1. Art and Diseño

India and Mr. Modi:
After the Honeymoon
Geoff Lewis, Ian Hui and Tai Hui
January 2015
India and Mr. Modi: After the Honeymoon
SYNOPSIS
Key observations
Key implications
What has India's new leadership done since coming to
power?
As long as the Indian economy remains on a cyclical
recovery track and Mr. Modi persists with his reform
agenda, we believe the start of U.S. interest rate
normalization by the Fed in 2015 poses a limited threat to
India’s capital account. While a gradually rising U.S. dollar
may be a headwind in 2015, it is unlikely to prompt large FII
outflows in India’s case, a country blessed with good
fundamentals and a strong secular domestic growth story.
The medium-term outlook remains highly positive.
• Mr. Modi seems to be taking a long-term view towards
India’s structural problems.
• So far, the majority of policy measures tabled are neither
surprising nor breathtaking. They are being implemented
across a broad front. Big reforms are expected to be
relatively few.
• A selection of reforms include greater co-operation
between state and central governments, revamping the
tax system, improving administration allowing greater
accessibility and ease of doing business, labor market
reforms and furthering financial inclusion.
How has India and its economy responded?
• Raising economic growth from multi-year lows, taming
inflation and getting previously spiraling external and
fiscal deficits under control are four key macro economic
goals. There has been reasonably good progress in 2H
2014 on all four fronts.
• India’s growth prospects already appear to be changing
for the better, with forecasts for an uptick in consensus
GDP growth in 2015 to 6% plus.
• Inflation has seen a conflux of fortunate factors to bring
it under control.
• The fiscal deficit issue is now seen as much more
contained.
What issues do they still need to be aware of and keep in
mind to tackle?
• From here on, much will depend on the pace at which
Mr. Modi can implement his reform agenda and how his
policies begin to have an impact over the medium-term.
• Sustaining CPI inflation below 6% through 2015 as
economic growth accelerates with the business cycle and
a relatively small output gap begins to close could still
prove challenging.
• Fiscal healing is still a very gradual process. Central
government fiscal targets are still likely to overshoot.
• The possibility of headwinds from a rising U.S. dollar and
the normalization of Fed policy.
2 | India and Mr. Modi: After the Honeymoon
Risk
• Weaker-than-expected recovery in private sector capex
and thus productivity
• A surprise rebound in world oil prices and the return of
inflation
• Corporate earnings that remain slow to recover from the
cyclical pressures of 2012-2014.
What to watch for
• For equity investors, the key near-term issue will be how
long it takes before corporate profits and margins start
to respond to the improving economy.
• Investors in Indian equities should stay focused on
domestic cyclicals, such as cement, materials, metals
and autos, infrastructure plays and private sector
financials, instead of exporters and defensive sectors like
utilities. In 2015 we expect new support for domestic
cyclicals and capex stocks from declining short-term
interest rates.
Geoff Lewis
Executive Director
Global Market Strategist
Geoff Lewis, executive director, is a Global Market Strategist based in Hong Kong. With over 25 years of
experience, Geoff is a frequent guest on Bloomberg, Reuters and CNBC, and is often quoted in the financial
press. He provides timely insights on the Asian economies and markets to clients and media across Asia,
and is a key speaker at investment conferences and seminars. He joined the firm in 1999 as Head of
Investment Services. Prior to joining the firm, Geoff served as Asian Regional Economist with Dresdner
Kleinwort Benson. Geoff began his career in 1970 as an Economic Adviser with the UK Treasury and was
seconded to the Japanese Government’s Economic Planning Agency in Tokyo. Geoff obtained a B.Sc and an
M.Sc. in Economics from the London School of Economics.
Ian Hui, associate, is a Global Market Strategist. Based in Hong Kong and an employee since 2012, he is
responsible for delivering market analysis and insights as well as regular publications and fundamental
research on the global economy and capital markets. Prior to joining J.P. Morgan, Ian was at AXA
Investment Managers as an Investment Analyst in the Tactical Asset Allocation Team, assisting with
economic research and asset allocation decisions. Ian obtained a Bachelor’s degree in Commerce majoring
in Econometrics and Finance from the University of Melbourne, Australia.
Ian Hui
Associate
Global Market Strategist
Tai Hui
Managing Director
Chief Market Strategist Asia
Tai Hui, managing director, is the Chief Market Strategist Asia, based in Hong Kong. With over 10 years of
experience, Tai is a frequent guest on Bloomberg, Reuters and CNBC and is often quoted in the financial
press. He formulates and disseminates J.P. Morgan Funds’ view on the markets, economy and investing to
financial advisors and their clients in the Asia region. Prior to joining J.P. Morgan, Tai served as the
Regional Head of Research (Asia) with Standard Chartered Bank in Singapore, covering the economic and
financial development of the Asia region and delivering his analysis to corporate and institutional clients.
Tai obtained a Master of International and Public Affairs from the University of Hong Kong and a BA in
Economics from Cambridge University.
