GST: Storm clouds and some bright spots

The goods and services tax (GST) roll-out has gone reasonably smoothly in the first week and the market is optimistic that the initial confusion will soon be sorted out. There are some storm clouds. Maharashtra and Tamil Nadu introduced new taxes. There are ongoing strikes by the textile industry in Gujarat and the match industry in Sivakasi. The Tamil Nadu theatre owners association also went on strike and is now negotiating for relief in state taxes. 

In contrast, the automobile industry and tractor-makers are gung-ho since cost to buyer has reduced considerably.  Other core industries like steel and cement are also happy. Exporters have been assured that offsets will be credited within seven days. But other sectors remain worried about the speed of offset credit since slow offsets will lead to a rise in working capital costs. 

In truth, nobody really knows what the initial impact will be. It will hit the unorganised sector and small businesses hard due to the lack of offsets and the need for compliance with unfamiliar, onerous accounting norms. But whatever Q2 revenues and earnings might be, the market will give the tax reform a “grace period”. Even Q3 corporate results are likely to be discounted if they happen to be below par. 

The monsoons have been reasonable so far, with floods in the Northeast and a pick-up in other regions. This should keep food prices down. Inflation is already low and if it stays down for June as well, the Reserve Bank of India (RBI) will be hard-put to justify not cutting rates and loosening monetary policy in its August policy review. However, the minutes of the Monetary Policy Committee indicate that the members are still divided on the subject. 

There are several important central bank meetings coming up in July. The US Fed is expected to continue hiking rates. The Fed has also indicated that it will start to unwind by selling some assets on that huge balance sheet. This means a reversal of QE, sucking liquidity out of the market. The Bank of Japan is expected to continue with its quantitative easing (QE). The European Central Bank is also making hawkish noises and discussing an end to its bond-buying QE programme. Growth and inflation are both up in the European Union. 

China could also see tighter policy since the government is trying to combat a housing bubble. Moody’s downgraded its credit rating in May, saying it expects China’s financial strength to erode as growth slows and debt rises. However, growth is expected to stay strong — gross domestic product (GDP) data is expected next week.

Central bank stances will have an impact on forex rates and that could influence the RBI’s stance as much as inflation trends. The RBI’s six-monthly Financial Stability Report is grim in its assessment of the non-performing assets (NPA) situation and the credit cycle.

The RBI expects a further rise in gross NPAs by March 2018. Debt stress is at a crisis point, with bad loans amounting to over nine per cent of GDP. The key default areas are mostly infrastructure-related and there’s concentration risk. Stress tests show that if the top borrower defaults, profits would be wiped out and a top three default would push capital adequacy ratios of some banks below required levels of nine per cent of risk-weighted assets. 

Investments hit a 25-year low in 2016-17 and the corporate capex cycle is likely to stay down given low return on investment and flat demand. Even big rate cuts will not necessarily lead to higher credit growth since banks are wary of lending and corporates won’t borrow until demand picks up. 

One bright spot is the services purchasing managers’ index (PMI), which indicates an uptick. June is at an eight-month high and it offsets a lower manufacturing PMI. The International Monetary Fund says GDP growth should accelerate, as GST takes hold and the negative impact of demonetisation eases. 

One possible danger could come from geopolitics if energy markets are spooked by the continuing crisis in Qatar, which is facing sanctions from other Arab states. India’s stand-off with China could also impact market sentiment at some stage if it escalates. The G-20 meeting may also have some impact, in either direction.

The market has ignored any signs of potential bad news. Valuations are at record highs with the Nifty running at over PE24 and mid-caps even higher at 30-plus. Given the bad debt situation and earnings growth in the low teens, this is optimistic. 

However, domestic institutions have little choice but to continue buying since mutual fund assets under management have expanded sharply. Foreign portfolio investors bought Rs 3,600 crore of equity in June and a massive Rs 25,000 crore of rupee debt as well, anticipating rate cuts. 

The Nifty is up 19 per cent in the calendar year despite weakness in June.  Technically, the market is stuck in a narrow range, with selling at above Nifty 9,650 coupled to buying in the 9,500 zone. This range trading is usually a sign that traders are waiting for some meaningful trigger. As and when that comes, a breakout of several hundred points is likely, coupled to expansion of trading volumes.

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