India was labelled one of the so-called Fragile Five1 (i.e., countries with unsustainable twin deficits: a current-account deficit and a government budget deficit) only about three years ago. This was during the “taper tantrum,” when U.S. Treasury yields surged as a result of the U.S. Federal Reserve Bank’s announcement to gradually reduce the amount of money it was injecting into the economy through quantitative easing.
India’s current-account and fiscal deficits were large, inflation was high, and the subsequent capital outflows led to a sizable depreciation of the Indian rupee. The economic slowdown that followed translated to an increasing number of non-performing loans on banks’ balance sheets as corporate profits dwindled.
India Embarks on a New Path
Only three years after this episode we have a very different narrative for India. It had one of the largest current-account adjustments among the Fragile Five and the government embarked on a fiscal consolidation path, albeit gradually. The decline in inflation from almost 10% at year-end 2013 to 3.4% by the end of 2016—also aided by the sharp drop in commodity prices—allowed the central bank, the Reserve Bank of India (RBI), to cut rates by a cumulative 175 basis points since early 2015.
In our view, what makes India a bright star among emerging markets is, however, more than this overdue macroeconomic adjustment. An impressive set of reforms, most desperately needed, are changing the narrative going forward beyond the current-account adjustment:
- Taxes, subsidies and spending: A goods-and-services tax (GST), similar to a value-added tax (VAT), was recently introduced and will for the first time create a unified internal market in India. (Historically, India has had different state taxes, which made doing business and investing across states difficult.) Substantial energy-subsidy reforms reduced fiscal spending.
Social spending on the impoverished segment of the population is now more efficient, thanks to an advanced identification system. It is also expanding financial inclusion to cover millions who had never had any formal banking relationship. A bankruptcy law was passed and made room for much-needed corporate restructuring. In the process, mighty state banks are, for the first time, subjected to some governance reforms and their recapitalization is tied to performance.
- Business and investment: Foreign direct investment (FDI) is now more liberal—including investment in retail, infrastructure, insurance, defense, and communication—and progress has been made to improve the regulatory environment to make doing business in India easier. When key reforms, such as the land reform, proved difficult to pass at the central government level because of a divided parliament, a healthy competition among states opened up new possibilities to reduce investment backlogs.
- Monetary policy: A flexible inflation targeting framework was adopted by the RBI. As part of this new monetary policy framework, policy rates are now decided by a monetary policy committee rather than just by the RBI’s governor.
All of these reforms were achieved at average annual growth rates of 5.8%―clearly lower than before, but still the envy of other emerging markets (Exhibit 1).
Despite Challenges, India Remains Resilient
This is not to say that India’s challenges are over. It still has a high level of government debt compared to its peers, which will continue to limit its options for fiscal expansion for some time. Corporations in some heavy industries and infrastructure remain highly leveraged, and especially state banks, after some write-offs in 2016, remain saddled with non-performing loans. Inflation expectations remain uncomfortably sticky at levels above the RBI’s target of 4% +/-2%.
From a short-term perspective, fixed income investors may just look at the current macroeconomic cycle and shrug. After all, the government’s currency-exchange policy for large denomination bills (i.e., the removal of certain bills from circulation to thwart counterfeiting) had a negative impact on consumption, the key driver of growth over this cycle. In a cash-based society, we believe this policy may slow growth for at least two quarters.
The policy comes at an inopportune moment, in our view. Oil prices are beginning to refuel inflation again, after the positive effect they had during their decline since 2014. Additionally, the rest of the world is bracing for several interest rate hikes by the U.S. Federal Reserve Bank. The RBI clearly moved to a neutral stance from its accommodative policy in February, and could well stay on the sidelines over the coming quarters.
Yet India is positioned to shine nonetheless, for several reasons:
- Remonetization: The so-called demonetization (the act of stripping a currency unit of its status as legal tender) is behind us and the economy is remonetizing fast. Indeed, the last quarter’s gross domestic product (GDP) number surprised on the upside and suggested that the impact may be more limited than feared. In the medium term, the remonetization policy should help reduce corruption and expand the tax base, while moving consumers to more efficient electronic transactions.
- Wage increases and agriculture reforms: The recent wage increase and housing benefits for civil servants will be there to support incomes and consumption, while supply-side reforms in agriculture should help limit the ever-present risks of a spike in food inflation.
- Fiscal policy: The fiscal budget announced recently struck the right balance between continued consolidation and growth-supportive expenditure, especially in infrastructure and the rural economy, where about 50% of the Indian labor force is employed. There is another important set of fiscal reforms being baked in the government’s various committees. We believe these reforms, through fiscal deficit targets, could help reduce India’s high debt-to-gross domestic product ratio to 60 over the medium term—a more comfortable level for an emerging market like India.
- Structural reforms: More importantly, several of the reforms that were passed in 2016 (such as the GST) are just getting started, and their potentially positive impact is still ahead of us. The implementation of the GST in the second half of the year will be an especially big positive. Corporate restructuring through banks, as well as through India’s new bankruptcy code, should take hold later in the year. FDI flows are already showing good signs despite significant portfolio outflows since last November. Last year, FDI was higher than the current account deficit, and there is clearly room for it to increase with more liberalization.
- Trade: Last, but not least, in the current global environment of uncertainty, we believe India’s trade linkages to the United States and its overall trade composition is significantly more insulated from adverse shocks to global trade than other peers.
For a country with low per-capita income and double-digit poverty rates, more structural reforms remain essential to reap the benefits of sustainable and more equitable growth. With a young population that has the potential to provide tailwinds to such growth, a rarity in an aging world, India’s story is just beginning.
But don’t expect a “big bang” any time soon. This is not China’s World Trade Organization (WTO) “moment” that ushered it onto the world stage. Given India’s democratic system, we expect reforms to be gradual but meaningful over the long run.
Investment Opportunities in India: A Look Ahead
India is not for the short-term investor, but we believe there are opportunities to be pursued over the long haul.
We maintain our favorable view of government and corporate fixed income securities of medium to long maturities and denominated in local currency. Additionally, we’re keeping a watchful eye on the Indian rupee for tactical hedging opportunities to capitalize on currency fluctuations.
1 South Africa, Turkey, Indonesia and Brazil are the remaining Fragile Four.↩
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Fixed income investing entails credit and interest rate risks. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Emerging and developing market investments may be especially volatile. Investing significantly in a particular region, industry, sector or issuer may increase volatility and risk.