Gemologist 2 Getting India back on track
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Newsletter
Issue 05 | May 2014
Gemologist
2 Getting India back on track
3 Reform priorities
6 Filling the gaps
6 Stock pick
Beyond
Modi
Madness
Key points
Expectations are high
that a Narendra Modi-led
government will tackle
India’s deep-seated
problems and put the
country back on to a higher
growth track
Any new government needs
to address India’s deficit,
prioritise asset rather than
consumption growth, cut
red tape, modernise its
cities and tackle energy
provision.
We see three main
investment themes: rural
growth, infrastructure
development, and
technology
Holier than thou: but it will take more than ascetisism to catalyse Indian growth
For professional investors only www.hermesfundmanagers.com
Newsletter May 2014
The Finnish tourists were chanting blissfully inside the temple, but
the holy man on the steps outside was reading the paper. He was
absorbed in the front page but as it was in Hindi I could only assume
he was reading about the latest sensation to sweep India, Modi
Madness. Then he flipped to the back page... was he checking stock
prices or the cricket? I’ll never know.
He has eminent company. Narendra Modi, the BJP’s candidate But India is more, and less, than Gujarat, just like America is more,
for prime minister, has cultivated a holy man image himself. His and less, than New York. Will Modi be able to win a strong mandate
declared celibacy (Modi claimed to have never married, having from India’s billion people, with their 780 languages, eight major
decided as a young man to dedicate his life to Mother India, though religions, and countless political philosophies and special interests?
he’s since acknowledged a marriage in his election papers) and And if he wins, can he put India back on track?
Hindu fundamentalist beliefs raise eyebrows in the West. Especially
as his beliefs raise India’s status as the Holy Land to the level of Getting India back on track
Israel to fundamentalist Christians and Orthodox Jews, for to Hindu The market, up 13.4% (vs the GEM MSCI benchmark, which is up
fundamentalists Vishnu not only lived in India but ruled as Rama, and 8.1%) in the past 12 months, is betting that he can. Of course, the
has returned again and again. number of seats he wins will be important: more than 220 and his
mandate will be seen as undeniable, less than 190 and it will be seen
In his career to date as chief minister of the state of Gujarat, Modi may as questionable. And whether he is able to convince his own party, let
have practiced personal austerity but he has nonetheless provided alone new coalition partners, to sacrifice vested interests in order to
much in the way of earthly benefits for his Gujarati constituents. reform, is an open question. His power as chief minister of Gujarat
Known for its banias, or businessmen, Gujarat has for thousands of was much more absolute than it would be as prime minister of the
years been home to gem cutters, spice merchants, ocean traders country, where he will face not only (probable) coalition partners but
- in other words, host to a rich entrepreneurial tradition, to put a also members of his own party who are opposed to reform.
fashionable title on an activity that is as old as civilisation itself. And
thus it comes as no surprise that under a dynamic and focussed
leader, Gujarat has flourished.
Those in favour: the coming Indian elections present the opportunity to opt for positive economic change
2Hermes Global Emerging Markets
India today is not in crisis, as the new Central Bank governor goods and services at the local, state and central levels, into a single
Raghuram Rajan has stabilised the current account and the currency. nationwide tax. It would remove the borders within borders that add
Although this fix is welcome, India remains off-track for sustainable expense and constrain growth today, creating a vibrant common
development, and many issues remain to be addressed. Growth is market.
slowing and inflation is elevated. Stagflation isn’t good for anybody.
The existing government has implemented a few reforms in recent
Chart 1. 1. While capex falls…
months, but much more is needed. A new government, it is hoped, will
at least tackle these problems, moving the economy back onto its old 4
growth track.
While hopes that a superman like Modi can solve most of India’s 3
problems are almost certainly misplaced, there are concrete steps
visible today that his government can implement to get India back on
track.
2
The BJP Manifesto was published on 7 April, and contains a number of
concrete proposals for projects which would certainly help achieve a
more balanced and efficient economy, such as building an agricultural 1
rail network for perishable farm products, extending the reach of gas
grids to include villages, launching a clean rivers initiative, drafting a
uniform civil code, and focussing on manufacturing. These discrete 0
projects are laudable, but what are the deeper underlying failings that 2004 2008 2009 2010 2011 2012 2013 2014E
need addressing, and what should be done to address them? Capital expenditure
We point to five major areas that Modi and the BJP need to address in Source: Baseera, November 2013
order to give India a chance to achieve its economic promise, but leave
to others the task of analysing the political challenges this will involve.
