Abbas Owainati - Sunset India

Abbas Owainati, economist – multi asset, Old Mutual Global Investors

Reforms in India won’t happen overnight; indeed, they are a process rather than an event. Abbas Owainati, economist – multi asset, at Old Mutual Global Investors, explains why a degree of caution is sensible when it comes to the current elevated level of Indian asset prices.

“I am, by calling, a dealer in words; and words are, of course, the most powerful drug used by mankind.”

Rudyard Kipling, in a speech to the Royal College of Surgeons, London, 1923

If you speak to most investors the consensus view on emerging markets sounds something like this: ‘China is at risk of a hard landing, the Russian economy remains recessionary in the face of sanctions, Brazil is stuck in stagflation while India is the clear winner’. India has a couple of things going for it after all, not least a moderniser in the form of Prime Minister Narendra Modi and the benefits of lower commodity prices given its enormous net oil importing position. This confidence has been reflected in the rallying Indian equity market.

A lot of focus is being placed on the government’s improving twin deficit, the budget and current account. This is due to a combination of lower oil prices and a tariff on gold which has helped heal the current account deficit while the abolishment of diesel subsidies has seen the government’s budget deficit improve. Modi has been fortunate, as this subsidy neutralisation has coincided with a collapse in oil prices, therefore creating little net effect on the consumer. It would have been much more difficult to implement otherwise. If commodity prices now normalise after one of the sharpest sell-offs in history the Indian consumer could find its pockets squeezed, hindering the country’s ambitious growth outlook.

Despite Modi’s landslide victory last year, he still lacks a majority in the upper house, preventing passage of key bills. This has meant that reforms have been delayed. The government has attempted to overcome this via executive fiat, issuing ordinances to enact reforms on a short-term basis. However, with a six-month life span the time is rapidly approaching where investors may begin to question whether these are permanently achievable. Furthermore, it appears Modi may have lost some popular momentum. Recent Delhi elections saw an anti-corruption party win a whopping 67 of 70 assembly seats, marking an end to Modi’s BJP party’s honeymoon.

Bureaucracy remains a key feature in Indian circles. There are US$300bn in stalled projects, at least half of which are held up by regulatory or other bureaucratic issues. Land acquisition is a particular problem, accounting for 33% of stalled projects. Furthermore, rigorous labour laws hinder businesses. Enterprises with more than 100 workers need government permission to scale back or close; so businesses remain small to avoid these regulations. Bigger businesses hire temporary workers to get round it. How then can investors take confidence in the face of finicky regulations? It is no surprise that India ranks 142nd in the world on ‘ease of doing business’ according to The World Bank. It is sandwiched between Uzbekistan and the Palestinian territories!

The Indian statistical office is at risk of estranging investors in the same light as many perceived China as a ‘data fixer’ in recent times. In late January it was reported that the Indian economy grew faster than China. A new methodology and change to the base year saw the economy grow 7.5% year on year in the fourth quarter of 2014, slowing from 8.2% a quarter earlier. To put things in perspective, the older series was reporting year-on-year growth of 5.3%. This partly highlights how difficult it is to calculate GDP with any accuracy, but the period also coincided with companies struggling with earnings and investments, banks seeing rising bad loans, credit growth slowing and exporters reporting negative growth. These are all signs that the economy was weaker not stronger.

India’s demographics make for a bright future. Roughly half of its 1.25 billion-strong population is under 25. Yet almost 70% of its working-age population has no education past primary school. The new budget offers some hope. The government plans to increase capital spending by 25%, predominately targeting railways and infrastructure. The budget also provides for a larger increase in spending for health, education and social security. A bankruptcy law reform has been tabled and a new Indian financial code to be brought to parliament. The government has also increased the revenue share of states, following the lead of China in this regard; in fact, many of these reforms follow a more Chinese model for economic growth – to one led by infrastructure and decentralisation. The challenge is that investors in corporates in China have generally fared poorly under this model. Profits have been ploughed into infrastructure investment and leaked out through corrupt practice rather than being available to shareholders as retained cash or dividends. The bottom line is that the Chinese economic model might be good for India’s economy but bad for its stock market. India’s high valuation multiples are often justified based on the high quality of their earnings, yet we know where the Chinese model leads – lower quality earnings.

Conversely if we see higher commodity prices and wage increases (on the back of pay commission recommendations) India could have less fiscal space ahead meaning their recent deficit improvements could prove to be a mirage. In a recent lunch with an ex-Reserve Bank of India deputy, it was clear that the government’s approach to reforms will be incremental rather than in a big bang.

We have learned from our European friends that politicians don’t run towards their reform targets, they walk. While this article is not on Europe, or indeed Japan, where we have endured an entire parliament with no progress on structural reform, it is perhaps appropriate to exhibit caution rather than excitement on Indian asset prices, particularly given the premium valuations at which they trade.


Read more