Small And Mid Cap Indices Are Fighting Back
As trading days go, Friday last week was a weak one
On Episode 516 of The Core Report, financial journalist Govindraj Ethiraj talks to Sachin Menon, senior tax advisor and former head of indirect tax at KPMG India.
(00:00) The Take: A Minister’s Bad Flight Sparks a Bigger Question
(05:38) Small and mid cap indices are fighting back
(08:45) Rupee is steady, forex reserves fall.
(09:29) Winter rains are short and the wheat crops might be hit
(14:18) Can a reciprocal tariff include GST as well?
NOTE: This transcript contains the host's monologue and includes interview transcripts by a machine. Human eyes have gone through the script but there might still be errors in some of the text, so please refer to the audio in case you need to clarify any part. If you want to get in touch regarding any feedback, you can drop us a message on [email protected].
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Good morning, it's Monday, the 24th of February and this is Govindraj Ethiraj, headquartered and broadcasting and streaming as always from Mumbai, India's financial capital.
The Take: A Minister's Bad Flight Sparks A Bigger Question
Union Agriculture Minister and former Madhya Pradesh Chief Minister Shivraj Singh Johan travelled economy last week on an Air India flight that by his own account did not go too well.
His seat was apparently broken on a Bhopal-Delhi flight. While he said that he did not care about sitting discomfort, he criticised the airline for charging passengers full fare for defective and uncomfortable seats, calling it unethical. Isn't this cheating, he asked.
He also expressed disappointment that despite Air India's takeover by the Tata Group, service levels had not improved as he had expected. He added that when he asked airline staff about his seat, they told him that the management was aware of its condition and the ticket for that seat was not supposed to be sold. It is of course interesting that the aircraft in question, a fairly new two-year-old Airbus A321 from my understanding, had seats that were in poor shape.
So the issue is not just whether the minister's seat was broken, but that the airline knowingly sold a full fare ticket for a defective seat, at least that appears to be Johan's argument. Now, this is of course not a new problem for Air India and reflects a larger issue that many companies face and that I'll come back to, which is the trade-off between repairing or upgrading products at a time of strong demand. Now, aviation is a cyclical industry.
Airlines naturally try to maximise revenue before the tide turns again as it keeps turning. Air India could perhaps be given the benefit of the doubt, but that is increasingly difficult because complaints about seat quality and in-flight entertainment on Air India's international routes, for one, especially the lucrative New York sector, are well known and legendary. I can personally vouch for at least one such experience having endured barely functioning seats and an in-flight entertainment system with almost no content, leave alone any entertainment, on a 14-hour flight from New York to Delhi.
And this is after privatisation or the Tata's took over. Last year, India's domestic airlines carried about 161 million passengers, up about 6% from 152 million the previous year, according to figures from the Civil Aviation Ministry quoted in the media. Now, Air India owns or rather holds about 26% of that market.
Behind IndiGo is 65%. A useful figure to look at is the passenger load factor or the occupancy rate. On December 24, Air India's load factor stood at nearly 85% compared to IndiGo's 91%.
But anything above 80% is considered strong for airlines. At present, global aviation demand is strong and still rising, particularly in Asia and the Middle East and of course India too, where load factors at this point are high. Now, these are averages obviously, which means there are sectors where flights are constantly going full as I'm sure you've experienced and I've experienced and must have been the case or may have been the case on the Bhopal-Delhi flight the minister referred to.
And when load factors are high and passengers are willing to pay more, relatively at least, then the airline is evidently tempted to take the money and deal with the consequences of poor in-flight equipment later. After all, an aircraft seat is a perishable commodity. Once the plane takes off, so does the revenue that could have been earned.
I asked Sanjay Lazar, a former Air India veteran who last held the position of team lead for customer relations about the standing operating procedure for faulty seats. According to him, flight engineers conduct thorough checks of seats and seatbelts before an aircraft's first flight of the day, particularly on domestic routes, where planes may complete or do multiple hops in one day. If a seat malfunction is discovered during a later flight, the crew logs the issue in a cabin defect logbook recording the seat number and nature of the defect.
In the pre-digital era, these log entries were quite physical with multiple copies, including for the engineer who was or rather is responsible for maintenance. Now, this manual system could mean slightly longer times in addressing issues, but software solutions ensure that seat usability information is updated in real time, allowing airlines to either release previously unavailable seats for sale or block defective ones before they're sold or forewarning passengers either way. So it's unlikely that such information is unavailable or not shared with all relevant teams.
