'India will be an underperformer in 2007'

Malcolm Wood, Asia Pacific Equity Strategist at Morgan Stanley expects interest rates to stay at lower levels across most of Asia. He expects Asian inflation to moderate, while currencies to appreciate. According to him, the risk appetite within Asia will stay high.

He predicts that India will be an underperformer in 2007. He believes that liquidity is an issue for India. Wood is not too positive on the financial sector in India. He anticipates some pressure on net interest margins and NPAs in India.

He further informs that Morgan Stanley is currently cautious on India and that they will sell when the market begins to rally. Moreover, Wood believes that IIP numbers in the month of October might have been only a blip.

Excerpts from CNBC-TV18's exclusive interview with Malcolm Wood:

How do you feel as you go into 2007 for the entire emerging markets or Asian emerging markets basket after what has been a very eventful year 2006?

We still believe that Asia, ex-Japan, can perform well in 2007. We are looking for another 13% upside for the Asia Pacific ex-Japan Index. So we are looking for the drivers for that. From a global soft landing, we think the evidence is building for that.

Secondly, we are looking for sustained low rates in Asia. We'd probably put India on side on that, but we think that rates in general will at stay low levels across Asia. Thirdly we think that there is more upside in valuation for Asia as a whole, and fourthly we think that investors' sentiment, both within Asia and also for global investors, can improve even further from here.

What do you expect to see on that front in terms of risk appetite for emerging markets including India in 2007 and what kind of liquidity do you expect to see next year?

I think it's important to differentiate liquidity from developed markets and liquidity in Asia. In our view liquidity conditions in developed markets are no longer positive. The US Fed has raised rates to probably modestly restrictive levels, Europe is at neural levels, and Japan is going to continue to gradually lift rates. So the idea that we can get a lot of liquidity flowing from the global markets is just wrong.

We will need to rely increasingly on the liquidity within Asia. On that score, the evidence is pretty good. As I said, we think rates can stay low and that's partly because we believe that inflationary pressures are moderate and currencies are going to be appreciating. So that combination tells us that rates can stay low.

At the same time, the money growth numbers, particularly in the money centres of Hong Kong and Singapore, look particularly healthy at this point in time with mid teens deposit growth. So we think that the banking system is liquid, rates can stay low, so the liquidity within Asia looks pretty good. So in our view, risk appetite from the global side is coming down, risk appetite within Asia could be doing the opposite.

How do you feel about India? It has been the stand out performer in this basket. It had a bit of volatility last week but do you think it can continue to trade in that premium valuation band throughout 2007 given what you are expecting from the fundamentals?

In our view, if you agree with us that global liquidity conditions are no longer accommodative, it's going to be increasingly difficult for a market like India, which is being very reliant on global liquidity inflows. So we think that perhaps one should differentiate India from some of the other markets in Asia where of course there are large current account surpluses and extensive deposits sitting in the banking system, which we think can begin to move into the market.

So we believe that India would be an under performer next year. Obviously we have been of the view that India would struggle for a while, so we have been early in this school.

What do you think will pin down the performance of the Indian markets; will it be that liquidity will get a bit more edgy for this market or something else?

We do think it is the liquidity factor that is going to be the issue for India. Global liquidity is no longer a positive. As far as domestic liquidity goes, I think the Reserve Bank of India is doing the right thing and I would like to see them do more of it.

I do think that liquidity conditions have remained too accommodative within India when you look at the situation with respect to underlying inflationary pressures and the current account balance etc. It would seem that India is running up against capacity constraints. This of course isn't to deny the long-term positive story for India, but we do think that the cyclical liquidity conditions have just meant that India has got a little bit ahead of itself at this point in time.

What are you expecting then by way of interest rates and how would you approach the financials, which have been the big out-performer in this market?

We think that the financials are a difficult sector to be invested in at this point in time. We think that there are signs that liquidity will continue to tighten. There is going to be pressure on net interest margins. There is going to be pressure on credit growth as rates go higher and we are of the view that non-performing loans are beginning to pick up as some of the rapid credit growth from the past couple of years begins to season. So we think that this is a sector to be quite wary off at this point

Even as you expect the market to under-perform a little bit tactically at this point, how would you approach a market like ours and how would you approach corrections like those that happened last week?

I guess you need to come to a conclusion as to whether the increase in cash reserve requirements or interest rates is a one off and this is the last of it or is it something different. We are of the view that there will be more of that in the case of India. What happened last week was the sort of thing we are looking for. I guess others might take a different view, but we would be cautious and perhaps look to sell rallies as opposed to buy dips.

Any concerns of the macro performance like the IIP numbers which most economist believe are a blip?

That is our view as well. Certainly looking at the cement production numbers for November, it would appear as if the October numbers were a bit of a blip. So we wouldn't be surprised to see a rebound there. But it is important to note that India's rapid credit growth, which we have to attribute some of the very strong economic growth in India to, seems to be starting to moderate, and this maybe a sign of moderation in GDP growth to come.

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