FIRST DOWN, INDIA

Takeaway: Independent policy proposals put forth today by the RBI & economic affairs committee are structurally positive for India’s GIP fundamentals.

CONCLUSIONS:

  1. We continue to think that India makes meaningful progress on the economic reform front in 2014. Specifically, this is likely to be the year that both monetary and fiscal policy finally address the country’s long-standing structural imbalances.
  2. India does, however, remain a certified disaster on our proprietary EM Crisis Risk Index (which was well out front of the INR's mid-summer plunge to all-time lows), so now might not be a good time to load up on your India exposure.
  3. Moreover, a base effect (easy comps) and annualized currency weakness are likely to contribute to #InflationAccelerating in 1H14 and incremental monetary tightening – perhaps beyond the ~two +25bps hikes over the NTM that are currently priced into the OIS market.
  4. That being said, however, long-term investors might just want to think about loading up on some longer-dated call options for India’s capital and currency markets. It's worth noting that the MSCI India Index is up +2.3% since our bullish OCT 29th note titled, “INDIA’S ‘TURNAROUND’ STORY CONTINUES”. That represents a material degree of alpha when benchmarked to the -5.8% decline in the MSCI Emerging Market Index over that time frame.
  5. By the time we are well into 2H14, we could be looking at a setup where easy comps and reform-minded foreign capital inflows have perpetuated a rebound in Indian economic growth and a structurally improved GIP outlook. Moreover, inflation should finally be well on its way to meeting the RBI’s proposed +8% 2014 target by then.

Today, we received not one, but two positive pieces of news out of India today. The first was the monetary policy guidelines proposed by the RBI (headed by governor Dr. Raghuram Rajan) and the second was the proposal to ease foreign investment quotas, as well as a general deregulation of foreign investment out of the economic affairs committee (headed by economic affairs secretary Arvind Mayaram).

Both proposals are still very much in the early innings (the RBI’s proposals need official support from Indian parliament; there is an APR 3rd deadline to submit a final proposal for the foreign investment rule changes), so we won’t waste any of your time digging into the weeds now. Instead, here are some key highlights we find supportive for the structural economic transformation India is undergoing – as outlined in our OCT 29th note titled, “INDIA’S ‘TURNAROUND’ STORY CONTINUES”:

  • RBI Monetary Policy Proposal
    • Adopt CPI as the official target for monetary policy in lieu of the outdated WPI series (it’s 60-plus years-old and does not account for India’s growing services sector);
    • Target +8% YoY CPI by EOY ’14 (at +9.9% YoY as of DEC ’13), +6% YoY by EOY ’15 and then implement a +4% YoY midpoint target in 2016 with a +/- 200bps band;
    • Implement a rolling 2Y time horizon for returning CPI to the midpoint of the target range;
    • Start releasing the minutes of its monetary policy committee meetings;
    • Produce a thorough bi-annual inflation report; and
    • Formally institute an officially independent monetary policy committee.
  • Foreign Investment Deregulation Proposal
    • Scrap separate caps on foreign direct investment (FDI) and foreign portfolio investment (FPI);
    • Apply a broad 49% cap across all sectors and industries in the proposed new composite cap on foreign investment (most sectors are capped at/around 24% currently); and
    • Streamline the registration and compliance processes.

The RBI’s proposals are structurally positive for the Indian economy because they directly target the #1 problem holding back Indian economic growth and development: inflation. Indeed, persistently elevated inflation has quashed a great deal of India’s growth potential in recent years, which is something we’ve been consistently pounding the table on over the past 3Y.

The issue with the RBI’s proposals lie in the fact that it will require parliamentary approval to set anything in stone, so these may just be soft guidelines that they follow for now.

