BackAn equity rally riding high on political hopes
A new government cannot swish a wand to change India's economic fortunes
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The Indian equities market has been on a roll in recent weeks. The benchmark indices have touched record highs. Some have already described it as a Narendra Modi rally as investors expect a more business-friendly government after the national elections.
Such hopes are definitely one explanation of what has been happening at Dalal Street. Two other countries that have been strong performers in recent times because of political optimism are Indonesia and Mexico. Indonesia is also headed into an election; it has done even better than India in recent weeks. Mexico has pushed ahead with economic reforms thanks to a unique deal between its major political parties on select policy issues. Investors expect the Gujarat chief minister to undo some of the policy tangles created by the second Manmohan Singh government.
But history tells us that rallies built on policy hopes fizzle out unless they are supported by economic fundamentals. India has been attracting foreign inflows at a time when emerging market funds have seen large outflows even as the US Federal Reserve continues to exit its extraordinary monetary stimulus. There are two fears here: the trouble below the surface in China as well as higher geopolitical risks after the Russian annexation of Crimea. Equity funds investing in China have seen record outflows, according to EPFR Global.
India has become relatively more attractive to global investors in recent weeks with its gradual transition towards greater economic stability. The current account deficit has shrunk even if we do not consider the trend in gold imports. Consumer-price inflation seems to be in gradual decline even though core inflation has not budged as yet. The improvement on these two fronts means that India is far better placed than it was last year to deal with a global risk shock. The current bout of disinflation—however needed—is a sign of demand weakness rather than the first sign of an economic recovery.
The fears about an economic slowdown in China have left India relatively untouched because of two reasons. One, India is far less dependent on Chinese economic growth compared to many other regional economies. Two, a commodity importer such as India could potentially benefit if lower demand from Chinese firms pushes down prices of crude oil and other commodities. However, it is hard to believe that any emerging market will be untouched by selling in case there is a spectacular financial implosion in China, a Lehman Moment that many China bears are expecting.
In other words, Indian equities have been attracting global investor interest because macroeconomic conditions in India have become more benign, there are hopes of policy momentum in New Delhi after May, and jitters about emerging markets have seemingly bypassed India. But this rally led by cyclicals could eventually run out of steam unless there is a growth revival in a domestic economy struggling with weak demand, high corporate leverage, a collapse in private sector investment and a massive bad loans problem for banks.
The next government will find it difficult to stimulate activity because inflation is still too high for interest rate reductions while there is little scope for a burst of government spending because of fiscal constraints. There are some early signs of corporate deleveraging through asset sales, but it must be remembered that the previous recovery more than a decade ago was based on a massive reduction in interest rates that helped companies save costs and provided banks with gains in their bond portfolios that allowed them to write off bad loans.
The situation thus is far more complicated than those betting on a Modi victory in May seem to realize. India will have to continue to disinflate. Corporate leverage has to be reduced before companies get back in investment mode. Banks need more than $50 billion of capital to clean up the mess before they fund the next economic expansion. The equity markets will have to face these hard facts at some point of time.
Is too much economic hope being bet on Narendra Modi becoming prime minister? Tell us at views@livemint.com
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