In previous viewpoints, we’ve highlighted that the Indian economy began its structural and transformative journey in 2014. Over the past three years, this process has been strengthened with a cohesive policy framework: This started with formalization reforms and a nationwide 4G-network rollout, creating a solid foundation for growth through digitalization.
Then came the policy initiative that’s focused on promoting manufacturing—we called this policy framework the 3Rs:
· Recycle: Privatization of state-owned enterprises to recycle capital,
· Rebuild: Tax cuts for corporates and middle-income households to boost savings, and
· Reinvest: Government policies to reinvest savings into domestic manufacturing.
The economic disruption caused by the COVID-19 pandemic has only accelerated this transformation. On the one hand, the government has consistently focused on long-term policies under formalization and its 3Rs policy framework. On the other hand, Indian businesses have embraced digitalization, using the process to counter any COVID-19-driven disruption. Due to supply chain disruption and increasing costs, growing domestic businesses have started switching to manufacturing instead of imports.
We’ve already articulated that the structural changes in the Indian economy have created two powerful themes that should serve as the primary drivers of India’s medium-term growth trajectory: India’s formalization through a digital economy and reinvestment in manufacturing.
Virtuous cycle of formalization and reinvestment
For illustrative purposes only.
First driver: formalization leading to expansion of the digital economy
India has experienced strong growth in its digital economy over the past five years. It’s now at an inflection point with digital businesses attracting global capital and new listings in the public markets.
The foundation of this transformation was laid in 2014 when the government started its formalization reform journey with the digitization of identity records and linking it to bank accounts and mobile devices (the so-called JAM trinity initiative).2 This has been further complemented by indirect tax reform that has plugged tax leakages.
Formalization reforms with digitalization initiatives are creating a virtuous cycle, driving the growth of a massive digital economy. In turn, the digital economy further propels the formalization process by boosting productivity and market share gains.
We’ve seen an exponential growth in smartphone users, with India’s total projected to reach one billion by 2025.3 It’s not just users who have adopted digital; India’s businesses have done so as well. Together, they’re driving digital payment and e-commerce growth. Even with the recent expansion, India’s e-commerce penetration rate (as a percentage of total retail sales) still ranks low globally, thereby implying strong future potential growth prospects.
Digital payment growth is robust
Long runway for e-commerce in India
As digitalization and formalization amplify each other, we’ve seen new digital platforms emerge that connect users and businesses using the power of smartphones and the mobile internet. Large platforms have emerged in areas where markets are traditionally fragmented such as personal services, transportation, food delivery, hospitality, and pharmacies.
As these platforms help businesses grow, smaller and informal merchants are now joining the formal economy. This, in turn, has opened new avenues for fintech companies to leverage the transaction data for better credit origination, underwriting, and collection. It also provides credit to new credit customers, reinforcing and perpetuating the virtuous cycle of digitalization and formalization. We see this journey to a more formal and digital economy as transformational.
These developments should open a new avenue for capital allocation and may make India the next big destination for internet businesses after the United States and China. Despite the strong growth seen in the past five years, overall e-commerce penetration remains low, and India’s user base is second only to China’s.
Second driver: reinvestment driving manufacturing growth
We believe India is at a crucial juncture where it can improve its share of manufacturing to GDP with a comprehensive policy push that we call the reinvest policy under our 3Rs framework. This comes from import substitution opportunities and the country’s export share of products where India already has a sizable presence—mainly as the world looks for an alternative sourcing base outside China.
To realize this opportunity, the policy framework has three pillars:
1 A lower corporate tax rate of 15% on new manufacturing investment, one of the most competitive in Asia;
2 A set of production-linked incentives (PLIs) designed to catalyze new investment and encourage production in India; and
3 Import disincentives in sectors where there’s a significant import component.
This policy push has resulted in investments into import substitution in products where domestic consumption has reached critical mass. In turn, this should make it more viable for global brands to use India as a manufacturing base and gain additional share in global exports despite the current environment, which is characterized by slowing globalization. Indeed, we already see this playing out with solid growth in domestic electronics manufacturing that should lead to high export growth in 2022.
Strong growth in domestic electronics production
The PLI schemes are, by far, the government’s most focused effort to increase manufacturing’s share of GDP. Currently, the PLI program envisages total incentives of around US$26 billion across 13 sectors over the next five years.4 Mobile phones were one of the first areas to receive a major policy push, as they have a high import dependency and a large market size. After seeing success with rising domestic production, we expect other PLI schemes to be announced in the following areas:
· Import substitution: telecoms equipment, air conditioners;
· Export growth in sectors where domestic production is competitive: automobiles, pharmaceuticals, textiles, chemicals; and
· New investment in emerging areas: solar photovoltaic cells, advanced chemistry cells for batteries.
