investment insights
India goes to polls in reform test for Asia’s fastest-growing economy
Lombard Odier Private Bank
Next year, voters in India go to the polls in an election that threatens to undermine Prime Minister Narendra Modi’s majority government. As Modi’s political opponents form alliances, the risk to his reforms and the probability of a spending splurge are on the rise with implications that, we believe, investors need to grasp.
In 2014 Modi steered his Bharatiya Janata Party (BJP) to its first single-party majority in 30 years, giving the governing National Democratic Alliance, or NDA, a historic reform mandate in the lower house of parliament, or Lok Sabha.
The Prime Minister has been a divisive figure. Described by his opponents as a Hindu nationalist and self-publicist who turned the election four years ago into a referendum on himself, Modi won a landslide with the slogan “good days are coming” and promised to run the country along the lines of his 12-year tenure as Chief Minister of Gujarat state. Controversy over his role in the sectarian violence of 2002 there continues, and now his record as Prime Minister divides opinion.
The April/May 2019 general elections in Asia’s fastest growing economy follow a four-year term in which Modi’s administration has carried out multiple reforms. While it is hard to fault Modi’s ambition for modernising India, the measures have had varying degrees of success. Reforms include accelerating bankruptcy and business arbitration, creating biometric identities for a national citizens’ register, renovating sales taxes and overhauling currency circulation (see below). Crucially, a promise to double farmers’ income by 2022 isn’t on track and just last week there were more farmers’ protests calling for an extension of loan waivers that have been rolled out in certain regions.
The general election may hinge on the rural population. With less than one-third of India’s citizens living in urban centres, media coverage of the build-up to the elections often focuses on rural discontent comparing Modi’s promises with what has been delivered. In response, the government has waived loans and raised ‘minimum support prices’ for crops, risking a spending increase in the lead-up to the election. Finally, complex labour laws remain mostly untouched, deterring companies from hiring and expanding.
Organising the opposition
Employment may be overwhelmingly agricultural, but India’s political landscape is vast and fragmented. The BJP is itself part of the NDA, a coalition covering 45 parties that was set up to contest the 1998 general elections, which it won. The country’s political fragmentation worked to the BJP’s benefit in 2014 when together with other members of the NDA it won 51% of the seats in the Lok Sabha, based on 31% of the vote in the first-past-the-post system.
The lower house is currently made up of 36 parties, of which 23 won 5 seats or fewer in the 545-seat chamber four years ago. The Indian National Congress, the party most recently in power from 2002 to 2014, won 8% of seats in the Lok Sabha in 2014 with 19% of votes, its worst result since India’s independence. The upper house, or Rajya Sabha, holds elections for one-third of its seats every two years.
Commentators in India regularly point to evidence for an anti-BJP movement at a state, rather than national level next year. INC president Rahul Gandhi said 1 November that the opposition would unite to form an alliance against the BJP. “All opposition forces are going to work together to defend India, our institutions and our democracy,” he told the media. For now, the consensus among analysts points to the NDA winning with a reduced majority in the Lok Sabha next year.
A series of state level elections representing almost one-fifth of the electorate, including Madhya Pradesh and Rajasthan, will report their results on 11 December. This will provide an early indication of the extent to which attempts to form anti-BJP coalitions are working. Analysts are watching Rajasthan in particular as the state that has made the most progress overhauling labour laws.
Bank notes and taxes
It is worth looking at some of Modi’s key achievements in office. In July 2017, the government introduced a national sales tax. Known as the Goods and Services Tax (GST) reform, it cleared bureaucratic regional and local levies that complicated trade within the country. Nevertheless, the GST is not as simple as it might have been with six rates, sometimes imposing high taxes on staple items, and little logic between them.
The GST followed another ambitious project. In November 2016, Modi’s government banned 500 rupee (USD7.08) and 1,000 rupee notes overnight, forcing people to exchange them for new notes at banks in a ‘demonetisation’ measure designed to crack down on corruption and untaxed ‘black money’. In the longer run, the move may begin to work as intended, kick starting the digitalisation of the Indian economy by forcing people into opening bank accounts. In the short run, demonetisation took an estimated 86% of India’s currency out of circulation. In an almost exclusively cash-based economy that created shortages and chaos, hitting the poor hardest with its effects visible in 2017’s economic slowdown. Nor, to date, has demonetisation increased the chronically limited tax base that draws on an estimated one percent of the population (see chart 1).
Any end of the NDA’s majority in the Lok Sabha threatens to undermine or even reverse Modi’s policies, including a promise to provide healthcare for the poorest 40% of the population, or half a billion people, under a programme nicknamed ‘Modicare’ that is estimated to cost USD1.6 billion a year.
Rate hikes and a booming economy
India’s economic growth this year has been second-to-none (see chart 2). In the second quarter of this year, the country’s gross domestic product expanded 8.2% compared with the same period a year earlier, after growing 7.7% in the first three months of 2018 as private consumption and exports rose, in part benefiting from falling oil prices. The government is due to publish third-quarter data on 30 November.
This pace of growth is likely to slow slightly as the economy shows signs of capacity constraints, signalling a cycle of interest rate hikes ahead. In June, the Reserve Bank of India raised its repo rate for the first time in more than four years, on the back of rising inflation, followed by a second 25 basis point hike in August, bringing the rate to 6.5%.
Modi was fortunate to inherit a central bank under the governorship of Raghuram Rajan who brought inflation under control, reduced the country’s current account deficit and established his credibility with markets by reducing inflation from 12% to 4% over one year (see graphs 3 and 4). Urjit Patel took over as central bank governor in 2016. He has managed to uphold the RBI’s credibility despite recent differences with Modi’s administration, which wants more leniency for a banking sector struggling with non-performing loans as the central bank tightens provision requirements. This has left foreign investors watching for reassurances that the central bank is still pursuing an independent monetary policy.
Investment outlook
Emerging markets have in general lived through a tough 2018, with trade tensions and a strong dollar weighing on their currencies. This is less significant for India, which depends less on external foreign investment and has relatively little foreign-denominated debt. While Modi’s government has put the country on a reform path, and the potential remains high, political risks to his restructuring have increased. We continue to believe that emerging market exposure should be part of a strategic portfolio, but lingering headwinds mean that our portfolios remain positioned in line with benchmarks. Meanwhile, differentiation remains of paramount importance, and India represents one of the most robust countries in our emerging market coverage universe.
Key takeaways
- India’s voters may undermine Prime Minister Modi’s majority as opposition parties begin to coordinate
- The April/May 2019 general elections are seen as a referendum on four years of reforms which may be rolled-back if the ruling NDA alliance suffers a setback
- The consensus among analysts remains for the NDA to retain a reduced majority
- With the economy at full capacity and rising inflation, India’s central bank is entering a hiking cycle. It raised its repo rate twice in 2018, for the first time in four years, to 6.5%
- Despite an expanding economy, Asia’s fastest growing, rural discontent has been the focus of media attention and may set the tone for next year’s elections
Important information
This document is issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter “Lombard Odier”). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This document was not prepared by the Financial Research Department of Lombard Odier.
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