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India’s 17th general election resulted in victory for Prime Minister Narendra Modi’s Bharatiya Janata Party (BJP), which in turn has significantly strengthened the political position of India’s National Democratic Alliance (NDA), a coalition of right-wing political parties led by the BJP. The BJP secured 303 seats, compared to 282 in 2014, which helped the NDA coalition win a total of 352 seats or 65% of the parliamentary seats, up from 336 seats in 2014. A breakdown of the vote, in our view, confirmed the dominance of national security and identity concerns over the concerns of economic distress and also revealed a strong pivot to Hindu majoritarianism, which was best encapsulated by the win of BJP member Pragya Singh Thakur1, who ran against a member of the Indian National Congress (INC), Digvijaya Singh, the former two-term Chief Minister of Madhya Pradesh and General Secretary of Congress. Rahul Gandhi’s INC was decimated in the election2 as regional parties outperformed with the liberal and progressive voter base.
Prime Minister Modi’s new cabinet brings some surprises, further centralizes power, hardens the populist bent, and sets up for tougher foreign policy stance. Prime Minister Modi has streamlined his cabinet by 17 ministers, from 74 to 573, signalling continuity in greater centralization and concentration of power. In terms of key appointments, the replacement of Arun Jaitley, the former Minister of Finance and Corporate Affairs, with Nirmala Sitharaman, the former Defence Minister, comes as a surprise as we had expected Piyush Goyal to be chosen for the role. We view Minister Sitharaman’s appointment as strategic in order to allow for a future cabinet reshuffle that will reappoint former Finance Minister Mr. Jaitley, should his health recover4. In the meantime, it is worth bearing in mind Minister Sitharaman’s dovish credentials as Commerce Minister, where she advocated aggressive rate cuts and a weaker currency to boost India’s competitiveness and growth prospects. Amit Shah’s appointment from BJP President and Chief Campaign Manager to Home Ministry, comes as no surprise. While the appointment formalizes a long-primed understanding, we believe that it also gives way to the possibility for further societal divisions and polarization in the coming years. The promotion of Subrahmanyam Jaishankar, a seasoned career diplomat who is credited with brokering the India-US nuclear deal and diffusing tensions with China in 2017, to Foreign Minister also signals a tougher foreign policy stance during Prime Minister Modi’s second term.
India’s economic growth is slowing due to both cyclical and structural factors. Growth has hit a soft patch as confirmed by the GDP print for the first quarter of 2019 and also evidenced across the board by consumption, construction, and export indicators. However, this is not just a cyclical issue. We think that the legacy of the Congress Government and a mis-coordinated policy response from BJP’s first term has gradually seeped into a structural slowdown. Additionally, we feel that potential growth has softened to below 7%, shaving off over 100 basis points from a decade ago.
That said, as domestic headwinds fade, we believe that economic growth could rise back to 7% in the second half of 2019, but that it will require active policy support in order to achieve this. India’s economic growth has historically been highly sensitive to policy uncertainty and tends to bounce back following a general election. We expect higher levels of investment as uncertainty wanes and liquidity within the banking sector improves over the next few months. We believe that the higher levels of investment coupled with normalization in cash to deposit ratios, should result in a gradual acceleration of bank credit. But for growth to be sustained and the cyclical uptick to translate into stronger investment trends and higher potential growth, we believe that progress on reforms must go beyond current enhancing reforms such as the Goods and Services Tax (GST) and the Insolvency and Bankruptcy Code (IBC).
We believe that only a new slate of measures aimed at capital deepening and labor reforms would systematically boost investment and could push economic growth closer to 8%. Total factor productivity enhancing reforms, such as the GST and digital payments, which have been undertaken in the last few years, have encountered significant implementation setbacks resulting in the transmission to success being limited. In the meantime, capital and labor augmenting reforms have been largely missing. Furthermore, the ease of doing business still remains a concern and judicial process and capacity requires an urgent upgrade. Private investment remains weak, and we believe that the investment climate needs a boost through fiscally responsible public investment and a comprehensive overhaul of the operating environment.