These reforms are:
Chart 2. … subsidies are India’s growth area
Cut the deficit
3.0
Let productivity catch up to wage growth by spending government
money on assets, not consumption 2.5
Remove Kafkaesque obstacles to doing business 2.0
Make India’s cities liveable, efficient, and modern
1.5
Unleash India’s coal, oil, gas and electricity reserves
1.0
We take each of these in turn. 0.5
Cut the deficit 0
2011
2005
2006
2007
2008
2009
2010
2012
2013
2004
After the credit crisis, India pursued an expansionary fiscal and
2015E
2014RE
monetary policy to push domestic demand through consumption
in the face of weak export income. In particular, the consolidated
fiscal deficit rose from 4.9% of GDP in 2008 to 9.9% in 2009 and has Subsidies
remained above 7.5% over the past four years. This made sense in
the immediate aftermath of the crisis, but should have been removed Source: Bloomberg
thereafter. High fiscal deficits and government spending have resulted
in a steady erosion of public savings (and hence overall savings),
Improving the quality of spending is the single most important thing
requiring the import of capital to finance a widening current account
the new government can do. Capex has steadily declined from 3.8% of
deficit. India’s energy deficit, in particular, could be partly alleviated
GDP in 2004 to 1.7% of GDP in 2014 (see chart 1). On the other hand,
by removing subsidies. But in general, a higher level of public savings
expenditure on subsidies has increased by nearly 1% of GDP between
would help raise the overall level of savings in the economy. This
2006 and 2014 (see chart 2), while growth has decelerated from over
would finance investment and preserve domestic capital by lowering
9% to under 5%.
the current account deficit.
Increasing tax revenues is not unprecedented in India, as they rose
as a percentage of GDP from 6.6% in 2004 to 8.8% in 2008. However,
in the near term, weak economic growth will constrain growth in tax
revenues. As the economy recovers, a Goods and Services Tax (GST)
would be an important milestone, subsuming multiple tax rates for
www.hermesfundmanagers.com | 3Newsletter May 2014
Overall redistributive expenditures accounted for 2.9% of GDP in 2013, Remove Kafkaesque obstacles to doing business
dwarfing capital spending of 1.7%1. Fuel, fertiliser and food subsidies India ranks 134 out of 189 in the World Bank’s Doing Business
all create distortions in the market and need to be addressed. report, which measures the prohibitive effect of business regulations,
comparing poorly with 131 last year. Public and private investment
Let productivity catch up to wage growth fell from a peak of 26.2% of GDP in 2008 to 17.3% in 2012. Even the
Unlike the US, where wages as a proportion of corporate profits 26.2% in 2008 was a huge slowdown from 43% in the previous five
remain at trough levels with little prospect of recovery, Indian wage years. There has been a large decrease in the marginal productivity of
growth, both rural and urban, has far outstripped GDP, especially in capital, or expected return on new investment The ICOR, incremental
recent years. Rural wage growth has been triggered by government capital output ratio, a measure of the inefficiency of capital use, has
redistribution policies, particularly the Mahatma Gandhi National risen from just over three times in 1996 to nearly seven times today,
Rural Employment Guarantee Act (NREGA), which guarantees 100 while total factor productivity has gone the other way (see chart 4).
days of employment each financial year to rural households that
volunteer for unskilled manual work. Since 2009, such schemes
Chart 4. Inefficient capital utilisation and lower factor productivity
have caused rural wages to rise above nominal farm GDP growth,
and have likely resulted in the externality of benchmark wages rising 8
throughout the economy, not to mention higher prices of agricultural High ICOR, Lower TFP to show
7
products (see chart 3). Wage inflation, at a time of deceleration in weakening productivity trend
investment, economic growth and new jobs growth, is a key factor 6
in today’s stagflationary environment. Corporate profit to GDP has 5
slid to a nine-year low. Low profits constrain corporate investment, 4
new job creation, and, coupled with rising inflation, undermines
3
the government’s own policy. The practical answer is not to undo
the NREGA programme, which is politically impossible in the short 2
term, but to perform a strict national audit to ensure that the scheme 1
engages the rural population to build productive assets. Outlays would 0
be dependent on these audits.
