Country in Focus: India

June 27, 2017 | Market Commentary

India is one of our most preferred countries from a top-down macroeconomic standpoint, not only within the emerging market universe, but within the entire global investment landscape. The country offers what we consider to be a scarce combination of rapid growth, improving macro fundamentals (both from a stability and cyclical growth standpoint), and inflation that has fallen on a structural basis to historically low levels. The weakness in oil prices is also a tailwind given India’s net-importer status. Most importantly, India is home to one of the best structural reform stories on the planet. While the country is still rife with challenges and remains a difficult place to do business, the direction and pace of change in India is clear.

Structurally, while the pace of reform has improved markedly since the election of Narendra Modi’s BJP party in 2014, the country still has a lot of low-hanging fruit with regard to structural reform and institutional development. India’s massive, youthful population is expected to provide a handsome “demographic dividend” in the coming years, while it also remains the world’s largest democracy. The latter should be viewed in context of widespread poverty, a weak education system, a very narrow tax base, as well as through India’s many complex societal divisions such as caste, class, and religion. The above factors have historically provided a potent brew of political gridlock, identity politics, and populism.

While the above realities are not going to fade away overnight, we do believe it is safe to say that the current political backdrop is probably more supportive of economic growth and business-friendly reform than it has been in decades. Although initial progress was disappointingly slow for the Modi government, he and his counterparts at the Reserve Bank of India have unleashed a steady stream of large and small reform measures that we view as coherent and rather complimentary. We believe that the totality of what has been accomplished, along with what is still yet to come, will be truly transformational for the Indian economy.

Though the list of recently passed reforms is long, the broad thrust of the reform package is most usefully viewed in the context of “competitive federalism.” Modi is essentially trying to use India’s federalist constitutional structure to his advantage by passing reforms at the central government level to equalize the playing field for individual states, and then incentivizing the states to compete with each other for investment and growth by passing their own reforms.

The Goods and Services Tax (GST) is one of the “big bang” reforms that was discussed for years in India but was always shelved due to chronic political paralysis. With the recent passage of this bill and impending implementation due this summer, the government will take a historic step to simplify India’s notoriously complex tax system and importantly, reduce interstate barriers to trade. As the new system will replace a slew of previous state-level taxes, it will level the playing field between states. States will be forced to compete for private investment based on the merits of their business environment and flexibility of their labor and markets, rather than as a competition to see who can provide the most tax incentives to special interests. The GST is a transformative measure that will improve the medium term growth outlook on its own. Perhaps more importantly however, is the potential for this legislation to pave the way for future state-level reforms through the lens of competitive federalism. Already we are seeing signs of states taking the initiative to loosen stringent labor laws, and we suspect others will feel competitive pressure to follow suit or miss out on job-creating private investment.

Another area where we are seeing the benefits of competitive federalism take shape is housing. India has a shortage of jobs and housing. Solving these bottlenecks will be critical to the long term prosperity of the economy and to the success of the world’s largest democracy. The government is attempting to boost housing supply and demand, which if successful, will address both shortages. In order to resolve the shortage in housing, the government announced its “Housing for All 2022” initiative in June 2015, which targets the construction of 50 million homes by 2022. The economic fundamentals are aligning for housing demand, and the government realizes the opportunity to strike while the iron is hot. Fortunately, due to rising incomes and falling borrowing costs, affordability is now extremely supportive without government help, though the government is now also providing support through reforms and via direct financial incentives in the supply and demand sides of the housing market.

The government’s recently expanded Credit Linked Subsidy Scheme (CLSS), which subsidizes the purchase price of a home, must also be viewed in the broader context of Prime Minister Modi’s competitive federalism drive. Essentially, it is a development incentive from the central government that will disproportionately benefit states that reform land and labor laws to expand the supply of housing. State-level policies on land acquisition, labor, and zoning will all need to fall in place to make affordable housing feasible to the degree that the company requires. A central government subsidy, along with GST implementation, should encourage reform through competitive federalism. Moreover, success on the housing front could buy the reformist government additional political capital, paving the way for even more market-friendly reforms. Making progress on the housing and job shortages is not only politically expedient for a leader trying to get reelected, but it also will have ramifications as to how India plays out over the next decade and beyond given the huge demographic dividend. Utilizing a popular policy, “housing for all,” to incentivize reforms at the state-level is a reasonable tactic in a massive but poor democracy.

