The Indian economy is at a crossroads with major structural reforms underway, such as a unified Goods and Services Tax (GST) that rolled out on July 1 and an Insolvency and Bankruptcy Code that was enacted last year. The GST would dramatically “formalize” the dominant informal sector that drives the bulk of the economy and open it up for credit access. The bankruptcy code will bolster a determined push by India’s central bank, the Reserve Bank of India (RBI), to clean up bank balance sheets of non-performing assets (NPAs) and provision sufficient capital buffers. Those and other structural changes would prepare the economy for sustained growth over the long term, according to Viral Acharya, the recently-appointed deputy governor at the Reserve Bank of India (RBI), who was formerly a professor of economics at New York University’s Stern School of Business.
Additionally, India’s equity markets are bracing for a much-awaited uptick in corporate earnings, an increasing flow of new investments from pension funds, provident fund retirement accounts and insurance, and a historical shift in domestic household investments in equities overtaking those by foreign institutional investors. With current stock market earnings multiples at “reasonable” levels, higher corporate earnings and a flush of new money chasing limited equity stock, the stage looks set for Indian stock market indices to triple over the next five years, according to Ridham Desai, managing director and head of India Research at Morgan Stanley.
Acharya and Desai discussed the outlook for the Indian economy and its stock markets on the Behind the Markets show on Wharton Business Radio on SiriusXM channel 111. The show is co-hosted by Wharton finance professor Jeremy Siegel and Jeremy Schwartz of WisdomTree. The segment also featured guest Gaurav Sinha of WisdomTree.
Here are select highlights from their discussion:
Fixing the growth drivers: According to Acharya, it is critical to realize that the Indian economy has “many different drivers of growth” such as private consumption, agricultural output, state-generated output and manufacturing. “It is best to fix the structural conditions for growth, and then when growth comes around, you are ready to capitalize on it in a big way,” he said. He listed the GST, the Insolvency and Bankruptcy code, and regulatory reforms governing the real estate sector among those.
Acharya acknowledged that those reforms may come with some necessary short-term pain. “It’s better to accept slower growth for a short period as long as you are doing the right structural reforms to resurrect that growth to a higher level,” he said. “What doesn’t work is when you do temporary fixes; you are just putting a Band-Aid on what really needs a deeper reform.”
Acharya felt the Indian economy is well-placed on other fronts. On the macroeconomic front, he said growth in output is reasonable with respect to inflation levels; the government’s balance sheet is “quite austere in terms of maintaining a tight fiscal discipline;” and the central bank’s foreign exchange reserves are “quite healthy” relative to imports, external debt and the short-term component of external.
“Credit is a lagging indicator,” said Desai. “You start fixing the growth problem and then credit will come back.” He also felt that the current distribution of credit — a fifth to the household sector and four-fifths to the corporate sector — would change in favor of the household sector borrowing more. “For example, 300 million new bank accounts have been opened after the new government took over. They are all going to come into the formal credit economy.”
“It’s better to accept slower growth for a short period as long as you are doing the right structural reforms to resurrect that growth to a higher level.”–Viral Acharya
GST a game-changer: GST will entail “some temporary hiccups and glitches,” but it would work well “as long as the system remains adaptive and focused towards ensuring good execution and delivery down the road,” said Acharya. “This is a game changer. The Indian economy and the consumers would be the ultimate beneficiaries of the removal of a large number of taxes and complications that have ridden the system to date.”
According to Desai, the GST rollout is a mammoth endeavor that overcame huge odds. “Imagine getting the 50 states [in the U.S.] to give up their power to tax goods and services. It would probably take decades to get that done,” he said. “A lot of people criticize India for having taken 15 years [to roll out the GST], but with the democratic setup that India has and the consensus that was needed to do this was going to take a lot of time. It is not easy to convince 29 states to give up their power to tax, so this is a very big change.”
Culture shift in India: Households in India have historically been reluctant to borrow, and people generally don’t use their credit cards other than for convenience, said Desai. “But the 20- and 30-somethings in the country have no hesitation to borrow,” he said. “With the culture shift that is happening, households will start leveraging much more in the next five or 10 years, which means our estimates for consumption will be too conservative. A fair bit of future consumption will come into current consumption, and it will be a while before household debt gets to a level that will be worrying — that may be a decade or two from now.”
“Foreign investors have invested more than $150 billion over the past 15 years,” Desai said. “We’re forecasting that over the next 10 years, Indian households could invest between $400 billion and $500 billion into equities. Unless it is matched by a huge increase in supply of equity stocks, there will be excess demand for equities in India.”
Institutionalization of equity savings: According to Desai, a huge savings pool that didn’t exist before is emerging and is headed for the equity markets. The National Pension System and the provident fund have always stuck to debt investments, even though they were allowed to invest in equities. But now with the Modi government mandating them to make small allocations for equity investments on a rising scale, they would become significant forces on the stock markets, he explained. Similarly, the insurance industry is also headed towards more equity investments with an expanding growth in a largely underpenetrated market, and the preferred match they find in equity in terms of asset tenures and returns, he said.
“The right way to do this is to get the system to a point where the underlying stress of assets is at rest.”–Viral Acharya
The third big institutional change occurring is the resurgence of domestic mutual funds with more and more individuals opting for “systematic investment plans,” or SIPs, where their investments are automatically deducted from monthly salary checks, said Desai. “The new generation driving those investments has no memory of the scandals of the 1990s and are looking at the equity markets with a fresh pair of eyes,” he said. It helps that the equity markets are now generating excess returns over almost every other asset class, he added. Domestic mutual funds in India currently have a combined value of $12 billion to $15 billion over a trailing 12-month basis, and that could easily grow to $50 billion, he added.
