Summary

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  • Prime Minister Modi is embarking on an ambitious structural reform agenda, which includes last November’s shock decision to withdraw and replace certain banknotes in circulation (demonetisation), in an attempt to tackle corruption
  • There has been a short-term hit to the economy. However, recent activity data has been firmer than expected
  • US policies pose risks to India, and to emerging markets more generally. However, in our view, India is well positioned to withstand risks of higher US interest rates, whilst its economy is relatively less dependent on exports, an important shield against any potential rise in global protectionism
  • The Goods and Services Tax (GST), a landmark indirect tax reform, will likely drive significant long-term benefits. This year will also see the rollout of other key reforms such as a new bankruptcy law, and expansion of the Direct Benefit Transfer (DBT) scheme, boosting financial inclusion
  • For Indian equities, the year-to-date rally has compressed the implied equity premium. Valuations now no longer look anomalous, however economic activity remains resilient and we expect a modest appreciation in the rupee over the medium-term
  • Meanwhile, Indian local currency bonds offer a relatively high carry relative to competing asset classes, and a decent premium over local cash rates. The RBI’s commitment to its 4 per cent inflation target is a positive. An extremely low share of foreign ownership also insulates the market from any potential rapid shift in global investor sentiment. In our view, these factors make Indian bonds an attractive proposition among local EM debt markets, and justifies an overweight position in multi-asset portfolios

The recent twin shocks to the Indian economy…

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Indian equities had a difficult end to 2016, with the MSCI India index declining 6.4 per cent over Q4 (in local currency terms). This poor performance was predominantly driven by two factors.

First, emerging market (EM) assets came under broad selling pressure following the victory of Donald Trump as US president. Trump’s outspoken advocacy of a fiscal stimulus package for the US economy – which is already close to (or at) full employment – boosted market expectations of a more rapid Federal Reserve hiking path. This would adversely impact EMs with large external financing needs and large US dollar debt piles. Concerns also centred on Trump’s isolationist US economic and foreign policy stance, raising fears of increased global trade protectionism. This would likely weigh on growth prospects for trade-dependent EM economies.

Second, on 8 November – the same day as the US election – the Indian government shocked financial markets. It announced INR500 and INR1,000 banknotes, worth around 86 per cent of total currency in circulation, would be withdrawn, to be replaced by new INR500 and INR2,000 notes. By forcing citizens to replace their banknotes, the scheme aims to flush out income illegally obtained or not declared for tax purposes (so called “black money”), remove counterfeit currency, whilst also promoting digital banking and financial inclusion.

Whatever longer-term benefits the scheme may bring about, the short-term impact has been disruptive. The resulting cash shortage has dampened consumer spending, particularly in cash-intensive sectors such as retail, hotels, restaurants, transportation, and construction. Many of the worst affected businesses operate in the "unorganised" sector. Given the use of “black money” and the cash-intensive nature of real estate transactions, activity in this sector has also been hit. Meanwhile, supply chain disruptions and a dip in business sentiment have hindered private investment.

…are unlikely to prove lasting headwinds

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Despite these “twin shocks” to the economy, there are a number of reasons for optimism, reflected in a strong year-to-date rally in the country’s equity markets.

Since Donald Trump’s election, doubts have grown over the extent of his isolationist stance, as well as his ability to push fiscal stimulus through Congress.

Recent Indian activity data and corporate earnings results have proved firmer than expected. In particular, having fallen sharply in November and December, the composite PMI and auto sales rebounded in the first three months of the year. Major port cargo and railway freight volumes have also improved. Meanwhile, December-quarter GDP growth slowed only slightly, to 7.0 per cent year-on-year from 7.4 per cent previously.

Looking ahead, growth this year should also find support from the lagged impact of lower Reserve Bank of India (RBI) policy rates. The post-demonetisation easing of liquidity conditions should help feed into lower lending rates.

Also positive, the government’s budget for fiscal year 2018 [1] (FY18) focuses on boosting infrastructure and affordable housing, as well as the rural economy. Pent-up consumer demand could also be unleashed as demonetisation-related disruption ebbs.



[1] April 2017 – March 2018

India is also less exposed to external risks

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India is likely to be resilient to any potential global shift toward protectionist policies. Indian exports account for only 11.3 per cent of GDP, one of the lowest rates among major emerging market economies, and second only to Brazil (Figure 1).

Furthermore, India is in a fundamentally strong position to tackle external uncertainties. The current account has seen a significant improvement, moving from a deficit of 4.8 per cent of GDP in FY13 to now being roughly balanced. This makes the country less reliant on external financing. Additionally, the country’s foreign exchange reserves as a ratio of short-term external debt is above 4, indicating a more than sufficient ability to cover short-term external liabilities. US dollar-denominated debt in the corporate sector (as a per cent of GDP) is also low by EM standards.

However, Indian IT services and business process outsourcing (BPO) sectors are exposed to the risk of tighter US immigration restrictions (including around H1B visa regulations [2]) and/or border adjustment taxes.

