India's Post‑Election Outlook: A Fine Balance
As Indians cast ballots in a general election that ends 19th May, we think it's a good time to take stock of the investment outlook. The election outcome could prove pivotal to global growth as well as India's.
Prime Minister Narendra Modi's government has initiated important structural changes that are likely to help sustain high growth rates over the next several years. However, to ensure that risks to the banking system and fiscal sustainability don't resurface, we think the next government will need to embark on a second generation of reforms.
We believe the National Democratic Alliance, led by Modi's Bharatiya Janata Party (BJP), would be more likely than the opposition United Progressive Alliance (UPA) to resist populist policies that could jeopardize fiscal sustainability and growth.
While both alliances have espoused populist policies in the current campaign, the BJP, since 2014, has avoided the legislative paralysis seen in the preceding UPA government. The BJP's implementation of demonetization and a value-added tax has weighed on demand, but nonetheless, goes some way toward shoring up the medium-term outlook and, at least as importantly, creates a single internal market for goods and services by eliminating tariffs on trade between states for the first time.
A fine balance between growth and prudence
Despite the reforms to date, India has yet to see a material GDP growth dividend, as growth slowed in the wake of the tax reform and demonetization to below the perceived trend rate of around 8%. Accordingly, ahead of the competitive general election, the authorities have eased both fiscal and monetary policy in an effort to stimulate growth. Bank credit has already begun to recover following signals from the Reserve Bank of India (RBI) that the asset quality review started in 2015 has ended.
The recent easing in financial conditions marks a welcome respite from the shocks of the government's demonetization in 2016 and last year's liquidity crisis in the nonbank financial sector, but the delicate balance between growth and financial prudence needs to be maintained.
We believe the following specific reforms could help keep that balance:
- The government could affirm its commitment to a fiscal consolidation path after recent slippage.
- The RBI could reiterate its commitment to the inflation-targeting framework implemented under former Governor Raghuram Rajan. Incumbent Governor Shaktikanta Das appears to have tilted the balance of the RBI's dual mandate in favor of growth.
- The government could continue consolidating state-owned banks and avoid further backpedaling on the 2016 Insolvency and Bankruptcy Code, which was designed to enhance the rule of law and help banks recover losses when corporations default.
- The RBI should also carefully manage the still-delicate funding risks of the nonbank financial sector, which continues to face higher funding costs despite two consecutive rate cuts by the RBI.
- To address the persistent weakness of investment demand, especially in manufacturing, we believe policy needs to focus on easing regulation as a means to boost export competitiveness and, ultimately, improve external balances.
- Additional reforms to the agriculture sector could serve to increase productivity growth and boost rural wages.
- Further efforts to develop local capital markets, including the gradual opening of the domestic fixed-income market and eventual inclusion in benchmark bond indices, would help to sustain the high domestic savings rates and, indeed, to mitigate current account deficits.
Although "Modi-phoria" has waned since the election in 2014, the current government has been successful in improving India's secular growth outlook. A second term would likely start with lower expectations than the first, but with reasonable odds of further reforms to consolidate and build on recent achievements.
In external credit, we remain constructive on selected fundamentally sound companies in the financial, energy, and infrastructure sectors. Financials, in particular, stand to benefit from easier liquidity conditions and a more accommodative regulatory stance. We remain neutral on the rupee given the looser monetary policy stance and the potential shift in the RBI's focus to a more growth-oriented framework.
While the BJP is projected to win the election, we recognize that the predictive power of Indian election polls has been poor in the past. In the event of a surprise upset by the UPA, we would expect a period of uncertainty that would unsettle Indian asset prices, with the currency serving as the primary shock absorber. Even then, however, we believe that the reforms of the past five years provide a strong anchor for Indian external credit.
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