May 18, 2021
Has India learned from its mistakes?
After some economic stumbles, India has corrected course and may be poised for explosive growth…once it stomps out the pandemic wildfire.
By Max Gokhman, Head of Asset Allocation, and Samuel Park, Director of Fundamental Research, Pacific Life Fund Advisors
- India has seen a sharp increase in COVID-19 cases in April.
- While the pandemic has temporarily stalled progress, India has been reforming policies to attract foreign investments.
- With investments into areas such as infrastructure and semiconductor manufacturing, India has the potential to play a greater role in the global supply chain.
The COVID Challenge
In April, India experienced a massive increase in new COVID cases, surpassing three million persons – making it the new global epicenter of the pandemic. The following chart illustrates the recent jump of active cases in India, while that of the world has declined from its peak at the start of the year.
The surge followed the premature reopening of India’s economy, and new variants of the virus that may have helped spark the outbreak in the densely populated country. Several nations have responded to India’s pleas by providing vaccines, healthcare equipment and other essentials to flatten the pandemic. As tragic as the COVID situation currently is in India, it is not permanent. We believe the country is still positioned for strong growth over the medium- and long-term.
India is already a powerhouse as the world’s fifth largest economy (according to World Bank) behind only Germany, Japan, China and the U.S. Still, in recent years, policies promoted by Indian Prime Minister Narendra Modi have unintentionally put the brakes on the country’s once-rapid expansion. According to World Bank data, India’s GDP growth rate slowed from8.26% in 2016 to 4.18% in 2019, a nearly 50% drop even before the COVID pandemic plunged nearly all global economies into recession.
But a series of new reforms has us and India-focused strategists feeling bullish again, with some predicting the country is poised to become a top three economic superpower by 2030. The International Monetary Fund (IMF) estimates that India will surpass China’s GDP growth rate for the next five years.
India has always had advantages in attracting foreign investors: More people speak English there than anywhere outside of the U.S., and its laws and regulations are more consistent with those of the West, which make India a friendlier trading partner than China.
At the same time, India’s economic progress has been hindered by government red tape, lack of infrastructure, a heavy reliance on the agriculture sector, and high tariffs that protect domestic producers. When Prime Minister Modi took office in 2014, some of his policies exacerbated these challenges. For example, an increase in labor costs via its employment-guarantee program cut into corporate profits. Additionally, the 2016 banknote demonetization policy, which was aimed at cutting corruption within India’s underground economy (or shadow banking activity), instead ended up causing disruption in the banking system, reducing consumer spending and dissuading business investments.
However, Prime Minister Modi may have learned from his initial mistakes and, with new initiatives, India may be on course for impressive economic growth in the years ahead. Here are some of the proposals and recent reforms that should attract more foreign capital and boost domestic growth:
- Reduction of red tape at all levels of government. India’s burdensome bureaucracies—in addition to corruption and nepotism—have hampered the buildout of its underdeveloped infrastructure. India must get this fixed if it wants to be a permanent and prominent place within global supply chains. If Prime Minister Modi succeeds in breaking open India’s infrastructure bottleneck, it may allow for a modernized economy that depends less on agriculture. There’s some urgency here because the U.S.-China trade conflict is causing companies to seek alternative supply-chain partners. By improving infrastructure, India could provide an attractive alternative.
- Lowering corporate taxes. India cut corporate tax rates from 30% to 22%, and new manufacturing companies would pay only 15% in taxes.
- Goods-and-services tax reform. This initiative seeks to simplify complex central and state tax codes by merging them under one structure, giving the central government control over the purse strings and therefore state government policies. For instance, in late 2017, Prime Minister Modi declared that the central government will not release funds to states that stall progress with regulatory burden, stressing the importance on “cooperative federalism” between the central and state governments.
- More public spending. The Modi administration has signaled its willingness to monetize some public assets and excess land holdings to reduce pressure on fiscal budgets. For many, this illustrates Modi’s seriousness in reforming the country.
- Production-linked incentive program. Late in 2020, the Indian government approved a $27 billion five year program to create jobs and boost manufacturing. Sectors targeted included electronics, textiles, automotive, pharmaceuticals, and food. Corporate deleveraging may have troughed with this policy shift toward supporting the manufacturing sector.
India’s Semiconductor Initiatives
The recent global chip shortage revealed the world’s reliance on a handful of countries such as Taiwan for semiconductor chips. Additionally, continued tensions between China and Taiwan further complicate the situation that has clogged supply chains throughout the world. Semiconductors represent core inputs to devices that impact all sectors, including automotive, agriculture and defense. The Indian government has recognized this challenge and is trying to turn it into an opportunity.
India has been ramping up its efforts to attract manufacturers to set up semiconductor factories in the country. In prior attempts India’s policy offered reimbursements rather than direct incentives to foreign companies. Combined with weak infrastructure and poor planning, these prior policies discouraged chip manufacturers. However, recent reports indicate that India would offer over $1 billion in cash to each semiconductor manufacturer to set up shop in the country, as it seeks to become a major hub in the global electronics supply chain.
These efforts should attract more foreign investments overtime, especially when India builds out its infrastructure. The following chart illustrates the increasing trend in recent years. Furthermore, the surge of flows in August 2020 reflects growing foreign interest after initial policy reforms facilitated the ease of doing business in the country.
Relative to China’s infrastructure, India’s significantly underdeveloped. India will need to industrialize its infrastructure before it will be free from its overreliance on agricultural sectors.
While there may be some short-term headwinds, medium- to long-term growth remains on track. Public spending on infrastructure should help recover lost growth potential over the next four to five years.
Some of these programs will likely finance incomplete projects. This may result in progress that exceeds projections, as these projects may be finished far earlier than those starting from scratch.
Finally, looking at Indian equities, the Modi administration’s earlier policies resulted in margin compression and weak sales growth that hammered corporate profits. This may have contributed to the subdued performance of India’s equity market between 2018 and 2020. While the global pandemic temporarily sank the market, India may be primed for a strong and prolonged rebound once the country gets a handle on the recent surge in COVID cases.
Today, price-to-book, which may be the more appropriate measure since it looks through earnings cycles, indicates that Indian equities have upside potential. Furthermore, relative price-to-book indicates India is undervalued relative to the overall MSCIEM (Emerging Markets) Index. Given the pro-growth policies we discussed, this presents an attractive entry point in our view.
Despite its lofty economic standing in the world, India has always been plagued with stubborn problems such as inadequate infrastructure and widespread corruption, and the Modi administration initially exacerbated those challenges with policy missteps that slowed economic growth. The recent spike in COVID cases also remains a temporary challenge.
Perhaps being humbled by the experience, the Modi administration enacted policies to knock down longstanding barriers that have blocked India’s path to achieving its full economic potential. Investors are taking note and carefully following India’s progress to see if the country has learned its lessons and put itself back in position to realize its significant growth potential.
The MSCI Emerging Markets Index tracks the performance of equity stocks in selected emerging foreign markets.
The MSCI India Index is designed to measure the performance of the large and mid cap segments of the Indian market.
The price-to-book ratio compares a companies market value to its book value.
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