India’s New Government Fires Up Investor Enthusiasm

India’s economy has been weighed down in recent years by both political and economic problems, which have dragged growth substantially below its potential. Deterioration in the fiscal and external accounts and an alarming rise in inflation with ensuing interest rate hikes by the Reserve Bank of India (RBI) have created stagflation type conditions and made the economy vulnerable to external shocks. This duly happened last year when India came to be regarded as one of the emerging economies most at risk once the tapering of quantitative easing (QE) got underway in the U.S.

Exhibit 1: GDP has fallen to its lowest level in over 10 years

Sources: Central Statistics Office, Consensus Economics, August 2014.

The lack of an effective response by the previous government also exacerbated the slowdown. A mixture of several major corruption scandals and political deadlock under coalition politics resulted in several years of policy paralysis. Much needed action to spur investment and tackle structural supply-side bottlenecks in inflation and infrastructure was simply stuck in government.

Landslide victory for BJP brings in strong government

Summer 2013 proved to be an inflection point for the market with the economy bottoming out and inflation beginning to fall in response to monetary tightening. The period also saw the appointment of a new and highly-regarded governor of the RBI. Raghuram Rajan, once the chief economist at the IMF, stabilized the rupee and the current account by stemming capital outflows and reassuring the market with an explicit inflation targeting policy.

But while these developments were important, the outcome of the May 2014 election proved the real game changer in restoring investor confidence. After 550 million votes were counted, the BJP emerged with an overall majority and Prime Minister Narendra Modi now heads the first government in 25 years that is not hostage to coalition politics. Moreover, India has a majority right-of-center administration for the first time since independence. Thus, the prospect that the government has both the desire and ability to implement pro-business economic reforms has ignited investor enthusiasm.

The hopes for Modi are so high because of the reputation he gained as a pro-business administrator. Serving as chief minister of Gujarat, one of India’s fastest-growing and most business-friendly states, Modi focused upon improving infrastructure, agricultural productivity and the profitability of state-owned enterprises. Investors anticipate that he will target the same goals in national government and seek to reduce the vast subsidy bill for items such as food and fuel. Modi has also vowed to eradicate corruption, condemning the previous government as being too “addicted” to graft to tackle the issue.

Against such high expectations, we have yet to see any major announcements and indeed the BJP’s first budget, announced in July, disappointed. The slow start may reflect India’s gargantuan and stubborn bureaucracy, the need to overcome vested interests and the competing forces of the central and state governments. Nevertheless, the administration’s intent is clear and we have already seen evidence of Modi’s “minimum government, maximum governance” mantra including the merger and streamlining of the coal and power ministries and the reduction of red tape to help accelerate government approvals. While these measures are lower profile, they are a step in the right direction and will improve the functioning of the current government system.

Economic growth and the pace of reform to accelerate?

The pace of reform should accelerate as the government addresses the fundamental problems plaguing various ministries and the economy, and growth should subsequently pick up. Investments could well lead the recovery, especially considering that new project starts have fallen to historical lows. While the return of government investment will depend on when the government loosens its purse strings and on effective implementation of infrastructure projects, the return of the private sector requires a revival of “animal spirits” among both consumers and corporates. This should boost corporates’ desire to invest in their businesses and feed through to better earnings.

Exhibit 2: New project starts unlikely to fall further; any pick up will potentially drive future growth

Sources: Central Statistics Office, Nomura, July 2014.

Data also points to a recovery in the fiscal year beginning in March 2015. Capital and consumer spending are starting to revive and we expect to see earnings results improve. Margins and returns are at 10-year lows with potential for upside as revenue growth strengthens, spare capacity is used and returns trend back to more normalized levels. Moreover, India is well positioned in terms of monetary policy given that it has already been through the tightening cycle and inflation is easing. Indeed, India could be one of the few countries where the central bank can loosen monetary policy going into 2015, when the developed markets are likely to be entering a tightening phase.

India’s long-term potential remains clear: the so-called “demographic dividend” of a relatively young and fast-growing working population; low levels of consumption with household penetration of many goods remaining low and giving huge scope for increased consumer spending; the potential for a big increase in infrastructure spending, which can ease structural bottlenecks; India’s democratic tradition encourages greater transparency and accountability than is seen in some other Asian countries.

Investment ideas

As the new government begins to put its stamp on policy, it will create investment opportunities not only in the domestic economy but also in sectors exposed to government-led reform, which is a theme that is becoming more prevalent in Asia as sluggish growth has encouraged governments to reassess their economic models. Below we have identified five ways to participate in India’s brightening outlook:

1. Improving economic activity: We favor the private banks among the financials, whose fortunes are directly linked to the economy. These institutions mostly maintained their asset quality during the downturn and we anticipate that lending opportunities, particularly in corporate, consumer and infrastructure-related areas, will improve as economic activity accelerates and the new government puts incentives in place to encourage lending.

2. Consumption recovery: We are also targeting companies that should benefit from a recovery in consumer spending, particularly in urban areas where high inflation and a weak economy have dampened real wage growth. The penetration rate of vehicles is low in India, even relative to other Asian countries at 20 per 1,000 people. As consumption recovers, helped potentially by lower financing rates, a return to the structural growth story should benefit India’s carmakers.

3. Infrastructure: With renewed focus on addressing structural bottlenecks in the economy, areas such as roads, rail and affordable housing should see a meaningful uptick in investment. The Dedicated Freight Corridor (DFC) is one rail project under construction that will connect East and West India and at least halve delivery times while quadrupling capacity. We would expect more such projects to be launched and spending to flow through to engineering and construction businesses as well as cement companies.

4. Subsidy reductions: We expect diesel subsidies, which have already been lowered, to be reduced dramatically with prices reaching market levels before the end of the year. The burden of fuel subsidies has been shared between the government and upstream, state-owned companies. This has proved a drag on the latter’s earnings and clouded visibility as the subsidy system was very opaque. As subsidies decline, upstream oil and gas exploration companies will benefit.

5. Exporters: We also favor some exporters, which continue to win international market share and enjoy good earnings visibility. IT services is an area where Indian companies are doing very well with most experiencing strong revenue and earnings growth. We also like the pharmaceuticals businesses, which are benefitting from the strong growth in the U.S. generics market by launching niche, generic products when established products go off patent.

The main risks to India’s positive outlook

Governments are generally quick to promise change but can be slow to follow through. Given that India’s equity markets have already risen sharply on the promise to renew the economy, they could react just as swiftly to any setbacks to the reform process. The risk is that initiatives by the central government may simply fail to have an impact on the ground given the layers of officials they will have to penetrate. Modi may find it much harder to push through reforms at the national rather than the state level. The government’s efforts may also drag on economic growth in the short term. Thus, reducing subsidies could affect consumption, particularly in rural areas, and push up inflation and prevent the RBI from lowering interest rates as quickly as it would otherwise be able to do. Finally, India remains vulnerable to external shocks, such as a sharp normalization of U.S. interest rates or a hike in oil prices, given that the country is a capital and energy importer.

While there will be speed bumps in the road to economic recovery and there will be times when market expectations and reform implementation do not align, the direction is clear and we believe that the Indian economy will be able to find its feet again at a higher and more sustainable growth rate. This should feed through to earnings and a recovery in return on equity (ROE), which in turn should be rewarded by the equity markets. India was one of the first emerging markets to enter the slowdown and, under the right policy environment, it should be one of the first to recover.

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