Research Team, 11 January 2017

Indian equities performed well in 2016. Let’s take this opportunity to assess if any progress has been made to justify recent performance.

The achilles heel of the Indian economy has always been a chronic lack of investment in infrastructure and productive assets. Without adequate infrastructure and productive capacity, the economy is prone to overheating and runaway inflationary pressures whenever growth accelerates. This is why, in our view, any sustainable economic expansion in India must be driven primarily by investment in infrastructure and productive assets.

The key factors limiting infrastructure and private sector capital spending have been a lack of foreign investment and a financial sector that has failed to recognise and provision for bad loans made over prior cycles. The latter is important because without clean balance sheets, banks are unable to extend the credit necessary to fund investment.

In our view, it is clear that Prime Minister Modi has made progress on all of these issues throughout the course of this year. Foreign direct investment has picked up, largely due to Modi’s hectic travel schedule during his first year in office to promote India as an investment destination.

Furthermore, in a surprising and bold step to crackdown on corruption and counterfeit currencies, India recently announced that it would be abolishing 500 and 1000 Rupee notes. Perhaps most importantly, in July of this year Modi’s government announced its intention to recapitalise 13 public sector banks.

So clear steps have been made to clear the field and allow for improved infrastructure and private sector spending. Unfortunately, in spite of the progress made on the above mentioned constraints to investment, there is still no compelling evidence that infrastructure spending and capital investment have increased.

In our April article, we highlighted the fact that enacting meaningful economic and political reforms is always a long and difficult process. India is an investment thematic that will play out over years (if not decades) rather than months. In spite of the lack of any compelling evidence that capital spending is increasing, we view recent initiatives by the Modi government to set the stage for increased investment very constructively.

While India is a higher risk investment destination and progress is likely to take place only gradually and over a long span of time, we view India as the one of the most compelling long-run opportunities in global equities.

Our positive view on India is based on the following key points:

  1. India’s demographics are among the most favourable in the world, with India set to surpass China as the world’s most populous country in 2022. According to The Economist, China’s population will peak at 1.4 billion in 2028; India’s four decades later at 1.75 billion.
  2. While the investment boom in many other emerging markets is just starting to unwind, India has suffered from a chronic lack of investment in infrastructure and productive assets. As a result, any sustainable economic expansion in India must be driven primarily by investment in infrastructure and productive assets.
  3. Following the election of Narendra Modi as Prime Minister in 2014, India has its first chance of material economic and political reforms in some time. Modi’s policies are focussed on removing constraints on infrastructure and investment, reducing corruption, and discouraging government spending from crowding out the private sector.
  4. These reforms have the potential to create a virtuous cycle for the Indian As investment constraints are removed and growth increases, both household and corporate savings will increase, supplying the necessary funding for further investment.Higher growth and increasing returns on investment will ultimately attract foreign capital inflows, providing a further boost to infrastructure and investment spending.

This article was originally published in the December 2016 issue of News & Views.