Awakening India's competitive economic growth
January 11, 2016
Editor’s note: The Asian Listed Equities team at Macquarie Asset Management has been managing Asian equities on the ground in Hong Kong since 2008. For more insights on China, India, and other Asian markets, please read the team’s 2016 Investment Outlook.
As equity investors who are focused on a region that includes 10 markets across Asia exJapan, we take a benchmark-agnostic approach, seeking out the highest-quality companies that we think represent Asia’s most notable growth stories and exceptional risk-adjusted return potential. With that territory comes a need for intensive risk discipline, and we take a highly conservative approach to identifying downside risks and scrutinizing corporate governance company by company. In a country like India, where past years’ expectations have sometimes led to disappointment about the pace of reform, equity analysis especially requires a good deal of macroeconomic context and understanding of the long-run prospects for the market.
For the first time in 30 years, it is possible that India’s economic growth is on track to outpace China’s. Could it actually be — to use a phrase popularized by economist Nouriel Roubini and others — that “the tortoise is about to become the hare” and vice versa? Granted, India’s economy has lagged far behind China's in per-capita gross domestic product (GDP), so any visions through rose-colored glasses should probably be tempered. But we think it’s worthwhile to carefully consider the notion of India as a sleeping giant with the potential for significant long-term growth.
|Average rate of growth, per-capita GDP
Data: International Monetary Fund
India has been cast as a beauty queen in waiting several times in the recent past. The most recent was in 2006, when it was a darling of prognosticators and fervent optimists. In 2007 and 2008, it became clear that lofty sentiments would be punctured, when India's GDP began a series of annual declines.
So why would 2016 be different? Below is a not-quite-exhaustive list of our reasons, but it helps describe what is transpiring:
- Most political parties in India have converged, so that they hold largely similar policy priorities on issues like liberalization, privatization, and fiscal consolidation.
- Revenue officials are aiming for a fair, stable, and just tax regime. Until now, taxation in India has been woefully inconsistent.
- The budget deficit is currently stable.
- Energy prices, driven by low oil, are providing tailwinds, given that oil remains India’s biggest commodity import.
- Corruption is the subject of a major clampdown.
- Monetary and fiscal policies are moving in the right direction, ensuring there are no overheating risks.
- Government is focused on increasing capital expenditures, through the budget as well as via public-sector involvement.
- India doesn’t face the problems of excessive debt and unfavorable demographics that are prevalent in a number of other emerging market nations. Indeed, India’s debt levels are relatively moderate, and the country stands to benefit from declining age dependency until 2040 (discussed below).
Interpreting India’s GDP
Beginning last year, India's commerce officials changed the data series used to calculate GDP. Much as with China, the methods for collecting and reporting economic data in India continue to evolve, and thus require a watchful and occasionally skeptical eye.
While headline GDP figures in India can be considered generally instructive currently, we believe more clarity is yet to come on precisely how reflective the headline number is of the underlying economy. In the meantime, we think it's important for investors to also track other indicators in this market, like credit growth, electricity production, fixed capital formation, auto sales, demand for content, and exports and imports — all of which at times can provide a more granular and specific view into the country’s economic future.
A groundswell of resolve
We think that India today is loaded with ambition, whether it be in government or private industry. As it stands, Prime Minister Narendra Modi, elected in May 2014, has issued a list of official pledges that outline his government’s vision for a more organized, functional, and competitive country.
The list is well documented and each item has a deadline, which is not surprising given Modi’s reputation for attention to detail. Some of the items involve heavy participation by the state, while a lesser number address conditions for private businesses. An example of the latter is the pledge to get India ranked in the top 50 of the World Bank’s ease of doing business index by 2017. The ease of doing business index, published by The World Bank, ranks economies based on how conducive they are to starting and operating businesses. To derive each economy’s rank, 10 attributes are considered, largely having to do with each economy’s regulatory environment. Areas of analysis include: starting a business, trading across borders, enforcing contracts, and obtaining construction permits. (India’s current ranking of 130 puts it at a less-than-comfortable distance from the bottommost rank of 189.) Other pledges that we believe help illustrate Modi’s ambitions include the following:
- Creating 100 million manufacturing jobs (target date: 2022)
- Laying down 30 kilometers (about 18 miles) of new roads daily (target date: 2017)
- Eradicating serious diseases like tuberculosis and measles (target date: 2020)
- Making continued progress on the country’s flagship financial inclusion plan, which has been stupendous with more than 195 million accounts opened so far
- Promoting the Skill India initiative, with a target of providing 400 million people with training in industrial skills (target date: 2022)
- Increasing manufacturing’s share of GDP to 25% (target date: 2020)
- Developing 100 smart cities (target date: 2020). Cities are the main engines of India’s economic growth, and they are projected to experience substantial population growth in the coming decades. Given their importance, Modi’s administration aims to make Indian cities “smarter” by way of enhancements that foster long-term sustainability. The list of initiatives is long. It includes improvements in waste management, efforts to recycle water, exploration into renewable energy, and methods for reducing congestion.