Ultimately, we believe that PLI schemes should attract significant investment and add incremental revenue to the tune of INR ₹35 to ₹40 trillion over the next five years,5 thereby improving manufacturing’s share of GDP. As this happens, this should create another virtuous cycle—added manufacturing value may raise domestic savings, improve government finances, and give the government room to support India’s manufacturing sector with better infrastructure and incentives.
Macro outlook: lower deficit, higher productivity
These two themes should feed off each other to create another virtuous cycle, creating more jobs, improving domestic savings, and enabling reinvestment in better infrastructure. Indeed, we already see the synergy of these themes driving improvement in India’s macro situation with an improving fiscal backdrop, as a more formal digital economy leads to increased tax compliance.
An increase in high-value domestic manufacturing can result in lower current account deficit, while policy incentives have reduced imports and increased exports. A higher share of digital and manufacturing in the economy has also resulted in improved productivity.
Higher tax receipts should translate to a lower budget deficit
This also makes India’s external accounts more resilient. Foreign direct investment and foreign portfolio investment inflows into India have exceeded the current account deficit of -1%.6 This leads to healthy balance of payment surpluses and makes the country more resilient to external shocks, such as a sharp increase in oil prices. Indeed, India’s foreign exchange reserves are at an all-time high of almost US$640 billion.7
India also has limited its international borrowing, which gives us comfort from an external accounts and exchange rate perspective if developed-market central banks were to start to normalize monetary policy. Meanwhile, Indian bonds may be included in the emerging-market indexes later this year. If this happens, there could be inflows of as much as US$40 billion over the next 12 months.8 Given the stable rupee outlook and current 10-year bond yields of around 6%, we believe that there should be limited upward pressure on yields.
Cyclically, India looks well positioned for a strong recovery in Q4 (calendar year 2021)—high-frequency indicators such as goods and services tax collection are showing strong year-on-year growth. We think that the Reserve Bank of India should keep monetary policy accommodative to support the recovery.
India also remains one of the few countries that has enough vaccine capacity to inoculate its entire population. This should further support the country’s economic recovery. Our belief is that most of India’s adult population has already received at least one shot, and we expect nearly all adult Indians to be fully vaccinated by early 2022, after which India is likely to become a net exporter of vaccines.
Finally, we also see opportunities in banking and financial services as domestic savings grow and new opportunities of credit deployment emerge. We expect Indian households to allocate more of their savings to financial instruments (e.g., insurance and mutual funds) as structural economic growth improves and inflation moderates. Indeed, the flow of domestic savings to equity markets could be a big source of strength moving forward.
As the government’s fiscal balance improves due to the emergence of a more formal economy and continued divestment, we expect higher allocation to infrastructure and support for manufacturing to materialize, in the form of incentives. After undergoing significant asset restructuring over the last five years, Indian corporate balance sheets are in good shape and we expect companies to invest more. This bodes well for opportunities in the industrial sector.
We expect these powerful thematic drivers—and the way they interplay with each other—to raise India’s economic growth potential and make it structurally more resilient. As reforms made through formalization initiatives and the promotion of manufacturing activities (and their subsequent macro impact) become more visible, we believe these factors should drive economic growth and earnings going forward, with room for the cost of capital to fall.
Over the next 12 months, we expect significant opportunities for public market investors to participate in the digitalization theme with more equity listings from the consumer technology, health technology, and fintech space. This represents a tremendous opportunity and a long growth runway for internet companies. Over the next year, we expect to see multiple large platforms go public.
India has adequate local vaccine supply
1 Bloomberg. 2 “Upgrades in Mobile Speeds in India Come with Expanded 4G Availability,” GSMA.com, October 28, 2020. The Jan Dhan-Aadhaar-Mobile (JAM) trinity leverages telecom infrastructure to use cash and paper less, bringing unbanked individuals into the formal economy. The proliferation of private investment in India’s 4G network since 2016 amplified this impact, which has driven 4G availability nationwide to near 99%. 3 Statista, Kotak Institutional Equities, September 2021. 4 India Brand Equity Foundation, July 27, 2021. 5 Crisil. 6 Reserve Bank of India, as of September 30, 2021. 7 Bloomberg, as of October 12, 2021. 8 Reuters, October 12, 2021.
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