-1
1996
1998
2000
2002
2006
2008
2010
2012
2014E
2004
Chart 3. Rural wages help stoke stagflation (%)
12 12 ICOR (X) Total Factor Productivity (%)
10 Source: RBI, Morgan Stanley Research
10
8
8
6
Improving the cities
6 4 It is well known that urbanisation correlates highly with development,
2 and many of the links are well understood.
4
0 Compared to many developing countries, India is under urbanised
2 (see chart 5). This is partly due to its agricultural legacy but also
-2
counter-productive government policies. These include the previously
0 -4 cited NREGA plan and a lack of focus on physical infrastructure.
2006
2007
2008
2009
2010
2011
2012
2013
Growth in many Indian cities is chaotic and poorly (if at all) planned.
Areas of focus should include improving public transportation and
Real GDP (LHS) Real Rural Wage (RHS) housing, creating business districts, improving health and sanitation,
sewage and solid waste disposal. Similar to changes that are planned
Source: Bloomberg, Labour Bureau, RBI, Morgan Stanley Research for China, India’s centre needs to delegate clear functions and
responsibilities to local authorities to ensure the delivery of social
services and grant them autonomy in decision making, increase
accountability to citizens and change the tax structure so that financial
resources are available at the local level.
1
Government subsidy payments, at 2.5% of GDP, added to subsidies on oil marketing
companies of 0.6%, constitute a substantial drain on public saving. They have risen from 1.6%
of GDP in 2004 to 2.6% in 2013.
4Hermes Global Emerging Markets
Chart 5. Sluggish growth of India’s urbanites
An opportunity not to miss
As optimistic as the markets are, Modi himself faces challenges.
90 Following scams in telecoms and coal, activism from the supreme
80 court and the auditor general of India has increased. This has resulted
in a paralysis within government, as civil servants and politicians fail to
70 take any bold decisions, fearing their moves would backfire.
60
Actions taken by the new RBI governor have cheered international
50 and domestic investors, but Modi’s own allies in the BJP-led National
40 Democratic Alliance are not all fans.
30 Popular hopes for a quick economic recovery post a Modi victory,
20
implying loose fiscal policy, run counter to the reforms needed.
10 Modi is known for his grand visions for India and inclusive economic
1955
1965
1975
1985
1995
2005
2015E
development plans. However, not much is known about the team he
will put together. Will they share both his vision and his capability?
Brazil Mexico Indonesia India China
India has had a volatile relationship with China and Pakistan which
Source: UN, Morgan Stanley Research
is complicated by presence of non state actors trying to destabilise
the relationship, such as the 2008 attacks in Mumbai. India has so far
reacted quite mildly to this and mostly in a diplomatic fashion. But, if
provoked, how patient will Modi be?
Unleash the energy of energy
India has an energy surplus and an energy deficit. She is third in coal
reserves globally and has probably discovered tremendous amounts
of gas offshore. Awash with huge potential energy resources, the
country nevertheless is the victim of epic blackouts. There is little India India has an energy surplus and
can do to improve its oil reserves, drill as it might. However, unlocking
the gas reserves (currently unavailable to power plants due to high
an energy deficit. Awash with huge
prices demanded by Reliance, the developer of those reserves) is potential energy resources, the country
eminently feasible, should the issue be forced.
nevertheless is the victim of epic
Coal reserves are plentiful but imports have risen from 0.4% of GDP
in 2005 to 0.9% this year as delays in environmental clearances have
blackouts
constrained domestic production.
Assuming he wins the election, Modi has his work cut out for him.
