The question of structural growth
As global investors rethink their India exposure, they should focus on the economy’ s long-term direction
After a long time, investors are once again questioning the investment case for India. Long taken for granted, one has had to address the question of why should someone invest in Indian equity markets at all. Global allocators ask: Do we need dedicated India exposure? This is what five years of under-performance and weak growth can do. Many investors are now underweight India in their portfolios or have no dedicated investments in the country. This is a far cry from just six years ago, when most were overweight the country and convinced that India had years of strong growth and market performance ahead.
When thinking about why to invest here, many considerations come to mind. On first principles, India has a lot going for it. A democracy, the rule of law, demographics, aspirational youth and well-developed entrepreneurship. There are also strong linkages between economic growth and market earnings, with a long runway for growth and product market penetration across sectors. With scope for productivity improvement, the catch-up potential is obvious as India is today where China was 20 years ago. With many quality companies, India has always been a stockpickers market.
The short term will be an obvious issue, with India experiencing a contraction in FY21, due to the pandemic. Most observers expect gross domestic product (GDP) to contract by 2 per cent to 5 per cent There will be a recovery in FY22, with a rebound in growth, causing the economy to exit FY22 at approximately the same size as it was in FY20. This is consistent with the pattern across economies globally.
The most important issue worth thinking about is what is India’s structural growth rate over the coming decade, once we bounce back from the pandemic in FY22. Is India now only a 4-5 per cent real GDP growth market as some of the bears maintain, which is similar to the growth rate coming into the pandemic? Or will India return to a decade of 7 per cent growth as the bulls postulate? The answer to this question will determine whether investors wish to be invested in India or not and whether they can be structurally overweight the country.
Rather than worrying about the short-term data, and the extent to which the economy shrinks over the coming quarter, investors would be well advised to look for clues and actions to help answer the structural growth question. Is enough being done to fundamentally raise India’s structural growth rate or have we lost our growth momentum permanently? That should be the focus of enquiry for investors.
The reason this is so important is because of the vastly different economic outcomes and problems/opportunities for the country depending on how fast it can grow. If India can truly only grow at 4 per cent, that will translate into 8 per cent to 9 per cent nominal GDP growth. At that growth rate, we will be unable to stabilise our public debt/gdp, nor deliver a better standard of living for the majority of the poor. We will not have the tax revenue buoyancy to invest in better infrastructure or health and education, nor keep our credit rating. With limited improvement in per capita incomes, consumption will lag. Why invest? Growth, earnings, multiples and the rupee, all will fade and deliver poor returns for anyone with money in the country.
However, it all turns around at 7 per cent real GDP, leading to 11-12 per cent nominal GDP growth. At that rate of nominal growth, our public debt ratios will stabilise and slowly start to decline. Tax revenues will be sufficient to allow investment, and faster per capita income growth will allow millions to move out of poverty, consume and drive investment and corporate profitability.
While growth has slowed significantly in India over the past few years, it can be argued that this deceleration has been driven by the fragility in the financial sector, upfront costs of attempted reform as well as the unwillingness to tackle structural weaknesses.
The financial sector has been the country’s Achilles’ heel. The government banks are undercapitalised, poorly run, and structurally lack the ability to take risk given their governance framework. Corporate debt markets are broken and the non-banking financial company (NBFC) business model has come into question for all but two to three players. There is distrust of the numbers and a flight to quality even among private banks. India is on the verge of another credit cycle post the pandemic, and the true extent of credit deterioration would be visible only after the end of moratorium period. Every financial institution in India is on the lookout for additional capital. After the IL&FS debacle, the sector has been exposed for its structural weaknesses.
We need to fix this sector, without this growth will not accelerate. The steps needed— additional public sector bank capitalisation, partial privatisation, an asset quality review for the NBFCS, a bad bank, among others — have been outlined many times by numerous commentators. We don’t need new ideas here, just execution and political will to do the obvious. Anyone hoping to see structural growth at 7 per cent, has to see movement on fixing the financial sector. If the system cannot fund growth, how will growth return?
Many of the reforms undertaken over the past few years— be it goods and services tax or the Insolvency and Bankruptcy Code or Real Estate Regulatory Authority — have led to increased formalisation of the economy, consolidation, deleveraging among corporations and better capital allocation. Over leveraged and poorly managed groups have been driven out of business. While these steps have hurt growth in the short term, the hope remains that India will see the economic gains from these measures in the coming years. Surely, if better managed and financed companies gain share in the economy, there should be productivity and growth improvements.
While a lot more needs to be done on the policy front, a start has already been made by the government over the past few months. The steps for agriculture seem genuinely transformative. We also see a commitment to privatisation for the first time. The reforms in ease of business, the power sector, local finance and public distribution being made a prerequisite for states to access additional borrowing are significant. One hopes more such measures are in the works. India remains far too complex a place to do business and it needs administrative and factor market reforms. While a clean-up of corporate India has been largely accomplished, it is time now to nourish those who are left behind and make businesses more sustainable.
I remain optimistic that India is not a 4 per cent growth economy. There is too much energy, talent and drive among the youth. Technology is in our favour. It would make sense to focus on these aspects of India’s economy, rather than whether GDP has declined by 2 per cent or 3 per cent in FY 21.