India: After a period of euphoria, doubts are resurfacing

ECONOMIC GROWTH APPEARS TO BE RUNNING OUT OF STEAM. CAN THIS BE CAUSED BY THE SUDDEN DEMONETISATION OF NOVEMBER 2016 ?

According to the most recent data, economic growth is indeed showing signs of deceleration. The country’s GDP only grew at a pace of 5.7% in Q2 2017, down from 6.1% in Q1. Naturally one’s first instinct is to blame demonetisation… then the implementation of the unified Goods & Services tax. However we feel it is important to go back further in time and to realise that the slowdown actually began after the peak in Q1 2016 – when GDP grew at a pace of 9.2% year-over-year. At the time, oil prices had turned around and the regulatory measures aimed at deleveraging banks had come into force (identification of bad debts, higher provisions…). This led to a slowdown in credit growth and a downturn in economic activity. The sudden announcement that 500 and 1000 rupee bank notes were to be withdrawn – accounting for 88% of fiduciary money in an economy where 80% of transactions are still made in cash – only served to amplify a trend that was already well under way.

SO WOULD YOU SAY THAT GOVERNMENT POLICY HAS HAD A TANGIBLE IMPACT ON ECONOMIC GROWTH?

The disruptive effect of demonetisation is undeniable in the short term. However, one should also understand that this move fits into the government’s long-term vision. Modi’s administration wishes to curb the “black economy” and bring India into the 21st century; and one way to achieve this is by increasing the role of banks throughout the economy. This is also one of the reasons why the unified tax system on goods and services was introduced at national level last July, replacing 15 different regional tax regimes.

Of course the government’s aim here is to simplify trade across the country, to increase the tax base and to clarify the environment for foreign investors.

However the new unified tax regime remains complex, involving several rates which differ whether applied to inputs or to final consumer goods. Many economic agents anticipated the fiscal change, preferring to reduce their inventories in order to limit tax discrepancies. This major countrywide fiscal reform therefore appears to have had a negative impact on output before July.

HAS THE GOVERNMENT REACTED TO THIS SLOWDOWN?

The government apparently expressed its concern over the most recent data published (industrial output up 1.6% over one year, down from 7% in June 2016). It announced several technical adjustments to the unified Goods and Services tax regime. These include exempting a number of companies, authorising the largest number to make quarterly rather than monthly statements, ensuring that exporting companies with cash flow issues can be reimbursed faster by the tax authorities, and finally, reviewing the principle whereby the client is accountable for paying the tax when making a purchase from a non-declared company!

However the government will do more than simply alter the enforcement of this symbolic measure, which was only pushed through after endless legislative debates. It has also announced several measures designed to support consumer spending in response to the downturn recorded in the most recent data estimations.

The government has indicated it would reduce taxes on petrol and diesel and is planning spending increases for the next budget.

In all likelihood, the upcoming local elections, followed by the general election of 2019, are not unrelated to these announcements.

SO THE INDIAN ECONOMY SEEMS DRIVEN BY A DIFFERENT MOMENTUM THAN THE REST OF ASIA?

Indeed, while the IMF continued to review its growth estimates upward for most Asian countries, the growth figures for India were downgraded (-0.5 point in 2017). The IMF is now expecting GDP to grow by 6.7% in 2017, before experiencing a slight rebound in 2018 (+7.4%). It is important to remember that India is rather closed to the outside world; exports only account for 15.3% of GDP and importantly, only 19% of total exports are within Asia. In comparison, over 36% of Chinese exports are shipped to other Asian countries and exports weigh a little over 20% of GDP. India is therefore much more sensitive to domestic demand; furthermore, farming accounts for a considerable share of the country’s GDP (15%), which means the Indian economy moves according to its own specific pattern. This explains why the government is keen to support domestic demand.

BUT BROADLY SPEAKING, HAVE THE POLICIES IMPLEMENTED SINCE MR MODI CAME TO POWER BEEN EFFECTIVE?

A major success was the central banks’ ability to control inflation. After culminating at 12% year-over-year at the end of 2013, the country’s inflation-focused monetary policy – based on a policy rate corridor and clear communication - enabled consumer prices to rise 3.4% year-over-year in August. This also led to the easing of monetary policy, which was needed to stimulate investment. Nevertheless, difficulties persist in extending this policy to the real economy. The interest rates applied to companies remain high, particularly those charged by public sector banks, most affected by the accumulation of bad debt. The latter account for 7% of total bank assets and rose 60% in 2016, in just twelve months! According to recent announcements, the government is considering further recapitalising some of the country’s public banks.

Another undeniable success was the reduction of the country’s current deficit. This was initiated in mid-2013, but has lasted, despite rising energy prices and their unfavourable impact on importing countries. Opening up to foreign investors by easing administrative red tape has meant that most of the current deficit – 2.4% of GDP at end June 2017 – has now been “covered” thanks to the net rise of direct investments, thereby vastly improving the sustainability of the country’s external funding.

TO SUMMARISE, IS IT WISE TO INVEST IN INDIAN EQUITIES TODAY?

It seems to us that the current environment is a little less favourable that it is elsewhere in Asia. While the demonetarisation and the unique Good and Services tax are transient and ultimately positive factors for the Indian economy, we believe the declining demand for credit, the situation of banks - and particularly how they will manage the sharp increase in bad debt, will reduce the probability of a fast recovery in economic growth. In light of these factors, the shortterm outlook for the Indian stock market is rather less favourable.

We are therefore underweight on India within our CPR GEAR Emergents strategy relative to the MSCI Emerging index.

However, opportunities for a return to the market may arise at the end of the year, or early in 2018, considering the country’s rather positive fundamentals. We are also encouraged by the upcoming elections - as these periods tend to be associated with stimulus measures - but also by the magnitude of the correction that has already impacted the market.