Rising Significance of Rural Demand
June 11, 2009
By Chetan Ahya | Singapore & Tanvee Gupta | India
The adverse global business environment and collapse of manufacturing growth have affected urban demand significantly. In this context, the importance of rural demand for top-line growth is rising in a number of sectors. Hence, as part of our 11th Annual India Summit held in Mumbai last week, we had a panel discussion to gain insight on the value proposition of rural India. The panel members included:
• Mr. C. V. Sarma, Vice President, Finance and IT, Agri Business Division, ITC
• Mr. Anil Jain, Managing Director, Jain Irrigation Systems Limited
• Mr. Anjanikumar Choudhari, President, Farm Equipment Sector, Mahindra & Mahindra Limited
• Mr. Sanjay Sacheti, CEO India, Olam International
• Mr. Vikram Akula, Chairman, SKS Microfinance
The panel discussion focused on issues like recent trends in rural demand, reforms in the agriculture sector, farmer income trends and composition, farm sector productivity, government policies to support rural incomes and structural challenges for the farm sector. The panel members highlighted that over the last two years cyclical factors have supported strong growth in rural spending and, potentially, with support from the new government's policies, the structural growth story could improve going forward. We elaborate on the details of the discussion in the following paragraphs.
Rising Importance of Rural India
All panelists highlighted the rising significance of rural demand from the perspective of top-line growth for the corporate sector. It is hard to get accurate data on the trend in aggregate rural demand and its contribution to overall demand in the economy. However, anecdotal evidence suggests that rural demand - particularly for consumer goods - has accelerated over the last two years. The fast-moving consumer goods (staples) sector (FMCG) and automobile players have echoed this story. As per industry sources, the rural economy contributed to about a third of the total FMCG demand and has recorded strong growth over the last three years. 70% of India's population, 56% of income and 33% of savings come from rural India.
Data for India's auto industry (A & C segments) indicate that rural demand has accelerated during the last few months, during which time the global credit turmoil hurt urban demand. The share of rural demand increased to 9% in F2009 (YE Mar-09) from 4% in F2008. The strength of the rural demand can also be captured from the growth comparison of the top 100 cities in the country versus the rest. The top 100 cities contribute 88% of the auto sales (for segments A & C). It is interesting to note that in F2009, sales from the remaining 12% of the geography (proxy for rural India) grew by 25%Y as compared to a 1% decline in sales for the top 100 cities.
What Supported the Acceleration in Rural Demand?
Rural demand has been growing in the last two years, driven by a number of factors that have put a lot more money in the hands of the rural Indian consumer. First, there has been an acceleration in the farm income of the rural population in India over the last two years due to higher minimum support prices (the price at which government purchases agricultural produce from farmers) for key products. Although the share of government purchases is small (around 30% of the total rice and wheat production in F2008-09 were procured by the government), it does help to improve the average realizations for farmers. This has resulted in improved terms of trade for the farm sector. Second, fortunately the agricultural production volume growth has been stable over the last four years on account of normal rainfall, supporting about 50% of the farmers who do not have irrigation facilities. Third, the government has managed to protect the farmers from sharp increases in prices of farm inputs such as fuel and fertilizers. Fourth, initiatives by the government in the form of social welfare schemes like the National Rural Employment Guarantee Scheme (NREGS), PM Gram Sadak Yojana, etc. increased the allocation of funds to the rural economy, thus supplementing rural incomes. Fifth, the waiver of farm loans to the extent of Rs600 billion (US$13 billion or 1.2% of GDP), effective in October 2008, helped to rehabilitate farmers' balance sheet.
Part of Rural Income Growth Acceleration Is Cyclical
Although growth in non-farm rural income is structural, our panel members argued that a part of the acceleration in rural spending was due to cyclical or one-time factors such as higher minimum support prices for farm produce and write-off of farm loans. A common opinion held by all our panelists was that the productivity growth in the farm sector has been improving at a very slow pace. The government's policies have been aimed more at transfer of income to the rural households or cushioning them from pressures, but not so much on encouraging increased mechanization or incentivizing consolidation of farm holdings, which are very small and fragmented. The output per hectare in India continues to be very low compared to countries like China and Brazil. This bias in government policy also explains the divergence in trend of rural consumption versus farm investment. Not surprisingly, tractor sales in the country have not shown the same strength as reflected in rural FMCG or automobile sales.
