The Return Of Reform

BMI View: Struggling under the weight of economic stagflation, burgeoning twin fiscal and trade deficits, and yet more allegations of corruption, New Delhi has finally jumpstarted India ' s reform agenda, announcing a series of measures designed to consolidate the public sector balance sheet and encourage private sector investment. To be sure, much of the country ' s economic woes have been largely self-inflicted, and we believe that a pick-up in economic reform could well ignite a cyclical recovery in the country ' s growth story. As such, we maintain our above consensus real GDP growth outlook and our fundamentally bullish stance towards the Indian rupee.

Earlier this year, BMI outlined the silver lining argument to India's ongoing economic malaise ( see 'Economic Growth: Down But Not Out', June 14 2012). Faced with an acute slowdown in economic growth, stubborn inflationary pressures, and precious little room for fiscal expansion, we believed that the Indian government would finally look to push through big picture reform in a bid to resuscitate domestic demand. As the chart below shows, India's economy has been suffering a toxic mix of stagnant growth and persistent price pressures and, having been forced into a corner, the government of Prime Minister Manmohan Singh has finally decided to act. Between September 13 and 14, the United Progressive Alliance (UPA), India's ruling collation, unveiled a series of reforms designed to get investment activity moving once more.

India - Industrial Production & Headline Inflation, % chg y-o-y
  • On September 13, the government hiked the retail price of diesel by INR5.00 per litre, a 13.5% jump from previous levels. It also limited the number of subsidised cylinders of cooking gas per customer to six per year. The hike will make only a cosmetic improvement to India's projected INR2.3trn (US$43.7bn) subsidy bill in FY2012/13 (April-March). Still, this was a politically bold step in the face of high global crude prices, a weak rupee, and the re-emergence of fuel price inflation.

Bold Step
India - Price Of Diesel In Major Cities, INR per litre
  • On September 14, New Delhi announced that it would allow 51% foreign direct investment (FDI) into the country's multi-brand retail sector, in a move which would allow global majors such as Walmart, Tesco, and Carrefour to sell directly to the Indian consumer. It also relaxed conditions on 100% FDI in single-brand retail, by making optional the clause on sourcing 30% of the value of products sold through single-brand outlets from local, small-scale manufacturers.

  • Two other sectors also saw a liberalisation in FDI regulation, namely broadcast media (the maximum limit raised from 49% to 74%) and aviation (foreign carriers will be permitted to buy up to 49% stakes in domestic lines). The latter is particularly significant given the precarious health of the domestic airline sector, with a number of carriers - most notably Kingfisher Airlines - facing a genuine threat of bankruptcy. India's banking sector is particularly exposed to a souring of aviation loans.

Crash Landing Concerns
India - Equity Market Performance Of Selected Airlines
  • Finally, the government announced small equity divestment plans of around 10% for five public sector corporations - Oil India, Hindustan Copper, NALCO (aluminium), MMTC (metals trading) and RITES (transport projects). Despite a full-year target of INR300bn, divestment proceeds have been minimal so far in FY2012/13.

Is This Time For Real

BMI has lost count of the number of false dawns for India's reform outlook and, as highlighted above, several of the measures are more symbolic than significant in terms of reining in fiscal largesse and putting the economy back on track. Moreover, one could argue that the revival of economic reform may have had as much to do with taking the heat off the government's from the ongoing coal auction scandal ( see 'Coal: Regulatory Improvement Unlikely In Near Term', August 29 2012 ) than a sudden desire to improve the country's business environment. Still, given the hostile economic backdrop, considerable coalition infighting, opposition obstructionism, and the spectre of general elections in 2014, it would have been easy for the UPA to pursue an explicit populist agenda. Judged against these criteria, we believe that the September announcements are, by some distance, the most important policy moves of the UPA's second stint in office since 2009.

We are not expecting a marked improvement in the country's fiscal performance this year following these announcements (although we may look to tweak our projection of a 5.6% of GDP nominal shortfall for FY2012/13). That said, the signal to investors is extremely positive. During the recent weakness in India's investment cycle , our contention has been that investors had not necessarily been put off by a lack of profitable opportunities in India (return on investment continues to outstrip the nominal cost of capital), but rather by government interference in the process of capital allocation. The recent measures should help to galvanise the country's investment recovery. Portfolio and foreign direct investment have already perked up in recent months, with FDI inflows hitting a monthly US$3.0bn (on a 12mma basis) for the first time on record earlier this year.

Will Reforms Stick?

