By any measure, 2016 was a year of seismic economic change for India, particularly with the surprise “currency exchange program” in November, also referred to as demonetization. Three months after this unprecedented move, the overhang already seems to be behind us. Industrial production surged sharply by 5.6%, capital goods within manufacturing recorded 15% growth after several months of contraction, and electricity generation picked up to 8.9%.1 Overall car sales also reported an increase of 16% year-over-year.2 These positive macro points confirmed the Greater China team’s view that the impact of demonetization would be transitory in nature.
Structural growth in India — especially domestic consumption — remains promising over the long term. Looking ahead, we expect corporate earnings and global liquidity to remain market drivers. We will closely monitor corporate earnings, together with the goods and services tax (GST) bill rollout and financial inclusion.
Demonetization: Short-term turbulence may lead to long-term benefits
On Nov. 8, 2016, the Indian government announced the imminent removal of the legal tender status of high-denomination currency notes (500-rupee and 1,000-rupee notes), which amounted to 86% of the currency in circulation.3 With this unprecedented move, the government aimed to reduce corruption, eliminate the exchange of fake currency and prevent terrorist financing. This move caused a temporary economic disruption, as the public had limited time to exchange their cash holdings for newly printed notes or deposit any old currency into authorized banks and post offices (with specified daily withdrawal limits). If money was not exchanged during the set time limit, the old currency notes became worthless.
In the past few months, consumption and services — such as real estate, hotels, restaurants, construction and transportation — were the most affected sectors, due to their higher propensity for cash transactions. In fact, the recently announced Union Budget provided relief for low-income individual taxpayers, who, along with small companies, were the most affected by this initiative. We expect these tax benefits to have a cascading effect that should boost consumer spending. Also, the consumption sector is already back to “business as usual.” We expect further pent-up consumer demand from wealth redistribution toward poorer households, along with lower lending rates.
In our view, the damage from demonetization was transitory, but the potential benefits are longer-lasting. These may include formalization of the economy, reduction in corruption, improved ease of doing business, positive wealth redistribution, a boost to higher government tax revenues and greater financial savings. This is also in line with the government’s anti-corruption initiative and reflects its strategy of “short-term pain for long-term gain.”
Corporate earnings: Assessing the data and talking to management
After the demonetization event, rather than relying on earnings revision estimates from analysts, we prefer to look at actual earnings results from companies while maintaining direct communication with their management teams on the impact. In the midst of the earnings results season, about 60% of the companies already announced results,4 and most of them were able to deliver decent earnings in the face of demonetization. In any case, it would be prudent for us to closely monitor earnings developments over the next two quarters.
Currently, we believe the key is to look for companies that can potentially gain market share during the demonetization cycle. We believe players with a competitive advantage and market share can gain at the expense of weaker, disorganized players. Furthermore, we feel that demonetization has expedited the consolidation cycle in select sectors, and stock selection remains key to differentiate the winners from losers.
Consumption likely to benefit
We have maintained a positive bias toward consumer spending. This structural bias is supported by our long-term view that consumption could remain by far the most important economic pillar in India, accounting for two-thirds of gross domestic product. Moreover, India is an inward-looking economy more focused on domestic economic activities, with favorable demographics that should increase consumption over time.
In fact, we are seeing a strong improvement in consumption, with the good monsoons and pay hikes recommended by the 7th Pay Commission all contributing to improved consumer confidence. Looking ahead, together with the GST rollout and the tax benefits from the Union Budget, we expect consumption to continue to represent a sweet spot for structural growth. This is the area that we are most interested in.
Looking ahead to a healthier economy
With demonetization ultimately helping to rejuvenate the economy, India has had a good start to 2017. This economic health has been reinforced by a number of initiatives announced by the government in recent years:
- GST bill passage — The combination of 16 types of taxes into a single tax. The rollout is on track to take place on July 1, 2017.
- Pradhan Mantri Jan Dhan Yojana — Since the launch of this financial inclusion campaign in August 2014, 255 million bank accounts have been opened.5
- Direct benefit transfer — Launched in January 2013, this program aims to transfer subsidies directly to people through bank accounts, promoting greater transparency while helping to avoid leakages and delays.
In our view, the recently announced Union Budget is also well-balanced, with proposals that may lead to further formalization of the economy. The budget was not a bold and revolutionary act by the government; instead, it represented a series of small, creditable and realistic steps designed to steer the economy onto a clear path toward long-term sustainable growth. The spending plans largely meet our expectations, as they fully address how the government should reflate the economy and spend money.
These combined initiatives point to India becoming a healthier economy with more accountable cash and less black money.
The iShares MSCI India ETF (BATS:INDA) closed at $30.05 on Friday, up $0.18 (+0.60%). Year-to-date, INDA has gained 12.09%, versus a 6.33% rise in the benchmark S&P 500 index during the same period.
Going forward, the government’s policy measures to reflate the economy, corporate earnings and global liquidity are likely to remain the key market drivers. Investors will also be watching out for policy news in the US and news related to implementation of the GST.
1 Source: Citibank Research. Refers to November 2016 monthly data.
2 Source: Citibank Research. Refers to data as of Jan. 31, 2017.
3 Source: Reserve Bank of India, as of November 2016
4 Source: Invesco Equity Investment Team in Asia, as of January 2017
5 Source: Pradhan Mantri Jan Dhan Yojana, as of December 2016
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