- Aiming to build 20 million houses in underserved urban areas (target date: 2020).
Closer to the ground, the mood within the Indian population seems to be one of determination combined with high expectations. Across the country, citizens are raising their standards and aspiring to services that are all but commonplace in many other parts of the world. They want better Internet connections, mobile telecommunications, reliable electricity, quality education, and better hospitals.
What’s more, Indians are increasingly holding elected officials' feet to the fire. If they fail to deliver on commitments or otherwise neglect their responsibilities, politicians run the risk of being summarily dismissed from office. This is a notable break from the easy passes on accountability that officeholders received not long ago. Increased expectations of government officials, together with state-level competition to attract higher investments, have resulted in a structural positive in our view.
Infrastructure: Struggles, solutions, and the quest for a leader
When it comes to infrastructure, India has a chance to tackle one of its thorniest long-term challenges. But it will take more than technical know-how and engineering skill. In our opinion, it will largely depend on the right combination of communication, leadership, and management talent. Roads, bridges, airports — all will continue disintegrating unless a steward can articulate a better plan for the future. In short, we believe that India needs an infrastructure czar who can piece together a plan that is at once prescient, transformative, and actionable.
Such a leader would also need talents in communicating with the public, helping Indians understand what they stand to gain from significantly disruptive and costly projects (with outlays reaching into the billions). We anticipate that there will also be challenges in balancing the need for growth with the need for fair regulation. In short, we believe the country needs nothing less than a master communicator, one who can help convince the investment community that if India is willing to invest in infrastructure, investors should be willing to invest in India.
That said, it’s worth noting that India’s effort to boost infrastructure spending is evolving. For instance, the public-private partnership model initiated last decade is being refined further. Specifically, a recent revival in deals related to roadways reflects government’s continued commitment to infrastructure development.
Raising the stakes
Due in part to his persistent energy and extremely focused approach to governing, Prime Minister Modi has at times been criticized for being impatient about promoting India’s growth potential. In his short time in office he has put forth "Make in India", a national program designed to foster innovation, facilitate investment, promote skill development, and build a world-class commercial infrastructure. The program has caught the attention of analysts of all stripes — academics, investors, diplomats, think tanks, and political advisors, among others. The program’s objective is to increase India’s manufacturing output as a percentage of GDP (with a target of 25% by 2020) and to create the cities where such manufacturing is to take place. Much like the railways initiative, it is an ambitious reform program. But it is not necessarily unrealistic, in our opinion. Among its prominent elements:
- Develop enough quality roads, railways, airports, and seaports to facilitate economic activity.
- Ensure the stability and competitive pricing of basic resources like electricity and water. (For example, power distribution companies, which have long posted losses and relied on bank debt, may see a reduction in the cost of servicing that debt.)
- Improve the quality of healthcare and other basic social services.
- Adjust the tax code to include reduced state border taxes, thereby facilitating a common national market.
All told, the program aims to create an environment in which many different types of enterprises can do well. An important fact that underlies all of this and that we think should not be overlooked: India’s economic health will not rely purely on external demand. Instead, it will cater to India’s home market, seeking to provide a more cost-effective system for making business transactions throughout the country.
Modi’s track record as an administrator and champion for aggressive goals ought to be a boon for economic growth. Luckily, India’s short-term economic outlook is already trending positively, owing to factors that include:
- Inflation is tapering off toward manageable levels
- An active and highly capable central bank
- A stable currency
- A reasonable current account balance
- Growth in industrial production, while declining in recent periods, appears to have reached a floor of support
- A healthy economic growth rate (at an annual clip of more than 7%, it seems likely to outpace China for 2015)
- Continued fiscal consolidation with a focus on increasing capital spending.