J.P. Morgan Asset Management | 3
India and Mr. Modi: After the Honeymoon
TABLE OF CONTENTS
India and Mr. Modi: After the Honeymoon
In brief
5
Progress check
5
Policy and reform measures in abundance
6
Making India's current systems work better
8
How is India's economy responding to “Modinomics”?
8
Kick-starting India's capex cycle
9
Fiscal healing – A very gradual process
10
Good fortune on inflation
10
Wage pressures subsiding
11
More interest rate cuts are looming
12
India and foreign inflows – Threat or opportunity?
12
Portfolio flows a combination of “push” and “pull” factors
13
How would FII flows to India fare if the USD strengthens further?
14
Investment implications
14
4 | India and Mr. Modi: After the Honeymoon
IN BRIEF
In this paper we look at how Narendra Modi has fared as the new leader of India since storming to power in May 2014. We also
review various reform measures and policies he has rolled out to improve India’s performance, as well as judge their impact on
the economy thus far. Mr. Modi has had some fortuitous luck in bringing inflation under control and his policies have been
generally well received, with the economy in the early stages of a cyclical recovery. Much now will depend on the pace at
which he can implement his reform agenda and on the cumulative impact of his policies over the medium term. For equity
investors, the key near-term issue will be how long it takes before corporate profits and margins start to respond to the
improving economy.
Progress check
Since becoming Prime Minister of India in May 2014, with a
landslide victory and lower house majority in parliament not
seen in 30 years, Narendra Modi has been seen as a beacon
of hope for India’s prospects, both economic and otherwise.
In this paper, we take a look at India’s progress after being
under the new leadership for over six months.
CHART 2: IN 2015, INDIA WILL TOP THE NOMINAL GDP
RANKINGS FOR THE INVESTABLE EMERGING MARKET
UNIVERSE
% nominal GDP growth
Switzerland
Russia
Japan
Australia
Saudi Arabia
Canada
United States
Everywhere we look, the signs are encouraging, with India
punching above its weight by contributing more than 12% to
world GDP growth this year (IMF WEO forecast), having
become the world’s fourth largest economy in 2011, behind
only the U.S., Eurozone and China when measured in PPP
dollars.
As seen in Chart 1, India in terms of current U.S. dollar GDP
may soon surpass both Brazil and recession-hit Russia, to
emerge as the second largest BRIC economy after China.
CHART 1: INDIA – A MAJOR EMERGING MARKET ECONOMY
THAT IS GAINING IN IMPORTANCE
India’s Nominal GDP and forecasts compared to selected countries, USD
trillion
4
Forecast
France
3
Brazil
Russia
2
Italy
Canada
1
India’s GDP level
0
2012
2013
2014E 2015E 2016E 2017E 2018E 2019E
Source: IMF WEO October 2014 database, J.P. Morgan Asset
Management. January 2015.
Brazil
Mexico
Turkey
Indonesia
Korea
China
India
0%
2%
4%
6%
8%
10%
Source: IMF WEO October 2014 database, J.P. Morgan Asset
Management. January 2015.
So far, India’s stock market has held up well amid growing
investor worries concerning the outlook for emerging
market equities in 2015, which face rising U.S. interest
rates, further economic slowdown in China and a sharp fall
in commodity prices. Local Indian markets - both bonds and
equities - were among the strongest performers last year,
with the BSE 100 gaining 32%, behind only China A-shares
with 53%, as shown in Chart 3. Post-election, Mr. Modi has
thus far has not disappointed markets with his chosen path,
though at some point a more meaningful Sensex correction
than December's 4% dip seems likely, as technical
indicators for Indian equities remain in overbought territory.
If that happens, we advise investors to increase their equity
exposure to India, as the market, in our view, has the best
long-term growth fundamentals of any major emerging
market economy.
What could trigger a market correction? Catalysts that might
test the patience of investors include a weaker-thanexpected recovery in private sector capex and thus
productivity, a surprise rebound in world oil prices or
corporate earnings that remain slow to recover from the
cyclical pressures of 2012-2014.
J.P. Morgan Asset Management | 5
India and Mr. Modi: After the Honeymoon
CHART 3: INDIA WAS ONE OF THE TOP PERFORMING
MARKETS IN 2014
Policy and reform measures in abundance
Local index performance in 2014, returns in local currency
A strategy of taking many small steps in the right direction
makes a lot of sense for India. They can accumulate over
time and eventually have a significant impact on underlying
productivity trends and macroeconomic performance.
Therein lies the real strength of “Modinomics,” which is
helping to turn India into one of the more attractive longterm prospects among global emerging markets.
Shanghai SE A Share Index
India S&P BSE 100
Philippines PSE PSEi
Indonesia SE Composite Index
Thailand SET
MSCI USA
TOPIX 1st Section
It is still early, but for his first semester our view would be
to award Mr. Modi an “A-” for overall performance. “Minus”
because a few things could have been done better, such as a
more cooperative stance from India in trade negotiations.
Broadly speaking though, Mr. Modi has met or exceeded
initial expectations in most of the key areas where we had
looked for change from the new government.
