The past five years: building a solid foundation for the long term
Over the past five years, we believe that the four Fs—formalization, fiscal stability, financialization, and reforms—have laid a solid and strong foundation. Collectively, the policies have formalized the country’s economic structure, widened its tax base, and pushed up tax-to-GDP ratios. As a result, the government has been able to increase public investment without incurring higher fiscal deficits. In addition, reforms around the resolution of corporate bad loans have led to a healthier banking system. A more formal economy, higher-quality public spending backed by revenue, and healthier private sector banks have also helped to underpin the country’s economic foundation.
However, such transformational reforms have created some short-term challenges: Incomes are lower due to a slowdown in the informal sector and lower food prices globally, while discretionary consumption is weaker due to a downturn in disbursements by nonbanking financial companies (NBFCs).
The next five years: India should grow on a strong foundation
India’s general election is currently taking place, with the seven-phase process running from April 11 to May 19, with results due to be announced on May 23. Our base-case scenario, echoed by publicly available opinion polls,¹ is that the ruling National Democratic Alliance (NDA) coalition could return to power. That said, we believe whoever forms the next government will have a unique opportunity to build on the existing reform agenda.
The first task of the incoming government will be to implement the fiscal stimulus policies announced by the incumbent government,² which couldn’t be fully implemented due to the elections. On the monetary policy front, the Reserve Bank of India (RBI) injected liquidity into the markets and cut interest rates to bolster growth. However, some of the RBI’s actions were less effective because the amount of cash in circulation typically goes up during elections, causing a temporary liquidity tightening, but this should reverse after the election.
Over the longer term, the next government will need to build higher income if it wants to lift economic growth rates. Indeed, we believe that the policy initiatives of the incumbent government and the election manifestos of both the Bharatiya Janata Party (BJP)³ and the Indian National Congress (INC)⁴ have one point in common: All of them will place a strong emphasis on income growth, although their approaches will be different.
Policy priorities of the two main parties: BJP and INC
Overall, both parties are committed to remaining on the incumbent government’s fiscal consolidation path. At the same time, each presented an ambitious growth agenda for the next five years, promising to increase public spending and raise manufacturing’s share of GDP. In our view, these goals are crucial for robust job creation, higher incomes, and better savings, which, in turn, should boost the country’s rate of investment.
Here are highlights of their proposals:
The BJP has pledged to spend US$1.4 trillion (roughly 8% of GDP, according to our calculations) on infrastructure investment over the next five years, which is higher than the current public sector gross fixed capital formation (GFCF) (i.e., net investment) of 7.0% to 7.5% of GDP. Beyond that, we believe that the BJP’s proposed social spending program and its expansion of income transfer plans (a quasi-universal basic income transfer plan)⁵ will cost less than 0.5% of current GDP.
The INC’s income transfer plan for the bottom 20% of families is estimated to amount to 1.5% of current GDP. However, the INC has stated that it will subsume other central and state subsidies into this program; therefore, the overall fiscal impact is expected to be much lower than 1.5% of GDP.
Building a growth agenda—attracting capital
To boost India’s economic growth rate, resources (capital) need to be mobilized. The marshaling of resources will be the key to lifting growth rates, rather than which party or coalition forms the government. We’ve identified three ways the next administration can attract capital and build an effective growth agenda: improving government efficiency and asset divestiture, enabling private capital expenditure (capex), and leveraging manufacturing opportunities.
1 Improving government efficiency and asset divestiture
We believe that the spending priorities of both parties can be financed through various means of government fund-raising without the need for additional borrowing. Potential sources of government revenue include:
An increase in tax revenues through improved tax compliance—The government has already made significant progress in this crucial area, with the revenues collected to GDP ratio increasing from 16.2% in 2015 to 17.4% in 2018; it’s estimated to reach 18.3% in 2019.⁶
Subsuming government subsidies into income transfer schemes—We believe there’s room for further savings with the efficient delivery of public benefits. Reforms to the JAM trinity⁷ have saved an estimated 1.2 trillion Indian rupees (around US$17.0 billion) through the implementation of direct benefit transfer, which has eliminated ineligible beneficiaries.⁸
Asset divestiture—The incumbent government is considering the divestment of its stakes in public sector units (PSUs) and listed companies in the private sector. If it retains a 51% position in PSUs and sells its entire stake in other nongovernment companies, the potential divestment opportunity may be as high as US$51.0 billion⁹ (approximately 1.7% of GDP). However, if the government’s holding is lowered from 51% to 40%, an additional US$82.0 billion¹⁰ may be raised (around 2.7% of GDP). Outright privatization of loss-making PSUs may boost sentiment, but could face political challenges.
Increased private investment in state-owned infrastructure, including railways and power facilities—This process has already started in the area of power distribution, where private companies are bidding for projects in some states. The government could also monetize existing infrastructure assets by selling income-generating infrastructure assets (e.g., toll roads) to attract global investors.