The list of measures needed for acceleration in farm productivity growth is long. The panel members mentioned a few of these, including improving irrigation facilities (via capital subsidies), improving rural infrastructure, allowing farmers to trade more freely with the private corporate sector, easier credit financing, changing fertilizer pricing to improve the soil nutrient (N:P:K ratio) and greater knowledge transfer. Mr. Anil Jain of Jain Irrigation Systems argued that increasing penetration for irrigation is one the most important focus areas for the government. Out of the 140 million hectares of land under cultivation, only about half is irrigated. The remaining 70 million hectares comes under dry land farming and is largely dependent on rainfall. Mr. Akula of SKS Microfinance suggested that instead of waiving loans and improving blanket subsidies, the government should channel these funds to help farmers transition to consolidated farming, which would be much more beneficial and productive in the long term. The government should also move to reduce fragmentation of land by discouraging plots less than 5-10 acres as being unviable. Some panelists were optimistic that the new government would initiate some measures as early as first week of July alongside the finance budget.
Non-Farm Incomes More Important than Farm Incomes
The share of non-farm incomes of rural households has been rising steadily. In 1980, two-thirds of rural income was farm income while one-third was non-farm income. By 2012, NCAER estimates that the situation will be exactly the reverse. In 2007, by NCAER estimates, the split was about 40-60, 41% being the farm income. The non-farm income acts as a buffer during the period when the agriculture output is affected due to poor rainfall, thereby reducing the volatility in rural spending trend. In this context, Mr. Akula, Chairman of SKS Microfinance (focused on providing credit access to the non-farm rural businesses), mentioned an interesting fact that non-farm incomes contributed more to the GDP of the state of Andhra Pradesh than the IT services industry. We believe that the increased government spending on a national rural employment guarantee scheme has probably played a key role accelerating non-farm rural incomes over the last three years.
Rising Credit Availability in Rural India
Panel members indicated that one of the factors helping rural spending is the steady improvement in credit availability. According to Mr. Akula, microfinance lending in India is growing in the high double-digits. He indicated that for the non-farm sector, only 10-20% of the credit requirements are met by the traditional banking system. Mr. Akula argued that microfinance lending tends to be very profitable and is likely to continue growing at a strong pace in the coming years. Drawing parallels with the trend of microfinance lending in Indonesia, he mentioned that Bank Rakyat Indonesia's (BRI) micro finance business had remained largely unaffected during the Asian Financial Crisis even as Indonesia's GDP contracted.
Prior to general elections, the government has also encouraged banks to increase availability of credit to farmers. The 12-month moving average of credit growth accelerated to 15.2% in March 2009.
Bottom Line
While we expect some of the cyclical factors to soften over the next 12 months, we are optimistic that the government will begin to address a few of the long-pending structural issues necessary to provide a sustainable improvement in farm incomes. All panelists displayed a similar optimism on the medium-term outlook for farm income growth. They expect the government to give priority to rural infrastructure and agricultural productivity through policy support. Moreover, we expect the non-farm rural income to maintain its healthy growth, lending stability to overall rural demand. We believe that over the next 12-18 months, as the urban employment growth remains slow, the importance of rural demand will continue to remain high.
We acknowledge the contribution of Hozefa Topiwalla and Divya Gangahar to this report.
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Who's Been Selling Gilts to the Bank of England?
June 11, 2009
By Melanie Baker, CFA & Owen Roberts | London
The following is an extract from the European Interest Rate Strategist: End of Easing: Implications, June 5, 2009.
Flow data from the Bank of England provide a glimpse of portfolio reallocation of Gilts since the BoE embarked on quantitative easing. Throughout March and April, the DMO effectively made up about 40% of the net selling flows, overseas investors 40% and domestic non-bank investors 20%. The BoE was the main buyer of Gilts in March and April, with small net purchases from banks in April.
The BoE has now purchased almost £80 billion Gilts, and the reserves of commercial banks held by the Bank of England have risen by a similar amount. We discuss the flows of Gilts and how the sellers of Gilts are contributing to the effectiveness of the BoE's quantitative easing programme.
Overseas Investors
Overseas investors appear to have been very big net sellers of Gilts in March and April. Although we can't tell exactly what role overseas investors have played in the reverse auctions (the data don't tell us about the maturity of the Gilts net sold for example), at face value the data suggest that many of the Gilts ultimately bought by the BoE originally came from overseas investors. That doesn't mean that QE has not been successful. If the proceeds from the sale found their way into riskier sterling assets, that would have helped liquidity in those markets and, perhaps, the ability of UK companies to raise capital. Some of those proceeds may have ended up directly in the hands of UK companies through new debt or equity issuance, for example. Even if the cash was simply retained, it might still be sitting in the form of deposits at a UK-based bank, which might now be encouraged to lend that money on. If the money left the country, there would presumably be a currency effect. On a trade-weighted basis, sterling ended April at roughly where it started at the beginning of March. We believe that this makes it more likely that Gilts sold by foreign investors have been replaced by other higher-yielding sterling assets.