Taiwan TAIEX
FTSE Straits Times Index
Hang Seng Index
ASX All Ordinaries
KOSPI Composite Index
FTSE Bursa Malaysia KLCI
-20%
0%
20%
40%
60%
Source: FactSet. J.P. Morgan Asset Management. December 2014.
One of the initial objectives for Mr. Modi and the NDA
coalition government was to stabilize the Indian economy
before tackling the many longer-term issues and challenges
that the country faces. Raising economic growth from multiyear lows, taming inflation and getting previously spiralling
external and fiscal deficits under control are four key macro
economic goals. There has been reasonably good progress
in 2H 2014 on all four fronts. At the same time, the new
government has sought to prioritise reforms and policy
adjustments necessary for the longer haul, recognising that
it cannot tackle every issue at once.
Mr. Modi seems to be taking a long-term view towards
India’s structural problems. He knows that he has a full fiveyear term in which to push forward with his agenda, and
more than likely two terms. After the passage of more than
six months, we have a clearer idea today of what the Modi
reform agenda entails. So far, the majority of policy
measures tabled are neither surprising nor breathtaking.
But unlike his critics, we see this as a major strength of the
government’s approach, not a weakness. Most measures
appear achievable given sufficient energy on the part of the
central government and a good working relationship with
key state administrations. They are being implemented
across a broad front; if we were simply to list them all, the
resulting table would run into several pages.
6 | India and Mr. Modi: After the Honeymoon
Initially, the government suffered few disappointments, with
the timely passage of legislation through parliament and a
greater degree of cooperation from state governments than
some had thought possible. More recently, the opposition
has been less willing to cooperate, causing delays to some
measures and forcing Mr. Modi to proceed by administrative
ordinance, which only provides a stop-gap solution. The
issue over which the Congress Party dug its heels in has
little to do with economics (the voluntary conversion of a
small number of non-Hindu Indians to the Hindu religion
organised by a small right-wing nationalist party). But it may
unfortunately be a sign that in India, as in the U.S., political
cooperation from the opposition is a relatively scarce
commodity.
Recent reforms passed by ordinance in the winter
parliament include re-allocation of coal mines to private
sector interests, raising the insurance sector FDI ceiling,
accelerating land acquisitions for Public Private Partnership
(PPP) projects by reducing owners’ consent from 70% to
50%, and amendments to India’s Companies Act. These
measures will go to the vote in the upcoming session of
parliament, which opens in February. The government has
also set an ambitious deadline of April 2016 for
implementing the Goods and Services Tax (GST), the key tax
reform for this parliament that was inherited from the
previous Congress administration.
The GST will require a constitutional amendment to get
passed, not to mention much hard bargaining on revenue
sharing between the states and central government.
Moreover, the initial bill deals only with the changes in
broad taxing powers (states give up entry tax but get to levy
services tax). Many of the practical issues will be dealt with
subsequently by the GST Council on a 75% majority vote.
This will require at least 20 of India’s 31 states to vote in
favour, and with the BJP currently only controlling 11, there
is plenty of scope for slippage and delay, although the final
outcome is not in question.
Most of the reform schemes announced so far look set to
put India on the right track for an improvement in long-term
growth or potential output. Big reforms are expected to be
relatively few, as Mr. Modi currently only has a minority in
the upper house of parliament. However, BJP wins in two
key state elections last September - Maharashta and
Haryana - have strengthened the government’s position in
the upper house and also demonstrated that Mr. Modi’s
popular appeal is undiminished. With these further electoral
victories, BJP-controlled states now account for 37% of
India’s GDP, in a contiguous geographical belt that includes
much of the nation’s industrial and technological base, the
powerhouse of investment activity and economic
development. Much of doing business in India today is more
about interacting with state governments than with central
government. Of course, this was the reason for Gujarat’s
ability to thrive economically under Mr. Modi, even during
the “policy paralysis” years of the last Congress
government.
The BJP may over time also gain a majority in the upper
house that will allow them to push forward with more farreaching or even controversial legislation. This may only
happen over a number of years and will also depend on
continuing voter satisfaction with the BJP. Better centralstate government cooperation could prove a great facilitator
for India.
A key reform here is the new government think-tank
announced on 1 January, the National Institution for
Transforming India Policy Commission (Niti Ayog), which
replaces the State Planning Commission. Headed by the
Prime Minister and State Chief Ministers, the new body will
improve central-state cooperation by taking a bottom-up
approach to development issues in contrast to the former
Planning Commission's top-down strategy. Niti Ayog will
aim for the speedy resolution of interdepartmental/centralstate disagreements, with a focus also on technology and
long-term development.
Some initial policy measures were unpopular but seen as
necessary by most India commentators. A railway fare hike
of 14.2% for passengers and 6.5% for freight, for example,
was not well received. The fare increases were initially met
with protests from communities in a country that had been
struggling with high inflation and where a majority of the
population is living on low wages. In addition, pre-election
promises to India's farmers for higher minimum support
prices (MSP) for key agricultural crops were not met. In late
October the Modi government announced an increase in
MSP for wheat of 3.6% and 0%-4.5% for other crops - the
lowest semi-annual increases since FY11, as shown in Chart
4. Minimum support prices are set twice a year in June and
October. The decision to scale back on agricultural support
prices was partly motivated by the need for public sector
financial consolidation and was welcomed as the right move
by India analysts.
