While the Indian economy is resilient enough to weather the ongoing tariff storm kicked up by the US, Desai remains watchful of the next round of negotiations for a bilateral trade agreement between the two countries and the ensuing second order impact of the US actions on Indian corporate confidence and capex cycle, which he believes are more relevant than the import duties themselves.
Edited excerpts:
What is impact that the 25% tariff and penalty on Indian goods’ exports to the US can have on the country’s economy and markets?
In FY25, India’s exports to the US were at $86.5 billion, while its trade surplus with the US was $40.8 billion (1% of GDP). Within sectors, India’s exports of electrical machinery are the highest at $15.9 billion, followed by pearls and other precious and semi-precious stones at $10 billion FY25. In terms of share of India’s exports to the US, textiles make up close to half of the exports, while the share of pharma products is ~40%.
That said, energy, automobiles/auto parts and pharma are excluded from the announcement made on July 30. Again, the talks are still on, and the final tariffs are likely to be different and probably lower.
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At an aggregate level, India’s goods exports to the US are 2.2% of GDP. This implies a less severe direct impact of tariff-related developments, notwithstanding the relative disadvantage vis-a-vis other nations. Further, nuances will emerge at the sector-level on the basis of the tariff differential with other economies and exposure to the US.
We remain watchful of the developments from the next round of negotiations and the second-order impact of the tariffs (through weaker corporate confidence and deferred capex cycle), which in our view is likely to be more relevant than the tariff itself.
Now, our terms of trade have changed. We need less oil and there is something that the world needs from us, which is our people and our services.
Profits of broader markets grew in single digits for eight straight quarters, as of March end. This slowdown doesn’t seem to worry you. Why?
Now, our terms of trade have changed. We need less oil and there is something that the world needs from us, which is our people and our services. And therefore the CAD (current account deficit), our saving deficit, is reducing. Last year, it was down to 0.6% of GDP and it’s likely to remain like that. Therefore, we need less funding from the world, and thus have decoupled from the global capital market cycles.
Compare this with 10-20 years ago, when we were highly coupled to the world; highly coupled to global capital market cycles because we had a big saving imbalance, and therefore, we needed to continue to rely on global capital flows. So whenever global capital flows shrank, which is what happened during US recessions, we got hit. If you plot the BSE Sensex correlation with US recessions, you get a very tight correlation, even though we did not have a very large share of global trade.
The reason why we were so tightly correlated was because of our balance sheet, and dependence for capital flows, not because of dependence on global trade. This has also changed profit structures in India, because now we are losing less profits to the rest of the world. Our profits are currently at about 5% of GDP. Our previous peak, which was hit in 2010, was 7%. And I think we will easily go past 7% due to these structural shifts, and therefore there is a lot more room for earnings growth.
Imagine a nominal GDP growth of 10-11% and profits gaining share in GDP; so profit growth will likely be higher than GDP and this cycle may have another 3-5 years to go before it peaks out. Eventually, it does peak out because investments become excessive, bad decisions start being taken and things start tapering out, like they did in 2010. But we are still not there yet, and are a few years away.
But can’t the relative slowdown in government capex hurt earnings, especially if private capex doesn’t fill the gap?
In February last year, the government took a decision that the time had come to lift the foot off the fiscal pedal—we did a lot of heavy-lifting during covid, now we got to hand the mantle back to the private sector. So one has to compress the fiscal deficit to prepare for the next crisis when it comes. You cannot be going into any crisis with an elevated deficit because you will not have any room to act. And so, the government announced a massive compression of 110 basis points in capex, which by July, when the final budget came, became 120 basis points.
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This should have simultaneously been accompanied with monetary easing, but that only came a little later. By the time you came to September 2024, the annualized fiscal deficit was not running at 4.9%, but at 3.4% because the first quarter was lost in elections and in the second quarter, heavy rains disrupted government activity. So, government capex was running way below what was budgeted. Such a deficit compression cannot come without a cost to growth and that is exactly what happened. That is now behind us. Government spending recovered very nicely after October, and with a lag that has come through in earnings. Last quarter earnings were better than expected, and this quarter’s earnings will also be quite okay. So that soft spot is behind us.
Given the secular shift in India’s terms of trade that now allows it to run a narrower current account deficit, I think the RBI can lower real rates.
On rate cuts—is there room for more, given the recent frontloading by the Reserve Bank of India (RBI)?
The RBI very appropriately started a big rate cut cycle, and now it must decide where real rates need to be. If you look at the current messaging from the RBI, it shows India needs to run 150 to 200 basis points of real rates. The real rate is what keeps your saving in line with the requirement rate of investments for a certain growth target.
Given the secular shift in India’s terms of trade that now allows it to run a narrower current account deficit, I think the RBI can lower real rates. This means if inflation is under control, nominal interest rates can be much lower than in the past. And I think we are about to enter such a cycle.
No country out of the top 25 is anywhere close to the 10-11% nominal growth that India enjoys–China is struggling to get to 5% and will probably end up at 4% because of deflation. The global growth is struggling to get past 3%. So, when you think about equities, the numerator has strong growth with less volatility and the denominator, which is your discount rate, is declining due to likely lower interest rates. If interest rates are falling, and your growth is intact, equity valuations go up. At 20 times, the market is cheap, and this will go much higher before it moderates.
So lower real rates, thanks to lower inflation, will spur household balance sheets’ shift to equity?
Why do you buy bonds in India? Ten years out, the bond yield for a 10-year bond, will yield 6.2%. Earnings growth in India of 11-12% means the equity yield 10 years out is sitting at 14-15%. Why would one buy bonds?
