Global woes hurting, not policy; rupee overvalued: Chetan Ahya

The deflationary trend in wholesale prices in India is because of overcapacity in neighbouring markets, and this trend could persist for a while, says Chetan Ahya, Co-Head of Global Economics and Chief Asia Economist, Morgan Stanley.In an interview with CNBC-TV18, Ahya says China is unlikely to cut back on capacity as it will have implications for its job market and financial markets.The best way for India to counter imported deflation is by ensuring that its rupee is 'fairly valued'. Ahya feels the rupee at the moment is 'over valued'.Ahya feels much of India's problems at the moment are because of global factors, and not because of policy inaction as is the general perception.He feels the market should not be having high expectations from the Budget in terms of higher government spending on capex. That is because Budget is not the platform from which government has announced big capex spending in the past.Also, it would be better if the government sticks to its schedule of fiscal consolidation, Ahya says, adding that "more harm could be done" if the government strays from fiscal discipline in a bid to boost growth through higher spending. Ahya expects a fiscal deficit target of 3.8 percent for FY16 and 3.7 for the coming year.Below is the transcript of Chetan Ahya's interview with Latha Venkatesh, Anuj Singhal, Ekta Batra & Guest Editor Ridham Desai of Morgan Stanley on CNBC-TV18.Ridham: Can you explain to us what is exactly happening in China and how is that impacting India?Ahya: They have been going through a period where exports collapsed. They still continue to invest, huge excess capacities have build up and over the last 45 months, we have seen the producer's price index (PPI) in China in deflation. So key message out of what is going on in China for all of us is that China has been in deflation and as far as the producers prices are concerned for now last four years and considering the fact that they are not going to be able to cut back the excess capacities in a quick manner because it has implications on job market, it has implications on the financial system, unfortunately, we will continue to live with this deflationary pressure from China over the next two-three years. So for us, the big message is be wary of the deflationary pressures continuing from China in the coming two-three years.Ridham: How do you think we can address that or what would your recommendation be from a policy perspective?Ahya: The biggest issue for India's macro is precisely that the deflationary pressure that is getting into India over the last 12 months with wholesale price index (WPI) being in deflation. Even last month's number, WPI non-food is at minus 4 percent. So, we are importing a lot of deflation. This is not structurally our excess capacity, it is the region outside India. Therefore, India should protect itself with a currency policy which is at least managing currency around fair value.Today the currency is overvalued. If you look at the trade-weighted exchange rate adjusted for inflation differentials, it is one standard deviation above the mean. So we think it needs to move down by 5 percent to bring us to fair valuation. So just bringing up the currency to fair valuation should help us ensure that we don’t absorb this deflationary pressure and hurt our corporate profitability.Latha: We were always told that you are a domestic facing economy, so when the world is in trouble, India should be the place to be. How much can a global recession impact Indian earnings?Ridham: It is already impacting. So look at it from a Nifty perspective, which is because everybody looks at Nifty. 45 percent of Nifty earnings are global so almost half so that is it.We did an analysis -- we have not done it for this season but we did it on the last season. We call it the Tough16, which is just 16 companies in our coverage universe of 130 companies. So it is a bigger universe than the Nifty. If you take them out, these include the state-owned banks, the material names and a couple of companies with large global exposures, the earnings performance in India is quite different. Even if you see this quarter, not only companies with domestic earnings done a lot better, but even inside the earnings of companies, you split domestic and global and then suddenly domestic looks a lot better. There is double digit growth and we are going to talk to Britannia later today. Britannia is not struggling to deliver earnings growth.There are consumer companies with large global exposures because a lot of our consumer companies over the last seven-eight years chose to diversify and go global and that is hurting them.In fact, I was speaking to a CEO of a consumer company and he said that my revenues in -- this goes back to Chetan Ahya's point -- global markets are higher when translated in rupee revenues. To underscore the point that the rupee has appreciated and that is creating further pain on local reported earnings because local reported earnings are in INR.Latha: You were making the point about this WPI disinflation or deflation, what are you pencilling in by way of rate cuts and basically will that improve growth or consumption or earnings because it is not getting translated in the bond markets?Ahya: I think that the most important benefit will be the corporate sector profitability comes back, corporate sector revenue comes back if you do manage to get some currency depreciation.If the currency stays overvalued then you will suffer that corporate profitability challenge. As far as the monetary policy is concerned, I think that has been very clear from RBI and the team there that they are watching consumer price index (CPI). Unfortunately, we have had four back to back crop failures and CPI remains high. So it will depend upon what happens to the next crop monsoons and whether food inflation comes down. However, at this point of time we are assuming a normal monsoon and forecasting another 25-50 bps more rate cuts coming in. In the next monetary policy in April, we expect 25 bps rate cut.Ridham: If I may use this opportunity to move to the next subject, which is hurting the markets more this year than China and that is what is happening in the US. In the US, we have seen inflation expectations fall considerably and I was looking at the chart and we are not very far away from the low point