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Apri 27, 2000

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Devangshu Datta

Stay with defensive stocks

At many levels, Reserve Bank of India governor Bimal Jalan has reason to be satisfied as he delivers the slack season Credit Policy this week. He has guided India through the Asian Flu, the post Pokhran-II sanctions, and two years of recession while deftly avoiding currency contagion. He has accomplished a near-miracle in delinking domestic interest rates from overseas rates.

What's more, he has managed to change the earlier bureaucratic philosophy of reviewing interest rates every six months into a policy of continuous management. That being so, there will probably be few changes of note in this policy. The last changes came through in early April. At that point of time, the Reserve Bank of India (RBI) cut cash reserve ratio (CRR), the repo rate and the bank rate as well. The Credit Policy is more likely to be a report of the RBI's take on economic growth in the current fiscal and the possibility of meeting growth targets of 7-8 per cent.

And yet, do you remember the Biblical story of seven fat years followed by seven lean years? Well, India has had its fat years in the form of good monsoons between 1992-1998. Last year wasn't too good, and the super-cyclone in Orissa didn't help. This year, western India is in a drought and famine situation that is already being reckoned the worst since independence. And, the monsoon is expected to be some 30 per cent below normal.

To put it mildly, this isn't good news. A bad monsoon means poor agricultural performance. In 1998-99, a phenomenal agricultural performance prevented the recession getting serious. In 1999-2000, a poor agricultural performance is going to prevent full-blown recovery. And, if 2000-01 is a successively bad year for crops with sub-par food production, some of our nightmares could become reality.

Obviously a poor agricultural performance will impact consumer offtake in the fast-growing rural and semi-urban markets. That will hobble the industrial recovery. India can live with another year of sub 6 per cent GDP although it won't be pleasant.

But we could see an even more "interesting" situation developing in the middle of an economic slowdown. Post-Budget, it had appeared that there was a genuine chance of negative interest rates at some stage of this fiscal. The logic was that the poor agricultural performance in 1999-2000 would raise food prices and hence, cost of living indices just as the government forced interest rates down to facilitate its own borrowing. The government's decision to cut fertiliser and food subsidies and downsize the public distribution system is otherwise impeccable. But it may just be terribly mistimed and add to inflationary pressures.

Inflation has indeed risen sharply in the last few weeks. The wholesale price index is around 4.64 per cent now and clearly heading upwards. The combined cuts in CRR, bank rate, and repo rates sent equally clear signals about the southward direction of interest rates. So a trend of rising prices versus lower rates is already established.

Even a small shortage in food production can translate into a very sharp rise in prices. If we don't see a good monsoon in 2000, the shortages will increase. Yes, the government has record foodgrain buffers at the moment. The government also has record forex reserves, which could be used for judicious imports to keep prices under control.

But the government also has a very poor track record of managing such situations. This is not an indictment of the BJP-NDA despite the onion crisis of 1998. Rather it is a generic problem that has always existed. India has always mismanaged its food production and distribution.

Devotees of Amartya Sen could use retro-analysis to argue backwards that a recurrence of famines and food shortages is one sign of governments that are not truly democratic, and of societies riddled with "unfreedoms", to use the evocative phrase of development economics. By that yardstick, India has never been democratic.

The economy may not head all the way to negative interest rates. But spreads could be squeezed to a point where money becomes very cheap indeed. Since there is plenty of liquidity in the system, it would be rational to borrow and create real assets. What's more, corporate credit offtake and working capital requirements will be low if consumer demand is reduced by a poor agricultural performance. So money could fly into unproductive assets like gold and real estate. Both make eminent sense in the economic scenario just outlined.

It is probably too late to prevent this situation from occurring. However, the worst excesses can be avoided if the government reacts fast. That is not in our hands and the best one can do is minimise personal damage in a possible stagflation blizzard.

On the personal finance front, it is sensible to stay with a core portfolio of defensive stocks. Obviously fixed interest instruments will deliver very low or negative returns in such a situation, while growth stocks will also underperform. Since the market is heading lower, a long-term player could leverage down along with it, buying growth stocks with a two-three year perspective. It may even make sense to borrow money, which will be cheap, to pursue an aggressive stock-purchase strategy.

This would also be the time to take out housing loans. Right now, real estate prices are still depressed and money is getting cheaper. If the scenario above unfolds, real estate will appreciate fast. Take a cheap loan, buy your house now and cross your fingers. I'm more hesitant about gold and other precious metals. Gold prices may spike globally as well as domestically, given that the US is heading for inflation. But it could be a gain of short duration - lots of central banks have long-term gold selling programs in place.

Devangshu Datta

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