Investment Insights India: Modi reforms pave the way to growth
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Investment Insights
India: Modi reforms pave
the way to growth
March 2015
A continuation of the emerging market boom that has been taking
place since the early 2000s appeared to be wishful thinking by
India: Modi
December 2014 as a number of nations faced fears about rising US
reforms pave the interest rates, sliding commodity prices (particularly oil), weakened
way to growth. currencies (compared with the US dollar) and equity markets that
lagged their developed market neighbours.
In this environment, some developing countries may find it particularly
difficult to achieve short- or medium-term economic growth. So where
does this leave emerging market investors? The simple answer is that
a greater differentiation is needed to distinguish between countries
that have the right policy packages in place to support structural
reform and economic growth, and those that do not.
India is a good example of a country with Indian state enjoyed faster GDP growth
strong reform credentials. Many investors and more vibrant employment and
will remember the frustrating 2010-13 industry than the rest of the country.
period that saw the country struggle with (From 2002 to 2012, Gujarat’s annual
rising inflation, low growth, a rupee in GDP growth rate rose approximately
free fall and substantial budget deficits. 10%, while India’s rose around 7.6%.)
It has also been hampered for many
years by arguably “anti-business” policies Encouragingly, since becoming prime
and a bureaucracy that has been ranked minister, Modi has pushed for a more
the “worst in Asia”¹. In short, it has been business and investor friendly approach
viewed as a country with economic to India’s much-needed structural
potential that failed to materialise. reform, targeting cutting red tape and
improving the bureaucracy’s efficiency
However, a number of positive and transparency. Rather than radical
developments have followed the change, however, progressive reform
landslide general election in May 2014, has been in evidence, with a clear drive
with new Prime Minister Narendra Modi’s to establishing greater coordination
pro-reform and pro-modernisation among ministries, and faster decision
Bharatiya Janata government seeking to making to resolve economic issues.
swiftly reverse years of decline.
What is apparent is that India has a
Modi’s credentials with regard to newfound confidence. In less than a year,
economic growth were strong before the country has turned around a negative
the election. During his time as Gujarat outlook to achieve a stable macro
chief minister (2001-14), the influential environment as a result of six key factors.
1. “Overall Country Risk Ranking” by Political and Economic Risk Consultancy, January 2012
thecapitalgroup.com.au Capital International, Inc.
1
thecapitalgroup.com/asia Capital Group Investment Management Ltd ABN 73 164 174 501Investment Insights
March 2015
India: Modi reforms pave
the way to growth
Exhibit 1: Potential GDP growth looks set to rise, driven by greater investments
Modi government’s reform and productivity
highlights since the May
Total factor productivity Capital Labour Potential GDP (RHS)
2014 election
10 Contribution (%) Change, year-on-year (%) 10
• May: “Super ministries” are
Forecast
created by merging ministries 8 8
with similar mandates (such as
coal and power). 6 6
• July: The government clears
4 4
long-pending changes to three
critical labour market laws.
2 2
• August: The extensive initiative,
“Digital India”, is cleared. This 0 0
includes the digitisation of all
government records. -2 -2
• Modi scraps the planning FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19
commission that had guided Sources: Haver, CEIC, CSO, NSSO, Goldman Sachs Global Investment Research (incl. forecasts)
India’s economic development
for six decades.
1. India’s growth potential rises
• The cabinet clears the proposal
for raising the foreign direct One of the government’s key priorities Much of Modi’s initial activities have
investment (FDI) limit in defence is to raise the potential growth rate² of focused on specific structural reforms
to 49% and railway infrastructure the economy through structural reform. that raise India’s potential growth
to 100%. This can generally be done through and there has been a gradual pick-up
• September: “Make in India” is raising labour market productivity (for in the implementation of projects
launched, aiming to turn the example, making it more flexible, and (see exhibit 2). As a result, India is
country into a manufacturing increasing education and training) expected to benefit from an increase
hub and make it easier for Indian and through the capital markets in potential growth over the coming
companies to do business. (such as increasing investment in new years. See box opposite for details on
technology – see exhibit 1). the timeline of reforms.
• Ratings agency S&P upgrades
India’s outlook to stable.