In that vein, we have little color the outcome of the general elections (due by MAY ‘14), though early indications continue to suggest the opposition BJP (led by pro-business Narendra Modi) is likely to overwhelm the “ruling” Congress Party in nationwide polls. Refer to our OCT 21st note titled, “ASIAN POLICY PROPULSION?: JAPAN AND INDIA SOUND OFF” for more details on how investors might capitalize on India’s changing political landscape.

Another issue is that their targets incorporate a fair amount of fiscal consolidation into their forecasts (i.e. a budget deficit equivalent to 3% of GDP by 2017, down from 5.7% as of 3Q13) – effectively sending a shot across the bow to fiscal policymakers.

FIRST DOWN, INDIA - Budget Balance

It remains to be seen if the latter will choose to comply with the former’s call to action; aggressive subsidy expenditures, profligate welfare spending and generally poor revenue forecasting continue to weigh on India’s fiscal position – effectively threatening a credit ratings downgrade to junk status over the intermediate term. Alas, we’ll see…

One final hurdle we see preventing the RBI from accomplishing its goals on the inflation front is India’s generally shoddy infrastructure, which contribute to supply bottlenecks, etc. that manifest in largely unchecked inflationary pressures across the economy. Per the World Economic Forum’s 2013-14 Global Competitiveness Report, India remains a Stage #1 factor-driven economy (well behind its peers in the EM space) and its Pillar #2 infrastructure score of 3.7 (1-7 scale) ranks 85th in the 148-country sample.

FIRST DOWN, INDIA - Countries at Each Stage of Development

Source: World Economic Forum’s 2013-14 Global Competitiveness Report

 

FIRST DOWN, INDIA - GCI

Source: World Economic Forum’s 2013-14 Global Competitiveness Report

FIRST DOWN, INDIA - Infrastructure

Source: World Economic Forum’s 2013-14 Global Competitiveness Report

FIRST DOWN, INDIA - MPFFDB

Source: World Economic Forum’s 2013-14 Global Competitiveness Report

One way India can help alleviate this headwind, at the margins, is by importing foreign capital to promote sustainable investments in undersupplied sectors such as transportation, storage and power infrastructure. But the only way for capital inflows to be rewarded for targeting “I” – instead of merely financing incremental “G” and “C” in the C+I+G+NX GDP equation – is for India to get inflation under control and its fiscal house in order. A dose(s) of economic reform won’t hurt either.

FIRST DOWN, INDIA - Current Account Deficit

That’s precisely why the proposal to deregulate foreign investment matters. India is a current account deficit nation, so to the extent policymakers can implement prudent fiscal policy and promote sustainable levels of consumption growth, we can see capital being diverted to much-needed areas in the investment arena.

So, India, what’s it gonna be: will 2014 be the year that both monetary and fiscal policy finally address the country’s long-standing structural imbalances or will 2014 come and go like years past with all its promises of reform and nothing to show for it?

For now, it appears increasingly likely that the answer to that question is that India makes meaningful progress on the economic reform front in 2014. India remains a certified disaster on our proprietary EM Crisis Risk Index (which was well out front of the INR's mid-summer plunge to all-time lows) , so now might not be a good time to load up on your India exposure.

Moreover, a base effect (easy comps) and annualized currency weakness are likely to contribute to #InflationAccelerating in 1H14 and incremental monetary tightening – perhaps beyond the ~two +25bps hikes over the NTM that are currently priced into the OIS market.

FIRST DOWN, INDIA - CPI Comps

FIRST DOWN, INDIA - FX YoY

That being said, however, long-term investors might just want to think about loading up on some longer-dated call options for India’s capital and currency markets. By the time we are well into 2H14, we could be looking at a setup where easy comps and reform-minded foreign capital inflows have perpetuated a rebound in Indian economic growth and a structurally improved GIP outlook. Moreover, inflation should finally be well on its way to meeting the RBI’s proposed +8% 2014 target by then.

FIRST DOWN, INDIA - GDP Comps

Feel free to email us with follow-up questions. Have a wonderful evening,

DD

Darius Dale

Associate: Macro Team