And yet, based on my experience and that of many others on Air India's international routes and evidently domestic as well, the airline has obviously unknowingly sold seats in poor condition. Whether or not Air India's information systems on the domestic sector are up to date, it is not the passenger's fault if the airline is unaware of these faulty seats if indeed they did not know, particularly when these high fares have been paid. The dilemma for any business leader or revenue head in this situation is to ensure that passenger trust is not lost or compromised during these strong demand periods by forcing a bad product simply because they have limited choices.
Remember, most people actually do not complain either because they don't have time or just don't see the point or they've moved on. Exactly what the minister pointed out. And then there's the question of percentages.
How many bad seats can an airline consider an acceptable business risk or any other product that a company might sell? The risk being damage to reputation and the possibility that a passenger won't return. Air India is quite clearly playing on the margins as numerous publicly posted complaints from upset passengers indicate.
Complaining about poor service is one thing. Suggesting that Air India's service was better before privatisation, at least to me, adds insult to injury.
And that brings us to the top stories and themes of the day.
The small and mid-cap indices are holding out and fighting back.
The rupee is steady as the forex reserves fall.
Winter rains are short and the wheat crop might be hit.
Can a reciprocal tariff by the United States include goods and services tax for the purpose of computation as well?
The Small Cap Indices Are Fighting Back
As trading days go, Friday last week was a weak one. The underlying trends are still weak, though there are a few promising signs here and there. More the suggestion that some segments of the market are still holding out or even putting up a small fight, like the small and mid-caps did last week.
And then there are some forecasts, the two bullish ones, and we'll come to that. On Friday last week, the 30-share SENZX fell about 425 points to close at 75,311, while the NSE Nifty 50 also ended lower by 127 points to close at 22,795. So the broader markets moved along with the benchmarks on Friday with an NSE Nifty mid-cap 100 and the Nifty small-cap 100 both closing down 1.3 and 0.7, that's less than a percent, respectively. So this is the second consecutive week the benchmark indices or the BSE and Nifty have been down even as foreign fund selling continues. To quote a fund manager from the other day, India is an easy market to sell, which obviously or hopefully means that India is also an easy market to buy when the funds return. Some sectors like pharmaceuticals have been hit harder in the last week thanks to those threats of reciprocal tariffs by US President Trump.
So while the mid and small caps did take a hit on Friday, they did actually do well on the week as a whole, rising 1.7 and 1.5% for the week. But you have to remember that they fell 7.5 and 9.5% in the previous week.
So at best or worst, the markets are still fluctuating, though at slightly lower levels than before.
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Meanwhile, there is not much hope around the corner, but maybe there is some hope on the horizon. ICICI securities analysts have said they expect corporate earnings to rebound to double digits starting fiscal year 25-26 with election debt uncertainty over and the growth-orientated union budget, which was presented earlier this month in place. All of this could take the Sensex to levels of 90,000 in the next 12 months or so they were quoted in a report in Business Standard.
There is some mathematics at play here. The Nifty 50 is down about 12% from lifetime highs, which were hit at the end of September last year. And the mid and small caps are down about 15 to 20%.
All of this is leading to the conclusion, which is somewhat mathematical, that valuations are quite reasonable and therefore should go up. Of course, there are others who feel that even these levels of valuations are high. So, ICICI securities says that on the Nifty earnings per share front, after the December 24 quarter, that's the last quarter, and incorporating revised profit after tax estimates for Nifty 50 companies, they're seeing a 4% earnings downgrade.
But keeping the price earnings multiple intact, their index target gets revised to 27,000 levels. That's nearly 21 times price earning on a 2627 earnings per share of 1,300 rupees. So that's forward.
The Sensex target that equals all of this is about 90,000, which is up, now here's the point, about 19.5% from the current level. So what they're saying is that if you were to invest now, at least at index level, you're looking at or could look at a close to 19 to 20% jump in the next 12 months.
That's if you believe or you're willing to go with what ICICI securities is saying.
The Rupee Steadies
Elsewhere, the rupee weakened slightly on Friday, thanks to dollar demand from importers and selling of stocks, as we've been saying, and more flight of foreign portfolio investment. The rupee closed lower at 86 rupees 71 paisa against the dollar after rising to about 86 rupees 48 earlier in the session. Though for the week, that's last week, the currency was slightly up and thus positive according to Reuters.
Meanwhile, India's foreign exchange reserves dropped to about 635 billion dollars as of the week before after rising for three weeks. So the reserves fell slightly by about two and a half billion dollars, which is the most in a month and had risen about 14 billion dollars in the previous three weeks, according to Reuters.