Could India’s stock indices triple in five years? Share prices on the Indian stock exchanges have been on a slow uptrend for several years now, “grinding higher rather than surging ahead” because “earnings growth has been missing,” said Desai. “There’s expectation that the growth cycle will turn, but it has not really been delivered.”
Going forward, Desai noted three trends. One is that the growth cycle is turning, and that it passed its low point last year. Earnings growth would have been higher were it not for the demonetization exercise, which caused a setback of two quarters, he said. The current growth cycle could see compounded earnings growth of about 20% annually. In the previous cycle between 2003 and 2008, earnings for the benchmark 50-share Nifty index compounded at 39% annually.
“Market valuations would grow at a faster rate than the projected 20% earnings growth, because the nature of markets is to get more optimistic as you get more growth behind you,” Desai said. “Predictions that the Indian stock market valuations could triple in five years are based on the assumption that it could post an estimated compounded annual growth rate of 24% in share prices, which is not very different from the 20% growth that you get on earnings.”
Two other factors contributing to a bullish outlook are the “growing likelihood” that current Prime Minister Narendra Modi will win the 2019 general election for a second term; and the structural shift occurring with increased household investments in equities, said Desai. The biggest risk for Modi not to make it through the 2019 election is that growth falters and joblessness rises, he added. He likened the surge in household investments in equities to the “401 (k) movement” in the U.S. in the 1980s that led to a secular increase in equity savings over the next 15-20 years.
Desai’s top picks for growth stocks include private sector financial companies and non-banking finance companies; industries focused on discretionary consumption; and technology stocks for their current, low valuations. At the same time, he is not bullish about stocks in the consumer staples industries “because they seem very rich, and a lot of growth is already priced in.
“Credit is a lagging indicator. You start fixing the growth problem and then credit will come back.”–Ridham Desai
Cleaning up NPAs: The bankruptcy code will be a big step in developing India’s corporate bond markets and the resolution of bank loans under stress, said Acharya. It will help clear the debt overhang on bank balance sheets, which has weakened private investment in the affected sectors, thereby aggravating the stress, and slowed bank credit exposure to those sectors, especially among the public-sector banks, he added.
On the flip side, some of the dip in credit growth has been substituted by growth in the corporate bond market, while private banks and non-banking financial services companies have stepped up their credit to fill the gap, said Acharya. But there is this lack of investment in substantial parts of the economy, he noted. “The indebtedness of the underlying sectors is the key issue we need to tackle in order to unlock the growth potential that I believe is still there in a very powerful way in the economy,” he added.
“The worst of the NPA cycle is behind us,” said Desai. “With increased economic growth, the NPA problem will also become smaller.”
Resolving the debt overhang: According to Acharya, the indebtedness could be resolved only by addressing the so-called “twin balance-sheet problem.” One part of that involves a debt reduction for corporations if they are economically viable; if they are not viable, the best option would be to liquidate them under the bankruptcy code, he explained. The second part is to recapitalize banks that would have to take haircuts because of the debt reduction for their stressed corporate borrowers.” What we have learned from the global financial crisis is that simply fixing banks is not enough, or simply fixing the asset — as in guaranteeing the corporate debt — may not be enough,” he said. “If banks are sitting on thin slivers of capital, they may not have the right and prudential risk-taking appetite.”
Such recapitalization of banks could involve consolidations and mergers; divestment of government stakes; some direct government injections of capital; and potentially also re-privatization of some banks if the government is looking at divestments and re-privatization as a way of doing this within its current fiscal constraints, said Acharya. Some of those banks “would gracefully shrink over a period of time, or they would gracefully rebuild themselves over a period of time.”
“Predictions that the Indian stock market valuations could triple in five years are based on the assumption that it could post an estimated compounded annual growth rate of 24% in share prices.”–Ridham Desai
Transmitting rate cuts: Although the RBI has in the last two years cut its short-term interest rate by 175 basis points, the pass-through to bank customers hasn’t occurred as expected. That is because banks prefer to use the liquidity that comes with lower rates “to evergreen their bad loans,” said Acharya, referring to the practice of extending fresh loans to repay earlier loans. Also, they choose to invest their monies in high-yielding securities where they get quick returns instead of advancing loans, stay risk-averse and avoid growth of their loan book, or choose to grow in a narrow groove in terms of incremental business and invest in risk-free instruments such as government securities, he explained. Any “good pass-through” of lower interest rates occurs at private banks or better-capitalized banks, he said. “The pass-through at weaker banks either happens in a bad way (such as ever-greening of bad loans), or it doesn’t happen at all.”
Acharya said the RBI doesn’t explicitly nudge banks to pass on the rate cuts to their customers. “I don’t think we should micromanage the lending itself,” he added. “The right way to do this is to get the system to a point where the underlying stress of assets is at rest.” He said the central bank has directed banks to send select aging NPAs to the bankruptcy court in the first round, and that it will be followed by subsequent rounds.
“This whole exercise addresses only 25% to 30% of the total NPA problem,” he said. “Once we have learned from these resolutions, we could roll out the resolutions on the remaining cases in a suitable way. Perhaps the banks would have themselves gained confidence on this process and they could carry the work forward on their own. We need to take that call in another six to nine months.”