India Warms to Reform: Part 2 of 3

The recent election results in India have reflected the country’s desire for change and bestowed a strong political mandate on newly-elected Prime Minister Narendra Modi. With expectations for growth sitting heavily on his shoulders, the question is whether the new government can create sustainable growth after years of sub-par economic performance. In a blog post earlier this week, we discussed three potential economic drivers that we believe have the potential to boost growth over the coming years. This post discusses three more.

Banking Sector Reform

One of the drivers discussed in our last post was a trend toward revitalized industrial output, which would help make idle capital more productive. That directly ties into the fourth driver, because generating returns from idle capacity will also help alleviate debt burdens and improve banks’ asset quality. Indian banks, particularly the state-owned banks, are hampered in their new lending efforts because they’re saddled with INR2.5 trillion (US$41.7 billion) of bad loans and INR3.5 trillion (US$58.3 billion) of restructured loans. Raising new capital for the private banks and privatizing the state-owned banks should be a solution to the problem. Action on this front would signal to investors the government’s determination to pursue reform and would be good for both the banking system and the economy in the long run.

Fiscal Reform

In the medium-to-long term, we expect the focus to be on structural reforms that promote efficiencies and higher growth. A common goods-and-services tax is needed to facilitate trade between states and to replace an arcane and inefficient system of local levies. This is already on the government’s agenda and may materialize relatively soon. The other urgently needed actions are related to fiscal consolidation. Reducing the fiscal deficit by removing subsidies on fuel and fertilizers would free up savings for the private sector. Fuel subsidies have been declining gradually; however, fertilizers may be more difficult to tackle given the sensitivities in the rural sector. Nonetheless, we expect gradual but steady progress on subsidy removals. Smaller fiscal deficits will free up private savings boost its availability for investment, a necessary condition for higher investment growth.

Bridging the Savings-Investment Gap – Foreign Direct Investments are Key

At just over 30% of GDP, India’s current investment rate isn’t low, but it needs to be higher, and the country currently lacks sufficient domestic savings for that. Given this savings-investments gap, boosting the level of foreign direct investment (FDI) is another very important condition to allow annual GDP growth to accelerate by 2% to 3%. Opening up retail, financial, and other protected sectors of the economy to foreign investment would bring much-needed long-term capital and, along with it, the know-how to boost productivity gains. India attracted only INR1.74 trillion (US$29 billion) of FDI in 2013, around 1.7% of GDP. Compare that to 3.4% in Thailand, 3.7% for Malaysia, or 2.1% for Indonesia. India is expected to have a current-account deficit of about INR3.0 trillion (US$50 billion) per year for the next couple of years, so doubling the FDI flows would fully fund the current-account deficit and make the external accounts and the currency much less vulnerable to variations in global liquidity conditions. In order to achieve that, structural reforms and removal of India’s notorious red tape are a must. We are cautiously optimistic on that item, but recognize that these will be the toughest reforms for Prime Minister Modi to tackle.

Overall, we are optimistic on the potential for growth acceleration and believe that India has its best chance in many years to do that. The rising urban middle class demands growth, jobs, and better living standards and these electoral preferences will dictate the behavior and influence the priorities of politicians and political parties.

In our next post, we’ll take a deeper look at the fundamentals of the Indian equity market and give our outlook given the potential government reform. Check back soon!

Mohammed Zaidi, portfolio manager for Principal Global Equities, contributed to this article.

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The information in this article has been derived from sources believed to be accurate as of June 2014. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity.

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