A Wheat Crop Faces Threats
India is facing more warm weather and sparse rain this month, threatening wheat crops. Rainfall across the country's northwestern region, which is an important wheat growing belt, has been almost 80% below normal since the beginning of the year, according to the Indian Meteorological Department, according to Reuters. Last month saw India reporting its third warmest January since 1901.
India is the world's second biggest wheat producer and a smaller crop could also, of course, lead to import duties being lowered from the current 40%. Reuters quotes the U.S. Department of Agriculture to say that while last year's output was a record, domestic stockpiles are near the lowest in 16 years.
HSBC PMI is Up
HSBC's Flash India Composite Purchasing Managers Index compiled by S&P Global rose to about 60.6% this month, jumping from 57.7% in January. Growth was led by the dominant services sector, with its index reaching 61.1%, which is the highest since March last year, from 56.5% in Jan. And this offset a slight dip in manufacturing PMI, according to those numbers, which fell from 57.7% to 57.1%, which is, in general or broadly, still a healthy expansion.
Analysing Tesla's Impact
So the question, now that it's imminent, that's the arrival that's imminent, will Tesla shake up the Indian market or not? Stock brokerage CLSA feels that even if Tesla launches a battery electric vehicle at a price of around $25,000, it does not anticipate a significant threat to Indian auto original equipment manufacturers, according to a report in Business Standard. Currently, the Tesla Model 3 and Model Y are the most affordable, priced around $35,000 at X factory in the United States.
Therefore, Tesla will have to sell these same models with reduced features to lower the cost for the Indian market or incur losses. CLSA also feels that even if one assumes the import duty is revised to about 15 to 20%, the price would be significantly higher than most of the four metre long electric SUVs offered by domestic players like Tata Motors, Mahindra and Mahindra, Maruti Suzuki and Hyundai Motors. Now this was, of course, the most logical question even for me to pose, at least for this current range of models.
So one theory floated last year was that Tesla would set up a car plant in India, which would produce much cheaper cars because they were being produced here. Now that's, of course, still possible, but clearly some time away, even if it does happen in the near term. And as of now, there is no service network that has been talked about, a deal breaker for many Indian buyers, which means all these Indian companies, which is the Mahindra and Mahindra and Tata Motors, among others, including Hyundai, who are present in India, would be still at an advantage.
CLSA says that even if Tesla launches at $25,000, features and specifications would be meaningfully compromised compared to Indian manufacturers who are offering compelling features and competitive pricing. CLSA draws a useful analogy. It says the situation would be similar to that of acceptance of the Harley X440 bikes by Indian consumers, which are priced about 20% higher than the Royal Enfield Classic 350, but the Harley has sales of about 1,500 and Royal Enfield Classic 350 has sales of about 28,000 units.
So, well, to be fair, Tesla is a little more iconic than Harley, at least in current times, though Harley-Davidson is well-known and much older. It's interesting that the Indian brands, like Enfield, of course, have been holding out very strongly and for many years. So all of this could mean that Indian stocks should not take a bigger hit than they have, which is more, I would assume, for demand reasons, rather than the potential or likely arrival of Tesla.
Presently, import duty on cars priced about $40,000 in India is 110%, including in agriculture sales, which CLSA believes is subject to change post those reciprocal tariffs from the United States, according to that Business Standard Report. And some more details getting down to pricing. The cheapest Tesla car, Model 3, is priced around $35,000 in the U.S., with tariffs lower to about 15% to 20%. And then there's road tax, insurance, and other costs. Remember, you have to pay all of that. The on-road price would be about $40,000 or 35 to 40 lakh rupees, which is definitely nowhere near any affordable segment.
If Tesla positions itself with Model 3 at an on-road price 20 to 50% higher than eVitara, eCreta, and XCV9e, it would not significantly impact domestic EV models, says CLSA, which has obviously done its homework on this bit. But the larger figure to remember is this one. Total electric passenger vehicle sales in India were about 100,000 units for last year.
Penetration is about 2.4%. This is for four-wheelers, compared to 12% globally. And 30% for China.
GST and Tariffs
Last week, President Trump put out a statement on social media, saying that the United States will consider countries that use the VAT or value-added tariff system, which is far more punitive than a tariff, according to him, to be similar to that of a tariff. Now, VAT is similar to GST, and there have been some concerns on whether the reciprocal tariff value could be higher than what might or might have appeared earlier. Trump also talked about sending merchandise products or anything by any other name through any other country for purposes of unfairly harming America and that that will not be accepted.