hit in March 2009. So why do you think that the Fed is not reacting more aggressively to these dramatic falls in inflation expectations?Ahya: Firstly, as a matter of reading the Fed actions, we should see that they are now moved up in terms of their reactions from being pre-emptive to more reactive. There are two reasons for this. Firstly, the unemployment levels in the US now is at 4.9, wage growth is pretty decent. So in that kind of environment, the Fed is unlikely to be getting too aggressive and pre-emptive in reacting to any kind of risk that they see on their growth and inflation outlook.Second is that these risks that we are seeing in the recent months or rather into the US specifically is coming out of external risk, which is China and emerging markets. So, the transcript which you can read from Fed's document is basically saying, if the risk is domestic then we can be somewhat pre-emptive and try to address it upfront.However, if the risk is external then they have to see that external risk emerge, see the impact on growth and inflation which in some ways they are saying that they are going to be reactive to that in terms of the impact once they see on the US economy.So, both these factors have met that the Fed's reaction function has changed. Broadly, whether it is US or China, what I would read as a message from this for asset markets is -- one is that we got to be getting more real about the nominal return expectations because the normal gross domestic product (GDP) growth globally is slowing. Second is because a big Central Bank like the Fed is not going to be always coming in to protect of any kind of downside risk they see quickly, we also will have more volatility.Ekta: What is your sense on the fiscal deficit targets and what might be announced in the Budget this time?Ahya: We are expecting the final deficit for March 2016 at 3.8 and next year will be 3.7 because you do have the problem of Pay Commission provisioning.Ridham: I have one more question on the domestic environment, which is that my conversations with CEOs, with investors, a lot of people complain that India has not done enough in terms of policy, India has not done enough in terms of reviving growth. How would you react to that, what is your opinion regarding that?Ahya: I think it is where your expectations are but more importantly, the outcome is what is making people conclude that India is not on the right track or the government is not doing the right thing. However, that outcome of low growth or low earnings growth or low corporate revenue growth is more linked to what I mentioned to you earlier.Global factors are hurting India and for more lower exports hurting manufacturing sector capacity utilisation as RBI's data shows capacity utilisation is closer to 2008 lows, low pricing power and therefore weak profitability and weak GDP growth. In reality, when you think from the government's actions, the first and most important one -- which all economists would want to see the change in India and that has been happening now -- is the control on government spending, cut back on redistribution and that has been bringing down inflation. So that is on track.Second is improving ease of doing business to accelerate private investment. The private investment in manufacturing is going to be helped by because of those factors that I mentioned to you earlier. The profitability is bad, they are not going to be investing but you see how the private investment from outside India is flowing in at such a good pace now. Last month was USD 5 billion of foreign direct investment (FDI), which is annualised run rate of USD 60 billion, almost all time high. So I think the government is doing the right thing and people are unnecessarily confusing this outcome of low growth to government actions.Anuj: You just made a point that we are not in an inflationary scenario that we were long time back. Even in earnings growth, we have slowed down. Is there a case now for our valuations also to be derated compared to what we historically traded in terms of the premium over the peers?Ridham: On valuations, we use the Shiller PE Ratio. Shiller PE Ratio, simplistically put, is the inflation adjusted real earnings. So the real price is divided by inflation adjusted earnings. That number is now at all time lows.So, a lot of people sight the headline valuations of the market. What that hides is that earnings are off cycle peak. So valuations will obviously look a little higher than history. When you adjust the cyclicality in earnings and you produce that adjusted number, it is at all time lows. When I look at the Shiller PE Ratio going back in time, you have never lost money buying the market with the one year view at these levels.In fact, all my valuation metrics are pointing to a fairly robust upside to the market from here which is why we wrote about this last week that valuations are now, finally for the first time in the last two years, supporting absolute share prices, they weren’t until now.Relative valuation India remains rich and I don’t think that will change dramatically because India is still commanding better relative growth. So, we are okay on valuations, the market is not that expensive. There may be pockets for the market that are still rich but then they are rich because they have better growth.However, on the aggregate basis, it is the earnings which had depressed, which make the market look a tad expensive. If the earnings normalise as they would and it is a question of timing maybe they do over the next year or over the next two years, when you look back, the valuations may not have been that rich.Latha: Manish Chokhani was making this point. At the best of times the capital expenditure in the Budget is Rs 2 lakh crore. That is what less than 2 percent of the GDP. Is that enough to kick-start growth, are we laying too much emphasis on Budget as an instrument to kick-start growth?Ahya: I completely agree with that. I think the Budget is not where we ever have done any big capex. So, yes, if they want to do some higher expenditure, even if they do 10 percent extra growth that will be like 0.2 percent of GDP and that won't much matter to the macro outlook.We should keep the discipline on fiscal consolidation, we can do more harm out of relaxing that deadline or timeline or fiscal consolidation than trying to get reviving capex through higher fiscal deficit.