The path of reserves held at the BoE does not suggest net ‘leakage' from the system. Reserves (a component of ‘base money') have increased roughly in line with the amount of quantitative easing done, a process managed through open-market operations. This effectively means that the liquidity position of the commercial banks has improved. This might then encourage banks to lend on more money.
The DMO
Some of the Gilts sold by the DMO have found a home at the BoE. We estimate that of the Gilts in the 5- to 25-year sector, about £20 billion could have found their way from the DMO. The remaining BoE purchases (£56.8 billion) have come from elsewhere in the market. Regardless of the BoE's programme, the DMO would still be issuing around £80 billion between March and July and would have found a home at the right price.
There is no denying that the BoE programme has helped the DMO to fulfill its remit so far this financial year. When demand for Gilts from the BoE comes to an end, another buyer will need to be found. A re-pricing of the Gilt market will be required to accommodate the supply/demand equilibrium.
Just because the DMO has ultimately been an effective seller of Gilts to the BoE also does not mean that quantitative easing is not effective. Gilt sales by the DMO represent cash needs of the government to finance spending in the economy. In other words, ultimately this money continues to circulate in the economy.
Domestic Non-Bank Private Sector Investors
The domestic non-bank private sector net sold about £9 billion of Gilts over March and April. It seems very plausible that most of this represents net sales by UK asset managers, and that much of the proceeds were used to buy riskier sterling assets. Even if these sellers chose to ‘sit on' the cash, this would still represent increased deposit liabilities at commercial banks and therefore funds that could potentially be lent on.
Those investors that have decreased the number of Gilts in their portfolio (of which there are plenty because the BoE is buying more Gilts than the DMO is net selling), and remain in sterling assets, are contributing directly to an increase in deposits (and potential on lending) or a shift to higher-yielding assets (so directly or indirectly putting money in the hands of households or corporations). There are several channels through which QE can work, and just because bank lending to corporates was disappointingly weak in April does not mean that QE is not already starting to help.
Even Those Who Just Participate in the Flow Are Still Helping
Those investors who have participated in the flow of Gilts and who may adjust their risk weighting but net-net still hold the same number of Gilts before and after QE do not necessarily contribute the shift to riskier assets but do improve liquidity and the functioning of the BoE's QE operation. They are still facilitating the flow of Gilts to accommodate the duration requirements of both the end investor and the original seller.
Have They Done Enough? If So, What's the Trade?
The BoE is about 64% through the current £125 billion programme, and at the current rate of purchases (£6.5 billion per week) could be complete by late July. We would recommend selling Gilts versus Bunds before the end of the programme. But it remains possible that the programme is extended, or at least further provisions are made available through an exchange of letters between the Chancellor and the Governor. In the short term, we recommend staying long Gilts versus Bunds, but we would look to reverse this position and go the other way if the Gilts versus Bunds spread narrows to 10bp.
Our central case is that the BoE will not extend its programme of asset purchases again, but extending the ceiling of asset purchases through the exchange of letters is a greater risk. The 10-year Gilt-Bund spread is currently trading at 21bp, whereas before QE, Gilts-Bunds traded around 50bp.
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Coming to Terms with the Term Premium
June 11, 2009
By Manoj Pradhan & Joachim Fels | London
With the recent sell-off in bonds, markets have moved to price in a first hike in the fed funds rate as early as December. In the meantime, long-term interest rates have continued their upward climb, with the 10-year US Treasury yield now at 3.9%. While central banks will certainly start to normalise policy rates once the recovery is entrenched, a beginning of rate hikes any time this year seems premature, in our view. For longer maturities, by contrast, we continue to believe that the medium-term outlook is for higher yields, for two reasons. First, with a large chunk of QE programmes yet to come, excess liquidity looks set to continue its rapid growth, supporting risky assets and the real economy, but raising inflation risks further down the road. Second, macroeconomic uncertainty is back with a bang, bringing with it rising term premiums. On our measure, which we discuss below, uncertainty regarding the path of inflation and growth is already beginning to manifest itself and the compensation that bond holders will demand for this uncertainty will likely contribute to higher yields over the medium term.
Front-end sell-off exaggerates how quickly central banks will tighten policy: The sharp sell-off in the front end of bond markets has now priced in 37bp of rate hikes from the Fed, 35bp from the BoE and 8bp from the ECB by the end of this year. On all counts, we think that markets are exaggerating the speed with which policy is likely to be tightened. Our economics team thinks that the first hikes from the Fed and the ECB are likely to arrive only in 2Q10, while the BoE will likely hike in 1Q10. Further, the Fed and the BoE have used another unconventional tool, a commitment to keep rates lower for longer. At present, we see no sound reason for central banks to go against their own guidance see "A Different Unconventional Measures", The Global Monetary Analyst, April 29).
