India’s prime minister Narendra Modi is facing pressing economic, social and political issues in the upcoming general election. Portfolio manager Aaron Armstrong, upon his return from an investment research trip to Mumbai, looks at the key implications for investors.
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Narendra Modi made history in 2014, leading the Bharatiya Janata Party (BJP) to become the nation’s first party other than Congress to win a majority in the lower house of parliament. Modi and the BJP swept to power on promises of reinvigorating a lagging economy and cracking down on corruption. At the end of Modi’s five-year term, however, his scorecard is mixed. Growth is below expectations, while unemployment remains a key challenge. Moves to undermine central bank independence and a populist tilt heading into the election have also raised eyebrows.
Despite these challenges, his government has made progress on some crucial economic reforms. Meanwhile, the MSCI India Index has outperformed the broader emerging market universe in US dollar terms in the past year, returning 3.9 per cent in the 12 months to 31 March 2019, compared to a decline of about 9.5 per cent in the MSCI Emerging Markets Index. (See chart below.)
Aaron Armstrong, global emerging market equities portfolio manager at Aviva Investors, explains why India’s 2019 upcoming election – to be held between April 11 and May 19 - has the potential to either take the country and its economy around a corner or a step back, and where he sees the most attractive investment opportunities.
What’s at stake in the upcoming elections?
Our base case scenario is for the BJP to lead a strong National Democratic Alliance (NDA) coalition. A lot depends on the number of seats the BJP wins in the lower house; a minimum of 230 to 240 seats will be needed to provide a strong power base on which to build a coalition. In this scenario, the current reform and development-focused policy set would likely continue.
A weaker BJP-led coalition would prove less stable for financial markets, but the worst-case scenario would be a Congress-led government. For investors, the fear is a possible return to an economic manifesto based on handouts and income guarantees. However, the latter scenario is remote at this stage.
How do the BJP and the Congress Party compare?
Modi and the BJP in 2014 campaigned on promises of a more vibrant economy. The government has raised infrastructure investments and improved the ease of doing business, but a revival in economic growth or employment remains elusive.
While a softer economy is a significant detractor from the BJP’s re-election bid, the opposition is not in a position to capitalise on the opportunity. The Congress party lacks a popular leader with a sufficient public persona to challenge Narendra Modi and a clear set of policies to address the needs of modern India.
How is the election affecting policymaking?
Predictably, a degree of populism has crept into fiscal policy, with the government using higher spending to target rural voters. Furthermore, the government abruptly replaced the central bank governor in December 2018 with an insider appointment more aligned to its political agenda; the change has resulted in looser monetary policy in the run-up to the elections. While this raises long-term questions about central bank independence, lower rates may provide a modest boost to the economy.
What about the government’s 2016 banknote demonetisation, which was heavily criticised?
This is possibly the most misunderstood issue of Modi’s tenure. In November 2016, 86 per cent of India’s banknotes (by value) were unexpectedly withdrawn from use, becoming worthless overnight. The policy forced everyone holding the two largest-denomination banknotes to declare their holdings at a local bank branch in exchange for new notes.
One aim of the policy was to flush out illegitimately earned ‘black money’ from the system. In practice, however, a far higher percentage of notes were legitimately exchanged than expected; in this regard, the initiative’s impact fell short of expectations. To focus on this factor, however, is to miss the importance around the formalisation of the financial savings system. Demonetisation forced millions of households to use formal banking services for the first time, helping to integrate them into the formal economy. In addition, the move will help mobilise billions of dollars in savings currently residing in unproductive physical assets such as gold and banknotes. Wealth and income declaration will also improve tax compliance, boosting government revenue.
Is the Pakistan situation an election risk, or opportunity, for Modi?
If you look back to 2014, there’s a stark difference in India-Pakistan relations. Modi invited Pakistani Prime Minister Nawaz Sharif to his inauguration in Delhi, and the early stages of the relationship were relatively stable in a historical context. However, tensions flared two years ago and again earlier this year when a Pakistan-based jihadist group claimed responsibility for an attack killing 40 Indian paramilitary policemen. The successful missile attack of a low orbit satellite in March was another nationalist move, demonstrating India’s space capabilities. Modi’s increasingly nationalist stance in response to these tensions has significantly boosted him and his party in recent polls.
India is often compared to China when tracking its economic progress. Will India follow a similar path to economic development?
The direction will be similar, but the way India arrives at that destination will likely be very different to China. While there are similarities, such as the potential for urbanisation and rising income standards, China's growth over the last thirty years was to a large extent driven by state policy. Conversely, growth in India’s economy is more determined by market forces and profit-maximisation incentives rather than concerted efforts dictated by a centralised government. On that basis, India’s journey could well prove bumpier than China’s, with a greater emphasis on private sector companies to drive the economy. This is a key point of differentiation for investors, with important implications for active stock picking in India’s more entrepreneurial environment.
Where do you see opportunities?
Financial markets are reflecting a higher probability of a Modi-led government, both in terms of equity markets and foreign investment flows. In this environment, higher beta stocks tend to outperform. The financial and infrastructure sectors stand out as being among those where investor sentiment is particularly aligned to the political outlook.