Why is India underperforming?

Once we get over current uncertainties, investors will return as India is the only long-term growth story

There is a growing sense of disillusionment with India among international investors. They have been selling stocks for most of last year, and India continues to underperform most other emerging markets (EM) year-to-date. The only large market down more than India this year is Australia. Among the larger EM markets, India is down the most. Many of the fancied mid-cap stocks in India are down 20-25 per cent. The mid-cap indices are down more than 10 per cent in dollar terms. Portfolios of many investors are now actually down on a year-on-year basis.

Why are markets underperforming? What are the issues investors are worried about?

Foreigners are concerned by the Punjab National Bank (PNB) fraud and the seemingly never-ending banking system clean-up. When will this end? When do the non-performing assets (NPAs) stop piling up? How can a banking system have 20-25 per cent of its corporate exposures turn bad in the absence of a recession? Even in its worst time, the Indian economy never grew below 5 per cent. What is the right NPA number for the system? Just when we thought the government was finally getting in front of the problem with the $32-billion recap plan, we learn that we may need at least that much more government infusion over the coming years. The delays for resolution of the big NPA cases also seem to be continuing. Essar Steel, seen as the poster child of NPA resolution and the case on the basis of which investors will judge political willingness to face up to vested interests, seems to be caught in controversy. If this asset goes back to the erstwhile promoters, either directly on even indirectly, the whole Insolvency and Bankruptcy Code reform will come into question. With the new Reserve Bank of India (RBI) norms on asset recognition and provisioning, we will see a bloodbath in bank balance sheets once again. Most of the banks will once again report losses and take huge provisioning charges over the coming few quarters. The NPA workout is now truly testing investors’ patience. We have been hearing for almost five years that the worst is over and we are two quarters away from numbers normalising. However, the clean-up just does not seem to end. Many investors believe that in the absence of a clean-up of the banking system and public sector banks (PSBs), the economy cannot sustainably move into a higher growth orbit.

There is fear that the goods and services tax (GST) may be more complex than first realised. The complexity seems to be leading to misuse, avoidance and collections continue to undershoot. Will this much heralded and critical reform also disappoint? The World Bank in a recent report called out the complexity and high rates of this reform. Measures to control tax avoidance such as the e-way bill seem to be continually delayed and may make the system even more complex. While no one doubts the GST is a much-needed reform, investors are worried that its benefits may take longer to come through than first anticipated.

The macro continues to weaken with oil at $65-70 a barrel, close to levels which will hurt the economy and fiscal. As we approach election season, fears abound on the inability of the government to keep a tight rein on the fiscal. Most observers believe that the fiscal targets will be missed and bond yields are also signaling concern.

With the RBI formally accepting a four percent inflation target from April 1, 2018, there seems to be no scope for any further monetary easing. Investors are in fact braced for the RBI to start tightening this financial year. The tailwinds of easy liquidity and falling interest rates are over. The question now is how much and when will the authorities raise rates?

While the economy does seem to be improving, many question the sustainability. Is this just the base effect of lapping the demonetisation? Or has the economy seen the worst? Will we get the double-digit earnings growth we need to sustain current stock prices? Having been burned waiting for the earnings cycle, many investors would prefer to have a wait and see. We have been talking up earnings since the Narendra Modi regime came to power, but have been disappointed. In the past five years, every quarter bar the last one has seen earnings expectations being downgraded. Investors will not forever pay up for non-existent earnings growth.

The new concern is around politics. Investors hate uncertainty. What was seen as a sure thing even a few months back (the current regime coming back to power), is now seen as more complex and not straight forward. At the moment global investors have little faith in any alternative to the current regime. As uncertainty builds on the election front, global investors will increasingly turn cautious.

While domestic flows have stayed rock solid to date, many foreign institutional investors make the point that these flows have yet to see a proper cycle. Will money continue flowing into equities with rising rates, volatility in prices and many investors seeing statements showing no returns over the past 12 months? The long-term capital gains (LTCG) tax has not helped. Most of the truly long-term capital investing into India from the US is tax exempt. The LTCG reduces their expected returns. It also reduces the relative return advantages for equities domestically. Any reversal of domestic flows and markets will immediately be in serious trouble. 

There is also the persistent and gnawing doubt about India’s preparedness and positioning in the new technologies. Unlike China, which leads the world in renewables, electric vehicles, artificial intelligence and precision manufacturing, India seems to have no play in these areas. Even in the consumer internet ecosystem, Chinese companies are slowly developing leadership. They will soon control vast chunks of our internet ecosystem as well.

While these concerns are valid all is not gloom and doom. India will see growth acceleration over the coming years. Seven to 8 per cent GDP growth is eminently doable. Earnings will rebound, profit margins will regress to the mean, and we will see double-digit earnings growth. Macro conditions will stabilise and political uncertainty will abate as we enter the latter part of this year. India has accounted for almost 10 per cent of incremental global growth over the past five years. Over the coming decade it will account for close to twenty percent of incremental global growth, a level similar to China (as it slows down to sub 5 per cent growth). The translation of our economic growth into corporate earnings and eventually stock market performance is far better than in China. Once we get through the current uncertainties, investors will come back to India. It remains a sustainable long-term growth story in a world devoid of structural growth.

The writer is with Amansa Capital