CHART 4: A LOW INCREASE IN AGRICULTURAL SUPPORT
PRICES WILL DAMPEN INFLATION
Minimum Support Price increases for wheat
25%
21%
20%
BJP
18%
Congress
BJP
15%
10%
10%
9%
8%
8%
6%
6% 5%
5% 5%
5%
4%
2% 2% 2%
2%
0%
Source: CLSA Securities, India Dept. of Food and Public Distribution,
J.P. Morgan Asset Management. January 2015.
J.P. Morgan Asset Management | 7
India and Mr. Modi: After the Honeymoon
CHART 5: INCREASED FINANCIAL DEMOCRATIZATION –
ANOTHER KEY MODI OBJECTIVE
Number of no frills bank accounts opened, millions
80
70
60
52
55
59
64
45
50
38
40
67
75
71
Forecast
30
30
20
18
10
0
Source: CLSA Securities, Reserve Bank of India, J.P. Morgan Asset
Management. January 2015.
Making India's current systems work better
Many of Mr. Modi’s policy actions have concentrated on
improving India’s current systems. Items such as
administrative reforms, simplification of approval processes,
including online project approval and easier environmental
clearance procedures, should improve business sentiment
and the ease of doing business in India. The “Make in India”
campaign is not inward looking, motivated by import
substitution, but rather is aimed at attracting more overseas
businesses to set up part of their global manufacturing
operations in India. The campaign adds to the positive
investment climate. Liberalisation of FDI limits in various
sectors and industries should also further encourage foreign
inflows.
There have also been various labour market reforms to
increase flexibility whilst still protecting workers. These
include portable retirement accounts and more access to
social security schemes for workers. A key objective of the
Modi government is to promote financial deepening in rural
India, via mobile banking and other non-traditional means of
bringing financial services to isolated rural communities.
Financial inclusion for every household is being pushed,
with incentives to open bank accounts, as shown in Chart 5,
providing accident and life insurance coverage, which in
turn should assist in encouraging higher household savings
and thus investment. A planned push for a more “Digital
India” with fibre optic connections to villages should also
foster the spread of e-commerce, mobile banking and ease
of access to government resources.
8 | India and Mr. Modi: After the Honeymoon
More decentralized decision making, greater transparency
in public procurement and rural and social welfare reforms
should all help at the margin to drive productivity and
growth. So too in the medium term will greater efforts to
scale back the direct role of government in the Indian
economy, where privatization had almost crawled to a halt
under the previous UPA administration. So far, the Modi
government has approved the sale of shares in Coal India,
ONGC and NHPC to raise a combined sum of Rs 43,000 crore
(1 crore = 10 million). Foreign investors in particular would
like to see a reduction of the state’s role in the economy as
a key long-term objective of “Modinomics.” At the same
time, investors realize that the privatization of a
nationalized industry or a large state-owned enterprise is
not something that can be rushed if it is to succeed whilst
also maximizing the proceeds of the asset sale. That was
certainly the experience of privatization in the UK during the
Thatcher years.
How is India's economy responding to “Modinomics”?
India’s growth prospects already appear to be changing for
the better, with forecasts for an uptick in consensus GDP
growth in 2015 to 6% plus. Recent economic indicators
suggest the worst is over for the Indian economy, and that a
cyclical recovery has begun. After the second quarter GDP
print of 5.6%, third quarter GDP declined to 5.3%, mainly
due to weaker investment and net export contributions to
growth. India's stagflation episode - low growth plus high
inflation - has been a painful one, as shown in Chart 6.
Policymakers and the RBI are determined to see that there
will be no repeat. Some moderation in the 3Q GDP numbers
was widely expected, and the high frequency data coming
out of India suggests a continuing rise in activity and
domestic demand. The HSBC/Markit PMI indicators are
consistent with this view, industrial production in November
rose by 3.8% YoY, reversing the dip in October, while auto
sales continue to recover from the depths reached in 2013
and 2014 (Chart 7). Manufacturing output improved from 7.4% in October to +3.0% in November (Chart 8), while
electricity and mining activity saw marginal declines.
The economic outlook for India in 2015 will partly depend on
how the global environment evolves, which will have an
impact on the demand for Indian exports. On the global
front, we are cautiously optimistic and expect an
improvement in global GDP growth in 2015 from 3.0% to
3.5%. If this unfolds, a return to 6.5% to 7% growth for India
is certainly possible this year. But we would caution
investors against expecting an early return to even stronger
growth for India without first seeing the implementation of
supply-side reforms, the removal of the worst industrial
growth bottlenecks and signs of a clear improvement in
trend productivity. Unfortunately, the jury will be out on
these key medium-term issues for some time; in the interim
the best news that we could hope for would be a revival in
private sector capex spending (output of capital goods did
pick up to +6.5% YoY in November, though it is a volatile
series); this is what we consider next.
