India has been my favourite “emerging” stock market for the past nearly 20 years. But there is no doubt that the Indian economy has become of late a victim of the shock therapy administered by the Narendra Modi government in terms of the blitzkrieg of structural reforms since he first took power in May 2014. This is why it remains remarkable that he was re-elected in a landslide victory in May, despite the initial deflationary impact of these reforms.
India’s Economic Detox Program
The base case here remains that the reforms will prove long-term positive, be it demonetization, the introduction of GST, the Real Estate Regulation Act (RERA) or the bankruptcy law, to mention the most important. But there is also no doubt that the initial shock impact of these reforms on the economy was underestimated by Modi’s BJP Government. Indeed, the Indian economy, and its entrepreneurial classes, could be compared to a former drug addict going through “cold turkey”; an analogy not viewed as an exaggeration by many Indian businessmen.
The BJP home minister Amit Shah, and the second most powerful man in India after Modi, stated in an open forum in Mumbai late last year that the government had undertaken “a detoxification of the economy” in the past five years and conceded that there were “some repercussions to the reforms” (see The Times of India article: “Past wrongdoings resolved, no need for fear: Amit Shah to India Inc”, Dec. 1, 2019).
Still, for now the focus in India in terms of the economy remains very much on the weak data. The third quarter saw real GDP growth of only 4.5% YoY. Still stripping out government consumption expenditure, which rose by 15.6% YoY in 3Q19, the growth rate was only 3.1% (see following chart). While real gross fixed capital formation grew at only 1% YoY (see following chart). The slowdown looks even more dramatic in nominal GDP terms, given the continuing weakness in inflation. Nominal GDP growth was only 6.1% YoY in 3Q19, the slowest growth rate since 1Q09 (see following chart).
India Real GDP Growth Excluding Government Consumption Expenditure
Source: MOSPI
India Real Gross Fixed Capital Formation
Source: MOPSI
India Nominal GDP Growth
Note: Based on GDP at market prices. Source: MOSPI
The Impact of India’s Structural Reform on Investment
All of the above suggests the impact of structural reform, most particularly on investment, since leading industrialists or “promoters” now know it is possible to lose an asset as a result of the Insolvency and Bankruptcy Code (IBC), which is the formal name of the bankruptcy law passed in 2016. As important, the law is now seen to be working.
In this respect, it was a game changer that the Supreme Court ruled in favour of ArcelorMittal in mid-November in the Essar Steel case. This means powerful, politically connected businessmen can now lose their businesses. It also means that the country has to adjust to a new way of doing business since the old modus operandi of using public sector banks as promoters’ private piggy banks is no longer viable.
If this is again a long-term positive, it is a shock to the existing business class, as has been a more aggressive stance on tax collection since the BJP’s arrival in power. It is also the case that assets locked up in bankruptcy court are frozen assets which will not be invested in. In this respect, ArcelorMittal is now free to invest but there are many other assets still locked up in bankruptcy proceedings. Indeed there are currently 1,497 cases in the corporate insolvency resolution process under the IBC, according to the Insolvency and Bankruptcy Board of India (see following chart).
Cumulative Number of Cases Taken Under the Insolvency and Bankruptcy Code
Source: Insolvency and Bankruptcy Board of India (IBBI)
Modi vs Crony Capitalists
In addition to the attack on what those around Modi like to call “crony capitalists”, the Indian economy has continued to be affected by the continuing ripple effects of the funding squeeze in the NBFC and related housing finance company space. The key issue here has been that since the IL&FS bankruptcy in September 2018 bond markets have only been willing to lend to NBFCs with established parents. Thus, in the first nine months of 2019 92% of the bond issuance in the housing finance company sector was accounted for by just two issuers, namely HDFC and LIC Housing Finance, both long established names.
Still, a positive from an “Austrian” perspective is that the bodies have now begun to surface. Dewan Housing Finance, India’s fourth largest housing finance company, was in late November taken over by the Reserve Bank of India and referred to the National Company Law Tribunal (NCLT) for insolvency proceedings.
Housing Market Stalled Due to “Stuck” Properties
The stresses in the property sector are not just limited to the housing finance area. There is also the issue of about 1,500 “stuck” residential property projects totalling 458,000 housing units. The government announced in early November a Rs250 billion (US$3.5 billion) fund to provide financial support for the completion of these projects, though luxury “high end” projects are not included (defined as properties costing more than around US$300,000). If this is a step in the right direction, an auction process would clear the market much more quickly. But there is a clear reluctance to take this step both because of the negative impact on lenders’ collateral values but also because individual end buyers have made down payments on such “stuck projects” and so are also among the creditors.
Meanwhile, so long as this overhang of unsold inventory exists, it will delay a new residential property investment cycle, and the employment-generating construction activity that will go with it. This area offers the best hope of a renewed investment cycle in India, which is why the overhang of supply remains the main reason why such a cycle is still not happening. It should also be noted that the regulatory discipline imposed in the property sector by RERA, combined with “demonetization”, has also been a game changer. Previously, property was bought to park cash or “black money” in the pursuit of capital gains. Both incentives have disappeared for now, while the rental yield on residential property is derisory, at around only 2%. This means demand has collapsed in the short term because the only buyers are end-users.
In the long term, end-user demand will clearly come back, most particularly as residential property looks affordable. It is also the case, amid all the current bearish focus, that the government’s affordable housing program continues to generate both supply and demand. Supply is rising because of tax breaks provided to developers to do affordable housing while demand comes from the subsidies provided electronically to home buyers who meet the qualifying income criteria.
A Remarkably Resilient Stock Market
What about the Indian stock market? The remarkable point is how resilient the Sensex has been in the face of the grim economic news and continuing earnings downgrades. It would be nice to think this is because the market has discounted all the bad news. But the resilience is primarily because of the narrowness of the rally that has been driven by a small number of highly rated large-cap stocks.
Meanwhile, with the Sensex recently reaching an all-time high of 41,810 on Dec. 20, the real damage from the economic downturn is best captured in small- and mid-cap indices, which remain 37% and 20% below their all-time highs reached in January 2018 (see following chart).
Sensex and Nifty MidCap 100 and SmallCap 100 Indices
Source: Bloomberg
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