Modi era: The roadmap for the economy and equity markets

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.

May 23, 2014 5:19 IST | India Infoline News Service
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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