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The English word "juggernaut" stands, among other things, for a huge heavy truck and has its roots in northeast India. The Rath Yathra Festival has been celebrated there every year for more than six centuries, when thousands of worshipers pull a massive, sixteen-wheeled chariot with the wooden statue of the Hindu god Jagannath through the streets of the coastal town of Puri. By chance the British stumbled into this sweaty show of strength of religious devotion in the 19th century, liked the sound of the name and the rest is - as the saying goes - history.
Even if India's stock markets have recovered in the meantime, they initially fell by around 6.5 percent after November 8th last year. On that day, the government of Prime Minister Narendra Modi announced its controversial cash reform, which panicked many people and put banks under siege for fear for their savings.
Just a few hours later, on the other side of the world, Donald Trump was elected the next President of the United States by US voters. Trump's threat to terminate trade deals makes exporters nervous. Judging by the current state of affairs, his policies will fuel inflation in the US. In return, the Federal Reserve could accelerate rate hikes, which would make the dollar stronger and emerging market assets less attractive. Last December, the Federal Reserve raised interest rates for the first time in a year.
India's reform politicians will have wondered what was going on, because just at the moment when the ponderous reform “Juggernaut” had finally picked up speed, the wheels seemed to seize up again and lead the extreme effort to absurdity.
The term demonetization describes the process by which a whole currency or individual banknotes are deprived of their legal tender status - an example of this was the abolition of the national European currencies with the creation of the euro zone in the late 1990s. In India, the government surprisingly decided to withdraw 500 and 1000 rupee bills, which made up almost 90 percent of the currency in circulation, or to replace them with new banknotes.
Unfortunately, the process of exchanging banknotes is taking longer than expected, especially in the heavily cash-based rural regions where the poorest parts of the population live. People were forced to queue for hours at the banks to deposit their soon-to-be-worthless banknotes or - if available - to exchange them for new banknotes. However, in the absence of these, workers' wages are not paid and many people can no longer pay their bills.
The growth of this huge and fastest growing economy in the world is likely to be slowed significantly by the arrival of banknotes in the next few quarters.
But cash reform advocates, including most of the top executives we spoke to during our recent visit to India, insist that the long-term benefits will more than outweigh the short-term problems.
Demonetization to fight corruption
The reform is intended to help track down the black money associated with corruption and tax evasion. Billions of dollars worth of cash have already been deposited into bank accounts and it is hoped that many new accounts will be opened (and more people integrated into the tax system). At the moment, however, the temporary shortage of cash means that consumers, especially in rural areas, are spending less money. This has eased inflationary pressures and given the central bank leeway to cut interest rates in a way that stimulates growth.
The cash reform is only a small part of the comprehensive reform program launched by Prime Minister Modi since he took office in 2014. Although it was mostly a tough job to implement it, it is impressive how much has been achieved in the past year. There is real progress in the form of “big bang” reforms that would have been thought impossible just a few years ago.
The so-called “Aadhaar” project is just one example of how India is using new technologies to break free from its structural shackles. It aims to produce biometric proof of identity for every single resident of India. Thanks to eye and fingerprint recognition software on smartphones - there are more smartphone users in India than in the USA - it will ultimately be possible to open a bank account simply by taking a selfie. This is a real breakthrough in a country where many people lack ID or similar papers and where a huge informal cash sector makes tax avoidance and corruption easy. More than a billion users have already signed up.
Reform steps are having an impact
The introduction of the new, uniform sales tax (Goods and Services Tax - GST) was generally regarded as a test of whether Modi is able to keep its reform promises. It took a long time for the Prime Minister to finally overcome resistance from the political opposition and pass the new law in August last year. When it comes into force, it will standardize a number of indirect taxes, thereby increasing efficiency. It should also improve tax compliance and broaden the tax base. It will bring logistical advantages as it will facilitate the cross-border movement of goods within India. The competitiveness of the export economy will increase and investments will be boosted by lower costs for capital goods.
At the same time, a new bankruptcy law (Insolvency and Bankruptcy Code) should lead to streamlining and accelerating the resolution process and help creditors to collect their claims. This is important insofar as public banks have many non-performing loans on their books and are thus hardly in a position to make their contribution to promoting urgently needed infrastructure projects. Due to the fragmented insolvency regime, the current proceedings take much longer than in many other large economies and the recovery rates are usually lower.
The Indian Central Bank (Reserve Bank of India - RBI) has made the country stronger against the dangers of global volatility. The foreign exchange reserves of around 364 billion US dollars (as of December 2016) are close to an all-time record and, thanks to sensible economic policy measures, the current account deficit has been reduced to manageable levels. Inflation and interest rates have fallen and major foreign direct investment remains at a high level.
Much of this is due to former central bank governor Raghuram Rajan. When he resigned in September last year, he left an institution that was highly regarded by foreign investors, also because the central bank was not subject to undue political influence. His successor, Urjit Patel, was formerly the central bank's deputy governor and chairman of the committee. He recommended the introduction of inflation targets. In a country that still had double-digit inflation rates in 2013, that was nothing short of revolutionary.
Patel's appointment represents monetary policy continuity and a commitment to preserve Rajan's hard-won progress. While Rajan, as a man of clear words, often clashed with representatives of the ruling Bharatiya Janata party, communication between the government and the central bank should improve under the reluctant Patel - this is not unimportant for a closer coordination of monetary and fiscal policy measures.
