Premature to implement taxation of farm income, says Sukumar Rajah

Sukumar Rajah, MD and chief investment officer (Asian equities), Franklin Templeton’s Local Asset Management Group, says he does not expect a steep increase in government spending over the next two years


The competitiveness of Indian exports is more impacted by bureaucracy and red tape, lack of infrastructure, and labour inflexibility, Rajah says.
The competitiveness of Indian exports is more impacted by bureaucracy and red tape, lack of infrastructure, and labour inflexibility, Rajah says.

It is premature to talk of taxing agricultural income in India, says Sukumar Rajah, managing director and chief investment officer (Asian equities), Franklin Templeton’s Local Asset Management Group, based in Singapore.

“More than 50% of the population depends on rural income and any such tax would create a lot of popular dissatisfaction. As such, we do not expect progress on agricultural income taxes this year,” he added.

Rajah, who is also the portfolio manager, Franklin India Fund, said he does not expect a steep increase in government spending over the next two years, even as the Narendra Modi government prepares to go into the 2019 general election.

Edited excerpts:

Some analysts are of the view that we are set to see a steep increase in government spending over the next two years as the Modi-led government begins to work towards getting re-elected. Do you agree? In that context, if there were to be a spending spree, which sectors do you think will benefit?

We do not expect a steep increase in government spending over the next two years. The Modi government has emphasized a balanced budget, deficit reduction and inflation control. Thus far, the Modi government has adhered to these goals quite closely and we do not expect the government to incrementally spend at the cost of expanding the deficit. In any case, the continued implementation of tax reforms—i.e. the GST (goods and services tax) reform and crackdown on black money—should broaden the tax base, increase tax revenues and increase the government’s spending ability.

That being said, the government has already emphasized the improvement of housing coverage via homeowner incentives and continued infrastructure investment. Related sectors will likely be the key beneficiaries.

What do you make of the discussion in India on taxing agricultural income?

We believe it is too premature for any political party to draft and implement taxation of agricultural income. More than 50% of the population depends on rural income and any such tax would create a lot of popular dissatisfaction. As such, we do not expect progress on agricultural income taxes this year.

The cabinet has cleared the ordinance to tackle Rs9.64 trillion of bad loans at India’s banks. How big and important a step do you see this to be?

The ordinance is a significant step towards cleaning up the banking sector. However, challenges remain and we believe further initiatives will be required.

A key challenge related to the write-offs is the corresponding impact on the bank’s capital. Moreover, we believe a sustained improvement in the Indian banking sector requires an improvement in the quality of both the management and board of directors.

The rupee has strengthened against not just the dollar but against a host of Asian currencies as well. This does affect the competitiveness of Indian exports. is this a concern?

As India is a low-cost country, the strengthening of the rupee is not a major concern for the competitiveness of Indian exports. Instead, the competitiveness of Indian exports is more impacted by bureaucracy and red tape, lack of infrastructure, and labour inflexibility.

India’s economy is growing at 7% today, but is it well short of its potential. Do you think that good policy would get it to double-digit growth, as China’s experience shows it can. If so, what needs to be done to hit that double-digit growth?

With good governance, we estimate that India’s economy can grow at 8-10%. We do not believe double-digit growth is sustainable in the Indian context. In China, double-digit growth was driven by access to a huge export basket, a closed environment, and significant government stimulus at the risk of long-term imbalances to economic growth. In contrast to the Chinese trajectory of economic growth, we expect Indian growth to scale up at a more gradual pace, but could have more sustainability.

Indian markets are hitting record highs. What is driving this rally? Is there more steam to this rally, or will the party be over soon and why?

In the longer term, we believe there is more scope for Indian markets to rally, given India’s strong structural fundamentals and nascent cyclical recovery.

With inflation under control, India has more scope for sustained lower levels of interest rates.

The containment of India’s twin deficits has also reduced market risks. Moreover, a large proportion of this rally has been driven by domestic fund inflows and we believe there is scope for a continued rally if foreign money also starts flowing back into the Indian market.

Are Indian markets expensive at this point? Why, or why not?

On a trailing basis, MSCI India index P/E has historically traded at a premium to that of MSCI EM index over the past 10 years. Presently, MSCI India P/E trades above its own historical average levels. However, we believe corporate earnings are currently depressed and P/E valuations will look more compelling as the earnings recovery plays out. From an alternative metric, India’s market capitalization to GDP (gross domestic product) stands close to the long term average of 78%—between FY06 and FY17—indicating reasonable levels of valuation in the Indian equity markets, compared with historical trends.

When and by how much do you see earnings recovery happening for Indian companies?

From a cyclical perspective, we are seeing recovery in sections of the economy.

Key indicators such as the PMI (purchasing managers index) and industrial production have been improving since January, with GDP growth being supported by consumption and government spending.

Private capex has been a laggard, but we believe there is scope for improvement. In fact, capital goods imports—a proxy for investments—have also been gradually improving.

Where does India stand in your emerging market (EM)/Asia preference? Why?

India is our top preference, given both the cyclical recovery and longer-term structural story.

From a macro perspective, India is also the fastest growing economy in APXJ (Asia-Pacific ex-Japan). Despite the uneven economic recovery in India, due to both internal and external headwinds, we believe that with accelerating consumption and public investment, combined with benign inflation, a reform-oriented government and robust external balances, India could be among the fastest-growing economies in the world for the next 3-5 years.

Crucially, India’s economic growth is underpinned by strong demographic tailwinds and the low base means that India has a good catch-up potential relative to its Asia peers such as China.

Will US President Donald Trump’s tax-cut plans impact emerging markets in a big way? How much impact do you see on Indian information technology and pharmaceutical sectors from the H-1B visa row and protectionist policies?

We do not want to draw premature conclusions on the content and timeline of Donald Trump’s tax reform plans.

Without the proposed Border Adjustment Tax or some similar funding offset, the proposed corporate tax cuts will not meet the standard of revenue neutrality.

As such, we believe, it would be extremely challenging for the Trump administration to implement his tax reform plan without coming up with a means of funding his proposed tax cuts.

In regards to the H-1B visa and its impact on the Indian IT sector, we do not believe that any directive around wage increases for visa-based employees implies a proportionate upshift in costs, though we do expect any adverse law to accelerate the companies’ process of making changes to their operating models.

These include the hiring of fresh and senior local talent, as well as attempting to move more work offshore.

If the transition is made gradually, these changes can be implemented without much business distraction, albeit with some margin pressure in the interim.

In fact, such business model changes have been underway for some time and the higher costs have more or less been absorbed so far by tier-I information technology companies.

Are geopolitical risks being ignored by global investors?

With VIX index at three-year lows, we believe there has been a near-term reprieve in perceived global risk in developed markets—specifically in the US.

However, we believe that the biggest geopolitical risks for emerging markets are currently centered on the Korean peninsula and north Asia—Korea, Taiwan and China.

India is relatively more insulated from this geopolitical risk, given its geographical as well as political distance from the Korean peninsula.

If the geopolitical risk in Asia were to be heightened, we believe the Indian markets could benefit from fund flows away from north Asia.

What are the key risks to this rally in emerging markets, particularly India?

The key risk to the current rally in emerging markets is the sustainability of the Chinese economic recovery.

The current macro stabilization is driven by infrastructure and real estate spending, and we are concerned that the government might not be able to sustain the level of spending due to fiscal constraints.

How the Chinese government manages this remains vital for a continued rally in emerging markets.

Which sectors in India are you overweight and underweight, and why?

We are overweight consumer discretionary, industrials, cement and consumer staples. These over-weights are based on our bottom-up stock selection criteria of quality, sustainability and growth.

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