Fiscal consolidation will act as a drag on growth: Daniel Murray
11 min read 09 May 2014, 12:28 AM ISTEFG Asset Management's head of research on the tasks ahead for India's next prime minister and the dangers of a slowdown in the pace of reforms
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Singapore: If the Bharatiya Janata Party’s (BJP’s) prime ministerial candidate Narendra Modi were to head the next government, he should be swift and decisive in policy implementation to keep foreign investors interested in India, said Daniel Murray, head of research at EFG Asset Management, EFG International’s private banking group headquartered in Zurich, Switzerland. Any slowdown in the pace of reforms could result in India and Modi going the Japan way, where the initial euphoria associated with the election of prime minister Shinzo Abe has waned over the past year, and foreigners have lost interest as policy momentum has weakened, he added.
Edited excerpts:
The International Monetary Fund (IMF) has warned about India’s corporate debt and said Indian companies have the highest degree of leverage in Asia. Is this a concern?
On the face of it, Indian corporate debt metrics do not look overly worrisome. At around 60% of GDP (gross domestic product)—according to BIS (Bank for International Settlements) data, non-financial corporate debt is meaningfully less than the equivalent Chinese ratio of about 160%, although it is more than the ratios for Indonesia and Thailand. The ratio is also low relative to developed markets: the ratio of non-financial corporate debt is about 80% in the US and 100% in the euro zone. It is not just the level of debt which matters but also the rate at which it has been growing. The faster the growth rate of debt, the greater the probability that debt has been extended to low-quality borrowers and, hence, one would expect more bad loans. India’s ratio of non-financial debt to GDP has been stable for several years, so this does not seem of great concern either (although this does, of course, reflect the fact that both nominal GDP and loan growth have been quite rapid). As ever, it is important to assess each individual credit on its own merits, including how much leverage any particular company has taken on board as well as its ability and willingness to repay.
How do you see foreign institutional investors (FIIs) approaching India during these times—in the run-up to a new government being formed—will the election results be a determining factor for FIIs’ future investments in India?
The third quarter of last year witnessed a difficult period in general for emerging markets (EMs) although, since then, there has been a discernible improvement in investor sentiment, with India being one of the beneficiaries. With specific regard to India, this newfound optimism has been associated with a number of factors including enthusiasm associated with the expected election result. The hope—at least from the perspective of foreign investors—is that if Narendra Modi is successful in his bid to become the next Prime Minister, he will be able to implement similar policies to those he adopted as chief minister of the state of Gujarat. In short, these include an anti-corruption drive, reducing inequality and improving the infrastructure. However, talk is cheap. While Modi does have some pedigree as a successful reformer at the state level, to maintain foreign interest it will be necessary for policy implementation to be swift and decisive after the election, something which may be more difficult to do in national government. To draw an analogy from another country, it is discernible how the initial euphoria associated with the election of Prime Minister Abe in Japan has waned over the past year; most of the rally in Japanese markets occurred shortly after Abe’s election and in anticipation of a change at the helm of the Bank of Japan since when foreigners have lost interest as policy momentum has weakened in spite of aggressive central bank easing. The actions of governor (Raghuram) Rajan at the Reserve Bank of India (RBI) have been greeted warmly by foreign investors. This combination of political optimism alongside an improvement in central bank credibility has been a powerful catalyst for foreign investors. For foreign sentiment to remain positive, it will be necessary to ensure that policy momentum is maintained in the months ahead as a new government is formed and settles down to the day-to-day business of running the country.
All opinion polls suggest that Modi will be the new Prime Minister. Considering that will be a while before the new government can bring about substantial changes that are required, how does one explain the record rise in the Indian stock markets?
Financial markets are mechanisms for discounting expected future outcomes. In this context, they often react ahead of and in anticipation of upcoming events. This helps explain why Indian equities have performed so well recently—the market is discounting the expected election result and the perceived positive impact it will have on the Indian economy and corporate environment. Other factors have also played a part including: the appointment of Raghuram Rajan as central bank governor, reduced public sector interference in markets vis-à-vis a cut in fuel subsidy and increased openness to foreign investors. As mentioned earlier, for markets to continue in this bullish phase will require impactful action from the new government and ongoing implementation of reforms.
Many are talking about a stronger rupee if Modi comes to power. Is a stronger rupee desirable for India at this juncture?
A stronger rupee is desirable in the sense that it would reflect a greater degree of foreign confidence in India’s economic situation. It would also help bring inflation under control. However, one would not want to see the currency strengthen by too much, too quickly, since this would be destabilizing in terms of its potential impact on trade. The most palatable path for the rupee would be a modest appreciation followed by a period during which the currency trades with low volatility, since this would also be more attractive from the perspective of foreign investors while enhancing the ability of Indian companies to plan ahead.
What is your growth outlook on India, 2014-15 through 2018-19?