Fortunately, the reformist government remains quite popular. A recent test for the Modi government came in the form of a state election in Uttar Pradesh, India’s most populous and also one of its poorest states. Despite the effect of a late-2016 decision to “demonetize” India’s largely cash-based economy by forcing citizens to turn in old currency bills for new, Modi’s party was awarded a landslide victory. The election was watched closely as it was assumed that the inconvenience from the cash ban would affect poorer, rural residents more acutely, and that they would voice their dissatisfaction at the polls. However, Modi was able to frame the move as an effort to reign in corruption in the underground economy by the wealthy elite. His gamble seems to have paid off in Uttar Pradesh, and the victory there not only increases Modi’s chances of being reelected in 2019, but also of being reelected with a majority in both houses of congress. Given the recent boost to Modi’s political capital, we expect the reform story to continue and are watching for reforms that will be economically effective and business-friendly, but also saleable to India’s voters.

From a macroeconomic perspective, we believe that India has achieved renewed stability, having improved its fiscal and current account deficits and built up a substantial buffer of foreign exchange reserves. Foreign direct investment remains strong. We believe the economy can continue to grow at a high level, as it is now rebounding from the demonetization shock, and oil’s recent pull-back further helps the macro outlook. We believe there is scope for growth to accelerate slightly from here. Lower lending rates, higher government investment spending, and a renewed housing push are all tailwinds to growth. A stronger external environment and the recent improvement in exports should pave the way for an eventual recovery in private investment.

Despite the favorable policy backdrop, one legacy issue continues to weigh on India’s medium-term economic growth outlook; the poor state of Indian bank balance sheets. Despite recent efforts to encourage the development of a corporate bond market, India remains a bank-dependent financial system, historically driven by government-owned banks. As it happens, these banks have a large portion of non-performing loans that have been extended to the corporate sector and various infrastructure developers. Many of these projects remain in limbo due to various land-acquisition issues and red tape. This vicious cycle has resulted in slow credit growth with little impetus for a renewed credit upturn on the horizon. The weakness of bank balance sheets is currently precluding a meaningful acceleration of fixed asset investment and economic growth, and this remains a difficult issue to deal with politically. While the recently passed bankruptcy code and amendments that allow the RBI to intervene directly in specific loan cases should help, the sector needs a large scale recapitalization. It is difficult to allocate budget funds to bailing out banks in any country, and even more so in a country where many remain very poor, especially with a Prime Minister seeking reelection.

Going forward, we will be vigilantly monitoring various risks that could throw off India’s recent progress. Perhaps the most important will be policymakers’ ability to continue taming inflation and encourage savings in financial assets and bank deposits (as opposed to stockpiling gold). Critical in this effort will be the maintenance of positive real interest rates, which should also support the currency. Those savings can then be channeled into productive investments such as infrastructure and housing via financial markets. We have seen progress on this front from an increasingly credible central bank and also the government’s own actions to encourage financial inclusion. Importantly, the Modi Government has continued an initiative called Aadhaar, put in place under the previous government to provide each Indian with a unique identification, which makes it much easier to open a bank account or a mobile phone account. The usage of bank accounts has exploded in the past few years.

While we recognize that aggregate market valuations are not exactly enticing given outperformance in recent years, India still offers a rare combination of high growth, an improving structural risk profile driven by coordinated policy reform, and benign inflation. Given these conditions, we believe that India is essentially peerless as an emerging market investment destination and should continue to provide an abundance of multi-year investment opportunities. We believe that a combination of demographic, macroeconomic, and regulatory conditions are providing an investment opportunity in the Indian housing market. These conditions, along with a confluence of factors including various past and present government reforms and new targeted incentives, should create long terms tailwinds for companies exposed to a sustained upturn in spending on residential construction, including building materials, finance companies, and consumer-facing companies. Additionally, Indians are finally putting their savings in bank accounts where it can be used as funding for productive credit creation, rather than under their mattresses or around their necks (in the form of gold). If these trends can be maintained, then the confluence of falling inflation and financial inclusion will truly be a game changer for India. The under-penetration of financial services, as well as rising incomes and reforms like those described above, are some of the reasons why we see compelling investment opportunities in Indian private banks and consumer companies. India remains one of our most preferred markets from a top-down perspective, and we look forward to continuing to hunt for profitable investment opportunities as this positive story unfolds, and India’s long-term potential is slowly unlocked and revealed to the world.


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