In 2014, about 86 per cent of H1B visas were issued to hire IT professionals from India. Indian IT services firms earned about 60 per cent of their export revenues from the US last year.

Figure 1: Emerging market degree of global integration

Source: HSBC Global Asset Management, Global Investment Strategy



[2] A non-immigrant visa which allows US employers to temporarily employ foreign workers in specialty occupations

Structural reforms bolster long-term growth prospects

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In the longer-term, growth prospects remain supported by Prime Minister Modi’s ambitious reform agenda (see Appendix for details). Modi’s Bharatiya Janata Party (BJP) scored a sweeping win in the recently concluded state assembly elections. With these victories, states accounting for around 58 per cent of India’s population and 54 per cent of its GDP will be governed directly by BJP and its allies. This should help the Modi government push key reforms and improve the implementation of existing schemes. The elections were also seen as a referendum of sorts on the demonetisation plan, and the results may be interpreted as an endorsement of that move.

Demonetisation should help improve tax compliance, accelerate financial inclusion, formalise economic activity, and promote the digital economy. There is already evidence of increased digital transactions. At the time of writing, more than 20 million people have adopted the Bharat Interface for Money (BHIM), a biometric mobile payment application launched by the government in December 2016 to promote digital transactions. Over 6 million users transact through the app regularly. Other government initiatives include the BHIM ‘Aadhaar Pay’ system, launched on 14 April, which enables people without debit or credit cards (or even mobile phones) to make cashless payments using their Aadhaar, or unique identification (UID), number.

Due to be rolled out on 1 July, the landmark Goods and Services Tax (GST) – which removes intra-state tax barriers and simplifies administrative procedures – may cause some initial disruption as businesses adapt to the new system. However, in the medium-to-long term, the GST should help bolster the ease of doing business in the country, boost productivity gains, and result in structurally lower inflation. Meanwhile, other anti-corruption measures (e.g. the income-declaration scheme) may boost tax revenues, supporting India’s fiscal health.

This year will also see the rollout of other key reforms, such as a new bankruptcy law, which consolidates various laws relating to bankruptcy proceedings. This should enable speedier insolvency resolution (for both corporates and individuals), helping improve the ease of doing business in India. This is also likely to bolster many banks struggling under the weight of non-performing assets (NPAs), giving them a legal path for debt recovery in a time-bound manner. Importantly, this may aid credit growth in the economy.

Meanwhile, expansion of the Aadhaar-based Direct Benefit Transfer (DBT) scheme – in which subsidies and welfare benefits are directly channelled to beneficiaries’ bank accounts – should help plug fiscal leakages. It also provides a platform to extend financial inclusion to bottom-of-the-pyramid consumers.

The latest budget also saw the government confirm it is abolishing its Foreign Investment Promotion Board, often seen as an obstruction to foreign companies in their efforts to invest in the country. Indian finance minister, Arun Jaitley, has also said the government is considering further liberalisation of Foreign Direct Investment (FDI) rules.

Less positively, progress on land and labour reforms has been limited, although some states have eased labour regulations and passed legislation for streamlining the process of land acquisition for investment projects. Private sector capital expenditure growth also remains sluggish, on the back of low capacity utilisation and weak balance sheets. The populist farm loan waiver programme will be rolled out in the state of Uttar Pradesh. There is growing demand for such a move in other states, although this may impact incentives for borrowers to repay, and would have negative fiscal implications. The general government deficit also remains high by international standards, limiting the room for fiscal policy to support the economy.

Overall, however, the government’s emphasis on fiscal discipline, with a focus on improving the efficiency of spending, the mobilisation of tax revenues and the effective targeting of subsidies paves the way for lower inflation and greater macro stability.

Investment Implications

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Overall, for Indian equities, the year-to-date rally has compressed the implied equity premium. Valuations now no longer look anomalous. However, there is positive economic growth momentum amid ongoing remonetisation, whilst a credible reform agenda and structural tailwinds (including demographics, improving infrastructure, urbanisation, a rising middle class, etc.) add to the positive cyclical picture. Furthermore, India benefits from a relatively closed economy in the face of any potential rise in global protectionism. We also expect a modest appreciation in the rupee over the medium-term, from which foreign investors would profit.

In a world of low global yields, Indian local currency government bonds offer a relatively high carry relative to competing asset classes, and a decent premium over local cash rates. They also provide an attractive diversification option in multi-asset portfolios. Furthermore, we believe the RBI’s commitment to its 4 per cent inflation target is a positive, both for Indian bonds and the rupee in the medium-term. Amid heightened global uncertainties, India local currency government bonds also benefit from an extremely low share of foreign ownership (Figure 1). Government bond limits for foreign buying have also been relaxed recently. In our view, these factors make Indian bonds an attractive proposition among local currency EM debt markets, and justify our overweight position in multi-asset portfolios.

Appendix: Selected key Modi reforms

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Bankruptcy law/bank NPAs

Single law governing insolvency and liquidation proceedings, providing legal basis for debt recovery and speedier bankruptcy resolution

Once fully implemented, the new bankruptcy code will help improve ease of doing business in India, deepen bond markets and solve non-performing asset (NPA) issues of the banking sector.

