India: The Standout Emerging Market (Part 1)

I am a long-term bull on India, However, I do have some concerns that make me cautious in the near to intermediate term. As a result, I currently only have a tiny position allocated to Indian stocks, but am ready to increase my position substantially upon a significant selloff or once my confidence increases that the Indian economy is about to accelerate.

History of Subpar Growth

Politics in the first half-century after Indian independence in 1947 was dominated by the Congress Party which had a socialist bent and looked towards the Soviet Union as an economic model to emulate. In the 1950s, steel, mining, water, telecommunications and electricity generation were effectively nationalized.

The Industries Act of 1951, which required all businesses to get licenses from the government before they could launch, expand or change their products, stifled innovation. The “licence raj” reigned. The government imposed import tariffs in the name of encouraging domestic production, and domestic firms were prohibited from opening foreign offices. Foreign investment dried up under stringent restrictions and lack of competition meant that Indian firms could survive with inefficient operations.

As a result, manufacturing was unable to be a driving force and the economy grew at a subpar rate of 3-4% while many other Asian economies boomed. Between 1950 and 1973, the Indian economy annually grew 3.7 percent, or 1.6 percent per capita. Japan’s economy grew 10 times faster and South Korea’s five times faster. China grew at a sustained 8 percent annual rate. All that began to change dramatically in 1991 with the dissolution of the Soviet Union and the realization that the capitalistic model was superior.

Economic Liberalization

In addition, India faced a severe balance of payments deficit in 1991, and could no longer rely on the Soviet Union for support. With no other option, the Congress-led government sought funds from the IMF in exchange for implementing policies that would open up the economy. Additional rounds of market-oriented reforms by later governments, helped to boost economic growth in the 1990s and 2000s. India’s massive low wage, English speaking, and technologically savvy labor force was well-suited to make India a global leader in the IT and BPO outsourcing industries and attracted much needed foreign direct investment.

Modi liberalization

Despite significant progress made by the different Congress governments over the years in freeing up the economy and boosting growth, there was a sense of disappointment with the pace of reforms, the many corruption scandals, and development which eluded the poor. For the 2014 general election, the National Democratic Alliance (NDA) named Narendra Modi who was chief minister of the Indian state of Gujarat, as its prime ministerial candidate against the Congress-led UPA government.

Narendra Modi stood for everything that the Congress Party and its four generations of leadership by the Gandhi family lacked: a track record of responsible development which saw Gujarat improve upon several human-development indicators; a history of strong leadership by running a small government and putting his foot down when officials were out of line; a squeaky clean image; and a rise from humble beginnings as a tea seller.

As a result, Narendra Modi delivered the most resounding electoral victory in 30 years. Indian stocks surges as excited investors were filled with the hope that Modi’s successful governance would be replicated at the national level.

However, two years into the Modi government, there is a feeling among some investors that Modi has underperformed by failing to pass key bills such as GST and land acquisition. However, I believe that there was excessive optimism about what Modi could immediately achieve given the political environment he was handed.

To become law, bills must pass both the lower house of Parliament, or the Lok Sabha, and the upper house, or Rajya Sabha. Members of the Lok Sabha are elected by adult citizens and they hold their seats for five years or until the body is dissolved by the President. Most of the members of the Rajya Sabha are indirectly elected by state and territorial legislatures. Members sit for staggered six-year terms, with one third of the members retiring every two years.

While the BJP does enjoy a majority in the lower house of Parliament due to its resounding 2014 election victory, it only has 55 seats out of 200 in the upper house, which means that the support of rival parties are necessary to pass bills. The BJP’s main rival, the Congress Party, is resisting many of the major proposed bills despite being in favour of them when it was in power. The Congress Party’s goal seems to be to prevent the BJP from achieving anything of substance while in power so that voters would view the Modi government as ineffective by the time of the 2019 elections.

However, the BJP’s seat share in the upper house is about to increase as a result of elections being held for a portion of its seats each year and due to the BJP’s electoral success at the state level in recent years. In fact, the BJP is due to overtake the Congress in seats later this year. Though still short of a majority, the BJP need only to garner support from a few small regional parties to pass bills currently being held up.

Once these major bills pass in the next year, the Indian economy’s potential growth level will rise, though the GST is expected to hinder growth in its initial two years. Moreover, Modi still remains popular, and according to a recent survey, is projected to win again in 2019. Several more years of a market friendly government will help to ensure that India achieves its potential of high single digit growth.

In my next post, I will examine the demographic dividend that India enjoys, changing leadership at the Reserve Bank of India, and Indian equity valuations.

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