Modi’s currency plan poses risk to growth

This article is part of
The Guide: Investing in Asia

Modi’s currency plan poses risk to growth
MSCI India vs Asian indices – one-year performance

In recent years India has been seen as one of the strongest markets in Asia, particularly since the election of Narendra Modi. But while many of his reforms have boosted investor sentiment on the country, last year’s decision to scrap 500 and 1,000 rupee notes in an effort to stem corruption has jeopardised recent economic performance.

The International Monetary Fund’s latest report on India highlighted the economy has recorded strong growth in recent years, helped by trade gains, positive policy actions and reduced external vulnerabilities. 

But it acknowledged: “The cash shortages and payment disruptions caused by the currency-exchange initiative have undermined consumption and business activity, posing a new challenge to sustaining the growth momentum. Growth is projected to slow to 6.6 per cent in the full year 2016-17, then rebound to 7.2 percent in 2017-18, due to temporary disruptions, primarily to private consumption, caused by cash shortages.”

Article continues after advert

It added: “A key domestic risk stems from the government’s currency-exchange initiative, where the near-term adverse economic impact of accompanying cash shortages remains difficult to gauge, while it may have a positive impact in the medium term.”

Sharat Shroff, co-manager of the Matthews India fund, admits investor sentiment was volatile in 2016 due to both global and domestic factors. While GDP growth seemed in line with expectations, corporate earnings were flat for most of the year amid low-to-moderate inflation expectations. 

“Defying fundamentals, the stockmarket continued to rally until prime minister Modi announced a major demonetisation of India’s mainstream currency bills and the US Federal Reserve raised interest rates, following which the market gave up its gains and settled at more reasonable levels,” Mr Shroff says. 

While the demonetisation appears to be a move in the direction of helping the majority of the population integrate with the financial system, the manager points out “its poor execution has led to social and economic backlash”.

He adds: “Current valuations are slightly higher than historical averages, despite earnings that have been depressed for the past several years. Earnings may continue to deteriorate in the near term, due to the negative demand impact of demonetisation, but should rebound once the government completes its note-printing exercise. 

“We believe the demonetisation has only postponed consumer demand as the country is slowly finding cashless solutions and innovative pooling methods to deal with its currency issues. In the long run this process can lead to a mainstream economy where more money is channelled into productive assets that create jobs and sustainable economic demand.” 

Sergey Dergachev, lead portfolio manager of emerging market debt at Union Investment, suggests in spite of headwinds, the general outlook for India remains mildly bullish.

Mr Dergachev says: “The economy is still on track and is maintaining strong growth momentum against other emerging market peers. A positive feature about India is that the Modi administration is actively attempting to implement reforms. Furthermore, India’s credit rating of BBB- is in solid territory. The risk of its sovereign rating being downgraded to junk status, which appeared imminent back in 2013, has been successfully reduced over time.”

Sanjay Sachdev, chairman of ZyFin Holdings, points out that among emerging markets India has materialised as one of “the most consistent and sustainable investment opportunities” in the past three years given its changing fundamentals.