NPAs are being addressed through various restructuring mechanisms (e.g. "Scheme for Sustainable Structuring of Stressed Assets S4A") as well as an Asset Quality Review which has led to realistic recognition and enhanced provisioning

Prompt Corrective Action (PCA) norms tightened. The PCA imposes restrictions on banks falling below thresholds on asset quality, capital or profitability

Improving governance in public sector banks

Demonetisation

Old bank notes in denominations of Rs500 and Rs1000 withdrawn and replaced with new bank notes

A move to curtail corruption, black money and counterfeit currency

Will help integrate the parallel economy with the formal economy; encourage a shift in household savings from physical towards financial assets; and promote the move toward a digital economy

Crackdown on benami transactions/property deals

Ease of Doing Business

Online environment and forest clearance approvals

Single web portal for online registration of units, reporting of inspections

‘Make in India’ campaign to attract FDI and create global manufacturing hub, aimed at increasing the share of manufacturing to 25 per cent of GVA by 2025 (from 16 per cent currently)

Validity of Industrial License extended from two years to three years Self-certification by citizens instead of affidavits

Energy/subsidies

Diesel price deregulation

New gas pricing formula

JAM (Jan Dhan-Aadhaar-Mobile) trinity plan - initiative to link Jan Dhan accounts, Aadhaar and mobile numbers to directly transfer subsidies to intended beneficiaries and eliminate intermediaries.

Better targeting of subsidy and welfare benefits will help curb corruption, cut leakages, enable fiscal savings and reduce the fiscal deficit in a structural manner

Direct benefit transfer (DBT) for LPG (cooking fuel) subsidy

DBT pilots are ongoing for kerosene, food and fertiliser subsidies and for payment under the employment guarantee scheme.

FDI

Liberalisation of FDI limits in railways (to 100 per cent), defence (to 49 per cent) and insurance (to 49 per cent)

Liberalisation of FDI norms in 15 sectors: construction (reduced project size and minimum capital requirement), airlines, defence in automatic route, broadcasting, plantation, single brand retail can sell through e-commerce, fungibility of investment limited for private banking)

Abolition of Foreign Investment Promotion Board (FIPB) - a move towards further easing of regulations, and potentially including more sectors in the automatic route of foreign investment

Financial inclusion

Financial inclusion plan (Pradhan Mantri Jan Dhan Yojana; PMJDY) - over 270 million bank accounts already opened since September 2014.

Launch of government-funded pension and insurance schemes

Goods & Services Tax (GST)

Expected to be implemented from 1 July 2017. A comprehensive indirect tax reform helping boost the ease of doing business via simpler tax administration and removal of intra-state tax barriers; raise tax collection; improve corporate logistics efficiencies; boost productivity gains; and result in structurally lower inflation

"Housing for All" scheme/Affordable housing

A government programme unveiled in 2015 aimed at building 20 million houses by 2022 to address housing shortage.

A credit-linked subsidy scheme (CLSS) - on home loans of eligible urban poor for acquisition and construction of houses

Aadhaar to be used for validation of beneficiaries of the scheme

Measures from the FY18 budget to support affordable housing (additional fund allocation, infrastructure status which could enable developers operating in this segment to raise loans at a cheaper rate, akin to other infrastructure projects, etc.)

Inflation/agriculture

Formal inflation targeting on headline CPI at 4 per cent +/-2 per cent for the years until March 2021. This, together with the setting up of Monetary Policy Committee of the Reserve Bank of India, improves the institutional framework for monetary policy to strengthen transparency, continuity and independence

Included onions & potatoes under Essential Commodities Act, 1955

Reform of Agricultural Produce Market Committee Act

Effective food supply management (restructure Food Corporation of India; set up a price stabilisation fund; etc.)

Modest minimum support price (MSP) hikes; imposed restrictions on states to announce additional mark-up over MSP

MSPs were raised and effective procurement mechanism was put in place to encourage pulses cultivation

Irrigation package (INR500bn) for next 5 years

Agri-Tech Infrastructure Fund (INR2bn) to integrate agricultural markets across the country through a web-based platform

Infrastructure

InvIT (Infrastructure Investment Trust); incentivise REITs

National Investment & Infrastructure Fund (INR 200bn) set up to incentivise infrastructure development in commercially viable projects, from both domestic and international sources

100 smart cities; Urban renewal scheme (AMRUT)/Rurban Mission: 300 'smart' village clusters by 2022

E-auction of coal mines; commercial coal mining; amended mining laws to allow auctioning of non-coal mines. Helps tackle corruption

Power distribution companies (DISCOMs) revival package UDAY (states held responsible, reducing banking sector stress, improving power offtake)

Five-fold increase in solar power capacity target to 100GW by 2022

Telecom spectrum trading approved

Roads: one-time capital infusion into BOT road projects, 100 per cent equity divestment two years after construction completion

Sagamala port development project

National fibre optic grid

Banks to issue long-term infrastructure bonds with no statutory pre-emption

Source: HSBC Global Asset management, as of April 2017

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