India: Modi’s Progress

By Stéphane Monier Chief Investment Officer Lombard Odier Private Bank

Elected amid sky-high hopes three and a half years ago, India’s Prime Minister Narendra Modi now faces a growth slowdown and rising critique of his reforms. Here we consider his progress so far, the necessary tasks ahead, and our views on investment opportunities in the world’s sixth largest economy.

India’s economic promise - a tempting jewel

India’s economy has vast potential. If growth reflects demographics and productivity, India’s youthful population is a trump card. Over a quarter of the people joining the global workforce between now and 2025 look set to be Indian¹. During his time in office, Mr Modi has also enjoyed two following economic winds: Raghuram Rajan’s highly respected stewardship of India’s central bank (he was hired by Mr Modi’s predecessor and left in September 2016), and low oil prices, which fell almost immediately after Mr Modi’s election to give India’s oil-hungry economy a boost.

In the years before the global financial crisis, India enjoyed break-neck expansion. Again under Mr Modi, 2015’s growth of 7.9% made India one of the world’s fastest growing economies. Foreign investment soared. But by the first quarter of 2017, growth had fallen below its pre-Modi level to 6.1%, and in the second quarter, missed market expectations at 5.7%. Bank lending to industry is now contracting. Investors have also begun to question Mr Modi’s flagship reforms, and his commitment to fiscal discipline in the months leading up to the 2019 general elections.

Credit where credit is due

Certainly, there is much to laud in Mr Modi’s actions to date. Under his watch, India has brought double-digit inflation, a bloated current account deficit, and to some extent its large budget deficit under control. Foreign investment and foreign exchange reserves have soared. India’s leading equity index has risen more than a third in value². Mr Modi has even made some limited progress on corruption, with India rising a modest two points in Transparency International’s ‘Corruption Perceptions Index.³’ But his major reforms have met with mixed success.

1. Inflation targeting – A policy change long-sought by Mr Rajan, Mr Modi’s government formally adopted a 4% official inflation target in March 2015, from the financial year ending in March 2017. Widely perceived as successful, India’s consumer price index rose 3.28% in September 2017.
2. Bankruptcy law – A new national Insolvency and Bankruptcy Code came into effect from December 2016, to replace the previous system of rival proceedings in different courts and regions, which had caused a severe judicial bottleneck. Early cases have, however, been settled with disappointingly large haircuts on the asset values recovered for lenders.
3. Biometric ID system – The ambitious ‘Aadhaar’ scheme, launched in 2016, aims to electronically register each of India’s 1.3 billion residents, and provide them with a unique ID code. A cheap and efficient way of channelling state subsidies to the poor, tackling tax evaders and thwarting corruption, it has nevertheless run into privacy and use of data concerns, which the Modi government has not fully assuaged. 
4. Demonetisation – In November 2016, two high-value bank notes responsible for 86% of the currency in circulation were withdrawn overnight, in an effort to tackle corruption and untaxed wealth. The move caused chaos and contributed to 2017’s growth slowdown. Nonetheless, the scheme’s proponents remain keen to point out its benefits in terms of outing money held by fraudsters, encouraging digital payments, widening the tax base and boosting banks and hence lending via an influx of fresh deposits.
5. Goods and Services Tax (GST) – Introduced in July 2017, this welcome move set a national sales tax, to replace a web on regional and local levies that caused confusion and added bureaucracy when trading across India. Yet the GST is complicated (with six rates, from 0-28%), and the rationale for different rates can at times be hard to understand. The GST also imposes high taxes on some everyday goods. 
6. Bank recapitalisation – In October 2017, the government announced a much-needed 32 billion dollar (USD) plan to recapitalise state-owned banks. The plan was welcomed, since banks’ toxic loans have long stymied lending and with it, growth. The size of equity injection should start to allow banks to lend again.

But much remains still to do

While Mr Modi has made a number of headline changes, his critics accuse him of being quicker to tout cosmetic reforms abroad than tackle underlying problems at home. The criticism tends to focus on three areas:

1. State involvement and bureaucracy – India’s state remains vast, with government-owned firms making everything from consumer staples to housing, and state-owned banks dominating lending. The state can also impose retroactive ‘windfall’ taxes on certain sectors of the economy, or demand price cuts if profits are deemed too high, causing uncertainty for industry. The biggest change desired here would be privatising and rationalising the number of state-owned banks (from 20+ to perhaps 10-15).
2. Labour and land reform – Labour laws are complex and can deter companies from hiring workers formally. India remains a lowly 130th of 189 countries in the World Bank’s ‘Ease of Doing Business’ report. Firms are sometimes reluctant to expand, since larger ones face tougher regulations, curbing sales and productivity. Only an estimated tenth of manufacturing employees work in factories with more than 200 employees, versus over half in China[4]. Meanwhile, buying and selling land remains complex, and can be open to corruption. Land reform has been handed down to state level, but few significant changes have been made.
3. Infrastructure – Domestic infrastructure, from transport to broadband, is largely behind other emerging market economies. Logistic costs can be high: subsidised passenger rail fares, for example, can push up freight fares. This year, many infrastructure projects have been stalled due to weak bank lending.

Investment opportunities

Our view on India is nuanced. In coming months, we believe economic activity will likely stay subdued. Further ahead, we note that 2019 elections give scope for fiscal slippage, and that ongoing bureaucracy, India’s democratic and multicultural nature, size and federal structure could all weigh on the pace and magnitude of change. Yet in coming decades, we believe India could be among the world’s most positive growth stories, given its demographics, low starting point (it remains one of the poorest of the world’s biggest economies) and scope for pro-business reforms.

We favour selected names in India’s consumer space, and a very few, high quality financials. While valuations do not look cheap, they have been high for some time now, and can often be justified by high returns on equity or double-digit earnings growth. India’s consumers are getting over the impact of demonetisation and the GST, while the rural poor look set to enjoy supportive measures ahead of the 2019 elections (Mr Modi talked about affordable housing in his February budget). In decades to come, consumer firms should also enjoy favourable growth as India’s low per capita income rises. And as India’s wealth grows, we could also see opportunities in fields such as online travel, financial inclusion and mobile payments, the latter following a trend kick-started by November 2016’s demonetisation.

¹ Source: The Economist, June 2017
² The BSE Sensex index gained 39% between 15 May 2014 and 8 November 2017
³ 2014 score 38, 2016 score 40 (latest data available). Countries are scored out of 100, indicating the perceived level of public sector corruption on a scale of 0 (highly corrupt) to 100 (very clean)
⁴ Source: The Economist, June 2017