India is not a market where growth is exhausted, so the small gap in the equity and the bond yield makes equities attractive. It’s no wonder that households in India are buying stocks. They are damn smart. It explains why households are making this shift to their balance sheet… people think this bid (investment in equities) is behind the rising stock prices. No. Stock prices are rising because the fundamentals are good, and the bid is coming because of that. It’s the other way around… It is because share prices are rising that the bid is coming. Because households can see they need to alter their balance sheets, which are severely underexposed to equities.
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In 2015, something quite historic happened in India. For the first time, retirement funds—which are provident funds and the National Pension System—were allowed to buy stocks. Until then, these two entities were not allowed to buy stocks, and the Modi government changed that. This is very similar to what happened in the US in 1980. In 1980, for the first time, 401k plans were allowed to buy stocks and that was Reagan’s decision, and what happened in the next 20 years is that US households piled up stocks. Every month, retirement funds would buy shares to lift their allocation and households came in. Essentially, you got the NASDAQ bubble by the end of 1990s.
A very similar thing will happen in India, with one difference, which is when we arrived in the present millennium, the baby boomers in the US started retiring and drawing down on their savings and the net flows turned negative. In India, that’s not happening for the next 30/40/50 years. We are still going to be adding to the workforce on a net basis. So, this bid is going to sustain.
The second difference is the starting point of exposure. Our starting point of exposure is 3%. Today 7% of household savings is in equities. The US is right now at 40%, Europe is at 50%, even Japan which is a conservative society has 20%+ in equities, and it has gone through a 30-year bear market.
India is at 7%; this number will easily go past 20%. Anybody out there who is saying the households are going to run away, they just don’t understand what is happening. They are not going anywhere.
This just sets you up for a very strong bull market, which of course will have corrections along the way, I mean, can we correct 20%? Of course, we can. Markets can correct any time. Just imagine how much this market has digested in the last six months.
It has taken in a meaningful slowdown, it has absorbed an India-Pakistan skirmish, it has absorbed an Iran-Israel war, it has absorbed a trade war. It has absorbed so much, and it is standing there like 6-7 odd per cent from all-time highs. So, I think the market wants to go up, not down, and there are fundamental reasons for it—growth is good, volatility is low, rates are falling, and as a consequence, households are shifting their balance sheet allocation.
In the trailing 12 months, households saved $800 billion. If they put 10% in equities, that is $80 billion, but they will not put in that much. They are not there yet because it is very difficult to move money at that size and scale, as a large part of corporate India is owned by the controlling stakeholders or promoters.
Despite these positive dynamics, why are foreign investors selling?
Even though we are a $5 trillion market, the free float is $2.5 trillion. Therefore, it is not like you have that size to absorb this, so that is why prices need to go up. I am just giving you the technical position.
Secondly, India is now 3.7% of world GDP – it is approximately 3.8 % of the world market cap. How much do foreigners own? 60 basis points. Free float adjusted, if they want to be neutral on India, they need to be at 1.9%. What is that bid? It is $1.8 trillion that they need to move to India. They are not able to do it because every morning at 9:15 am, the domestic investor is standing there to buy stocks; foreigners can’t buy and there are only two cohorts in the market. Foreigners and domestic. If domestics have decided that they are coming every morning to buy, foreigners can’t buy, they must sell.
They can only buy if promoters and corporates decide to sell and that is happening only in a small way. That is the only time foreigners are able to buy, when some corporate comes to sell, either primary or secondary.
Promoter selling of ₹70,000 crore this year is not worrisome?
In 2007-2008, new issuances in the market were running at about 3% or $30 billion of market cap at $1 trillion. Today, the equivalent number is $120-150 billion, which means I need INR 80,000 crores every month for 12 months before the pain will be felt.
I am not seeing that type of capital raising happening. And the reason is because corporate balance sheets are very light. Corporate debt-to-GDP in India is 50%, down from 62%. There is so much ability to borrow, but they are not borrowing. The first thing that corporates will do is borrow money, it’s cheap. Why will you dilute? You will borrow money. The exits that we are seeing are largely PEs (private equity) and VCs (venture capital funds) who have to exit because they are running into cycles for their funds. There is very little primary that is happening, it’s all secondary. The primary will happen in large scale when corporates have borrowed money. So the first thing you will get is a credit cycle, then you will get an issuance cycle.
Is the credit cycle not taking off because of capacity utilization not happening?
I think the structure of the economy has evolved and comparing this with the 2007/2010 cycle is not fair. In that cycle, we were still building steel, cement, and a lot of other things that were basic industrial stuff. That stuff is not needed in that large quantity; we’ve already built a fair bit of infrastructure. There is more work to be done but a lot of heavy-lifting in rail and roads has been done.
The other thing that people don’t appreciate so much is that India’s productivity has gone up. And my guess, it’s up 10% over the last 15 years. If productivity is up 10%, it means you need 10% less capital to generate the same unit of output. So, our capex cycle is not going to 39% of GDP, as it was in 2010. It is probably going to peak at 35-36%, and we have another 3.5-4% to go before this capex cycle peaks.
I think people who are looking for that largescale capex will be slightly disappointed. It is not going to be at that scale as we saw then. But yes, credit growth will pick up, and in fact what I think will happen is that a large portion of that pickup will happen on household balance sheets. Household debt to GDP is still very shallow, so there is room for it to rise, and there is a culture shift that has happened.
What is borrowing money? It is essentially spending your future income. The US has already done that. China has already done it; China is sitting at 320% debt-to-GDP. Europe has done it. India will do it next.
So, the next 20-30 years, is going to be a secular rise in household debt-to-GDP, and we are going to spend our future. But by spending your future, what you do effectively is raise your current growth rate. You will have to give it up later, but that story is perhaps three or four decades away. So, it’s still too early because our starting point is low.
I won’t be surprised if we have a multi-year credit growth cycle, led by households, and then supplemented by corporates because when households demand so much, capacity creation will happen.
