Has the business environment turned?

Businesses are cautiously responding to the changing business environment. V Balakrishnan, CFO, Infosys, says, “I am less optimistic today on the India growth story than I was in the beginning of the year,” The CFO of an FMCG company, who did not wish to be quoted said, “While it was anticipated that 2011-12 would be a difficult year, in the recent past things have worsened further.” On the other hand, Ashish Agrawal, Head – Finance and Taxation, LG Electronics, says, “We do not see any change in the business environment. It has neither improved, nor has it deteriorated. The fundamentals of the Indian economy are still very strong and we are as optimistic as earlier.”

So, what is the reality? It is a bit of both, because India today stands at a cusp faced with some fundamental challenges. Which direction it goes in depends on how it responds to them. It also depends on how global factors play out.

Impact of the global situation The global economy has been tottering for a while, but things have taken a plunge for the worse in the recent past. The risk of contagion in the Euro area has grown with not just the peripheral economies like Greece at risk, but also the bigger ones, such as France, and Italy. Similarly, the US economy does not appear strong enough to withstand the withdrawal of economic stimulus. The task before these economies is to strike a balance between short-term fiscal stimulus and long-term fiscal consolidation and it is not clear whether they will be able to do it. As a result, the emerging market economies are likely to grow at a measly 1.5 per cent in 2011, and just 2 per cent in 2012, with the risks to the downside, according to the latest World Economic Outlook report of the IMF. Economists are not ruling out a double-dip depression in the developed countries.		Commodity prices, adverse exchange rates, discounts and interest costs have been posing challenges for business – Ajay Seth CFO Maruti Suzuki India

	What do CFOs expect? GDP growth in the region of 7-7.5 per cent in FY2011. Exchange rate volatility to continue in the short term. Rupee to strengthen to Rs 46-47 by March 2012. Inflation to ease on account of softening of commodity prices and the RBI’s efforts. Interest rate reversal to kick in by Q2-Q3, FY2012. Cost pressures to continue and make it difficult to maintain profitability. Advanced economies remain vulnerable and exports could be hit. How are they coping with the changed environment? Continuing with investment plans in the current year, though keeping a close watch to decide next year targets. Price increases to offset cost pressures. Hedging currencies and major commodities. Greater efficiencies in manufacturing, marketing, and the supply chain. Support weakening consumer demand through continued investment in brands, improving distribution, and ensuring adequate consumer finance, where relevant

I am less optimistic today on the India growth story than I was in the beginning of the year – V Balakrishnan CFO, Infosys		While it is true that India’s economy is driven more by domestic consumption, the global business environment has an impact for several reasons. First, India’s exports have been rising quite fast, and have reached US 108 billion in April-July 2011, which was nearly 54 per cent higher than the year ago period. The exportoriented IT services is one of the brightest spots in the Indian economy and it depends squarely on the conditions in the developed world, especially the US and Western Europe. Turmoil in those markets will have an impact on this vital sector. “The Indian economy today is more globalised and whatever is happening in the developed markets will have a bearing on the growth story of India,” says Mr Balakrishan. He adds, “The large developed markets like US and Europe are trying to cope with high sovereign debt, coupled with high fiscal deficit, lower GDP growth and high unemployment. This limits their ability to make monetary interventions to stimulate growth. I don’t think those markets have emerged from the downturn in 2008 after the Lehman collapse. They were seeing artificial growth due to huge the economic stimulus by their respective governments. With the stimulus coming to an end, the economies are struggling and trending towards another recession. All the macro economic indicators in these markets are negative,” he adds.

 

Third, the expansionary monetary policy of central banks of these countries is leading to a slush of funds into commodities leading to a speculative rise in their prices. This will make the goal of the RBI to control inflation difficult.

Mr Balakrisnan sums up the challenges facing his business as follows, “Most of our revenues today come from exports. So, the global economic situation is a big concern for us. Add to that the fact that global currency markets too, are volatile. A drastic movement in currencies will have an impact on our margins. The regulatory environment is also evolving globally and many nations could take steps to restrict the movement of people as their economies are witnessing high unemployment. We need to watch those developments very closely”.

Inflation

The biggest thorn in the Indian economy’s flesh is inflation. The RBI has been waging a war on inflation for the past 18 months. However, it is nowhere close to being tamed. The ADB’s Asian Development Outlook report in September 2011, raised the inflation outlook for India for the year to 8.5 per cent from its earlier estimate of 7.8 per cent, made in April. The Governor of the RBI, D Subbarao acknowledged recently that inflation has been ‘fairly stubborn’.

No country can afford persistently high inflation, but poor and developing countries, even less so. Though all emerging economies are facing inflationary pressures, India has the highest inflation (9.8 per cent) among the BRICS countries; China (6.2 per cent), Russia (8.2 per cent), Brazil (7.2 per cent) and South Africa (5.3 per cent).

