The beginning of India’s transformation

India has had a strong start to 2017. After a shaky period at the end of 2016 when the reformist government took the radical step of withdrawing 86% of the currency from circulation overnight to tackle the ‘black economy’, economic growth has recovered and equities have rallied.

Modi’s reform programme was given a huge vote of confidence in March when it won a victory in the state of Uttar Pradesh, India’s most populous state with 200 million people. Modi’s BJP party had not won in the state for 15 years, yet won 80% of seats this time round. With the next national elections due in 2019, Modi appears likely to win another term in office and have the time to make real change.
We believe now is the most exciting time to be investing in the country since we launched our first India-dedicated investment strategy in 1998. India is turning a corner. Modi and his BJP party are executing big bang reforms and sweeping away the old government paralysis. As they do so their popularity is growing.
Before the BJP’s 2014 election victory there was limited appetite to tackle India’s extensive subsidies and endemic corruption. For example, the price of diesel at the pumps was capped, which played havoc with public finances. However, Modi deregulated the diesel price after coming to power, passing on fuel price moves to the electorate. This has helped to improve India’s notorious twin deficits – its fiscal and current accounts.
These twin deficits were the main reason why international investors avoided India in previous years, yet the central government is targeting a fiscal deficit of just 3.2% for 2017-18 and the current account deficit has been falling due to a better balance of trade.
With the deficits now under control, the coming years look promising for India and its equity market. The reforms that have started to be introduced in the last three years will take some time to bear fruit. As they do so they are likely to help free this country to achieve its economic potential, with a young and growing population of 1.3 billion,1 or nearly a sixth of the world’s population.

Modi’s big bang reforms
The most dramatic reform to date was the November 2016 demonetisation initiative. More than 80% of the currency was cancelled overnight to tackle the black economy and corruption. To this end, demonetisation has not been successful as nearly all the cancelled notes were deposited back in to the financial system. It has brought more of the working population into the taxable, formal economy, which should be positive for tax revenues in the future. It has also inadvertently been a political coup for Modi and his popularity has soared due to his hard stance on corruption.
Another major reform was the introduction of a single goods and services tax on 1 July 2017. Different state and central taxes will be levelled to a single tax system, removing multiple layers of bureaucracy and reducing the cost of doing business. It is India’s most significant tax change in recent decades. More reforms are needed; not least those that will help job creation. India currently is benefitting from a strong demographic dividend with nine million new workers entering the workforce every year. A new affordable housing policy is a start. Construction is very labour intensive, especially in India. A focus on affordable housing, along with improving affordability, may well spur new housing construction after a multi-year lull.

Becoming a digital economy?
Another important area of improvement is digitisation. While India is not regarded as a digital economy, digitisation is beginning to have a major impact. Most importantly, the unique identification card (UID) programme that began in 2009 aims to biometrically register every individual and, so far, has registered over 1 billion people through their finger prints, iris scans and addresses (see Figure 1). A lack of identity excludes many from the modern economy. UID has allowed 200 million people to open bank accounts – ending the financial exclusion that has perpetuated poverty.

Once people have opened bank accounts, the government can transfer subsidies directly to those who need them. Previously, intermediaries and distributors would take a cut. The main subsidy affected so far is for gas cooking cylinders.
The government is also encouraging electronic payments, promoting the cashless economy. It has recently announced an electronic payment gateway so that transfers can be made in real-time even with a basic feature phone.
Finally, mobile phone access to the internet is very high. Nearly 80% of people access the internet via mobile. India is already one of the cheapest places in the world to make voice calls and now competition is slashing data prices so that more people can afford to surf the internet via their mobile phones. In the next couple of years India will be a superstar for digitisation. It is transforming everyday lives. People are feeling there is more opportunity as a result.

Growing fast
Turning to the economy, India is growing faster than any other large country (see Figure 2). Despite the uncertainty that followed demonetisation, it has recovered well. Economists are forecasting GDP growth of 7.0% for the fiscal year ending 31 March 2017. For 2018 they are expecting a small increase to 7.3%.

A pick-up in infrastructure spending, especially in areas such as roads, is what has primarily driven the economy’s acceleration. Economic growth is now spreading out from urban to rural areas, helped by a better monsoon. Furthermore, industrial production is improving and exports to developed markets are rising. The stronger economy is supporting companies from most sectors, which is expected to increase earnings. While the equity market is trading above its 10-year average price/earnings ratio at about 19 times the 12-month forward forecast, this can be justified by an earnings growth recovery, which broker consensus has estimated at 16% growth for the fiscal year to March 2018.
The other interesting point is that locals are buying equities. After a long decline, equity investment is growing as real estate and gold – historically the investments of choice – look less attractive. Demonetisation has played its part here, with more cash now having moved into the formal economy being available for investment. Households have a little over 4% of their assets in the equity market. It would not take much of an increase for this to help drive equity prices higher.

An exciting time
Over the next few years, it seems that the world’s biggest democracy may finally be on the point of realising its huge economic potential. The BJP government is not just talking about change, it is delivering. A lot of young people are entering the workforce, paying their taxes and helping to lift prosperity.

Natasha Ebtehadj – Portfolio Manager – Columbia Threadneedle Investments