While the successful implementation of the IBC code will serve to unclog the banking system, we believe that further steps to deepen capital markets are also required, such as diversifying sources of funding and improving the business and regulatory environment. India continues to face substantial supply side constraints, which Prime Minister Modi’s first term did little to address. We think that a comprehensive and coordinated regulatory overhaul is required to bring the agriculture, power, and banking sector out of distress, which in turn requires the government to reduce its footprint and create better governing incentives for fiscal federalism. We think that labor and land acquisition laws need to be relaxed, while safeguarding workers’ rights. As part of its drive for competitive fiscal federalism, India would, for example, benefit significantly from special economic zones. These could serve as experimental labs for coordinated policy frameworks tackling land, labor, and environmental issues, ultimately geared towards implementation at a national scale, which remains a major pre-requisite for unlocking India’s growth potential. Finally, India’s informal sector, as proxied by currency in circulation, versus global norms, is still very large, and we believe steps to address this need to go beyond the cosmetics of demonetization schemes.
We believe it is unlikely that a new productivity-oriented reform agenda will be unveiled in the near-term. For the first year of the second term, we think that the authorities will rely on coordinated policy easing to buy time as focus returns to ensuring the full adoption and success of Reform 1.0. The upcoming budget and first 100-day plan, likely to be presented in early July, should provide a first look at the new government’s policy priorities. We believe the government is likely to broaden its cash transfer scheme to include more farmers and present a large infrastructure package for the farming sector. We also see scope for the government to provide funds for bank recapitalization, something that was not included in the February 2019 interim budget, but is a necessary pre-condition to reviving the banking sector. Fundamentally, we believe that the new administration needs to focus on enhancing revenues. Some of the untapped options it can lean on include one-off measures such as further divestment of government holdings in companies and monetizing government land holdings, but more importantly boosting permanent revenue streams by enacting a new and improved Direct Tax Code and improving the GST structure.
We expect that the Reserve Bank of India (RBI) will remain supportive. While the real repo rate has adjusted downwards, real corporate bond yields remain elevated, reflecting a combination of fiscal excesses and liquidity considerations. We expect the RBI to address these considerations with a 25 basis points rate cut in June, with a strong possibility of further rate cuts announced at future meetings combined with a surplus liquidity stance, involving OMOs and FX swaps that effectively bring down funding costs for corporates.
Although we expect that the fiscal stance will remain accommodative, by delaying consolidation to later in the current term, we think that government yields, screened relative to monetary stance, more than factor this in. We would secure more comfort in this view as and when GST revenue collections gain traction on a sustained basis, but in the meantime, we view India fixed income inflows as being supportive in a low global growth environment and an oil price world. We think that equities fully price in the reform momentum, but with limited foreign participation, can benefit from diversification flows looking for jurisdictions shielded from trade dispute related concerns.
We also expect that the authorities will take on a nuanced approach in addressing Non-Banking Financial Company (NBFC) woes that will enrich the opportunity set. System-wide credit is not as restrictive as the contraction NBFC in activity, with commercial banks picking up some of the slack, however, specific stress of the NBFC sector needs to be addressed as it continues to exert a disproportionate drag on growth. We expect that increased coordination between the Ministry of Finance and the RBI will prioritize and tackle these issues. The government could act on these issues even before it presents the budget. We expect a strengthening of the regulatory framework which NBFCs are subjected to, but think that the government is open to selective defaults and restructurings to avoid being viewed as tolerant to moral hazard while provisioning enough liquidity to ensure the system avoids a collapse. At the current juncture, we suspect the government would like to contain the market impact and limit re-profiling to within the banking system, which can be backstopped by recap pledges.
1 A politician formerly charged with planning a terrorist attack that killed 10 Muslims in 2008.↩
2 Mr. Ghandi lost his home parliamentary seat.↩
3 Now comprised of 24 cabinet ministers and 33 ministers of state.↩
4 Mr Jaitley stepped down from his position as Finance Minister due to ill health.↩