There is a risk, of course, that the current slew of reforms could yet face significant dilution, or even reversal in the coming weeks. The decision to allow 51% FDI in multi-brand retail was initially taken in November, only for the Singh administration to announce an embarrassing about-turn in a matter of days due to resistance from allies such as the All India Trinamool Congress (TMC) and opposition parties. The TMC remains opposed to much of the reform agenda - in particular multi-brand retail liberalisation - and party leader Mamata Banerjee has threatened to pull her support for the coalition. Still, we believe that the vast bulk of the announcements will be applied with minimal fuss this time around. Firstly, the government has left implementation of multi-brand retail up to individual states. A number of state governments - including those of Delhi, Maharashtra and Andhra Pradesh - have already expressed their support for the policy, and the increased degree of autonomy is likely to represent a tolerable compromise for grumbling coalition partners. Secondly, as we said in July ( see 'INC Victory To Jumpstart Reform', July 23 2012), Banerjee has seen her wings clipped in recent month, and she is unlikely to risk breaking ranks from the dominant Indian National Congress (INC) at this important juncture.

Is There More To Come?

We believe so. While the monsoon session of the lower house ( Lok Sabha) turned out to be another wash-out, there is much the government can do on the policy front without parliament's blessing. We expect to see the government fast track project execution (there are 89 so-called 'mega-projects' currently stuck at clearance stage). The power sector is likely to witness a major overhaul following widespread black outs earlier this year. Other measures that could follow include allowing insurance companies to invest in debt infrastructure funds, easing overseas borrowing rules for non-banking financial companies, scrapping plans to retrospectively tax foreign companies, and expediting the long-awaited goods and services tax (GST) and direct tax code (DTC) legislation. The latter, in particular, would act as a genuine game changer for long-term fiscal consolidation. Finally, we anticipate further divestment announcements in the coming months, with companies such as Steel Authority of India ( SAIL) expected to go under the hammer.

Macro Implications

We believe that there are three main takeaways in terms of India's near-term macroeconomic prospects. Firstly, the odds of a ratings downgrade from one of the major agencies have lengthened dramatically. Despite outlook downgrades from Standard & Poor's and Fitch Ratings, we have long held the view that India would not see an investment grade demotion this year ( see 'Does India Deserve Junk Status?', June 20 2012). These recent announcements have put any concerns of such a scenario to bed, in our view.

Twin Deficits To Improve
India - Fiscal & Trade Deficits, 12mma

Secondly, interest rate cuts will be a question of 'when' not 'if' despite the recent uptick in headline inflation. The re-acceleration in the benchmark wholesale inflation rate to 7.6% year-on-year (y-o-y) in August from 6.9% in the previous month will probably dissuade the Reserve Bank of India (RBI) from cutting rates at its policy meeting later today (although we would not be entirely surprised by a 25bps cut). However, as we explained earlier this month ( 'Growth Concerns To Trump Anti-Inflation Stance', September 14 2012), we believe that the central bank will turn its attention increasingly towards reviving growth and away from containing inflation - and the recent attempts at more controlled fiscal expenditure should provide some breathing space for monetary easing in the coming months. We maintain our forecast for 50bps worth of cuts, taking the benchmark repo rate to 7.50% by end-FY2012/13.

Thirdly, we maintain our above-consensus real GDP growth outlook for India for this year and next. To be sure, recent economic data has been disappointing and, as such, we have been forced to tone down our expectations of a near-term growth rebound in H2 FY2012/13 in recent weeks. Still, we have not wavered on our view that India's investment cycle is in the process of bottoming out, and that the consensus view had become overly bearish. From a longer-term perspective, we reiterate that India's growth downturn has been cyclical in nature and that the country does not face the structural downshift currently underway in neighbouring China and other parts of the region. While a return to the pre-crisis days of plus-8.0% is unlikely given the more challenging external backdrop, we continue to project real GDP growth of 5.9% and 7.2% in FY2012/13 and FY2013/14 versus Bloomberg consensus forecasts of 5.5% and 6.0%, respectively.

Rupee Gaining Paise
India - Exchange Rate, INR/US$

Staying Bullish The Rupee

One of our major conviction calls in H212 has been our bullish stance towards the Indian rupee, and following several weeks of consolidation, the unit has finally engineered a forceful break to the upside on the back of the reform measures and the QE3 announcement late last week. Looking ahead, we continue to see plenty of room for upside over the medium term. The currency remains cheap on a real effective exchange rate basis, sentiment lingers at bearish extremes, and external weaknesses are set to improve. Technically speaking, the currency faces decent resistance at the INR54.00/US$ area, a clean break of which would put our long-term target of INR48.50/US$ back into focus.

This article is tagged to:
Sector: Country Risk, Food & Drink, Infrastructure, Retail
Geography: India, India, India, India

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