India is currently one of the fastest growing economies in the world, in addition to being one of the largest. It is likely to surpass Italy and Brazil in nominal GDP within a year or so, and it will almost certainly surpass China as the fastest growing major economy in 2015. India has become a world class hub for business process outsourcing, information technology services, and consulting. Its large, English-speaking population has allowed it to become an important exporter of these high-value services. The country’s transition from an agrarian economy to one that is increasingly driven by services makes India a global anomaly in terms of its economic composition—few major economies have made such a transition before developing a competitive manufacturing backbone. Going forward, India’s massive, young, and growing population provides it with enormous potential and a long runway for growth. At a time when China’s immense working-age population is actually set to shrink in the coming years, India’s is set to grow faster than any other major economy. The country also will add more people to the global labor pool than any other country in absolute terms. Therefore, it goes without saying that India will be increasingly important as an investment destination, as well as a more important driver of the global economy.
With great opportunities often come great challenges. If India is to truly reap its demographic dividend and realize the economic prosperity that its young and growing population could deliver, it must deal with the structural rigidities that are currently holding back the economy. The list is long, but we believe there is a plethora of low-hanging fruit in terms of productivity-enhancing and growth-inducing reforms. Many of the things holding India back are in fact self-inflicted. The country suffers from a glaring infrastructure deficit and fiscal laxity, both of which contribute to high structural inflation and a high cost of capital. The country’s excessive regulation and red tape, along with its antiquated and rigid labor laws, encourage informality and reduce access to capital for businesses, which acts as a barrier to scale, productivity, and competitiveness. Widespread corruption and an inefficient bureaucracy also are barriers to rapid reform. There is a need for massive infrastructure investment, but the process to acquire land is complicated and the underfunded state of the banking sector (due in part to mandatory lending to government priority sectors) make such investment difficult to realize. Meanwhile, the macroeconomic environment continues to be characterized by large and repeated public deficits, high public debt, and an extremely narrow tax base.
All of these issues have left the Indian economy rather vulnerable to global events in recent years. In 2013, in the absence of a credible policy response and structural reform, the potential development of a vicious cycle of currency pressure and current-account and financial-sector weakness was a significant risk. At that time, with India’s twin deficit (the sum of the current account and fiscal deficits) approaching 12% of GDP, there was speculation that India was close to suffering a late 1990s-style balance-of-payments crisis. The Indian rupee depreciated by around 30% against the U.S. dollar during the four months following the U.S. Federal Reserve’s announcement that it intended to “taper” its monthly asset purchases.
Much of our current enthusiasm for India’s growth outlook is predicated on macroeconomic improvements that have occurred since mid-to-late 2013. At that time, we were concerned that policy tightening in response to increasing capital outflows would harm the economy, even if it might be a positive in terms of setting the stage for sustainable growth. Specifically, we were concerned that high borrowing rates and persistent funding risks meant that India would face the danger of an extended slowdown in growth. Narrowing the current account deficit also would be a painful process. As a caveat, we noted that India—as a huge energy consumer and importer—could get lucky with a lower oil price. It turns out that this was exactly what happened, in extreme, around a year later. The dramatic collapse in oil also occurred only a couple of months after the Indian electorate rewarded Narendra Modi’s Bharatiya Janata Party (BJP) with a historic majority in the lower house of parliament on a decidedly pro-business agenda.
India has indeed experienced a reversal of fortune since 2013, outperforming other emerging markets handily since the “taper tantrum” sell-off of that year. Raghuram Rajan, who we regard as one of the most competent global central bankers, took the reins of the Reserve Bank of India (RBI) in late 2013, which marked the beginning of a strong policy response to capital outflows. The RBI hiked interest rates—leading to a restoration of positive real interest rates—which encouraged savings and facilitated an adjustment in the current account. This, along with some momentum in terms of government reform, has set the stage for more sustainable growth. The current account is now much smaller and more manageable and inflation has rolled over aggressively. The RBI has built up its buffer of foreign exchange reserves and has even been able to commence a series of rate cuts, which markets have perceived positively given the macroeconomic adjustment that has taken place.
It has now been a little over two years since India’s macroeconomic turnaround began, and it remains one of our most preferred emerging markets. India is one of the few places we can point to where things are moving in the right direction in terms of the economy and reform. The government slowly has had some successes: lifting restrictions on foreign investment, removing subsidies, and implementing reforms to the electricity industry, to name a few. It has also made progress with its financial inclusion initiatives aimed at encouraging Indians to use banking services, as well as reducing waste in the welfare system by making payments directly into the accounts of recipients. To complement the recent restoration of positive real rates (which reduce the incentive to hold gold as an inflation hedge), the government has recently passed several measures designed to reduce demand for gold imports (which are a huge contributor to the trade deficit). The government hopes this will channel savings and investment in gold into productive uses such as funding for badly needed infrastructure projects. These are all positive steps. Nonetheless, reform remains a two-steps-forward, one-step-back process. For instance, the expiration of a government decree to ease land acquisition regulations before a new law could be passed to solve the problem was a disappointment.
Nevertheless, the political environment is probably the most favorable in India’s modern history, though reform will be a grinding and difficult task. Market expectations of massive “big-bang” reforms were extremely elevated following the BJP’s election win. We were cautious at that time, noting that India, as the world’s largest democracy, has a fractious and unwieldy coalition system. It has many heterogeneous constituencies and hundreds of political parties at the state and national levels, not to mention the prevalence of powerful vested interests aiming to thwart attempts at change. We perceive that market participants have been largely disappointed in the reform program so far.
We believe, however, that the market may have moved a little too far to the pessimistic side. Despite a lack of headline-grabbing reforms, the new government is making smaller improvements which we believe have the potential to be meaningful and more effective than most observers realize. As these many small reforms are implemented under the radar, they could in the aggregate drastically improve the business environment. Given that large scale, nationwide reforms are so difficult to agree upon and implement, the Modi administration has sought to take advantage of India’s federalist structure under the banner of “competitive and cooperative federalism.” This concept is the framework for incentivizing the states to compete with each other by implementing state-level reforms, and we have seen meaningful progress in terms of cutting red tape, streamlining tax payments, and reworking state-level land acquisition rules.
There is an enormous amount of heavy lifting still to be done, however. Reforms aimed at increasing productivity will be key to generating sustainable growth. The government needs to pass a credible land acquisition regime, open up the economy to foreign investment, and repair banks’ balance sheets. We would welcome other changes such as the long-awaited reform of the country’s goods and services tax, which would help to streamline the tax system and broaden the tax base. There is also much work to be done in terms of cutting red tape and weeding out corruption in order to increase transparency and strengthen the rule of law throughout the entire economic system.
All of these issues need to be addressed if India is to reach its full potential over the coming years. Fortunately, India has the structural fundamentals in place to be able to control its own destiny. India is one of the few places where a rising tide will likely lift many boats, and the next few years will therefore be India’s game to lose. As investors, the bottom line is that the weight of the evidence suggests the wind is at our backs—the county’s risk profile and medium-term growth outlook both are improving. Therefore, we will continue to take advantage of investment opportunities which provide exposure to India’s long-term potential. We prefer exposure to companies that are likely to benefit from the long-term structural tailwinds that are in place in India, namely the rise of the consumer and the development of badly-needed infrastructure.