• October: Fuel subsidies are cut, Exhibit 2: Projects under implementation* — year-on-year (%)
Public Private Total
swiftly followed by the approval
Public Private Total
of a decree that moves India
40 %
closer to the end of a four-
decade state monopoly on
mining and selling coal. 30
Steady improvement
• November: The government
takes advantage of declining oil 20
prices by hiking the excise duty
on petrol and diesel to augment 10
its revenues; the additional
funds have been allocated for
0
infrastructure development.
• December: Modi issues an
-10
executive order to clear a
Dec 10 Dec 11 Dec 12 Dec 13 Dec 14
proposal to allow 49% FDI in
domestic insurance companies. Sources: CMIE, Morgan Stanley Research
At present, India allows local * Includes all government and private projects that were either announced/proposed or were
insurance companies’ foreign under various stages of implementation
partners a capped 26% stake.
2. The potential growth rate of an economy is defined as the level of output that an economy can
a constant inflation rate.
2Investment Insights
March 2015
India: Modi reforms pave
the way to growth
2. Real interest rates move into positive territory
There is also a raft of
other progressive reforms One major obstacle to India’s growth only if real interest rates are positive,
currently under discussion, plans has been the banking sector’s meaning that the nominal interest rate
inability to attract deposits into the minus inflation must be positive.
such as: banking system. This has been due
• The anticipated national Goods to the protracted period of negative We believe this is now a strong priority
and Services Tax (GST) which real rates the country has experienced for India’s policymakers and following
aims to replace the current since 2009 (see exhibit 3), combined the Reserve Bank of India (RBI) policy
complex system of nearly with Indian domestic savers’ preference meeting in January 2015, the central
20 different taxes and levies for “unproductive” hard assets such as bank stated that a reasonable objective
imposed on commodities by housing and gold. Channelling savings for it would be a real policy rate of
different states. into precious metals not only increases 1.5%-2%. Note that real interest rates
• Improvements to the country’s the current account deficit, but also have been negative in the past but with
infrastructure – including the means companies are not able to finance policy rates currently at 7.5% (as of 4
building of 100 new “smart productive investment. March 2015) and inflation projected
cities” across India with hi-tech at 6% in January 2016, real interest rates
communication capabilities, For a sustainable investment cycle to are now in positive territory.
and new high-speed dedicated get under way, domestic savers need to
freight lines. channel their funds into bank deposits, The Indian finance ministry reported in
which banks can then lend to companies December that it expects the country’s
• Ramping up India’s traditionally
to fund investment. Savings can rise economy to grow at more than 5.5%
weak manufacturing sector by
focusing on new high-growth
sectors such as solar technology.
Exhibit 3: Indian inflation and policy rate
Manufacturing makes up only
15% of GDP in the country, and
Prime Minister Modi wants to Headline inflation Policy rate
raise that to 25%-30% to help 18 %
create millions of extra jobs
16
every year. (In comparison,
manufacturing makes up 24% 14
of Malaysia and Indonesia’s
12
respective GDP, while in Taiwan it
is 27%. In Thailand and China, the 10
figure is more than 30%.) 8
6
4
2
0
Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 Jan 14 Jan 15
Data as at 31 January 2015. Source: Thomson Reuters Datastream
Real interest rate defined here as nominal policy rate minus current headline inflation
Historically, foreign institutional government was struggling to rein in
investors (FIIs) have not been active its current account deficit.
within the Indian local debt market.
The reasons for this are a quota FIIs now have the option to buy debt
system and significant bureaucratic securities freely, until 90% of the total
impediments in the country. available limit of US$25 billion of
In September 2013, the Indian government debt is reached. Once
government removed some of these the 90% limit is reached (i.e. US$22.5
restrictions in a bid to encourage billion), local currency government
capital inflows at a time when the debt is sold in an auction to investors.