CHART 6: INDIA’S PRIMARY MACRO OBJECTIVE: END
“STAGFLATION” BY RAISING GROWTH AND LOWERING
INFLATION
16%
Offical CPI measure
14%
Real GDP growth
12%
OECD CPI measure
10%
8%
6%
4%
2%
0%
'03
'05
'07
'09
'11
'13
Source: Ministry of Statistics & Programme Implementation, FactSet,
OECD, J.P. Morgan Asset Management. January 2015.
India's stagflation episode – low growth plus high inflation
– has been a painful one. Policymakers and the RBI are
determined to see that there will be no repeat.
CHART 7: INDIA’S ECONOMIC CONDITIONS APPEAR TO BE
IMPROVING: VEHICLE SALES ON AN UPTICK
Vehicle sales %YoY
30%
Private Vehicle Sales
Commercial Vehicle Sales
20%
10%
0%
-10%
-20%
-30%
'11
'12
'13
'14
Source: FactSet, J.P. Morgan Asset Management. January 2015.
CHART 8: OUTPUT INDICATORS IMPROVING
IP 3-month mobbing average %YoY and PMI
10%
Industrial Production 3MAV %YoY
Markit/HSBC PMI (RHS)
60
5%
55
0%
50
-5%
Kick-starting India’s capex cycle
Investment had fallen to uncomfortably low levels in India
these past few years and a revival in the investment cycle is
crucial for any sustainable revival in economic growth.
There is broad agreement that weak private sector
investment is the main culprit behind India’s growth
slowdown - real GDP growth fell to 4.75% in 2Q FY13 from
an average of 9.5% in FY09 and FY10. Gross domestic fixed
capital formation, which had grown by more than 15% on
average before 2008, only increased by 1.75% in 2012-2013.
Endeavors by the Modi government to improve India’s
investment climate mentioned earlier have seen some
successes, but overall progress has been disappointing, with
many hoping for a more significant improvement in the
“animal spirits” of Indian entrepreneurs in response to the
end of “policy paralysis” and a reduction in business
uncertainty. Empirical research by the IMF had pointed to an
index of policy uncertainty as having been statistically
significant in explaining both the sharp drop off in new
investments and the surge in shelved investment projects in
FY11-FY12. Lower policy uncertainty since Mr. Modi came to
power should reverse this trend.
45
'11
'13
Source: FactSet, J.P. Morgan Asset Management. January 2015.
J.P. Morgan Asset Management | 9
India and Mr. Modi: After the Honeymoon
CHART 9: ECONOMIC POLICY UNCERTAINTY AND NEW
INVESTMENT PROJECTS
Fiscal healing - A very gradual process
A. NEW PROJECT ANNOUNCEMENTS
Rupee billions
Government
Private sector
9,000
Last year the fiscal deficit problem and uncertainties over
India’s ability to finance itself caused significant volatility in
currency and market performance. Mr. Modi and the BJP
have taken important steps to rectify these problems.
Included in this are the cutting of subsidies, which while
painful for the populace, were widely considered necessary,
and the planned overhaul of the tax system to a Goods and
Services Tax system (GST), a policy inherited from the
previous regime. The government has also instructed
departments to cut discretionary spending by 10% and set
up an expenditure reform commission to streamline
government spending.
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
'02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14
B. PROJECTS STALLED AS % OF GDP
9%
8%
7%
6%
5%
4%
3%
2%
1%
The fiscal deficit issue is now seen as much more contained,
though it is widely expected that in the next budget Finance
Minister Jaitley will seek to ease back on further fiscal
consolidation by maintaining an unchanged central
government (CG) borrowing target of c. 4.0% of GDP for
FY16 instead of the planned cut to 3.6%. Recently, there
have been indications of fiscal pressures at the state level,
in part due to lower ad valorem petroleum taxes. And
provisional CG revenue and expenditure figures for the April
to November period indicate that some sharp spending cuts
are required in 1Q 2015 if this year’s fiscal target of 4.1% is
to be hit. Nevertheless, a moderate overshoot of the FY15
target will not shake the market’s faith unduly, though the
less certain outlook for state budgets next year may well
constrain the central government's ability to deliver any net
fiscal stimulus.
0%
'04
'05
'06
'07
'08
'09
'10
'11
'12
'13
'14
Source: CLSA Securities, CMIE, J.P. Morgan Asset Management.
January 2015.
So far, however, there has only been a slight uptick in the
latest numbers for projects approved, while the number of
stalled projects has not seen a significant decrease, as
shown in Chart 9. This should not be taken too negatively, as
the most recent uptick is a good sign and the new measures
will take time before having a more visible effect. We
strongly believe that a combination of the government’s
policy reforms, a cyclical upturn in aggregate demand and
improving “animal spirits” among Indian entrepreneurs will
lead to a pick up in investment spending and increased
project activity in coming quarters.
