“A moment comes, which comes but rarely in history, when we step out from the old to the new, when an age ends, and when the soul of a nation long suppressed finds utterance”. Thus spoke Jawaharlal Nehru, India’s first Prime Minister in his celebrated Tryst with Destiny address to the nation on the eve of India’s Independence in August 1947. While India woke up to life and freedom at the stroke of that midnight hour, successive Left-of-Centre governments never allowed India to attain its true economic freedom and her full growth potential. Between 1950 and 1990, India’s GDP growth Cagr was a low 4%. The economic reforms that helped India to elevate growth in the 1990s happened in large part due to the external crisis India faced then and ever since progress in reforms have been rather arduous as if in a ‘two steps forward and one step back’ mode. Nonetheless, GDP growth improved to 6.5% Cagr between 1990 and 2010. This momentum of positive change though broke in 2010 as the Congress led UPA-II recoiled back more vigorously to the centrist-socialist, entitlement driven, welfare-state model (partly to overcome the stigma that came from the revelation of a series of corruption scandals). The policy environment turned regressive, business sentiment soured, job creation nearly stagnated, investment cycle weakened, productivity waned and the resultant stress, as is well known, drove a slump in growth and spike in inflation over the past three years. There is little doubt that a large part of the pain was self-inflicted due to the faulty policies (or the lack of right ones), poor execution and bad governance of the outgoing government.
Figure 1: Key macro variables – FY91-96 (Congress), FY96-04 (Third Front, NDA), FY04-09 (UPA-I), FY09-14 (UPA-II)
Source: CEIC, IIFL Research
Notwithstanding all the complexities of the Indian polity, the business cycle postulate that the seeds of the boom are sowed in the bust seems true for cycles in politics too. A venal government (UPA-II) and a weak leader (PM Singh) sowed the seeds of public anger and disgust; born out of it was an overpowering desire to have a decisive and strong leader who could lead India out of the current economic morass. Lo and behold, Narendra Modi, with a proven track record of good governance and strong leadership in the state of Gujarat, stepped into the electoral scene as the beacon of hope. That beacon was powerful enough to break traditional determinants of electoral outcomes like caste-based voting; above all it appealed to the aspirations and yearning of the electorate for better living standards. The agenda of development and good governance, reinforced by an adroit, well-planned and robust electoral campaign eventually proved efficacious enough for the Modi-led right wing BJP to get voted to power with an absolute majority of its own. This is the first time in India’s post-colonial history that a party other than Congress has secured a majority of its own; and voters in large part decided to vote for a progressive growth agenda and seek freedom from Left-of-Centre, ‘povertarian’ politics. And no person was or has been vested with so much political authority as Modi, ever since the demise of Indira Gandhi in 1984, as the swing vote that enabled BJP to win so decisively was for him. The soul of the nation, so to speak, has yet again found its utterance.
Figure 2: BJP achieves absolute majority (272+) of its own for the first time in India’s history
Source: Election commission of India, IIFL Research
Make no mistake; the outcome of the May14 elections and the elevation of Modi as the Prime Minister heralds a tectonic shift in India’s political and economic history, a new tryst with destiny. Here is it why.
Modi is moving to Delhi for the long haul. He is a man with a lot of ambition backed by copious energy, a will to work hard, boundless passion, an unwavering focus on achieving goals and one who revels in winning again and again. His goal will be to remain the Prime Minister of India not for one term but for more. In him, perhaps India has found a PM not just up until 2019 but much longer. Such long-term assertions no doubt carry risks, but the probabilistic case of it turning out to be true is neither insignificant nor unremarkable if one were look at his more than a decade long track record of winning multiple elections in Gujarat. Unlike Rajiv Gandhi who, despite having no administrative experience, strode to power on the back of a sympathy wave (on account of his mother’s assassination; he blew away that opportunity in the very next election in 1989), Modi earned it the hard way having successfully fought multiple elections on the basis of his administrative performance.
