Will India be the star of emerging markets?

India has lagged the EM rally in 2016 but is India’s Star is set to shine? Adrian Lowcock, investment director at Architas, gives his view.

Will India be the star of emerging markets?

India has lagged behind rallies in Brazil and Russia in 2016, delivering returns of 6.7% compared to 9.74% for the broader MSCI Emerging Markets Index.

The rebound in emerging markets has been driven by a rally in value stocks, particularly in markets which had been worst hit. Both Russia and Brazilian markets had suffered from political issues and were impacted by the collapse in commodity and oil prices.

India on the other hand has slipped behind as the initial euphoria of Modi’s election gave way to disappointment that changes were not likely to immediately impact the economy. However this is set to change.

Why India’s Star is set to shine

Valuations – Market valuations are high but not particularly so for India. Relative to world and emerging markets they are pretty close to their long term average. That was when earnings were growing at less than 5%. Earnings have been weak the past couple of years but are expected to grow in the double digits as reforms begin to have an effect.

Economic strength –  GDP growth is strong, the Indian economy grew by 7.3% in 2015 compared to 6.9% in China and 3.1% for the world. This is expected to rise to 7.5% in 2017. India is also forecast to generate earnings growth ahead of other emerging markets over the next couple of years. In addition India’s current account deficit has fallen from 4.7% of GDP in 2013 to 1% expected this year, whilst overseas debt is now 23% of GDP. As such the country is less sensitive to rising US interest rates or a strong dollar.

Favourable demographics – Around 55% of the population are below 30, whilst 54% are in working age, which will rise given the skew to under 30s. Median age is around 30 compared to around 40 in the US and nearer 45 in China.

Modi’s Reforms

Narenda Modi came into power in May 2014 with a strong mandate to reform India and remove the red tape which was stifling the country.  Such reforms take time to get through parliament and to have an impact on the underlying economy. Modi has been successful in making some changes but the full effects on the economy have yet to be seen.

Goods and Services Tax – The introduction of this tax is seen as a huge victory for Modi. Its introduction replaces the patchwork of state by state taxes which have held India back and is a significant move toward India creating a single unified economic zone.  It could add as much as 2% to GDP.

Financial inclusion – One year ago 50% of the population had access to a bank account. That has now risen 99%. There are over 200 million bank accounts in India. Having a bank account helps reduce corruption as benefits can be paid directly to the individual entitled to them.

Foreign Direct Investment – Under the previous government FDI was limited in favour of domestic oligarchs. Modi has reversed that policy in an attempt to reduce corruption. FDI will not only help tackle corruption but will bring much needed investment and expertise into India.

Bankruptcy Code – Aims to reduce the time it takes for insolvencies to be resolved, by consolidating existing laws and bringing them under one process. Currently it takes an average of 4.3 years to resolve insolvency in India, compared to 1.7 in China and 2 in Russia.  The new law sets a time limit of 180 days. The full effects of this law are not expected to be felt for at least three years.

There is still a long way to go before Indian reforms are complete and there are risks when investing in any emerging market. However, the reforms being made today could unlock India’s potential.

Much of the reform will help reduce corruption which has plagued the country and bring the informal economy into the mainstream. Modi is also making India a much easier place for companies to conduct business.

The growth potential of India and indeed the growth already coming through is not currently reflected in the market’s valuations which are trading close to their long term averages.

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