The government has - it deserves credit for that - resisted the urge to interfere after Rajan's departure. It would have been easy for her, for example, to fill half of the central bank's six-member monetary policy committee with “yes-sayers”. She did not do that and thus ensured that interest rate decisions can be made on an independent basis and that there is more democracy, transparency and
Control there. The remaining seats are occupied by representatives of the central bank itself.
The central bank's decision to leave rates at 6.25 percent in December came as a real surprise, as it was widely believed that there would be another rate cut to encourage growth. This decision - after two cuts in the course of 2016 - shows that the central bank is able to withstand public pressure.
Fears that the cash reform would slow growth in the short term initially caused share prices to decline. In addition, investor sentiment with regard to the emerging markets had deteriorated, and the local stock markets were also unable to escape this entirely. Should Trump pursue anti-immigration policies, US-based IT companies that regularly recruit IT professionals from India could be affected. It is also not yet entirely clear how Barack Obama's health reforms or a possible successor instrument to the Trump administration will actually proceed. This can play a role for Indian pharmaceutical companies with significant generics business in the US.
Advances in bonds
By contrast, bonds initially picked up significantly. The falling bond yields reflect the low foreign participation in the local bond markets - this means that the domestic market is better sealed off and protected from global volatility. There is also evidence that wealthier sections of the population have tried to circumvent measures to combat black money by investing cash, such as in government bonds.
For foreign investors, investing in India has always been a good portfolio diversifier. Domestic demand accounts for around 60 percent of the gross domestic product in India. This means that the country is not as dependent on exports when it comes to growth as some of its neighboring countries. India's population of around 1.3 billion people is young and that will sustain growth. Urbanization and the growing middle class will increase the number of people with higher disposable incomes.
While only one in ten Indians was classified as “city dwellers” in the last census, the population living in cities accounts for more than 70 percent of the market for so-called fast-moving consumer goods. In rural areas, the market for fast-moving consumer goods is expected to rise to more than 100 billion US dollars by 2025 with around 700 million Indians living there.
Indian companies are promising
According to Aberdeen Asset, Indian companies are among the best in Asia thanks to their operational efficiency, strong balance sheets and resilient business models in industries with high entry barriers. These companies also meet higher standards when it comes to corporate governance. Some companies, such as Bosch India, Hindustan Unilever and Nestlé India, are branches of large, world-class multinational corporations. At others, such as the Calcutta-based company Emami, key management positions are held by members of the founding families.
However, these stocks aren't cheap. Even after the sale, the MSCI India index was still trading at 21 times current earnings. The MSCI Asia Pacific ex Japan Index and the MSCIEmerging
Markets Index, the ratio is 16 times (as of December 2016).
The uncertainty triggered by the cash reform, the inauguration of the new US president and a higher rate of US interest rate hikes will have a negative impact on companies in the next few quarters
impact. However, our fund managers consider the medium-term outlook to be largely positive as the initial shock effects will subside and the reforms are starting to take effect. In the meantime, the inherent strengths of the best Indian companies will come into play.
The cash reform should be positive for the banks, as it has increased the deposit base and reduced refinancing costs. Lenders will also benefit if the Indian central bank cuts rates further. The public-sector banks will gradually improve thanks to capital injections. However, we still prefer private credit institutions such as Kotak Mahindra Bank and ICICI Bank as they are managed more efficiently, have better fundamentals and are expanding their market share.
The cash reform eases the consequences
Over time, the acute effects of the cash reform will subside and consumer goods companies will benefit from the reforms. While the details of the new sales tax are still being worked on, the tax rates for consumers appear to be lower than the current ones, which could benefit companies like ITC and Godrej Consumer Products. In our opinion, sales by manufacturers of cyclical consumer goods, such as Hero Motocorp, should recover as a result of the economic policy support for the rural economy.
US regulators should gradually drop their reservations about Indian pharmaceutical companies as they improve their manufacturing processes. We think there will be some approvals in the near future and we maintain our long-term positive outlook for this sector. Companies like Sun Pharmaceutical Industries should also benefit here. Industrial companies should also rebound thanks to significant operational leverage. If government infrastructure spending increases, this will translate into higher corporate profits in the long run. However, many of Indian banks' bad loans come from this sector.
Many European languages are enriched by India. Loan words such as “bungalow”, “pajama”, “shampoo” and “veranda” all have their origins in the Indian subcontinent. The less common word “pundit” (in English “pundit”) is also of Indian origin. It originally stands for an Indian religious scholar and is now used for self-appointed experts of all kinds. Many of these experts will now claim that Modi has overstepped the curve with the cash reform and dealt a severe blow to the Indian “investment story”.
Operating in India long before Modi, Aberdeen Asset has seen Modi's reforms make the country an investor darling. Anyone who has been in this market long enough knows that it is often two steps forward and one step back. This shouldn't really surprise anyone. What is more surprising is how fast and how far Modi's reforms have progressed.
Investors are excited about the changes that are taking shape here. Those of us who want to see the reforms succeed should not despair. Because once a real reform “Juggernaut” has picked up enough speed, it can hardly be stopped. //
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