To believe that his focus would be to boost his chances of winnability ever again means that he has but to think long-term, as he has done during his 12 year tenure as Chief Minister in Gujarat. He simply cannot afford to do anything that can potentially derail that goal, especially with the heightened scrutiny by the coterie of intelligentsia orphaned by the change in regime. As luck would have it, he has the gift of an absolute majority in the Lok Sabha and has the luxury of pushing through tougher long-term reforms unconstrained by the compulsions of coalition politics. No other PM in the past quarter of a century has had such an opportunity; and unlike others Modi earned it. A disciple of Swami Vivekananda and a staunch believer in karma yoga, he is less likely to fritter away this historic opportunity and more likely to put it to best use.
Modi’s eternal fixation on development and good governance helped him earn popular support in Gujarat; and that agenda has to a large extent catapulted him to the top political post in the country. Unlike most of his predecessors, he is neither an “Accidental Prime Minister” nor is he privileged by birth to belong to one of the modern political dynasties. He directly went to the electorate entreating to elect him as the PM, not just highlighting the accidents that arose from having an accidental Prime Minister and the ills of perpetuating a dynastic rule in a democracy, but with the promise of providing decisive leadership and turning the poorer regions like UP, Bihar to one as good as Gujarat. Having won the mandate on the back of such promises, he now carries the onus to meet the expectations of voters. It is only fair to assume that his top priority would be to do all that is needed to accelerate growth and improve governance.
The Prime Minister’s office (PMO) is the most critical functionary in the government and the PMO derives its strength from the political authority of the Prime Minister. The key reason why UPA became dysfunctional was because it had a PM with little political authority and coalition compulsions further debilitated it; more often than not, different arms of the government worked in a disjointed and uncoordinated manner, sometimes at cross-purposes. It is akin to having a CEO with neither the required authority to run the company nor the accountability that’s expected of a person in that role. In striking contrast, backed by a landslide electoral victory Modi comes with possibly as strong a political authority enjoyed by any Prime Minister in the past three decades. A strong PMO bodes well for a well coordinated functioning and better control over the various ministries and arms of the government.
For the past twenty-five years, the federal government in Delhi was run by coalitions, with no single party having had a majority of its own. Some of these coalitions were forged together between parties of different ideologies and running the government involved compromises galore. The 1990s saw the collapse of two governments much before their 5 year tenure, due to sudden withdrawal of support by one or other partners. To a reasonable extent, the “two steps forward, one step back” syndrome arose due to compromises that had to be made between coalition partners, as the overriding objective was to prolong one’s stay in power. The whims and fancies of a few of the larger coalition partners dictated at times the economic policy making of the government. Some of the larger scams of the UPA regime, like the coal and the telecom ones happened due to the venality of the coalition partners and the inability of the lead party and the PMO to rein them in. In the process, good governance got badly compromised and as a consequence, decision making stalled and growth momentum weakened. The tyranny of coalition management and compromises now stands broken with BJP having secured a majority of its own. With no room for excuses, Modi has little choice but to deliver.
The Opposition in the newly constituted Lok Sabha would perhaps be the weakest since 1989. The Congress Party is the lead opposition party but has just 44 seats (or 8% of the total strength) in the house. Having secured less than 10% of seats, the Congress Party has lost even the constitutional right to appoint a Leader of Opposition. Juxtapose this with the 282 seats of BJP and 336 seats of NDA. The rest of the opposition is splintered between a large number of regional parties and if one excludes the two large ones (ADMK from Tamilnadu with 37 seats and Trinamool from West Bengal with 34 seats), the tail is indeed a long one. The Modi-led government is thus in a much better position to successfully transact legislative business in Lok Sabha. The NDA is still a minority in the Rajya Sabha, the upper house of Parliament; in a deadlock, it can always call a joint session of both the houses if needed. All said, putting through tougher legislations or raising the productivity of the Parliament should not be as difficult a task as it was for the past few governments.
The basic ethos of BJP is built around the Right-of-Centre framework. India is all set to move away from Nehruvian socialist planning model; it is a well known fact that for the large part of the last seven decades, policy making edifice was built on the foundations of this model. This effectively means that the government will gradually move away from an era of entitlements based welfare state model to a more progressive agenda of accelerating growth and job creation, reviving the investment cycle and having a strong focus on efficient execution and implementation of policies. Modi is personally a great believer in this as illustrated by the growth mantra he unwaveringly adopted while running the state of Gujarat. This policy shift is a diametric and material one that has positive long-term implications on India’s long-term growth potential.
