Do Modi’s reforms herald an economic breakthrough?

This article is part of
Emerging Markets - November 2014

For those in the international community interested in the region, India’s general election has been the story of the year.

Observers have been encouraged both by the size of prime minister Narendra Modi’s majority – which has effectively removed the paralysis that a long series of Indian coalition governments have faced – and his administration’s reform aspirations.

Some are sceptical because the previous government failed to deliver on its reforms. But there are many reasons to suggest things are different this time, and that the political and economic environment is set right for international investors to benefit from the growth of well-run and fairly valued companies.

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India’s recovery was in fact already underway as the political guard was changing. Its GDP had accelerated to a two-year high of 5.7 per cent in the second quarter of 2014, driven by growth in the services industry. Industrial production has been expanding at a healthy pace for a few months and inflation has been moderating.

In the year to the end of September, foreign reserves have increased by approximately $4bn (£2.5bn) to roughly $316bn. The rupee has also been trading in a tight range and confidence has been restored in the currency.

The government’s priorities are inflation moderation, infrastructure, manufacturing, job creation and fiscal consolidation. Fiscal consolidation is a key focus; the 2015 financial year target is pegged at 4.1 per cent of GDP and, by reducing subsidies and increasing tax collections, the aim is to bring this down to approximately 3 per cent by 2017.

Mr Modi’s government has rightly focused on plucking a few low-hanging fruits first, the largest being clearing a pile of stalled infrastructure projects to push growth. Projects of up to $100bn have been cleared in the past few months.

The subsidy on diesel fuel has now been abolished with monthly price increases effective since January 2013.

Already, measures have been taken to increase the foreign direct investment limit in the defence sector and in railways, and labour laws have been tweaked to make conducting business easier for companies.

Equity valuations do not entirely reflect the benefits of the range of reforms and measures underway. Valuations are no longer at the distressed levels seen in the third quarter of 2013 and have normalised to historic mean levels, but from many perspectives they are only at fair levels now and are not stretched.

Consensus estimates suggest earnings growth is expected to be approximately 16 per cent for the current and next two calendar years, up from the single-digit growth of the past three calendar years. This does not yet reflect any meaningful earnings upgrades.

History suggests that analysts’ revisions usually lag the market. With the expected expansion in economic activity, companies with operating leverage and strong cashflows particularly can witness significant upside to their earnings estimates.

Cyclical sectors such as financials, industrials and the consumer discretionary space tend to benefit from growth recovery phases. Some of these areas have already proven their worth for investors in India; examples include selected banks and beaten-down companies active in the Indian industrials space, which were poorly valued in 2013 and have come back into favour more recently.