 "The growth outlook in India is dependent on pace of reforms: Amar Gill")
It is still early days for the government in India but Prime Minister Narendra Modi seems to have hit the ground running, with the slew of reforms and policies his government announced after assuming charge in May-end. Hong Kong-based Amar Gill, head of Asian research at CLSA, shares his views with Puneet Wadhwa on the key reforms he expects in India and their likely beneficiaries. The biggest low-hanging fruit for the new government is to improve the efficiency of the bureaucracy and accelerate decision-making, he says. Excerpts:
How do you think India is placed among its Asian peers, especially the ones that are poll-bound in 2014, given the set of macros each region has?
Major political-economic reforms happening in the Asia-Pacific concurrently are unprecedented. Japan, China, India and Indonesia — arguably the four most important markets in the Asian universe — have all had political leadership changes within about 18 months. In each country, the reshaping of policy is leading to radical alteration in the way business is done.
These changes will have major implications for the sustainability of growth and quality of corporate earnings in many of these markets.
What is your interpretation of economic progress in China and Japan? What are your key concerns?
China's economy is in transition, with rising wage costs and massive overcapacity. The leadership has aggressive plans, especially for financial reform and reducing corruption. But if the country cannot execute, it will fall into the middle-income trap. While China's property-market growth has been solid for 15 years, we expect a slowdown. We believe it would be better to allow the economy to slow, rather than stimulating to reach a high growth target.
Japan stands out with one of the highest tax rates among OECD (Organisation for Economic Co-operation and Development) countries. As an export-oriented economy it can ill-afford high tax rates for its companies As inflation comes back to Japan, the real yield will go negative unless nominal yields rise. This poses the risk of major losses on the bond holdings. We believe the GPIF (Government Pension Investment Fund) is set to shift its allocation to equities. The greater swing will come if this also helps change the mindset of retail investors.
Talking specifically about India, what are the key concerns and which checkboxes have you ticked in terms of what you wanted changed or wanted to see an improvement in terms of policy reforms?
Prime Minister Narendra Modi's first Budget has laid out a road map for fiscal consolidation, a boost to infrastructure and construction, and carried forward the opening up of the FDI (foreign direct investment) agenda, thus ticking most of the right boxes. A better growth outlook is dependent on the government's ability to introduce widespread reforms.
Can you highlight the specific reforms or policies that you expect the new government should focus on? Can you identify reforms that will be crucial to kick-start an investment-cycle recovery?
The biggest low hanging fruit for the new government is to improve the efficiency of the bureaucracy and accelerate decision making. Success here could see more than $100 billion in investment projects start moving. Initial progress is visible.
Our wish list includes faster approvals, improved decision making and land acquisition across many sectors. Additionally, there are sector-specific policy issues such as coal production, rail modernisation, reducing fuel subsidies and public sector bank liberalisation that are much desired.
Many of these reforms do not need parliamentary approval (even though the BJP has a majority), although state involvement might be needed to achieve better results.
Reforms related to the oil and gas space have been high on the wish list of the most market participants. Do you think the government will be able to deliver here since it will entail doing away with subsidies, which is a politically sensitive subject?
India's oil and gas industry suffers numerous problems and we expect the new government to address these with a slew of reforms. Reducing oil subsidies will be a clear priority. This, in turn, will cut the fiscal deficit as well as reduce the burden on state-owned companies. Steps taken yet to steadily increase diesel pricing and curtail LPG subsidies are in the right direction. The new government will also need to tackle tough issues such as better targeting of kerosene subsidies. Since this is politically very tough to implement, the Modi government can improvise the Direct Benefit Transfer scheme.
Financial/banking and infrastructure sectors have been in the limelight against the backdrop of policy announcements. What is your interpretation of the developments and which companies, according to you, will be the top beneficiaries?
The new government has taken charge at a time when new project announcements are at a multiyear low; stalled projects (eight per cent of gross domestic product) and time taken for environmental clearance (30 months) are at all-time highs. FDI (Foreign direct investment) relaxation in defence and more private-sector participation in defence equipment making could help domestic manufacturing and reduce imports.
