Modi’s Bharatiya Janata Party (BJP) surpassed all expectations to sweep the board in India’s general election. Paving the way for continued reforms, this gives plenty of cause for optimism in what is already one of the world’s fastest growing economies. But we think it’s too soon for fixed income investors to celebrate. And the muted reaction to the election result in bond and currency markets suggests we are not alone in remaining pensive.
Bold reforms are needed to unlock India’s full potential
India’s growth over the past five years outshines much of the rest of the world, but we believe subdued inflation and capital utilisation rates point to it being below its current potential. And bold structural reforms, particularly in land and labour laws which currently inhibit private sector development, could further lift the potential growth rate, in our view.
Despite early attempts at revising the Land Acquisition laws, Modi’s first five years in office didn’t deliver on that front. And due the lack of a majority in the upper house of parliament (the Rajya Sabha), we don’t expect Modi to attempt to pass such bold reforms for several years.
The fact that Modi’s five-year-old “Make in India” export push has yet to deliver tangible results further highlights how there is no quick fix to reinvigorating India’s economy.
An economic balancing act
Population growth means India’s labour market needs to create more than eight million new jobs every year. And while positive for the macroeconomy longer term, policies such as the Goods and Services Tax and demonetisation have weighed heavily on much of the working population – more than four out of five Indian jobs are in the informal sector.
Similarly, the low inflation that has been a macroeconomic positive translates into rural distress among the farmers facing lower prices for their goods. Modi has committed to doubling farmers’ income by 2022, but he will need to achieve this without stoking inflation. It will be a tricky balancing act.
Banking system needs to get liquidity flowing again
A further challenge to India’s growth comes from the need to sort out its Non Banking Financial Companies (NBFC). These have been crucial to supporting overall credit growth as banks have been trying to rectify their balance sheets. Accounting for 15% of India’s banking system, NBFCs are a significant cog in the financial machine.
Since the default of Infrastructure Leasing & Financial Services Limited last year, banks have been reluctant to lend to NBFCs, posing problems for an industry which has typically borrowed short term to finance long term asset growth. The knock-on effect has been tight lending conditions for many private companies and a dampening effect on durable goods consumption, investment in real estate and auto sales etc. While the Reserve Bank of India (RBI) has considered opening a special credit line to ease liquidity pressures for NBFCs, at the time of writing it decided against doing so as it did not perceive the issue to be systemic. However, the matter is firmly on the RBI’s radar and it stands ready to act should the situation become more systemic in nature, which is encouraging.
The government may struggle to balance the books
This summer will bring more clarity on India’s fiscal health and outlook, with the budget due to be announced in July. We see several headwinds that will make it difficult for the government to meet the overly-ambitious targets it has previously set and believe India’s fiscal deficit will widen, which will keep bonds under pressure.
To improve its fiscal balance, Modi’s government will need to improve tax collection, particularly via the much-vaunted Goods and Services Tax (GST), which has delivered underwhelming revenues since launching almost two years ago. And on the expenditure side we are concerned by the recent deterioration in the quality of fiscal spending. Given recently announced healthcare (Modicare) and other policies, including farmer support payments – all of which helped Modi secure his landslide victory (see grey box below), we see a further crowding out of much-needed capital spending, necessitating a wider fiscal deficit and/or slower growth. We have seen a recent trend of capital spending falling more on the balance sheets of state owned entities to enable the government to meet its fiscal deficit target, but this still requires financing via bond issuance – this additional supply of bonds is preventing bond yields moving lower.
The economy remains sensitive to oil prices and other external financial conditions
Under ‘normal’ circumstances, India’s solid growth rate (6-7% in real terms and 10-11% in nominal terms) should translate into capital inflows that comfortably finance a current account deficit of approximately 2.5% of GDP. However, a backdrop of rising US interest rates has had a counterbalancing effect: higher US rates effectively deterred investors from selling US dollars to buy the rupee, creating a scarcity in the supply of dollars in India (among other countries), which last year forced India’s central bank to sell down a portion of its foreign currency assets to finance its current account deficit.
High oil prices leave little room for oil-importing India to reduce its current account deficit. So to avoid a repeat of the above, India needs to ensure it is offering attractive enough returns to foreign investors so capital can continue to flow into the country. Again, this links back to the reform agenda and the government’s ability to effectively implement.
We are neutrally positioned
We are neutrally positioned in Indian bonds and the rupee in our local currency emerging markets debt strategies. While the election result was positive news for India, India’s rates and FX valuations already reflect this and for upside potential in these assets to be realised the Modi government has to focus on effecting bold reforms and correcting for the existing headwinds facing the economy, all of which will take time.
Modi’s star ascends
In a result that none of the polls came even close to predicting and in stark contrast with the outcome of the state elections in December, Narendra Modi’s Bharatiya Janata Party (BJP) gained 40% of votes in India’s general election. This cements the BJP as a national party with a clear majority in India’s lower house of parliament and is the first time since 1971 that an incumbent prime minister has secured an absolute majority for a second successive term.
The BJP’s highly successful campaign cleverly capitalised on Modi’s popularity. In what felt more like a presidential election than a general election, Modi travelled to 27 states to address 142 rallies, clocking 105,000 km. Enjoying better funding levels than other parties and facing an opposition in disarray will only have helped.
During five years in office Modi’s squeaky-clean image from a corruption standpoint has become increasingly apparent, making a welcome change for the Indian electorate. Other factors that helped secure him such broad and deep-rooted support that spans age, gender, caste and creed include:
- His strong response to Pakistani air strikes
- Handouts and support for the poor in the form of toilets, electrification of villages, Modicare, handouts and loans
- Support to farmers.
Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.
Investments carry a risk of capital loss.