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Posted on 31-May-2019 Comments  0

Ethanol Story

Why Indian sugar stocks must be wary of the ethanol story

Sugar stocks in the April quarter had some reasons to cheer about. While the core sugar business continued to be under pressure due to oversupply, there was good news. The ethanol business which contributed nearly 12% to the revenues in the quarter ended up contributing nearly 50% of their profits. This has given hope to sugar stocks, but there is need for caution. Here is why!

Only ethanol is viable now

Among the various bio-fuels available only ethanol blending is actually viable in India. Other sources like Jathropa are not exactly scalable and the yield is too low to justify a full-fledged business model. Modi and Gadkari have spoken about the need to reduce dependence on fossil fuel imports and that is only possible through ethanol.

Ethanol has other costs

While it is true that ethanol blending can reduce the cost of fuel meaningfully, there are some costs that we need to be conscious of. Production of sugarcane and distilling ethanol is very water intensive, which becomes a major challenge in a country with rampant water shortage. Also sugarcane growing for ethanol takes away a large share of fertile cultivable land. That is almost equivalent to forsaking food production, which is hardly acceptable in a country like India where agricultural yields and efficiency are already quite low. 

Problem of size

If you look at the global pecking order of ethanol production, India does not even figure in the top 10. For example, the US produces 41 MT of ethanol and Brazil 20 MT while India produces only 0.30 MT of ethanol. That is because of low ethanol productivity and it would really take a very long time for India to really become a significant player in the ethanol blending value chain. 

But, where is the water?

That is the million dollar question. While the US makes ethanol out of corn and Brazil out of sugarcane, India makes ethanol out of molasses. That is very water intensive. The average water requirement in India is 2.5 times the water required to blend one liter of ethanol in the US or in Brazil. While the US and Brazil largely depends on rain water, India relies on ground water resources for half of its ethanol needs.

Numbers don’t add up for India

There is a dichotomy to begin with. India blends just 2-3% ethanol whereas it is 45% in Brazil. If India were to even achieve up to 10% blending, our water consumption would be twice that of Brazil. India does not have so much cultivable land. Sugarcane accounts for 3% of cultivated land which will have to touch 7% to blend 10%. That hardly looks like a practical solution!

Bond Yields

Why are bond yields falling so sharply in Indian debt markets

The bond yields had been range bound for a long time on the benchmark 10-year bonds in India. However, in the last one month, the bond yields have fallen nearly 40 bps from around 7.43% to a multi-year low of 7.03%. Let us look back at the key factors driving lower yields in India.

Low inflation expectations

Inflation, at the consumer level and the producer level, which had risen sharply in the last one year, has shown signs of tapering in the last couple of months. Despite a bounce in food prices that was supported by higher farm MSPs, the overall inflation has remained subdued. That is because fuel inflation and non-core inflation are down. Also with a global slowdown, the thinking is again veering towards low growth and lower inflation in the coming quarters.

US bond yields taper

The domestic bond yields have a link to the US benchmark yields because it is this spread that determines whether FIIs will invest in Indian bonds or not. The spread normally varies between 4% and 4.5% but of late the spread went up above the 5% mark. The US bond yields have fallen to a low of 2.12% on the back a dovish outlook by the Fed and lower growth expectations. This has also pushed the Indian bond yields lower and it has already lost over 120 basis points since September last year.
Expecting liquidity boost

The markets are already factoring in a major liquidity boost. The RBI is infusing nearly Rs.20,000 crore on a monthly basis through OMOs. On top of that, the RBI is also doing regular dollar swap auctions which also infuse liquidity into the system. With the kind of liquidity surge into bond markets, the yields are likely to be under pressure. Normally, liquidity pulls down yields at the shorter end and that gets transmitted to the longer end of the curve also.

Real rates need to fall

One thing that we often overlook is that Indian real rates are among the highest in the emerging markets. Indian bonds pay real returns of over 4% where the norm in other countries is between 1% and 2%. A fall in real rates was long called for and with the inflation consistently at lower levels there has been a real case to lower the interest rates. That is what is reflected in the yields on the benchmark bonds.

Global slowdown fears

With the trade war sustaining and the US yield curve inverting, there is fear of global recession that is engulfing the market. Normally, rates move lower when the growth expectations are downgraded. IMF has already lowered GDP expectations by 70 bps. That is really what yields are reflecting!

GDP and Jobs

How the Finance Minister must address the crisis in GDP and Jobs

On the day Nirmala Sitharaman took charge as the Finance Minister of Modi 2.0, there were two discouraging pieces of data. GDP came in lower at 5.8% annualized for the fourth quarter and 6.8% for the full year. At the same time, unemployment at 6.1% was at a 45 year high. How can the new finance minister deal with the twin challenges?

Tax reforms a must

Indian consumers are one of the most taxed and at multiple levels. In the last few years there has been limited improvement in tax collections or in tax compliance. The reason lies in the steep rates of taxes. Simplify tax for business and for individuals. Keep rates low so there is limited incentive to not pay tax. Corporate taxes must be cut if net profit margins have to really improve. But the big challenge is simplification of taxes and the on-boarding process. Merely simplifying will substantially increase the tax traction and also promote growth.

Focus on monetary macros

The immediate focus will have to be on two things. A sharp cut in interest rates supported by a proper mechanism to ensure that the rate cuts transmit fast to the borrower. Second, is the issue of liquidity! The tight liquidity conditions have taken its toll in the third and fourth quarter and that has hit the GDP growth in a big way. OMOs and dollar swaps may have a big role to play.

Give exports a thrust

If India needs to sustain the growth advantage over China of 100 to 150 basis points, then it cannot happen without a major thrust on exports. The point is that today we really do not have an export story to tell the world. At one point we had products like textiles, gems & jewelry, pharma and IT. In the last 10 years, we have hardly created any worthwhile big export story that can give a boost to the total exports. If you take examples of countries across East and South East Asia, the growth has been predominantly driven by exports. India is turning from a net exporter of steel to being a net importer, which only worsens the trade deficit. India’s oil dependence is another big area of concern for the FM and needs to be addressed on top priority. 

Don’t waste the crisis

Ironically, some of the most potent reforms came about in the midst of a crisis. Be it 1991, 1997 or 2000; India has pushed through significant reforms in the midst of a crisis. That is why the mandate for the Finance Minister is not to waste the crisis. Chart out the big picture. Should India focus on creating capacity on the lines of China or purely give a big thrust to services? Should India open up its markets in a big way and also make the INR freely convertible? These are tough debates but this is the time to bite the bullet!

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