10 | India and Mr. Modi: After the Honeymoon
Good fortune on inflation
Mr. Modi has been exceptionally fortunate, as a conflux of
favorable factors have allowed Raghuram Rajan, Governor
of the RBI, India’s central bank, to deal a severe blow to high
inflation, until recently one of India’s greatest economic
problems. After hitting double digits in 2013, the new CPI
measure has seen inflation fall to a low of 4.4% in
November, the lowest since the series’ inception three years
ago. The headline CPI, as expected, rose a little in December
to 5% and may rise a bit further in coming months as
favorable base effects dropped out of the 12-month
comparison. Encouragingly, core CPI inflation eased from
5.6% in November to 5.4% in December.
Similarly to the improvement in the CPI, headline inflation
for wholesale prices (WPI) also fell to a five-year low,
becoming flat at 0% in November 2014, as shown in Chart
10. These are huge improvements after earlier worries that
India might have entered a prolonged period of stagflation,
an environment of persistent low growth and high inflation.
The sharp drop in inflation has helped India to switch from a
WPI-based inflation target to a broader CPI-based target
sooner than expected. In April 2014, the central bank
adopted the new Consumer Price Index as its key measure
of inflation. This followed the report of the expert
committee under Urjit Patel last January, which
recommended that the RBI’s medium-term inflation target
should be CPI inflation of 4% (within a +/- 2% band) to be
achieved through its monetary policy tools. The committee
said the RBI should reach the medium-term goal by
targeting a reduction in headline CPI inflation (which was a
daunting 9.9% at the time) to 8% within 12 months (by
January 2015), and 6% within two years (by January 2016).
With the RBI well ahead of this schedule, Mr. Rajan is
currently in talks with the government that should also see
the latter adopt a formal CPI inflation target for India.
CHART 10: CPI INFLATION CONTINUES TO DECLINE; THE
DROP IN OIL HAS ALSO HELPED
CPI %YoY, WPI %YoY and WTI Crude oil prices USD/bbl
160
12%
140
10%
120
8%
100
6%
80
4%
60
WTI oil USD/bbl (LHS)
40
WPI %YoY (RHS)
20
CPI %YoY (RHS)
0
2%
0%
-2%
'05
'07
'09
'11
'13
Source: FactSet, RBI, J.P. Morgan Asset Management. January 2015.
Part of the success in lowering inflation is due to
government measures to control food inflation and a lucky
recovery in the monsoon rains after an initially poor start to
the season. Another major factor is lower commodity prices,
especially the plunge in the crude oil price, which has
resulted in lower fuel and heating costs. Cheaper oil prices
have been a particular boon to Mr. Modi, who reassuringly
took the opportunity this provided to deregulate the retail
diesel price and streamline various other fuel subsidies,
which until recently had been a growing burden on
government expenditures. These bold unexpected cuts in
fuel subsidies will help the government in its efforts to reach
an ambitious FY15 budget deficit target of 4.1% of GDP. The
decline in the oil price, if sustained, could take 1.5% off the
CPI and reduce the fiscal deficit by 0.6% of GDP.
Wage pressures subsiding
Until recently, rural wage pressures were seen as an
important factor contributing to India’s inflation problem,
but this is no longer the case. Rural wage growth has fallen
sharply over the past 18 months and is no longer out of
control. There is some disagreement regarding the degree
to which the previous government’s rural wage support
policies, principally payments under the Mahatma Gandhi
National Rural Employment Guarantee Act (MGNREGA or
NREGA for short) scheme, contributed to the emergence of
strong rural wage pressures. There is no doubt, however,
that strong rural wage growth in India from 2009 to 2012
did feed first into food prices and then into urban wages,
igniting a stubborn wage-price spiral.*
Some Indian economists think the role of NREGA in adding
to national inflation pressures is exaggerated since the
scheme has only ever accounted for a small percentage of
rural days worked. Nevertheless, the NREGA daily wage may
have set a floor under rural wages, which then soared due
to the overheating economy. Under the Modi government,
the NREGA scheme has been retained as it serves key social
objectives, though it has been made more flexible, with
greater emphasis on obtaining value-added benefits for
work done.
_______________________________________________________________________________________________
* For details on food prices and their interaction with wages and
core inflation in India, see “Food Inflation in India: The Role for
Monetary Policy,” by R. Anand, D. Ding, and V. Tulin, IMF
Working Paper WP/14/178, September 2014.
J.P. Morgan Asset Management | 11
India and Mr. Modi: After the Honeymoon
More interest rate cuts are looming
CHART 11: KEY INTEREST RATES
12%
As noted previously, inflation has already fallen below the
RBI’s 6% target for January 2016, causing some speculation
of rapid interest rate cuts in the months ahead, commencing
with the February RBI meeting. Base effects last year
certainly helped to keep inflation low in year-on-year terms.
The RBI surprised many when it made a bold move of
cutting its policy repo rate by 25bps, to 7.75% (Chart 11), in
an unscheduled monetary policy review ahead of its planned
February meeting and the government’s annual budget
statement at the end of January.