Allowing public sector banks to work more professionally by reducing government stakes and intervention is the biggest potential banking-sector reform. Potential reforms to reduce the statutory liquidity ratio (SLR) and priority sector requirements fall under the purview of the Reserve Bank of India (RBI).
Recent relaxation on asset-allocation rules on infrastructure and housing loans is encouraging. Key beneficiaries, according to us, are the public sector banks, including State Bank of India (SBI).
With a better asset mix, we estimate that banks can potentially lower their lending rates to such infrastructure projects by 150-200 (basis points) bps without compromising on spreads. Given strong growth prospects and the increasing requirement on capital adequacy per Basel standards, we estimate that Indian banks will need to raise $70 billion in fresh capital over the next five years. A dominant proportion of that would be need by the public-sector banks given their large size and inadequate capitalisation.
What is the road ahead for corporate earnings in India? Do you see a ray of hope?
Return on capital peaked for Asia Pacific ex-Japan around 2010. Last year, companies' generation barely covered their cost of capital. However, we forecast operating profitability to improve over 2014 and 2015. There is generally a high correlation between PB (price-to-book) and ROE (return on equity), but, interestingly, we find an even higher correlation across of ROIC (return on invested capital) with market book multiples.
Higher operating profitability, through pushing return on capital above weighted cost of capital (WACC), improves earnings quality. Companies would thus be deemed value-creators by the economic value-add (EVA) definition. Industrial reform that supports higher profitability will boost valuations and is crucial for markets to re-rate sustainably. This is likely in India, Indonesia and Japan.
So, what is the road ahead for the Indian markets and FII flows over the next one year in this backdrop?
As return on capital improves as we expect for India, it will help pull inflows from equity investors and sustain somewhat higher valuations for the market.
What is your portfolio strategy as regards India and which sectors and stocks/investment themes appear attractive from six to 12-month horizon and why?
Our favourite picks to play the reforms expectations are ICICI Bank, SBI, ONGC, NTPC and Larsen and Toubro (L&T).
How do you think India is placed among its Asian peers, especially the ones that are poll-bound in 2014, given the set of macros each region has?
Major political-economic reforms happening in the Asia-Pacific concurrently are unprecedented. Japan, China, India and Indonesia — arguably the four most important markets in the Asian universe — have all had political leadership changes within about 18 months. In each country, the reshaping of policy is leading to radical alteration in the way business is done.
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The winds of change across practically all of the Asia Pacific have never been stronger. India's new government has signalled that it is willing to make tough decisions. Korea is pursuing chaebol reform; Taiwan is finalising a services pact with China with wide-ranging implications for trade and finance; the Australian government has plans for a "roads of the future" programme to revamp infrastructure; the Philippines has overhauled the process for awarding infrastructure projects; Malaysia is addressing its power industry, and Singapore its transport sector; political reform is driving change in Thailand and coming to the boil in Hong Kong.
These changes will have major implications for the sustainability of growth and quality of corporate earnings in many of these markets.
What is your interpretation of economic progress in China and Japan? What are your key concerns?
China's economy is in transition, with rising wage costs and massive overcapacity. The leadership has aggressive plans, especially for financial reform and reducing corruption. But if the country cannot execute, it will fall into the middle-income trap. While China's property-market growth has been solid for 15 years, we expect a slowdown. We believe it would be better to allow the economy to slow, rather than stimulating to reach a high growth target.
Japan stands out with one of the highest tax rates among OECD (Organisation for Economic Co-operation and Development) countries. As an export-oriented economy it can ill-afford high tax rates for its companies As inflation comes back to Japan, the real yield will go negative unless nominal yields rise. This poses the risk of major losses on the bond holdings. We believe the GPIF (Government Pension Investment Fund) is set to shift its allocation to equities. The greater swing will come if this also helps change the mindset of retail investors.
Talking specifically about India, what are the key concerns and which checkboxes have you ticked in terms of what you wanted changed or wanted to see an improvement in terms of policy reforms?