This lack of fuel for electricity generation has caused power supply to India’s governance has been poor under Congress; indeed, it has
be unreliable for the past five years. Added to this, inadequate power never been exemplary since Independence. But the answers to the
tariffs for distribution over past decades has engendered crippling challenges facing the country are well rehearsed, and a sophisticated,
levels of debt at the state electricity boards, which required a bailout focussed leader could make substantial progress in implementing
several years back but remain unprofitable at current tariff levels. them. All else being equal, a strong win for Modi and the BJP would
set the stage for tackling India’s big challenges and putting the country
Growing an economy requires power, and the answers to India’s
back on the growth track. The market is almost certainly due for
power puzzle are clear. They involve granting environmental
a cold shower when it realises that Modi’s abilities are limited and
clearances to unlock the coal supply, banging heads together to
progress will be halting, but once it resets expectations to the middle
release Reliance’s chokehold on India’s gas requirements, and taking
ground between euphoria and despair, we think that with a degree of
the bitter and unpopular medicine of raising electricity tariffs such that
success on these issues, the market can make steady progress over
state electricity distribution companies (and therefore independent
the medium term.
power producers) can generate a return for shareholders. A tough
new government can achieve these goals, though at a political cost. With China busy reforming in order to move to sustainable long-term
growth (and therefore increasing economic, diplomatic, and military
power),the country will need all of Modi’s spiritual power to catch up. If
the holy man’s newspaper headlines are to stay upbeat, India cannot
afford to miss this opportunity. Otherwise he may as well go join the
chanting inside.
www.hermesfundmanagers.com | 5Newsletter May 2014
Filling in the gaps The bank’s margins have been stable across several interest rate
cycles, which it has managed alongside an impressive expansion plan,
The last time Gemologist covered India, we laid out our thoughts on doubling its branch network in rural and semi-rural areas over the
the challenges facing the country, and potentially promising areas. We past four-to-five years. NPLs remain very low – 0.97% gross and 0.20%
stopped at giving concrete examples as to how we might invest in this net in 2013 – consistent with its culture of careful growth.
market, but promised to develop this later. With our last visit to the
country, later has become now. It is the most technologically-advanced bank in India: 44% of
customer-initiated transactions were internet and mobile in 2013.
On our last visit, we had rarely seen the Indian financial community in While most other banks try to read the cycle and tack accordingly,
a better mood. Modi Madness has gripped the market. HDFC thinks ahead.
Analysts, fund managers, and even corporate executives were bullish The stock is trading at the lower end of historical earnings. Given
on the country’s prospects. The market mood notwithstanding, India’s growth potential, and the bank’s strength, we saw a good
we met several excellent companies whose outlook seems bright opportunity to buy.
whether Modi wins or not. These companies fell under three themes:
rural growth, infrastructure development and technology. An example
of each is below: Chart 1. From laggard to leader since the crisis
HDFC Bank: a best in class retail and corporate bank; fast growing in 3,000
under-banked rural India, with one of the lowest non performing loans
(NPLs) in the region (see below). 2,500
Power Grid: central electricity transmission backbone with a US$17bn 2,000
order book, creating a national electricity grid to solve country’s
chronic power problems. 1,500
Tech Mahindra: an ex-BT JV and a new entrant into the large-cap 1,000
Indian IT club, with a strong niche in telecoms and diversified industry
exposure after merging with Satyam Computers, itself well positioned 500
in the enterprise mobility space.
0
2000
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2011
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2004
2014
HDFC Bank: well positioned and well capitalised
India’s banking market is dominated by the State Bank of India,
which controls more than a fifth of the market. Privately-held ICICI, at HDFC Bank MSCI India MSCI India Financials
number two, has 5.6% market share. HDFC Bank is the third-largest Source: Bloomberg
commercial bank in the country, and the second largest of India’s
private lenders.
The market fundamentals look attractive. Credit penetration is only
55% and, even with conservative growth assumptions, there is much
to play for. Add to this the fact that state-owned banks across the
board have weak balance sheets, with the government in no position
to fund them, putting a well-capitalised private bank in a good position,
almost by default.
But HDFC Bank is not a default option – it’s India’s best-capitalised
bank, with a solid 11% Tier one position. Having met its management
a number of times, we have been impressed by its clear, consistent
strategy of providing best in class levels of service based on extensive
use of technological expertise, high levels of training, and judicious
expansion in low risk areas – first in the larger cities, now in rural
India. It has a current account/savings account ratio of near 50%,
which ensures a low cost of funding.
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