7th January 2016
India has been the standout performer in emerging markets since the beginning of 2014. However, investors have recently become increasingly concerned about India’s future growth potential.
But Kunal Desai, manager of the Neptune India Fund identifies five key areas that he believes could hold the key to the continuation of India’s growth…
The current approach from policymakers is to look away from the headlines and focus on the detail. In reality, it is our view that micro reforms matter most for India at the moment, given the disarray that the Congress party had left behind.
IndusInd Bank spoke of the extent to which administrative reforms – which require no parliamentary approval – had already laid the foundations for accelerating growth. They are confident that big-ticket legislative reforms, which excite global investors, will be squeezed through, but no concrete timeline was provided.
Political analysts argued that Modi had to be more collaborative with the opposition and move away from the perceived arrogance attained by his absolute majority.
This was reinforced by the BJP’s defeat in the recent Bihar election. It was noted that the day after the loss, the BJP relaxed FDI restrictions in 15 sectors (the biggest move in 18 months), so it is believed that the loss has the potential to focus the reform intent.
We believe the reform agenda is not broken. Expectations have reset to react positively to incremental newsflow and global investors should hopefully understand the merits of the micro reforms once their impact on earnings becomes clear.
2. Capital expenditure
India is still the fastest growing major market in the world, with Neptune’s estimates for GDP growth in FY 2016, 2017 and 2018 currently standing at 7.35%, 7.40% and 7.90%, respectively. However, it has not felt like that recently. Private sector capex has been absent, due to companies having over-leveraged balance sheets and being in a period of capex restraint, so it has fallen to the public sector to stimulate economic growth.
As a result, we have seen evidence of public sector participation, particularly in roads and rail. Macro sensitivities remain strong, with falling twin deficits, a low oil price, improving FX reserves and falling inflation, but to move from a GEM relative return story to an absolute return story requires an earnings upgrade cycle in order to kick-start a fresh investment cycle. India is still the fastest growing major market in the world.
This area has been the major disappointment for us thus far. India still struggles to break free from the disinflationary and falling global trade influences – whilst the country’s current account deficit has improved, exports in October fell -17.5% year-on-year and imports were down -21.2%.
In our opinion, a critical driver for the market over the next 2 years will be the extent of a recovery in earnings; we remain optimistic about this. Firstly, asset utilisation is at a low of 72%; secondly, as mentioned above, demand is now coming through in a few areas; and thirdly, corporates are still conservative on capital expenditure.
The combination of these three factors presents a fertile environment for ROE improvement and rising return ratios. As return ratios exceed the cost of capital, companies are incentivised to increase capex to capture the promise of future growth, thereby kick-starting the aforementioned investment cycle.
The companies we have met agreed that our thesis holds, but the delay in this phenomenon taking hold has been frustrating for them and for us.
4. Devolution and distribution of public money
We believe that by the next general election in 2019, one of the most significant legacies of Modi’s term is likely to be the ‘Cooperative Federalism’ model, which incentivises States to compete with each other on development.
Ranking systems are now being put in place for the States, based on metrics such as FDI investment, public infrastructure, job creation and social indicators.
As a result, reform is just as important from a bottom-up basis (driven by the States) as from top down.
There is an understatement of what has already been achieved and the State governments, with their increased power, are also applying political pressure to obstructionism at the Centre. This cooperative yet competitive approach is disrupting the political landscape and inducing what we view as real change.
5. Automation and technology
The threat that automation poses to jobs has been topical in recent months. The bear case for an emerging market like India is that labour-intensive sectors are dwindling just as India reaches its demographic dividend and emerges as the largest labour pool in the world.
The view from companies and consultants is more constructive though, driven by a shift in government focus towards the ‘New Economy’. They use the analogy between a clunky, state-owned bank and a brand new private bank – which one is more likely to drive and take advantage of digital banking? Clearly the latter, since they are free of sunk capital in inefficient investments.
From our experience, Indian companies see technology disruption, emanating primarily from the US, as an opportunity.
They argue that the innovation and disruption brought about in the late 1990s was a huge growth driver for India; it created the IT services industry from nothing, providing millions of jobs, whilst the second and third derivatives created wealth that had a higher relative impact on India than it did on the source of the innovation.
This is reinforced by our research on economic complexity, a measure of the production capabilities of countries on which India scores favourably.
In short, we believe India is well positioned both demographically and economically to benefit from technological advancements.”