Prime Minister Narendra Modi's first Budget has laid out a road map for fiscal consolidation, a boost to infrastructure and construction, and carried forward the opening up of the FDI (foreign direct investment) agenda, thus ticking most of the right boxes. A better growth outlook is dependent on the government's ability to introduce widespread reforms.
Can you highlight the specific reforms or policies that you expect the new government should focus on? Can you identify reforms that will be crucial to kick-start an investment-cycle recovery?
The biggest low hanging fruit for the new government is to improve the efficiency of the bureaucracy and accelerate decision making. Success here could see more than $100 billion in investment projects start moving. Initial progress is visible.
Our wish list includes faster approvals, improved decision making and land acquisition across many sectors. Additionally, there are sector-specific policy issues such as coal production, rail modernisation, reducing fuel subsidies and public sector bank liberalisation that are much desired.
Many of these reforms do not need parliamentary approval (even though the BJP has a majority), although state involvement might be needed to achieve better results.
Reforms related to the oil and gas space have been high on the wish list of the most market participants. Do you think the government will be able to deliver here since it will entail doing away with subsidies, which is a politically sensitive subject?
India's oil and gas industry suffers numerous problems and we expect the new government to address these with a slew of reforms. Reducing oil subsidies will be a clear priority. This, in turn, will cut the fiscal deficit as well as reduce the burden on state-owned companies. Steps taken yet to steadily increase diesel pricing and curtail LPG subsidies are in the right direction. The new government will also need to tackle tough issues such as better targeting of kerosene subsidies. Since this is politically very tough to implement, the Modi government can improvise the Direct Benefit Transfer scheme.
Financial/banking and infrastructure sectors have been in the limelight against the backdrop of policy announcements. What is your interpretation of the developments and which companies, according to you, will be the top beneficiaries?
The new government has taken charge at a time when new project announcements are at a multiyear low; stalled projects (eight per cent of gross domestic product) and time taken for environmental clearance (30 months) are at all-time highs. FDI (Foreign direct investment) relaxation in defence and more private-sector participation in defence equipment making could help domestic manufacturing and reduce imports.
Allowing public sector banks to work more professionally by reducing government stakes and intervention is the biggest potential banking-sector reform. Potential reforms to reduce the statutory liquidity ratio (SLR) and priority sector requirements fall under the purview of the Reserve Bank of India (RBI).
Recent relaxation on asset-allocation rules on infrastructure and housing loans is encouraging. Key beneficiaries, according to us, are the public sector banks, including State Bank of India (SBI).
With a better asset mix, we estimate that banks can potentially lower their lending rates to such infrastructure projects by 150-200 (basis points) bps without compromising on spreads. Given strong growth prospects and the increasing requirement on capital adequacy per Basel standards, we estimate that Indian banks will need to raise $70 billion in fresh capital over the next five years. A dominant proportion of that would be need by the public-sector banks given their large size and inadequate capitalisation.
What is the road ahead for corporate earnings in India? Do you see a ray of hope?
Return on capital peaked for Asia Pacific ex-Japan around 2010. Last year, companies' generation barely covered their cost of capital. However, we forecast operating profitability to improve over 2014 and 2015. There is generally a high correlation between PB (price-to-book) and ROE (return on equity), but, interestingly, we find an even higher correlation across of ROIC (return on invested capital) with market book multiples.
Higher operating profitability, through pushing return on capital above weighted cost of capital (WACC), improves earnings quality. Companies would thus be deemed value-creators by the economic value-add (EVA) definition. Industrial reform that supports higher profitability will boost valuations and is crucial for markets to re-rate sustainably. This is likely in India, Indonesia and Japan.
So, what is the road ahead for the Indian markets and FII flows over the next one year in this backdrop?
As return on capital improves as we expect for India, it will help pull inflows from equity investors and sustain somewhat higher valuations for the market.
What is your portfolio strategy as regards India and which sectors and stocks/investment themes appear attractive from six to 12-month horizon and why?
Our favourite picks to play the reforms expectations are ICICI Bank, SBI, ONGC, NTPC and Larsen and Toubro (L&T).