3Investment Insights
March 2015
India: Modi reforms pave
the way to growth
during the fiscal year ending March government’s GDP forecast materialises,
2015, stating that declining oil prices it would mark an improvement from two
presented “a golden opportunity” successive years of sub-5% growth.
for many beneficial reforms. If the
3. Inflation heads in the right direction
Anirudha Dutta is a macro analyst Until recently, inflation in India had been both of the RBI’s targets (see exhibit 4).
at Capital Group with broad sector drifting upwards since the early 2000s
and macro research responsibilities and was the country’s central challenge. An obvious reason for this sharp decline
in India. Based in Mumbai, he has But while the problem may have been can be attributed to the fact that India,
24 years of investment industry acute, it has also been at the forefront of like many other emerging market
experience, and has been with the RBI and the government’s agenda, nations, is a major beneficiary of the
Capital Group for one year. even before Modi’s election. sharp drop in oil (and other commodity)
prices; India was the third-biggest crude
“What is clearly visible to me is that The experienced and respected oil importer in 2013 behind the US and
business sentiment has seen a very Raghuram Rajan was appointed the China. The declining oil price has not
rapid turnaround since the new new governor of India’s central bank only helped to lower India’s inflation, it
government was formed. There in August 2013, at the height of India’s has also boosted the country’s GDP and
is a renewed sense of optimism recent economic crisis. Straight away, he improved its current account balance.
percolating down to the village announced fresh steps to stabilise the
levels, and the bureaucracy is rupee and outlined an ambitious plan However, the origins of India’s long-
enthused and reinvigorated. This is a to shake up the country’s conservative term inflation challenge lie with
welcome change from what I saw in banking system. These words were structural problems that need to be
the country between 2010 and 2013. followed by deeds in early 2014 as India solved if the CPI is to remain stable
joined most advanced economies as well and manageable. High food inflation,
“India has been ranked very low as several emerging markets in adopting for example – which India has been
on the ‘ease of doing business’ an inflation targeting regime (8% for battling for more than a decade –
indices for decades. A key January 2015 and 6% for January 2016). equals 50% of the goods basket and is
objective of Prime Minister Modi’s a key driver of headline CPI. It is also
government would therefore be India’s economy has certainly improved a reflection of infrastructure flaws:
to ensure that the country moves in the months since: in November 2013, the estimates of the share of food in
up those rankings, and many of his shortly after Rajan’s tenure began, the India that spoils due to inadequate
incremental initiatives are looking to year-on-year Consumer Price Index (CPI) transportation and storage facilities
do the same. was 11.2%; in November 2014, it had range from 20% to 40%. Furthermore,
declined to 4.4%, which is well below the country’s traditional food subsidies
“However, given the realities of a
cacophonous multi-party democracy
and the fact that Modi’s Bharatiya Exhibit 4: India’s inflation coming down
Janata Party does not have a majority
in the upper house of parliament, 12 Year-on-year (%)
legislative progress will be slower
than desired. I also believe private 10
sector investments will take some
time to kick start, and the first leg of 8
investment uptick will be driven by
6
public investments.
4
“Nevertheless, the government will
still find creative solutions like it 2
did in the case of the relaxation of
the labour laws. It will give a clear 0
message that India is open for Mar 12 Sep 12 Mar 13 Sep 13 Mar 14 Sep 14 Dec 14
business once again.”
Inflation measured by the three-month moving average of one-year percentage change of CPI.
Source: Bloomberg
4Investment Insights
March 2015
India: Modi reforms pave
the way to growth
and wage support mechanisms have • has taken various steps to abolish
contributed to erode fiscal balances, the Agricultural Produce Market
drive unsustainable demand and Committee (APMC) Act, which would
disincentivise efficiency improvements. check rising food prices.
• oversaw a moderate increase in the
India’s food inflation reached an all-time minimum support price for key crops
high of 14.7% in November 2013, and in October.
a lower-than-average and regionally • asked officials in December to
skewed 2014 monsoon added to fears HCUVtrack the implementation of a mega
that agricultural growth may be lower irrigation scheme to provide facilities
than expected in 2015. A weaker output to every Indian farm, and instructed
would drive up inflation and negatively the water resources ministry to
affect GDP. identify river-interlinking projects
that could be taken up immediately.
Encouragingly, though, the government
has recently taken steps towards Things are certainly moving in the right
finding long-term solutions to improve direction, as India’s food inflation figure
the country’s inadequate agricultural hit a record low of 3.5% in November
infrastructure, and therefore food 2014. The challenge now will be to
inflation. For example, Modi: keep it there.