So what he means is, for example, a Chinese company manufacturing in Vietnam or Mexico and then exporting to the United States from there. Trump also said that provisions will be made for non-monetary tariffs and trade barriers that some countries charge in order to keep their products out of their domain. So, conceptually, what's the linkage between tariff and GST?
I reached out to Sachin Menon, senior tax advisor and former head of indirect tax at KPMG India, and I began by asking him if the GST or VAT comparison was a fair one.
INTERVIEW TRANSCRIPT
Sachin Menon: If you look at the structure of Indian customs duty from an Indian perspective, there is a basic customs duty which is between 7.52 to 20 percent. Some items, very few items, will have a prohibitive tariff, which will be more than that. But generally it is between 7.52 and most of them are at 10 percent and some of them are 20 percent. So there is a basic customs duty that is 7.5 percent to 20 percent. On top of it, there is an integrated GST at the rate of 18 percent normally and it depends upon what is the rate which is locally applicable. The same rate applied on as integrated GST on the accessible value plus basic customs duty.
On top of it, if you add the accessible value plus basic customs duty plus the IGST amount, there is a 10 percent social welfare surcharge which is meant for certain purposes which the government makes a fund. It's kind of sad. Now, if you see this IGST amount, whatever you are paying as a part of the import duty that will be available to the reseller or manufacturer or trader as an input credit, 100 percent input credit.
So essentially that element of GST is concerned. It is a neutralising impact. It is not affected because the same GST is charged on the goods manufactured locally as well.
So therefore, the Trump statement to say that he said that the use of the VAT system, which is far more punitive than a tariff to be similar to that of a tariff is not correct. I disagree with that observation. So that may perhaps not fathom what the rules are.
Govindraj Ethiraj: But the principle of it or at least what he seems to be saying now, none of this may eventually pan out this way, but is that basically if the product is, let's say, worth 100 rupees, you are putting, let's say, 20 percent import duty, but then you're adding another 18 percent GST. So the effective cost to a consumer in your country as opposed to mine, which is in the United States, is much higher whichever way you decide.
So how would that work then, let's say, for other countries where duties are?
Sachin Menon: Essentially, it seems that what he's saying is that you charge whatever customs duty you charge, I'll charge you as well. So it is fair play, equal ground. And he's also saying that supposing the neighbouring country lowers the tariff.
The USA also reduced the tariff according to that domestic country's tariff. You have a higher tariff, but what you are doing is we are routing those exports to the US through those other countries. That possibility also he is mentioning in his statement, that if you are sending any of the merchandise through another country, then we'll have provision for unfairly harming America.
And then again, they are saying that there are subsidies given by some countries in order to take economic advantage of the US. That also they will make provision. They are also talking about other non-tariff barriers, trade tariff barriers, which is essentially talking about import ban or quota system and rules of origin requirement, then export subsidies, then the planted animals, they have phytosanitary certification and other veterinary certification, etc.
Quality conditions imposed, licensing requirements, then anti-dumping and countervailing duty, etc. All this he is saying that we will also make the similar provisions. But then many of these subsidies are perhaps discussed and endorsed by the WTO under the general agreement of trade and tariff, the GATT agreements.
The way he is talking about unilaterally imposing such kinds of duties and restrictions would be in collision with the terms of the WTO agreement as of today. So that is going to be a disastrous scenario where there will be many disputes.
Govindraj Ethiraj: Right. Last question. So when we negotiate with other countries, when we are negotiating with other countries, how do they see the GST factor?
And is our sort of GST decision linked at all to what the international pricing or landed price might be of similar products?
Sachin Menon: Not really, because at the end of the day, whatever may be those exports, what they are making. And in case that export is subsidised in the exporting country, so that the goods enter the market of another country at lesser cost. Actually, the cost is subsidised by the government, by their own funds, whereas actual cost is much higher since the government is subsidising the exporter to sell that product at a very throwaway price to the destination country.
Those kinds of issues aside, as far as the VAT element is concerned, there is no, it's a neutralising effect as far as VAT is concerned. When you are exporting the goods to another country, India is not charging any VAT. If at all they charge VAT, then that will be reimbursed.
And similarly, when importing also, they are giving that benefit of either refund or the credit as based on what are the conditions attached to it.
Govindraj Ethiraj: Sachin, thank you so much for joining me.
Sachin Menon: Pleasure.