We believe the RBI will be wary of continuing to cut interest
rates too quickly, as food and energy prices are volatile and
could easily reverse course. A number of Indian economists
have warned against relying solely on low commodity prices
to justify a rapid easing in monetary policy. The RBI may
wish to assess the unfolding economic situation with care,
including the likely response of India’s currency to a cut in
local rates close to an expected first U.S. rate hike around
mid-year. We are not pessimistic on the scope for rate cuts,
as we do not see the USD-INR short-term interest
differential as a major impediment (An 800 bps differential
in India’s favor did little to support the INR during the 2013
taper episode). With a relatively easy external financing
outlook, a gradual rise in the U.S. Fed funds rate will
conversely not pose much threat to rupee stability in 2H
2015.
The latest move is undoubtedly positive for India and a firm
signal that the RBI believes that India should focus more on
growth. Under Rajan, the RBI has gained much credibility in
handling policy. It has brought inflation under control and
succeeded in restoring confidence in the Indian rupee, one
of the emerging market currencies that was worst hit during
“Taper Tantrums” in 2013,
10%
8%
6%
4%
2%
Cash Reserve Ratio
Repo Rate
Marginal Standing Facility
0%
'10
'11
'12
'13
'14
'15
Source: FactSet, RBI, J.P. Morgan Asset Management. January 2015.
While one can argue that “lucky” inflation shocks should not
be ignored by central banks, but should be taken advantage
of, the main reason for the dovish guidance is that the RBI is
now more comfortable that after the inflation target of 6.0%
is reached in March, inflation will remain in that vicinity over
the following 12 months. With real interest rates of 6.7%
(deflated by the WPI), three times the regional average,
there is scope for nominal short rates to fall by another 50
to 75 bps this year whilst maintaining a positive real interest
rate to encourage household savings.
At the same time, investors should not become complacent
and regard the Indian inflation dragon as slain. Sustaining
CPI inflation below 6% through 2015 as economic growth
accelerates with the business cycle and a relatively small
output gap begins to close could still prove challenging.
In the medium term, the RBI must surely aim to push India’s
inflation rate lower still, say to the 4% mark suggested by
the Patel Committee. While the recent sharp fall in energy
prices has made this task a lot easier, Governor Rajan may
yet earn himself a reputation for stinginess that will not find
favor with Mr. Modi and the government.
India and foreign inflows - Threat or opportunity?
How will Foreign Institutional Investor (FII) investments into
Indian equities fare when the Fed tightens policy in 2015?
This has been a constant source of worry to domestic
investors, who tend to see portfolio inflows as a source of
vulnerability rather than a blessing, or at best a doubleedged sword. If the Indian economy starts to underperform,
then local Indian investors fear a big surge in outflows.
Conversely, if the Indian economy is doing well, local
investors worry whether positive FII inflows can be
sustained.
12 | India and Mr. Modi: After the Honeymoon
We do not wish to downplay or minimize the potential
volatility of portfolio flows and the problems that this can
cause for investors, governments and business (indeed, the
IMF referred recently to capital flows as being “fickle
everywhere, every time”). History, however, seems to show
that India is blessed with a greater degree of persistence
than the average emerging market when it comes to
portfolio inflows.
CHART 12: INDIA IN 2014 ATTRACTED POSITIVE EQUITY
INFLOWS IN MOST MONTHS
Equity flows, USD billions
4
3
2
1
0
-1
-2
-3
Domestic Equity Mutual Fund Flows
Domestic Institutional Equity Fund Flows
Foreign Instiutional Equity Flows
-4
Source: BofA Merrill Lynch Global Research., J.P. Morgan Asset
Management. January 2015.
During the market “taper tantrums” in 2013 and in the more
recent October correction, India suffered outflows along
with other emerging market equity markets, especially
during the “Fragile Five” episode 18 months ago. But
recovery in portfolio flows after each disruption has tended
to come sooner and more convincingly in India’s case than
for other emerging markets, as shown in Chart 12. In the
market correction last fall, triggered by spread-widening in
the U.S. high yield market, net equity flows to India returned
to net positive by late-October, to total USD16 bn in 2014
(versus USD20 bn in 2013). FII debt inflows were also very
strong last year, a record USD26 bn, and a rise in the stock
of close to 100%. FII inflows into Indian Government
Securities (G-Secs) reflected the very attractive yields
available for international investors seeking income in a low
global rate environment. The foreign share of the domestic
Indian G-Sec market still remains low, however, at c. 6% to
7%, with a stock outstanding of around USD40 bn.
Portfolio flows a combination of “Push” and “Pull”
factors
Indian investors should keep in mind that FII portfolio flows
in practice always reflect a combination of both external (or
“push”) factors, like U.S. interest rates, or global risk
appetite, and domestic (or “pull”) factors, like domestic GDP
growth, or corporate profits, etc. They are never driven by
just one set of factors, with the sole but important exception
of major financial panics, such as after the Lehman collapse
during the global financial crisis. In these exceptional
circumstances, which fortunately are few and far between,
international investors simply turn tail and head for home,
pulling money out of overseas investments indiscriminately.
Such shocks followed by a rapid collapse in international
investor risk appetite are by their nature unpredictable.
