I have heard it discussed in the media that India has tremendous potential for growth, because of positive demographics (meaning a young population), substantial debt capacity (meaning a consuming population with low debt) and substantial untapped consumption growth from the first 2 factors.
Let us examine this a little more in detail. While at first glance, the first 2 factors are factually correct, it is the logical inference, with which I have a quarrel.
To suggest that the debt capacity of the Indian population should be calculated as a proportion as a GDP, is misleading. This has happened because it is common practice in the US, to calculate debt as a proportion of total GDP. For example, total US debt is running at 3.6 times GDP, with net external indebtedness at a shade above 25% of GDP. By comparison, India’s ratios look low, and hence the conclusion that there is substantial scope for debt-led consumption before we enter a debt bubble. For example, it is often mentioned that the US mortgage market is over 80% of their GDP, while India’s is less than 5%. This is often used to justify the case that we are far away from a retail (finance) bubble.
But look at the story on the ground. Measuring an economy’s debt capacity as a proportion of GDP is like measuring my personal debt capacity as a percentage of my income. If I have high income (say, Rs.10 lakhs per annum), I would need, say, Rs.250,000 to ‘maintain’ myself, I, take care of basic needs like food, clothing, education & housing. My actual ability to service debt now comes from my ‘revenue surplus’, in this case, Rs.750,000 or 75%.
But if I had a low income of, say, Rs.100,000 per annum, my ‘revenue surplus’ would be only, say, Rs.10,000 or 10%. That is because basic needs (or ‘fixed expenses’) take away a larger chunk of a poor man’s income, than for a rich man.
It is the same with economies. For the Indian economy, with 35% of the population below the Poverty Line, and with an equal number at subsistence level, the ‘middle class’ is less than 10% of the economy. And within that, the consuming class (defined as the credit-card happy, BPO-employed ‘young consumer’) would be even smaller.
The so-called ‘growth’ of the Indian economy, and in particular, the growth of its debt capacity, has been concentrated around the middle class, which is in the service sector. This sector is largely focused on export of services, and gets its value from selling services to the West.
How large is this sector, and is it large enough to support the trebling of consumer credit in the last few years (from Rs.59000 crore in ____ to Rs.160,000 crore in ____). Who is taking all these houses on finance, fuelling the housing boom? Where is he getting his income from, and how secure are his income flows, to ensure that this build-up of credit will not end in grief for the banking sector?
Let us take a closer look at this build-up of retail credit. 80% of incremental retail credit is in housing finance, a sector where asset quality is dependent on the market value of the asset financed. Appraisal of a prospective borrower takes on 2 dimensions, a look at the client’s income and cashflows, and a view on the future value of the underlying asset.
So far, the latter issue has been a no-brainer. Housing prices have seen little cyclicality, because of the fact that very few houses had loans outstanding against them. Supply (of houses) has always been short, creating a perpetual scarcity, and hence, a perpetually rising price trend, at least in nominal terms. For the retail investor, housing has always been a good investment, because prices always rose, taxation was lower because of Capital Gains, and anyway, half the returns came in cash.
However, we should not lose sight of the fact that prices are a function of supply and demand. In asset markets, they are a function of incremental supply and incremental demand. At the margins, the price of a share or a house is determined by the no of houses coming on the market, vs the amount of incremental money being invested into housing stock.
What is the probability that more houses will start to come on to the market? Suppose there are 100 houses in a village, all of them without leverage. The probability that any of them will get sold is, say, 1%. Then suddenly, 20 new houses get bought, all of them on leverage. It is very likely that after this, say, 5 houses will come on to the market. So a 20% increase in housing stock (all funded with leverage) will create a 500% increase in the number of houses coming up for sale. This is not a mathematical relationship, but an observed behavioural trend. Whenever a stock of assets is built up on leverage, it increases disproportionately the ‘propensity to sell’ of the population as whole. This creates disproportionate increase in incremental supply, which exceeds incremental demand at some point, causing a downward spiral in prices.
We will now look at what happens to the incremental demand. If there are only 200 people in the village mentioned above, and 100 of them had houses, and now 20 more have borrowed, what is the likelihood that more people will borrow for new housing. Demand for credit has a way of exhausting itself, just like a drinker who has had 6 pegs of whisky is less and less capable of having (and holding down) the next peg.
Like I explained above, for a given ‘revenue surplus’, every increase in debt outstanding will reduce the borrower’s incremental debt capacity. However, markets being what they are, the supply of debt continues unabated, regardless of the dwindling debt capacity of the debtors. This causes a debt bubble, with rising NPAs and dwindling quality of credit.
“Professional institutions” are always focused on maximizing revenues and profits, and hence, contrarian thoughts like the one above can never be institutionalized in large
banks. Even though I know that at least some senior Risk Managers at the top of the big banks do agree with me, they express helplessness in being able to control or reverse the trend. This is the Principle of Institutional Stupidity, which I mentioned in an earlier article.
The opportunity for a savvy trader………… wait till the trend is mature, and then go short on the leading lenders. You will get 2 clear reasons why you will make good profits:
i. Once a trend of rising disbursements, profits and good recoveries has been established for a period of 3-4 years, the market will give the bank a ‘confident’ valuation that factors in the continuance of the above. For example, look at the valuations of ‘holy cow’ HDFC (and the bank). The linearity of assumptions about its continued good performance, will keep rising, even as the probability that it will be able to maintain the momentum of its performance, keeps falling. You will get a very nice, fat, over-valuation (like the Infosys P-E of 200 in 2000) to short-sell from.
ii. As the base keeps rising, the ability of the banks to find ever-rising volumes of good business, good recoveries and fat margins, will keep dropping. Quietly, asset quality will drop, but it won’t show up in the numbers, because the business volumes keep rising. And then….boom…..business will slow down, and it will all come apart together.
The “fat valuation” banks are therefore, very attractive short- sells. Their top managers know it, so watch out for big insider selling. I think some of it has already happened.
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