Inflated reform hopes may have to be trimmed in India
Is India still the darling of emerging market investors?
Next Tuesday will mark the one-year anniversary of the formation of Indian premier Narendra Modi’s government following the resounding election victory of his Hindu nationalist Bharatiya Janaata Party (BJP).
One of the world’s most charismatic and skilful politicians, Modi has won admiration from both ordinary Indians and foreign investors for his ambitious plans to modernise India’s economy, stamp out corruption and, crucially, radically improve social services - in particular health and education - for the country’s growing population of 1.3 billion.
Modi is nothing if not bold. His finance minister, Arun Jaitley, now claims India’s economy will grow at a faster pace than China’s due to a surge in public and private investment in infrastructure and the swifter implementation of structural reforms.
The government has already made significant progress. The long-awaited liberalisation of India’s coveted insurance sector has taken place, improving the prospects for foreign direct investment. Costly diesel subsidies have been scrapped (partly because of the collapse in oil prices), while the allocation of natural resources will be undertaken through competitive auctions in order curb graft.
Just as importantly, India’s economy is in better shape.
Real GDP growth this year is expected to reach 6.3 per cent, compared with 5.5 per cent last year, while the country’s current account deficit is expected to fall to just 0.7 per cent of GDP (compared with an anticipated 2.5 per cent in Indonesia), according to Bank of America Merrill Lynch (BAML). Inflation, moreover, has dropped sharply, from nearly 8 per cent last summer to less than 5 per cent in April, allowing India’s central bank to loosen monetary policy.
Yet over the past few months - and particularly in the last several weeks - market sentiment towards India has deteriorated.
Indian equities -which enjoyed one of the most spectacular rallies in the months leading up to, and following, Modi’s victory - have fallen 8 per cent over the past three months, compared with a 6.2 per cent rise for Emerging Asian stocks and a 5 per cent increase for EM shares. The rupee, moreover, which has been one of the most resilient EM currencies, has fallen 3 per cent against the dollar since early March.
There are a number of reasons for India’s recent underperformance, some of them technical, others which cast doubt on the “reform story” that has been the main catalyst for the rally.
The technical reasons relate to what became one of the most overcrowded trades in EMs that was bound to experience a correction at some point.
The trigger was the recent sell-off in global government bond markets which has led to renewed outflows from EM equity and bond markets, with emerging Asia bearing the brunt of the sell-off. According to a report from the Institute of International Finance (IIF) published on Tuesday, India has suffered the sharpest outflows, particularly in the equity market.
Yet as JP Morgan notes, heavy investor positioning in India - foreign holdings of Indian local bonds have risen sharply since the end of 2013 - “increases scrutiny [of] local developments.”
Despite the progress achieved by Modi’s cabinet over the past year, there are increasing signs that the government is struggling to implement crucial reforms. Policy execution, as the credit rating agencies like to call it, remains a serious problem in India - and one that overly enthusiastic investors clearly underestimated.
The latest indication of this came last week when the government failed to push legislation on implementing a much-needed goods and services tax (GST) through the upper house of parliament. If Modi’s cabinet was not even able to gain the necessary votes to pass a GST - an uncontroversial reform that even the previous government championed and is vital to streamlining India’s unwieldy tax system - then the prospects for much more contentious labour market and banking reforms appear bleak.
More worryingly, while Modi may be a moderniser, the ruling BJP’s reform credentials still leave much to be desired.
A damaging tax row with sentiment-shaping foreign institutional investors centred around the minimum alternative tax (MAT) - a levy traditionally applicable solely to domestic firms but suddenly extended to foreign ones - contributed to the recent outflows of capital from India.
Still, the investment case for India remains compelling - particularly when compared with other large EMs, notably Russia and Brazil which are suffering deep economic downturns and where the prospects for meaningful reform are much bleaker.
Investors simply need to lower their expectations somewhat after months of “Modi mania”.
Nicholas Spiro is managing director of Spiro Sovereign Strategy