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Marcuard's Market update by GaveKal Dragonomics
A fortnight ago India’s much hailed reforming government unveiled its first budget and everyone yawned. Former Prime Minister Manmohan Singh got it about right when he said that the new finance minister’s programme could just as easily have been presented by his own maligned Congress-led administration. For investors the problem was the absence of a credible fiscal consolidation plan or a road map to curtail boondoggles such as India’s vast subsidy programmes. Indian equities are 3% off their July 7 peak and more declines may follow. Yet despite the government’s naive expectations in management strategy, we contend that India’s reform story lives, and any pull-back in equities offers a strong buying opportunity.
In addition to a gathering cyclical recovery as shown by increased trade activity in June, our upbeat view rests upon a read of the political calculations being made by Narendra Modi’s government. Put simply, it needs to keep relatively clean hands ahead of provincial elections including the key state of Maharashtra in the next six months. Major reform initiatives that threaten labour groups or trade guilds will cause a backlash for candidates in Modi’s Bharatiya Janata Party. Despite the BJP’s majority in the national legislative body, the key to the “stealth” reform initiative that Modi looks to be pursuing relies upon capturing regional strongholds and working the revolution from the bottom up.
The country’s federal set-up empowers provincial administrations to legislate in key policy areas such as electricity tariffs and land acquisition; legislation passed by state assemblies can even supersede central legislation if it gets Presidential assent. Modi has long argued for more power to be devolved to the states and he is more likely to deliver if he can help install like-minded administrations with a positive view on implementing tough reforms.
The power sector is an ideal example of this dynamic. Most of India’s generation capacity has been developed under the control of the central government and Delhi has helped build lots of shiny new power stations—the new capacity means that the peak demand-supply deficit should have fallen from as much as 17% in 2008 to about 5%. The problem is that much of this capacity is not being used for local reasons. In particular, state-controlled electricity distribution firms are too cash-strapped to buy power at market rates, while tariffs are dictated by state governments which in catering to their electorates’ wish for cheap electricity neglect the financial health of utilities. Cajoling state governments to adopt unpopular but vital tariff hikes requires a carrot-and-stick approach. A simple promise of further autonomy or a greater share in tax revenues should prove to be a sufficient catalyst to enact more such needed reforms.
To be sure, this rather generous read on Modi’s political strategy does not excuse his first budget which was weak where it need not have been. It reiterated the last administration’s fiscal consolidation plan to cut the deficit from last year’s 4.5% of GDP to 4.1% this year and to 3% by March 2017, but this somewhat fantastically assumes 19% growth in revenue. Already in the first two months of the fiscal year, the deficit has reached 45% of the target and it is unlikely that a targeted INR584bn from privatisation sales will be realised.
If there was one positive from an otherwise lacklustre budget, it was the support for investment, especially in infrastructure. The foreign direct investment cap was raised for the insurance and defense sectors to 49% from 26%, tax incentives were granted to trust vehicles investing in real estate and infrastructure and banks were offered regulatory forbearance if they make long term infrastructure loans. We like these initiatives because they help kick-start an investment cycle without forcing the Reserve Bank of India to stop leaning against inflation and cutting rates. In this regard former PM Singh is dead wrong in his statement about the two government’s sameness. Finance Minister Arun Jaitley did not browbeat the RBI and effectively endorsed its idea for a formal inflation targeting framework.
Such a positive development should militate against a policy mistake exacerbating short term inflationary risks resulting from sub-par monsoon rains or the threat of an oil price spike due to Middle East events. And it reinforces our belief that the government is signed up to the long game on supply side reform to end India’s stagflation problem. As such, despite valuations looking stretched we would continue to treat any sell-off in the Indian markets as a buying opportunity, particularly among cyclicals.