Enter the private sector
Another positive factor is the inclusion of private industry in areas formerly dominated by the state. There have been success stories in a wide range of sectors, from private banks and airlines to emerging sectors like e-commerce. Government is consistently exploring the scope of further liberalization and reducing regulatory approval requirements. Gradually, private firms are toiling in defense industries, encouraged by India’s decision to raise limits on foreign investment (from 26% to 49% of any joint venture). The insurance industry is another example — its cap on foreign investment has likewise been raised to 49%.
Although still in its infancy, we believe that the effort to recruit the private sector into India’s heavily subscribed and hard-working transport railway sector presents yet another major economic opportunity. India’s railway head, A.K. Mittal, plans to introduce avenues for private contractors to help run the train system, whether by managing network operations or renovating train stations. In the long run, such efforts could mean a more transparent, more market-oriented future for the rail network. It will be a large undertaking, with a price tag of approximately $1 trillion. (After all, it is the largest railway system in the world.) We anticipate some interesting investment opportunities to result — but we realize it will take time before this type of reform bears fruit.
Lastly, we believe demographics are providing reasonably positive indicators for broader prospective economic gains overall. India’s age dependency ratio, for instance, is very competitive relative to the rest of the world . (The dependency ratio is calculated as the ratio of dependents to the working-age population. Dependents are assumed to be younger than 15 years of age and older than 64, while working-age people are assumed to be between 15 and 64 years of age.) What’s more, India accounts for the world’s youngest workforce, with a median age well below that of Organization for Economic Cooperation and Development (OECD) countries (data: Government of India, Planning Commission).
Beyond traditional labels
Rather than hold on to stale stereotypes, we think of India as an important growth market. We believe investing in India should begin on the ground, following a fundamental process that is driven by a strong corporate governance focus that seeks to minimize downside risks. Our disciplined investment approach has led us to focus on the domestic demand growth that is structural in India and has the potential to deliver attractive risk-adjusted returns.
We think the focus should be on execution and delivery of corporate earnings growth, as valuations are still relatively expensive compared to the rest of Asia (and emerging markets overall). As such, we are cautiously optimistic and remain relatively neutral as we continue to meet corporate management teams and keep a close eye on company performance at street level. We are more positive on sectors related to domestic demand, such as private sector banks, healthcare, and consumer sectors.
It’s important to view India at times through the widest lens possible. Change in the world is happening so quickly that no single country can take growth for granted. All in all, we expect that the absolute level of global growth to be lower as the demand outlook is slowing overall. This also makes India interesting, as economic and corporate earnings growth remain higher than developed markets while shares are trading at relatively lower price-to-earnings multiples.
It’s important that we stress active investing in this part of the world, because markets are more volatile and information is asymmetric. Long-term domestic demand growth remains structural, and we believe in being very conservative, with a strong, unwavering focus on evaluating corporate governance in order to minimize risk.
In our opinion, today’s circumstances in India call for investor discipline, while focusing on factors such as domestic demand, local consumption, and corporate governance risks. The stakes are intensified by the fact that wrong decisions are met with very little room for error. In other words, risk remains a big component of emerging markets and investors cannot afford to be passive. We think investors are best served by keeping in mind that growth opportunities remain in India, but execution is very important. We are cautiously optimistic about prospects for 2016, even as volatility remains high, because we think opportunities to find real value will emerge.
India has significant room for growth, and we believe there is a strong chance that this sleeping giant will awaken as reforms unlock its long-term potential.
The views expressed represent the Manager's assessment of the market environment as of January 2016 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
Charts shown throughout are for illustrative purposes only and not meant to predict actual results.
The Consumer Price Index, or CPI, measures changes in the general level of goods and services that are consumed by Indian households. As measured here, headline inflation is the pure, raw measurement of inflation; it does not account for seasonal factors, and it omits price changes in the broad food and energy categories.
Headline CPI, as measured by the new index, aims to capture price trends more precisely than the country’s long-standing CPI measure. The new index, which has a base year of 2010, captures price activity in sectors that are excluded from the original index. It also analyzes price trends in service industries, which represent a substantial portion of gross domestic product and are likewise excluded from the original index.
The Wholesale Price Index, or WPI, measures changes in wholesale prices for essential commodities. As such, the index tracks price levels for goods traded between organizations; this is in contrast to the CPI, which measures prices for goods and services bought by consumers.
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