From a structural perspective, the Indian economy has an attractive demographic profile with a high proportion of the population aged 14 or under and a relatively high birth rate. The relative youthfulness of the population is helpful because today’s schoolchildren will be part of tomorrow’s labour force. In turn, this will help support the economy. The other important factor for growth is the rate at which productivity can improve. Again, here, India has an advantage because it is starting from a low base. Putting the two together suggests the trend rate of growth of the Indian economy is currently about 6% per annum, and this serves as a baseline estimate for the rate of economic expansion over the next five years. The more successful the government is in terms of implementing reforms, updating the infrastructure and encouraging productivity enhancing investment in both labour and capital, the greater the opportunity for growth to exceed this ballpark figure. On top of this, one has to overlay cyclical factors. Fiscal consolidation, which is desirable from a long-term perspective, will act as a drag on growth over the coming year. Furthermore, the lagged beneficial impact of the weak currency will diminish as the year progresses, which will also act as a headwind to growth. In terms of the political situation, there is clearly a possibility that once elected, however willing the new government is to impart growth-enhancing policies, their objectives will be frustrated by the political process. It is also true that even if this is not the case, there will be little time for meaningful reform to be implemented in a manner which benefits the economy in 2014. Market expectations for growth in 2014 are around 4.7%—from Bloomberg. Taking these temporary factors into consideration suggests that this is a reasonable estimate in terms of its departure from the trend, but that the balance of risks is to the downside.
Have EMs bottomed out? If so, is this the time to increase one’s exposure to them? Or should one wait to see further improvement in EM fundamentals?
Following the mini-crisis of last year, many emerging equity and bond markets sold off sharply. In many cases, foreign investors experienced a double whammy from associated currency weakness which occurred at the same time. This is normal—for many emerging markets, there is a high correlation between foreign flows, the performance of domestic equities and the currency. A discriminating factor for markets at that time was the size of the current account and budget deficits, both of which are harder to finance in an environment of capital flight. In general terms, those countries for which the sum of these two deficits was the largest experienced the sharpest drawdowns in their domestic equity markets and currencies. For example, the sum of Indian current account and budget deficits was around 12% of GDP in 2013; and from peak to trough, the rupee sold off by more than 25%, with the Sensex falling by around 12%—a combined compounded loss of over 40%. For Malaysia, the sum of the current account and budget positions was a small surplus; the peak to trough decline for the ringgit was only 12.5%, whereas the equity market sold off by a modest 6.8% before swiftly recovering. However, following that re-pricing of markets and currencies, what has become important is not just the level of big macro drivers—such as current account and budget deficits—but also the degree to which they are improving (or deteriorating), and the speed at which that is happening. It is of course no coincidence that those countries like India and Indonesia which experienced the sharpest currency falls last year have also seen the most improvement in their trade positioning, and this has been viewed positively by foreign investors. However, judging by the extent to which the foreign flows have re-entered some of these markets, much of this improvement now seems to be priced in. Against this background there are two factors to bear in mind with regard to emerging market investing in the current environment. First, further catalysts may be needed to drive the next leg of foreign interest in emerging markets and, second, it’s increasingly important for foreign investors to differentiate between emerging markets on the basis of country-specific risks and opportunities rather than making generic emerging market allocations.
How big a concern is Ukraine? Will the US and European sanctions on Russia impact global markets?
Events in Ukraine are, understandably, grabbing a lot of headlines at the moment; yet, the market impact has so far been relatively muted. One reason is because the Ukrainian economy is relatively small. At around $175 billion its GDP is less than that of Greece’s. Hence, a sharp contraction in Ukraine’s economy will not have much of a direct impact on the rest of the world. The two markets, for which Ukraine is an important player, are those for corn (about 12% of global exports) and wheat (about 6% of global exports), the prices of both of which have risen by over 15% for the year-to-date. So there is a potential issue with regard to food security for importers of these commodities although it does not seem insurmountable at present. The bigger issue is Russia’s involvement. Given that Europe relies on Russia to supply about one-third of its energy needs, it is difficult for European leaders to adopt too hard a line with regard to sanctions against Russian individuals and businesses. Similarly, Russia is reliant on Europe as a major source of foreign income; so it is not ultimately in the interests of Russian politicians to antagonize NATO too much. This suggests that it is in the interests of all parties to reach a diplomatic solution and helps explain market calm. What is unknown and potentially more destabilizing are the political aims and objective of the Russian elite which are not necessarily in tune with what seems logical on the basis of shared economic interests. One interpretation of events is that President Vladimir Putin is seeing how far he can push NATO and how much he can get away with before more severe sanctions are imposed.
Do you think investors should invest a small portion of their portfolio in European funds to benefit from a likely recovery in the European markets? Especially since several world-class companies are available in Europe at valuations below their Indian counterparts, thus providing an excellent opportunity?
As ever, it’s impossible to make general comments about what investors should or shouldn’t do because so much depends on each individual investor’s risk preferences, return expectations and liquidity needs. However, with this in mind, there are a few points to note. The attractions of European equity markets are: they are relatively cheap, although absolute rates of growth are expected to remain low, Europe is the region where the greatest improvement in growth is expected to come in 2014, and central bank policy is expected to get looser before it gets tighter. Furthermore, many companies listed in Europe have relatively large business exposures to other parts of the world and so potentially will benefit from growth in other regions. However, it’s also worth bearing in mind that Europe still faces many structural challenges including: the need to reform the welfare state, poor demographics and inflexible labour markets while the strength of the currency over the past couple of years will act as a headwind to growth in the coming months. So there does look to be an opportunity in Europe at least from a cyclical perspective; but meaningful structural changes will need to take place for this opportunity to persist.