Public sector investment has remained relatively strong and we believe this could continue with more capital becoming available through the recycling or monetization of assets.
Even if the incoming government tilts more toward benefit transfer, funded through recycling or asset monetization of assets, it will likely help rebuild income and eventually create demand, jobs, and savings.
2 Enabling private capex
Despite stronger public sector investment, overall GFCF has fallen over the past five years due to weak capex, but this is set to change, if it hasn’t already taken place.
Private capex has been weak for the past five years due to industry overcapacity and stagnant real estate prices due to policy-related disruptions (economic formalization reforms). However, we see green shoots emerging in both areas. There are signs that overall capacity utilization is increasing, which means an improvement in industry-linked private capex shouldn’t be far behind. In real estate, we’re witnessing industry consolidation following economic formalization reforms—the next phase should be the resumption of capex.
As the private sector assesses its capex plans, it also needs access to capital at a reasonable price. Therefore, we believe it’s imperative for the government to raise resources by monetizing assets and leaving more savings for the corporate sector. A revival of private sector capex should lead to job creation, better incomes, and higher savings.
3 Leveraging manufacturing opportunities
India can also bolster economic growth by leveraging manufacturing opportunities. In particular, we’re carefully watching China’s transformation to a more innovative, value-add, and green economy.
As the transition progresses and labor costs in China continue to rise, a portion of lower-value manufacturing jobs currently based in the country could move elsewhere. India is well positioned to benefit from this development, with a surplus in electrical power, a large working age population, and recent improvements in the business environment as a result of reforms.
India is also home to the third-largest consumer market in Asia after China and Japan.¹¹ Multinational companies view large domestic volumes, along with potential exports, as highly lucrative.
The Indian smartphone market illustrates this commercial opportunity. Indeed, we’ve seen leading smartphone manufacturers, such as Foxconn, Xiaomi, and Samsung, establish operations in the country. Although the value-add aspect of current production is still low, we believe it’s a good start. Furthermore, foreign companies that establish operations in India won’t only help the economy through increased investment and employment but will also augment savings with the attraction of foreign direct investment.
Our outlook for India is constructive over the medium to long term due to the right structural reforms being in place. The current headline valuation of the market is at 15.5 times earnings,¹² which seems reasonable in our view, as it’s only around 5% higher than the 10-year median valuation.
We believe that short-term volatility around election results can’t be ruled out. That being said, the medium- to longer-term outlook will continue to be driven by the incoming government’s policies and global developments.
Our medium- to long-term sector view is as follows:
Private sector banks—We have a favorable opinion on private sector banks, as they’re the primary beneficiary of banking sector reforms. Our view is that they can gain both deposit and loan market share from weak state-owned banks and NBFCs. Additionally, corporate-focused private sector banks could witness a sharp drop in provisions for bad loans as asset quality improves.
Industrials—We’re also constructive on industrials, given our belief that the incoming government will focus on capex spending; a manufacturing revival will help support employment and income growth.
Consumer—We like select consumer names where the organized sector is gaining market share as a result of economic formalization policies. These industries include jewelry, apparel, and home improvement. We’re also positive on sectors that would benefit from increased public spending, such as electric consumer durables, in view of the introduction of electrification programs.
Negative view—We have a near-term negative view on autos and NBFCs. These companies have come under pressure—both from a funding and net interest margin perspective—after a firm that was once categorized as systematically important by the central bank missed a series of debt payments; as a result, NBFCs have sharply cut disbursements. We also remain cautious on global cyclicals such as metal and energy, not only because of underlying commodity price volatility, but also due to the high financial leverage of these firms.
With the existing structural reforms and the prospect of a stable government over the next five years, India has the opportunity to achieve a higher growth trajectory. In our view, an appropriate policy pivot from the incoming government to free up resources to invest in infrastructure (hard and soft), coupled with further improvements in the business environment, is the right recipe to realize this unique opportunity.
1 CLSA, April 16, 2019. 2 The incumbent government proposed fiscal support to augment farmers’ income and give tax breaks to the middle class in the budget. 3 The leading party of the NDA, the current ruling alliance. 4 INC is the main opposition party and the leader of the opposition United Progressive Alliance (UPA). 5 Pradhan Mantri Kisan Samman Nidhi (PM-KISAN) income transfer scheme, Manulife Investment Management estimates, April 2019. 6 CEIC, Kotak Institutional Equities estimates, April 2019. 7 The Jan Dhan-Aadhaar-Mobile (JAM) trinity is an initiative aimed at preventing benefits fraud by linking bank accounts with unique identification features to the account holder’s mobile phone number. 8 dbtbharat.gov.in, February 2019. 9 Bloomberg, as of March 29, 2019. 10 Total market capitalization, Bloomberg, as of March 29, 2019; Stake data, Kotak Institutional Equities, March 2019. 11 World Bank Databank, December 2017. India is the third-largest economy in the Asia-Pacific region. 12 Bloomberg, MSCI India Index, as of April 1, 2019.
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