So while a gradual rise in the Fed funds rate in 2015 will be a
“negative” push factor for FII portfolio flows to India, it is
unlikely to outweigh a combination of favorable “pull”
factors, notably a strong, stable government, a macro
economy that has bottomed out and begun to recover,
relative stability on the external front and domestic
investors who are clearly warming towards their own equity
market for the first time since FY09.
India appears better placed than most to weather future
bouts of Fed-related market turbulence. Since the “taper
fears” emerging markets have made efforts to strengthen
their macro economies and reduce external balances,
efforts that have been reflected in a drop in their current
account deficit (ex-China) from 3% of GDP to around 1%
now. Of those economies that have made significant
improvements to macro imbalances, none has made better
progress than India. So much so, that we, like the
International Institute of Finance, believe that India has
successfully exited the “Fragile Five” class that became the
centre of international investor concerns in 2013. Should
market tremors accompany the first Fed rate hike expected
later this year, we doubt very much that India will again be
at the epicenter of emerging market concerns.
J.P. Morgan Asset Management | 13
India and Mr. Modi: After the Honeymoon
CHART 13: NARROWING CURRENT ACCOUNT BALANCE
SHOWS ISSUES COMING UNDER CONTROL
Investment implications
% of GDP
• Mr. Modi’s policy measures since the election in May 2014
have been well received, as he leads India onward into
cyclical recovery and beyond. In bringing inflation under
control he had a helping hand from lower food and energy
prices, while short-term growth prospects for India have
improved steadily since the summer.
4%
3%
2%
1%
0%
-1%
-2%
-3%
-4%
-5%
-6%
'97
'99
'01
'03
'05
'07
'09
'11
'13
Source: Bloomberg, Ministry of Statistics and Programme Implementation
,J.P. Morgan Asset Management. January 2015.
How would FII flows to India fare if the USD strengthens
further?
It has to be admitted that the trend towards a stronger U.S.
dollar has in the past proved a headwind for emerging
market equities as an asset class, which has only managed
to outperform the global benchmark on about 33% of
occasions in a rising dollar environment. A weaker local
currency will add to inflation pressures, may increase
energy subsidies and may also put upward pressure on local
interest rates.
But in India’s case, the external financing need is now quite
modest and should not prove difficult to finance, especially
with domestic inflation clearly on a downward path and the
current account balance much more under control, as
shown in Chart 13. The next move in local rates is clearly
down, not up. In the rupee’s case, there is perhaps less to
fear from a stronger USD in coming months than is the case
for a number of other emerging market currencies. India
should continue to attract a significant share of emerging
market capital inflows in 2015, both foreign direct
investment (FDI) and portfolio inflows, although the total
may be lower in 2015 compared to last year as a result of
rising U.S. interest rates.
14 | India and Mr. Modi: After the Honeymoon
• From here on, much will depend on the pace at which Mr.
Modi can implement his reform agenda and how his
policies begin to have an impact over the medium-term.
For equity investors, the key near-term issue will be how
long it takes before corporate profits and margins start to
respond to the improving economy.
• If the stock market’s patience is tested over this, then the
Sensex may well correct more sharply. This would offer a
good opportunity for investors to add exposure to Indian
equities, since the medium-term outlook remains highly
positive.
• As long as the Indian economy remains on a cyclical
recovery track and Mr. Modi persists with his reform
agenda, we believe the start of U.S. interest rate
normalization by the Fed in 2015 poses a limited threat to
India’s capital account. While a gradually rising U.S. dollar
may be a headwind in 2015, it is unlikely to prompt large
FII outflows in India’s case, a country blessed with good
fundamentals and a strong secular domestic growth story.
• Investors in Indian equities should stay focused on
domestic cyclicals, such as cement, materials, metals and
autos, infrastructure plays and private sector financials,
instead of exporters and defensive sectors like utilities. In
2015 we expect new support for domestic cyclicals and
capex stocks from declining short-term interest rates.
GLOBAL MARKET INSIGHTS STRATEGY TEAM
Americas
Europe
Asia
Dr. David P. Kelly, CFA
New York
Stephanie H. Flanders
London
Tai Hui
Hong Kong
Andrew D. Goldberg
New York
Maria Paola Toschi
Milan
Geoff Lewis
Hong Kong
Anastasia V. Amoroso, CFA
Houston
Vincent Juvyns
Luxembourg
Yoshinori Shigemi
Tokyo
James C. Liu, CFA
Chicago
Manuel Arroyo Ozores, CFA
Madrid
Grace Tam, CFA
Hong Kong
Julio C. Callegari
São Paulo
Tilmann Galler, CFA
Frankfurt
Ian Hui
Hong Kong
David M. Lebovitz
New York
David Stubbs, PhD
London
Ben Luk
Hong Kong
Gabriela D. Santos
New York
Lucia Gutierrez
Madrid
Ainsley E. Woolridge
New York
Kerry Craig, CFA
London
Hannah J. Anderson
New York
Alexander W. Dryden
London
Abigail B. Dwyer
New York
Nandini Ramakrishnan
London
J.P. Morgan Asset Management | 15
India and Mr. Modi: After the Honeymoon
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