According to the ADB, “high fuel costs, bottlenecks in food supply, a hike in minimum support price for food production and signs of a wage-price spiral” are the main drivers of inflation. There is evidence that though it started as a commodity related (especially food and fuel) inflation, it has since become generalised. Mr Subbarao has said that a rate of “4 to 6 per cent is the short-term comfort range”

ADB expects inflation in India to slow down to 6 per cent in FY2012, due to softer global commodity prices, and the lagged impact of monetary tightening moves. Mr Subbaro has also expressed hope that inflation will slow down by March 2012, but more slowly than initially expected. In fact, several economists interviewed by CFO Connect over the previous 12 months, had expressed hope that a good monsoon and the coming on stream of several projects that had re-started in early 2010, would reduce inflation by late 2010. Yet, inflation has continued to march on. It remains to be seen if the beast will actually be tamed.

The IMF’s World Economic Outlook report paints an optimistic picture of fuel and food prices globally over the next few quarters. Should this turn out to be the case, the hope that inflation can be brought down to 6 per cent by the financial year-end may be justified.

A rise in commodity prices and wages is denting the profitability of companies. Ajay Seth, CFO, Maruti Suzuki India Limited, says, “This year is a challenging one with turbulent markets and mounting cost pressures. Commodity prices, adverse exchange rates, discounts and interest costs have been posing challenges for business. The same is true of our business partners and we had to ensure that the health of their businesses remains sound.” Maruti is hedging major commodity exposures as part of its comprehensive risk management strategy.

Infosys has not yet changed its profitability expectations for the year, but Mr Balakrishan says they are ‘cautious’. LG Electronics which operates in a price-sensitive market and consumes a lot of commodities will face the heat on the profitability front, acknowledges Mr Agrawal. He says that, “profit expectations have been scaled back due to increasing input costs and high forex impact”. LG is responding to the challenge by “bringing more efficiency in marketing, manufacturing, supply chain, and other operations”, he adds.

 

Mr Balakrishnan says that Infosys is working closely with its customers to understand their needs and make sure that the impact on its business is limited. “We are actively hedging our currency exposures for the short term, so that the impact due to drastic currency movements can be minimised. We are not taking any long-term call on currencies. We are also keeping our cost structure flexible so as to minimise the impact due to economic volatility,” he adds.

Though the government and the RBI have been following a hands-off approach to the foreign exchange market for some years now, allowing the Rupee to find its own mark, this may change in the near future. Finance Minster Pranab Mukherjee said in Washington recently that intervention in currency markets would be considered. The RBI believes that there are no India-specific factors leading to the fall in the Rupee’s value, and it has to be seen as part of a global phenomenon.

In the coming weeks and months, volatility may increase, with a bias towards further depreciation. However, over the next few quarters, things may improve. Mr Agrawal expects FII fund inflows to increase in a big way in Q1 2012, which will more than compensate for the outflow on account of debt repayment by Indian corporates over the coming months. This, he believes, will lead to the Rupee’s appreciation and it should rise to approximately 46 to a dollar by the end of this financial year.
 

Fiscal consolidation and its impact One of the biggest weaknesses of the Indian economy is the high fiscal deficit. It results in the crowding out of private investment and contributes to inflation. Further, it reduces the wriggle room for the government in case of a slowdown. According to Standard & Poor’s (S&P), “Continuing the fiscal consolidation policies in the next financial year, would be a key challenge for India.” It has warned that loose fiscal policies which impact growth could result in a downgrade of the country’s sovereign rating. On the other hand, it says, if India is able to reduce the public sector deficit materially, it could lead to a rating upgrade.

The Indian Rupee has depreciated significantly due to the growing contagion risks of the Western crisis – Anurag Adlakha CFO - India and South Asia, Standard Chartered Bank

 

Policy paralysis

The Indian economy got out of the decades-old Hindu growth rate syndrome when the Narasimha Rao- led Congress government introduced economic reforms in 1991. It will not be an exaggeration to say that the initial momentum imparted by those reforms has been propelling the economy forward since then. However, that momentum is not adequate to overcome the supply-side constraints the economy now faces. For that, a new set of reforms ranging from labour to investments and financial sector reforms is needed. However, the government is in a state of paralysis, besieged as it is by the opposition over corruption charges against its ministers, as well as infighting within the party and the coalition. Says Mr Adlakha, “After the 2G scam, we have not seen any policy decisions. There are a series of legislations like food security, direct (DTC) and indirect taxation (GST) tax reform, and mining among others, which need action by the government. While the need to incorporate diverse views in a democratic setup slows down the reform process, we are seeing little action on the reforms front.” He adds that, “the lack of urgency on reforms could potentially worsen supply bottlenecks and damage the medium-term growth potential”.

Investment

A serious concern about the economy is the lack of capital formation, which not only pulls down the current industrial growth, but more importantly puts future economic growth at risk. The prevailing uncertainty about the global economic direction as well as the policy environment has led to a deferment of investment decisions by many organisations. Says Mr Adlakha, “We do see corporate clients going back to the drawing board to assess their strategy and business expansion plans. On the wholesale banking side, we see challenges in corporate spending and investments due to the hesitation in the government’s decision making”.

