India is on the right track

When France sneezes, the rest of Europe catches a cold” is a 19th century quote attributed to Austrian chancellor Klemens Von Metternich. Since then, we have heard variants of this quote with the words “France” and “Europe” getting replaced most commonly with “the US” and “the rest of the world”. More recently, as global markets entered a tailspin, the focal point seems to have been a sneeze from China.

It is human tendency to rely on causal reasoning to explain every event. As global markets took a nosedive last week, the most proximate cause attributed to the event was the woes in the Chinese stock markets. Interestingly, on one of the local channels in India, a “market expert” attributed the volatility even more specifically to the weak Chinese Purchasing Managers’ Index (PMI) data reading as the real reason for the crash. Some others attributed it to the devaluation of the Chinese yuan.

Whatever might have been the so-called cause of the crash, it has reinforced the fact that India is not immune to shocks in global markets. Not quite surprisingly, the sentiment in markets also seems to define the popular perception about the effectiveness of the government’s economic policies. Immediately after the general election last year, it was widely held that India would embark on major structural reforms and the markets zoomed in anticipation. In fact, we wrote in June last year that it would be naive to assume that the government would embark on economic BHAGs (big hairy audacious goals) immediately after assuming office. Now, as we speak to political and economic commentators, the mood seems to have swung to the other extreme as a sense of fatigue and déjà vu has set in with this government.

As long-term investors in the markets, our view has been that as sentiment gyrates between extremes, the truth often lies somewhere in the middle. In this context, it is worth cutting through the noise to look at five trends that characterize the current economic situation in India. In our opinion, these trends are not fleeting, and will gain further strength in the coming months and years.

1. Fragile no more

India’s external vulnerability has significantly diminished. As we wrote in detail in our last essay, foreign direct investment (FDI) has for the first time in seven years exceeded the current account deficit. While clearly more can be done to make it easier to attract FDI, India today does appear to be in a sweet spot in FDI-current account equation, making if far less vulnerable as compared with 2013.

2. Gradual and uneven

In our view, economic recovery will be gradual and uneven. It has been hard to pinpoint specific reasons, but one witnesses buoyancy in some pockets and continued sluggishness in some others. A case in point is divergent growth trends between relatively good growth in scooters versus sluggishness in motorcycles. While motorcycle sales have been flattish compared with five years ago, scooter sales are up more than 2.5 times. However, the fact remains that despite different economic indicators throwing confusing signals, the economy is undoubtedly bottoming out. The pace of recovery will likely be slower as the tailwind of strong global growth that existed in the past is missing this time.

3. Financialization of savings

There are early signals of household savings shifting from physical savings (gold and property) to financial savings. Domestic mutual fund flows into equity markets have been positive for 15 consecutive months in a row. This makes it the longest streak of net inflows since 2000 when data on fund flows is available. In contrast, India’s gold imports have shrunk by about $25 billion from the levels of 2013. Similarly, property demand continues to remain sluggish, with the Reserve Bank of India’s pan-India index for residential property prices indicating, at best, meagre price increases.

4. Rise of the states

Earlier, advertisements from state governments rarely went beyond the statutory tenders or appointments. If at all, they were typically related to tourism such as Kerala’s “God’s own country” campaign some years ago. That has now changed with states advertising their potential as an investment destination. The states’ share in the Union government’s tax receipts has risen from 32% to 42% based on recommendations of the 14th Finance Commission. A recent Credit Suisse report showed that cumulative spending of states is now 1.6 times that of the Union government. How each state will use the increased tax allocations will be an interesting trend to watch. Initially, the proceeds may go towards cleaning up state electricity board losses or reining in borrowing. Eventually, the extra money in the hands of states will find its way into the economy.

5. From doles to capex

After seven consecutive years of spending more on subsidies than capital expenditure, this year the government is likely to spend an equal amount. This will be a big positive, particularly if the trend of lower subsidies and higher capex continues in the coming years. In the first quarter of fiscal 2015-16, capital expenditure is up 18% year-on-year, led by spending on road, railways and defence.

To conclude, in our opinion, India will always be a two-step forward followed by one-step backward story. When markets are euphoric and extrapolate positive trends, it’s time to be cautious and vice versa. As we look through some of the criticisms from the cynics on India and compare notes with our views on trends noted above we are reminded of a quote by Joan Robinson, “Whatever you can rightly say about India, the opposite is also true.” We continue to believe, amid the scepticism, that India is on the right track.

Amay Hattangadi and Swanand Kelkar work with Morgan Stanley Investment Management. These are their personal views.

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