Are Structural Reforms in India Paying off?

Over years, much buzz around about the so-called BRICS (Brazil, Russia, India, China and South Africa) took place. Let’s then look more closely at India, in order to find out if and how much it can be interesting.

“Faith is the bird that feels the light and sings when the dawn is still dark”.
This verse by Rabindranath Tagore (1891-1941) may be the metaphor of the Indian growth: faith in a development that would come, indeed.

India’s potential growth is rising, not falling. That is the conclusion to be drawn from a number of structural reforms unleashing the economy’s productive power. The reform momentum buoys confidence in India’s prospects. Structural reforms – including a nationwide goods and services tax – are weighing on growth near term, but clearing the way for faster potential.

The Reserve Bank of India cut rates in August and is likely to ease policy further, which could help tamp down real borrowing costs and spur growth. With inflation slowing and anchored below the Reserve Bank of India’s 4% medium-term target, there’s scope for a rate cut in December 2017. Favorable rains have led to productive crop sowing – which bodes well for rural growth. The economy is poised for a gradual, non-inflationary recovery in the months ahead.

The government is laying the groundwork for faster growth by reducing bottlenecks. The Prime Minister’s office has streamlined regulations on agricultural distribution and bankruptcy. It is also bringing public services online and lowering reliance on cash transactions.

These spell accelerating potential growth.

Structural reforms are pushing up potential growth, but high real interest rates are preventing a full-fledged recovery. This suggests the output gap – which the Reserve Bank of India estimates at 1% of GDP at end-2016 – will persist or even get wider. In the meantime, inflation continues to surprise on the downside, therefore prompting the central bank to cut rates again at its policy review in December 2017 or February 2018, without fear of stoking inflation to allow actual growth catch up to potential. Looking ahead, inflation is likely to inch lower in coming months, undershooting the central bank’s projection for 2H fiscal 2018. This would provide scope for a rate cut at its December policy review to spur growth.

India’s GDP growth is expected to edge up to 7.2% in fiscal 2018 from 7.1% last fiscal, and then recover meaningfully to 7.7% in fiscal 2019.

The rupee is expected to appreciate further against the dollar to 61.1 by March 2018 from 67 in March 2017, on a quarterly average basis. As capital flows and trade seasonality align in 2H, the rupee is likely to post sharper gains. India’s economic stability, reform momentum, and political stability are attracting strong capital inflows. The result: foreign exchange reserve accumulation at the central bank and appreciation pressure on the rupee, which is supported by the traditional pattern of rupee’s relative strength against the U.S. dollar from December to April each year.

The table and chart below track actual and forecasted key statistics about the Indian economy.

Source of data: Bloomberg

Source of data: Bloomberg

Let’s now take a closer look at some key sectors of the Indian economy.

Agricultural growth is projected to hit the 4% mark in fiscal 2018, thanks also to more rural areas connected to the electricity grid. The mining sector should also see a gradual pickup in the coming fiscal year as higher growth generates demand for coal, crude oil, and minerals.

India’s industrial gross value added is likely to rebound to nearly 8% year-on-year growth in fiscal 2018, after a slowdown to 6.7% in fiscal 2017. High real borrowing costs – the main reason for the 2017 slump – started coming down, with banks cutting lending rates following demonetization and manufacturing inflation picking up. The implementation of the goods and services tax adds impetus as well.

India’s service sector gross value added is set to pick up to 8% growth in fiscal 2018, with most areas performing better (public and social services are exceptions). That would be up from the official estimate of 7.2% in fiscal 2017. Lower rates and interest subsidies on low-cost-housing may drive construction. Pent-up demand from the demonetization squeeze is set to boost retail trade, real estate, and banking services. Higher government capital expenditures may spur transportation.

As Finance is – at its heart – a forward-looking discipline, chances are the favorable prospects of the Indian economy are discounted by financial markets. The chart below shows how the Indian Sensex equity index is closing the gap that opened up in late 2015 against the broader MSCI World equity index, in Indian rupees.

Source of data: Bloomberg

Keep your eye on India: it could be a rather good place for your investments…

Author – Prof. Leonardo Etro, MISB Bocconi
Leonardo Etro, Italian, SDA Professor of Accounting, Control, Real Estate, and Finance Department at SDA Bocconi, Milan; Professor of Corporate Finance and Corporate Valuation at Bocconi University, where he is also Director of M&A Observatory. His main areas of research are Corporate Valuation, M&A transactions, Corporate Restructuring and Private Equity.