Foreign direct investment (FDI) into India is an important source of capital formation, but it has been lackluster as well. After falling by nearly 20 per cent in 2010-11, India’s net inbound FDI in April-June 2011 rose to USD 13.4 billion (up from USD 5.8 billion a year ago). July’s figure of USD 1.1 billion (down from USD 1.8 billion last year), however, raises questions on whether the short upswing indicates a true reversal of an earlier downtrend. Net FDI inflows in FY12 may yet touch last year’s level of USD 30.4 billion, as several big-ticket investments start to flow in, and if the government pushes forward on the reforms front.

Not all organisations have applied brakes on investment, however. Maruti is going ahead with its planned investment for the year, as “it will not get carried away by short term considerations”, according to Mr Seth. Likewise, Standard Chartered Bank is staying the course. “Our investment plans are generally set at the beginning of the year and we believe that investments are crucial to set up the base and be ready to grab the opportunities that will arise when the economy will improve. So unless some really big crisis hits the economy, we will stand by our investment plans,” says Mr Adlakha.

LG is also not wavering from its investment targets for the year, but is ‘revisiting its targets for the next year’. If the economy slows down and uncertainty continues to prevail, those sitting on the fence will be forced to scale back their investment plans – if not in the current year, then surely in the next.

Personal consumption

Unlike many developing countries whose model is based on exports-led growth, India’s economy is driven largely by personal consumption. This is evident from the fact that it accounted for nearly 62 per cent of GDP in 2005, which was larger than even Japan’s 57 per cent! Though the share of personal consumption has been falling for several years (because as incomes increase, savings increase as well), it continues to be the mainstay of the economy. This protects India’s economy from swings in the global economy. However, a slowing economy means falling personal consumption as well, both because of lower disposable income, and also because in uncertain times, people defer spending on non-essentials. This is reflected in reduced demand for retail credit. Mr Adlakha says, “On the retail banking side, we see the impact of rising interest rates, and high inflation on the customer’s decision to avail credit.”

Consumer demand will also be impacted by an increase in prices that companies are now forced to effect. LG is planning to increase the pricing of its products between 5 and 7 per cent, says Mr Agrawal. It is also ‘re-looking at its sales targets for the next year’. It is also relying on consumer finance schemes to encourage customers to spend. One FMCG CFO we spoke to said that ‘calibrated price increases’ is part of the strategy to counter cost pressures. The company is also not scaling back its investment in brands.

Should personal consumption take a hit, it will impact the strongest pillar of the Indian economy, and together with slowing global demand, have a harmful impact on economic growth.

Interest rates

A sustained increase in interest rate hike by the RBI over the past 18 months has taken the benchmark repo rate to 8.25 per cent and reverse repo rate to 7.25 per cent. The increase of 325 basis points since March 2010, amounts to the fastest increase since 1935. Given that the RBI has expressed its resolve to continue its fight against inflation, should it not abate, it is expected that another 25 basis points increase is likely by December 2011. The RBI governor has said that the policy stance should remain unchanged to not negate the earlier gains.

High credit cost can dampen India’s economic growth trajectory, therefore a reversal of interest rate hikes is vital for the economy. Most analysts expect that interest rates are close to peaking and the reversal should begin in Q1-Q2 of FY2012. According to Mr Adlakha, ‘With inflation expected to be in the range of 6.5-7.0 per cent by March 2012, the RBI could start reversing the interest rate cycle by mid 2012.” There is at least a glimmer of light at the end of what has been a long dark tunnel.

Not all gloom and doom

Though there are a host of negative factors besetting the economy, all is not gloom and doom. Despite concerns of a global slowdown, at least so far, exports have held up. FDI flows have witnessed strong recovery (even though its sustainability is still in doubt), and the south-west monsoon has delivered above normal rainfall this year. Advance crop estimates suggest that we are likely to see at least 3-3.5 per cent growth in agriculture this year. As a consequence, rural demand is likely to be buoyant which will help businesses that have rural linkages.

Despite the general policy paralysis, some reforms that have not been noticed much, such as enhanced foreign investor limits for corporate debt, will have a positive impact. Though the land acquisition and mining bills have yet to be passed by Parliament, considerable progress has been made in accommodating diverse views and arriving at a final draft. In any event, the GDP growth forecast of 7.7 per cent is nearly twice the global average and nearly four times that of developed countries. Yes, there are clouds on the horizons, and serious downside risks persist, but there is also an opportunity to build on the positives by removing supply bottlenecks through legislative and administrative action. The government cannot control global events, not even all domestic ones, but the levers that it controls can also make a big difference.

The trouble is that the seat is merely uncomfortably warm right now and not unbearably hot as it was in 1991. Whether this is enough to jolt the government into action is another uncertainty in an already highly uncertain environment. Meanwhile, it is certain that companies in India need to tighten their belts and give way neither to gloom nor to overconfidence and closely monitor which way the winds are likely to blow.