India Election 2009: Business as usual

Friday, 29 May 2009 13:22

What will be the impact of the Indian election on the country’s burgeoning economy?

by Shyam Kumar, Director & CEO, Kotak Mahindra (UK) Ltd

India has been jockeying for position as one of the markets best placed for sustainable recovery from the financial market carnage. The Indian election this month – this piece is being written before the results are known - will have an important role in helping towards a sustainable recovery in India and the outlook for investment in one of the world’s most important emerging markets. In this article I will outline my views on the likely impact of the election results and the outlook for foreign investors in the subcontinent.

With 714 million voters, India is the world’s largest democracy. Whilst socio-cultural and security issues have featured prominently in campaigning, voters have in the past proven to be highly sensitive to economic issues. Polling has been taking place in five separate phases across the sub-continent during the course of the past month. The final result has been very difficult to predict but a clear majority for any one party had been thought unlikely due to the many issues and interests across such a vast country. The impact of external events such as the global financial crisis on domestic sensibilities have also been difficult to call.

The main parties are the incumbent United Progressive Alliance, the National Democratic Alliance, and the so-called Third Front comprising an alliance between the communist and regional parties. Post election, parties will form coalitions which will go further than any pre-poll alliances and be based on ‘Common Minimum Programmes’ (CMPs) that relate to both their economic and political agendas.

Although the situation is fluid and there are many possible outcomes, we at Kotak believe that no matter which party comes to power, continued reform alongside political and fiscal stability will be the key to financial recovery and protection of growth in the medium to long term. We can be optimistic that a balanced coalition government will have a good chance of progressing with reforms relating to foreign investment - just as a ‘lumbering elephant’ may move slowly but once it sets off, it rarely reverses its course.

Financial markets have largely factored in political uncertainty post elections, and have not been upset by the major party manifestos as these are largely seen as necessary political positioning. However, large risk would exist if there were to be a hung Parliament with no clear winner or a shaky coalition. A sustained turnaround in growth will still need a fiscal response and continued reform, which in turn depends on a stable government.

India’s long term growth story continues to be driven by consumption and investment, which we believe will remain largely intact and possibly see a fresh impetus with the formation of a new government. There are four key themes that are likely to continue to drive India post-election:

Consumption

India’s strong domestic consumption has its underpinnings in demand from semi-urban and rural India, which together account for 55% of total domestic consumption (Source: RBI, IIFL Research). Unlike China, where the population is already ageing and the labour force is expected to peak in the near future, India’s population is young and its ratio of labour force to overall population is growing. According to the Asian Development Bank (ADB), India is expected to be the second largest economy in the world and have the largest consuming middle class by 2040.

The current Indian Government has taken various measures to boost consumption. In early March this year, the government reduced the service tax rate by 2% to 10% (exclusive of the surcharge) to keep more money in people’s hands. In fact, all the main parties contesting the election have referred to their intentions to reduce the overall tax burden, leaving consumers with higher disposable income and providing an additional boost to the economy. We therefore expect India’s consumption growth to remain firm, despite the current environment of weakening global demand and the slowdown in investment and corporate profit growth.

Infrastructure

Infrastructure in India has expanded swiftly in line with the rapid growth of the economy in the past decade. There have been significant investments in electricity, transport, telecommunications, irrigation and water supply, which we expect to continue. Infrastructure spending and development is a particularly strong driver of growth and remains one of the key spurs to economic growth.

The current Indian government set ambitious targets to almost double investment in infrastructure over the next five years, injecting US$300 – 450 billion into the sector (Source: Planning Commission). Projects include modernising secondary airports, adding electricity generating capacity and port-related development. Should the Congress-led government return to power it is likely to continue this investment, which is essential for India to maintain the high growth rates witnessed during the last five years. The BJP has also indicated that it would increase infrastructure spending beyond current levels, which is encouraging. However we feel that even if a third front comes into power; any drastic change in policy might be unlikely. We may see some minor changes, but in our opinion, the broader direction would remain the same.

Urbanisation

The industry and service sectors in India are growing fast, generating significant employment potential in urban areas and attracting youth to cities. In addition, advertising and the media have exposed traditionally rural areas to an “aspirational” existence, further feeding the impulse to migrate to cities for a young working population with a new disposable income. In this environment, certain sectors of the financial services industry, such as credit card providers and insurers, are likely to benefit more than others.
India also has strong rural growth, continued buoyancy in the service sector and the benefits of the falling oil prices. The rural economy has seen significant changes in the past few years. While only around 17-18% of India’s GDP now comes from the agricultural sector (Source: CSO), around 60% of the population still lives in rural areas, making them more or less dependent on the agriculture sector. Inflation seems to have at least benefited the farmer. Farmers have seen a huge jump in profitability as input costs have remained more or less stable whereas prices of agri-products have seen a significant rise. The much ignored rural sector is bouncing back and the impact of this is now continuously being seen in mobile phone subscriber growth, two wheeler sales volumes and growth of consumer staple companies that have a significant rural portfolio.

Outsourcing

The Indian outsourcing model has proved popular for global firms, who have taken advantage of the twin attractions of India’s large intellectual capacity and cheap labour. The Information Technology and Communications sectors in particular have benefited greatly from outsourcing to India and the industry has enjoyed high employment and sustained growth for a number of years.

It is estimated that India’s outsourcing sector contributes about 25% of the country’s total exports. Analysts are predicting that growth in this sector is likely to slow down sharply this year following a decline in demand caused by the global financial crisis (Source: National Association of Software Services Companies (Nasscom), as published in Financial Times dated 5th February, 2009). Yet many in the industry remain hopeful that the Indian government’s ongoing economic policy will renew confidence in the sector and that it will continue to expand as companies outsource in order to cut costs.

Indian outsourcing also includes engineering, pharmaceutical, petrochemical and auto-ancillary exports and there is still scope for exploring investment in these sectors. Demand for outsourcing from these industries, particularly in pharmaceuticals and auto components, are diversified across the globe, which reduces reliance on the United States and the United Kingdom during the economic downturn. One advantage is that the weakened Rupee has meant Indian businesses can price their services more competitively, so comparatively outsourcing still remains cheaper in India than other markets.

Current valuations in the Indian markets present a good opportunity for investment. While short term market performance is hard to predict, with valuations being close to the bottom end of the historical range for the market, levels are attractive for investors seeking medium to long term gains.

Just as the potential rewards of investing in emerging markets like India are higher than returns expected from the developed markets, so too are the risks. Market volatility is significantly higher and liquidity can be variable. In addition, emerging markets have their unique geopolitical risks. Of course, the normal risks applicable to investments such as risk of loss of capital and exchange rate risks all apply.

That said; we strongly believe that talk of ‘green shoots of market recovery’ in India is not premature. We have seen increased liquidity, lower lending rates, improving sentiment, attractive valuations and an increasing appetite for risk. India is well positioned to recover well and its real economy is likely to follow this trend. Investors will be watching closely the new government’s approach to reform and fiscal stimulus but our view is that the outlook will improve significantly in India by the start of 2010.