Rate hikes should not be considered in isolation when such large QE programmes are in place as a supplement to traditional policy. In an earlier note (see "QExit", The Global Monetary Analyst, May 20), we reasoned that central banks would likely begin hiking rates and starting to unwind QE simultaneously for two reasons. First, embarking on either a rate hike or an unwinding of QE first would send mixed signals to markets. Second, unwinding QE first would send longer-dated bond yields sharply higher. Tightening policy this year would put at risk the beginning of the tepid recovery that we expect in 2H09. Having worked so hard to get policy traction, we believe that central banks will err on the side of caution to ensure that the recovery gets underway.
At longer maturities, bond yields are being driven by inflation expectations: At the longer end of the yield curve, bond yields have continued their rise and are now pushing mortgage rates up as well. The main driver of the move in bond yields has been inflation expectations. While breakeven inflation has risen sharply since the beginning of the year, real yields have actually fallen over the same period. With 10-year breakeven inflation at 2%, we believe that there is still a large move in breakeven inflation and nominal yields ahead of us over a longer horizon (see "Bond Bubble Bursts - Benign or Malign?" The Global Monetary Analyst, June 3).
The Fed, the BoE and the ECB are not yet close to finishing their planned purchases of assets. The Fed and the BoE are only around halfway through their QE programmes and the ECB will only start buying covered bonds in July. With a significant quantity of money yet to be injected into the economy, excess liquidity (the excess of money growth over GDP growth) is set to rise even further (see "The Global Liquidity Cycle Revisited", The Global Monetary Analyst, May 27). In the short run, the rise in excess liquidity supports the recovery and risky assets. However, as central banks keep these policies in place longer to ensure that economic recovery is entrenched, the spectre of inflation is likely to rise further down the road.
Enter the term premium: As we see it, apart from the outlook for central bank policies - conventional and unconventional - and the inflation-deflation debate, another driver of bond yields is now beginning to assert its impact on interest rates. The term premium - a compensation for holders of long-term bonds for the macroeconomic risks over long maturities - has been rising and will likely rise further as the economic outlook remains cloudy.
During the Goldilocks years, the term premium on bonds had all but disappeared (see "The Term Premium: A Puzzle Inside a Riddle Wrapped in an Enigma", Global Strategy Bulletin, December 19, 2006). With the onset of the Great Recession and the panic in risky asset markets, the flight-to-quality bid had denied investors compensation for the sharp rise in macroeconomic uncertainty. However, the sharp revival of risky assets has meant that the term premium in bonds has started to reassert itself.
Macro uncertainty will require compensation through higher yields... In fact, on one measure, uncertainty regarding the macroeconomic outlook (defined as the standard deviation of the individual forecasts in the Survey of Professional Forecasters around the mean forecast) has been rising steadily throughout the crisis. The uncertainty regarding near-term growth is understandably very high at the moment. However, the most worrisome part of the survey is the uncertainty surrounding long-term inflation expectations. Uncertainty about CPI inflation over the next ten years is now at its highest level since the survey started in the early 1980s. It is interesting that the 10-year breakevens are only around 2% when the inflation outlook is so uncertain. Since breakeven inflation is supposed to compensate investors not just for expected inflation but also for the risk of inflation, we believe that there is more upside to breakeven inflation as this uncertainty percolates to the broader market over time.
...and the bond market has taken notice: The uncertain inflation and macroeconomic outlook has not gone unnoticed in the bond market. As we noted in last week's GMA, our fundamental model puts the fair value for 10-year Treasury yields at 3.1%, some 80bp below the current bond yield. This is striking because it is the first time since mid-2004 that bond yields have traded noticeably higher than the fair value, suggesting an end to a period described by former Fed Chairman Alan Greenspan as a "conundrum". The term premium in MS-FAYRE has increased sharply of late, a trend that we think will likely stay in place if not get stronger.
However, the ride towards higher yields is unlikely to be monotonic. The risk of an increase in the Fed's purchases of US Treasuries or disappointment from economic growth could yet lead to lower bond yields. Our US economics team thinks that an expansion of the QE programme is now unlikely, but the risks of such an expansion are lower but still present. Disappointing growth, however, could manifest itself all too easily. The economy is now unlikely to sink further in 2H09, but we expect the recovery to be gradual, rather than V-shaped. If the strong rally in markets is also pricing in a strong recovery, disappointment in economic growth could come through high expectations not being realised rather than through absolute poor performance.
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