The roadmap for the economy and equity markets
Making long-term forecasts is a mug’s game and invariably fraught with too many uncertainties and risks. All long-term forecasts are nothing but a qualitative assessment (of the person who makes it, subject to his biases and prejudices) with little quantitative data to back up, an attempt which analysts are recommended to avoid. Be that as it may, given our hypothesis that the arrival of Modi is a turning point in India’s political and economic history, our surmise for what could potentially happen over the next five years is as follows:
India’s long-term growth potential will rise. Like the proverbial Gulliver tied down by little Lilliputians, India’s growth potential has been constrained by a number of factors linked to the socialist and centralized control model that India has adopted all these years, rendering India as a country that “grows stealthily at night”. Modi is a man who believes in untying these knots and he is backed by the authority to do what he believes. It is fair to assume that the policy environment will turn progressive and conducive and that will drive a turnaround in business sentiment and investment cycle. India’s GDP growth on a structural basis is now upward sloping.
Both revenue and fiscal deficit will head down. As we highlighted in our previous notes (please see “How bad is the fisc” dated 14th May, 2014 for the most recent commentary), growth is one panacea that can help remove the stress on a number of macro variables and in particular, fiscal deficit. The elasticity of tax collections to marginal changes in real GDP growth is high and as we saw during the high growth phase of FY05-08 period (annual tax collections grew 7ppt higher than nominal GDP when real growth averaged at 8-9%), tax revenues will more than proportionately rise when real growth picks up. In FY14, taxes as a % of GDP was 10.8%, almost 1.2% lower than the FY08 peak. Given the basic ethos of BJP to move away from an entitlement model, expenditure management will be better. Cumulatively, this will help rein in deficits and government borrowings.
Inflationary pressures will ease. Three key reasons why inflation remained elevated in the past few years are: a sharp worsening in revenue deficit (and consequently, fiscal deficit), ever exacerbating supply side bottlenecks and linked to that, poor quality of growth. Between FY08 and FY14, India’s revenue deficit jumped from 1.6% of GDP (Rs806 billion) to 3.3% (Rs 3,703 billion), entailing a sharp rise in government borrowings. A slump in investment cycle and faulty policies in the agricultural sector aggravated supply side bottlenecks. And with a large part of the growth driven by private and government consumption and not by investments, quality of growth deteriorated; productive investments are needed to sustain higher growth without stoking inflation. A fall in ICOR from the current elevated levels will drive improvements in capital productivity. While the steps that the new government takes may take time to play out, it is suffice to say that inflationary expectations will progressively get anchored at lower levels.
Investments and savings will rise, cost of capital will come down. Lower government dissaving will drive up overall savings and that will feed onto a virtuous loop of rising savings and rising investments. Savings are down by 8% of GDP from the peak, while investments are down 7%; the declining trend in both will reverse. Higher savings would enhance the ability of banks to lend more thereby creating an enabling climate for higher credit growth. Against the backdrop of a stable political and progressive policy environment, foreign capital flows will remain buoyant. This will not just induce growth reflexivity but also have a benign impact on savings. Coupled with a likely fall in India risk premium, long-term cost of capital will come down.
Equities are in a sweet spot. Of all macro variables, corporate earnings are most elastic to changes in real growth (see our note ‘What drivers corporate profit growth’ dated 10th April, 2013); understandably so, as the cyclical sectors are the most levered. As real growth picks up, earnings will see upgrades and capital efficiencies will get better. Improving earnings outlook, rising RoE and falling cost of capital will drive a more sustained valuation re-rating. Despite the big run up in the past few weeks, markets are still reasonably valued (Nifty trades at FY15 PER 16x, FY16 PER 14x). The near-term risks are more external than internal, in our view.
Our sanguine view as exhibited above does not mean that India has no challenges to overcome. Right from addressing the health of the Indian banking system to undoing the damage done in the past few years, the new government has a lot on its plate. The comforting factor is that we have a competent steward to see us through from the rough to the halcyon. And the liberated soul of the nation to back him!
Source: IIFL Institutional Equities
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