at a banking conference and there has been so much talk and spotlight on asset quality, restructuring of loans. We have had a mixed bag of earnings this quarter where some banks have reported bad asset quality, some have not. Do you think this whole fear is overblown or are we still in a downward slopping cycle with asset quality this year? A: The sense I am getting, at this stage of the cycle, is a lot of the challenges on asset quality relate to 40-50 companies. At this stage, it does not seem to have spread dramatically beyond that. But these 40-50 companies are pretty leveraged and the exposures are pretty large of the banking system. Therefore, I think banks have to manage these exposures carefully and make sure that there is no contagion spillage out of this into various other companies across the sector. That is one. Two, with reference to the credit quality issues, I think banks need to focus on how they are evaluating returns on their lending book. A lot of the pain in Indian banking is coming because banks are taking equity kind of risks for debt returns. If there is a downside, the banks take the pain of the downside. If the company recovers, banks just get their money back. Time has come for banks to focus on risk adjusted returns as they manage their lending book. _PAGEBREAK_ Q: Do you expect more bad news in the months to come on those 40-50 companies? They are companies of significant size. As we have seen some of the restructurings, 10 of them can drive pretty significant holes in many of the bank balance sheets. A: I think some of it is reflecting in valuations of the banking sector and individual banks. You need to go laser into each of these situations. I think the banking industry will be a bottom up story. Each bank will have to be looked on the merits of it. Fundamentally, in banking, balance sheet is more important than short term P/L. Q: Banks are regarded by many investors as proxies to economic growth. In the last few days, it has been a scare with almost a raise to the bottom from global bank trying to go down close to 6.25%-6.4% GDP growth. Is that too pessimistic you think? A: My sense on GDP is 6% to 6.5% for 12-13. It is not the end of the world. We just got to make sure that we are doing things which fix our health. That’s the focus of the banking industry this year. Make sure that your balance sheets are in good shape. If there is pain, much rather take it out, raise equity if you need to rather than trying to assume that things will sort themselves out. Q: You spoke about the good sides of the rupee depreciation. But as a banker, from many of the clients that you may be working with and the large FCCBs they have, do you think the kind of depreciation we have seen in a short span of time relatively has driven big problems for many of these companies who have large overseas loans? A: It’s back to the stock problem. If you are exposed in a foreign currency for your rupee business then it’s a risk management issue. I think the accounting treatment allows you to take that pain overtime, but you can't wish it away. Fundamentally, I do not believe the fair value of the rupee is anywhere near 45 any longer. Now whether it is 50-52-54-56, we can debate. But the fundamental value of the rupee has changed. If there is a stock problem, investors and bankers need to adjust that stock problem from the equity of these companies and look at their numbers without that. Q: What’s mood like? You have got advantage point of speaking to so many CEO’s, so many diverse kind of businesses. Is it still quite bleak or do you think it’s on the margin beginning to improve? A: It depends on who you are. If you are an exporter, the mood is very positive. I was just meeting two people in the export business a few days ago and they were rejoicing. If you are meeting a company, which is in the import substitution business, therefore the competition is import, but they are domestic producers, they are happy. If you are a company with disproportionate import content in your product, you have pressure because you are not able to price on the full import hit out of the rupee depreciation. So, it really depends on these three categories and which category you fall in. Q: So you are saying even mood is squarely a function of the currency these days?
A: I think the mood has become very reflective of currency and we are underestimating the role of currency. In a way, I think this is the price we have paid for some of our inefficiencies in our model in the past.
A 20-25% improvement in currency makes us significantly more competitive if we can make use of it as a micro company. We are now at 40-50% price advantage compared to China. Indian industry used to complain a few years ago that it was not able to compete which China.
You now have this depreciation. Let's see Indian companies now go out there and compete. I understand the market is sluggish, but this is the time to grab share and grow with such a huge competitive advantage.
Yes, there is short-term pain as the capital markets reflect a lot more of companies that are disproportionately dependent on imports. But there are pockets in the economy which will benefit from the rupee's depreciation. Q: Do you think the Sensex will ever touch 14,000-15,000 levels over the next few months as this drama plays out or do you think we are close to a bottom and one should be buying?
A: There is Greece and the Euro zone. How events shape up in Europe will determine a lot in the short run. But in the medium-term, with the rupee-dollar at Rs 55-56 and the Sensex at 16,000 or Nifty at around 4800, I think a lot of the pain is fundamentally priced in.
Can the markets overreact in the short run? Of course. But if you think about it over the medium term, a 16,000 index and a Rs 56 rupee-dollar already prices in most of the pain.