4. The rupee stabilises
The rupee remained stable in 2014, falling Moreover, the RBI stated several times
only 2% against the US dollar. In contrast, in 2014 that it needs to prepare against
the currency fell 11% in 2013. The rupee the impact of a US Federal Reserve
also performed better than most other interest rate hike. It kept Indian rates on
major currencies last year: the euro and hold throughout 2014 – and even raised
Japanese yen both declined 12% against hopes in some quarters that they could
the US dollar, while emerging markets as be cut. It finally surprised markets with
a region slipped 13%³. two reductions in interest rates in mid-
January and early March as inflation
Admittedly, the rupee did not remain showed signs of slowing.
immune to all threats: the currency hit
an 11-month low in December when it The central bank is therefore likely to
suffered from some emerging market- intervene where necessary to prevent
wide contagion, and stocks declined any further sharp depreciation against
on weak trade data. However, it still the US dollar. Over the long term,
only fell 2% on the month against the we expect interest rates in India to
US dollar, outperforming its emerging continue to fall as Modi’s structural
market peers at the time. reforms are implemented.
5. Current account narrows
According to the RBI, India’s current But if there is only a slight decline,
account deficit narrowed sharply to investors should not consider this a
US$4.2 billion (0.9% of GDP) in the third cause for concern. There is plenty of
quarter of 2013-14, from US$31.9 billion scope for foreign direct investment (FDI)
(6.5% of GDP) in the third quarter of and equity flows to support the rupee
2012-13. The RBI said the reduced deficit and the deficit, especially following the
was primarily a result of a decline in the government’s removal of limits to FDI in
trade deficit as merchandise exports the defence and railway infrastructure
picked up and imports moderated, sectors. We would be more concerned
particularly gold imports. We expect about a lack of structural reform activity,
this deficit to deteriorate mildly as as a resurgence in inflationary pressures
investment picks up. could accelerate capital flight.
3. Source: JPMorgan GBI-EM Global Diversified Index 5Investment Insights
March 2015
India: Modi reforms pave
the way to growth
6. Equities rebound and bond markets turn bullish
On the back of the developments upwards its outlook for India to stable,
outlined above, the MSCI India Index from negative, in September 2014.
gained 26% in 2014 (in local currency
terms). When compared with the MSCI Meanwhile, Indian local currency bonds
Emerging Markets Index – which rose were up 14.3% in US dollar terms in
5% – this figure is striking. In addition, 2014 and have had a good start to 2015,
credit ratings agency S&P revised up 4.2% in January 20154.
Advantage India
While India’s current economic • The country’s media (particularly its
prospects look positive, there have private media) has been “free and
admittedly been a number of false independent” throughout most of
dawns in the past. However, based its history. A free press that does not
on our proprietary analysis, we share the same aims as government
believe things are different this time, or business should, in theory,
particularly as India boasts numerous encourage action when it is required.
advantages over other developing • Modi’s government unveiled plans
countries that should support Modi’s for a comprehensive new intellectual
progressive mandate for change. property rights policy in September
Critics used to accuse the country
• India has a young and growing QHfailing to offer sufficient protection
working population. Its dependency to its people; it is hoped that this
ratio is one of the best in the world new policy will improve matters.
and will remain so for a number of
years. The economy will benefit from The first few months of 2015 are crucial
this “demographic dividend”. for India’s “new era” under Modi,
• India’s economy began to change especially as market expectations are
dramatically in 1991 with the shift very high. The biggest risk to India’s
towards freer markets. In September prospects is that the government fails
2013, the government removed some to take the difficult incremental steps
of the remaining restrictions in a bid towards structural reform. Another
to encourage capital inflows. Modi threat revolves around commodity
is looking to continue relaxing FDI prices: significant increases could affect
rules, as can be seen by his executive inflation, the current account and growth,
order in December. especially if the government’s policy
• The strength of Indian democracy reforms slow down and implementation
(the world’s largest) and the takes longer than expected.
independence of its judicial system
provide a more level playing field for Regardless of the challenges, however,
long-lasting business compared with India is well placed to differentiate itself
its economic rivals – provided Modi’s from its emerging market rivals through
structural reforms are successful. economic actions and results.
4. Source: Bloomberg
All information as at 2 March 2015 unless otherwise stated. This communication is intended for advisors and professional investors only, and should not be
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