Global Market Commentary

India Makes Progress Under Modi’s Steady Hand

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India Makes Progress Under Modi’s Steady Hand

Back in September, we gave readers a rundown of the big digital strategy of India’s Prime Minister, Narendra Modi — an effort which will be critical in the unleashing of Indian economic growth and India’s rise on the world economic stage in coming years.  

It is difficult to describe the depth and intractability of the problems Modi is confronting.  Though India and China are both developing Asian economies with powerful economic growth trends, they are completely different beasts.  One major difference is the nature of central power.

How India Differs From China

Though both China and India struggle with deeply ingrained corruption, China’s Wild West economy operates within a framework of tight political control.  India, on the other hand, lacks that central political control; it is a riotous democracy in which the development of a modern economy has been hindered by countless layers of local authority and bureaucracy which have created a thicket of contradictory rules.  Commerce and industrial development have been stifled in this environment.  This is one factor that has hindered the development of infrastructure that would allow India to inherit China’s low-wage manufacturing mojo as wages have risen in the Middle Kingdom.  Modi’s program since 2014 has included many elements to streamline and simplify taxes and regulations on a national level.



Graft and Corruption, Indian Style

However, outright fraud and graft are also endemic in India.  The system of Indian transfer payments to the poor has been particularly problematic.  Many of India’s local and national rulers since independence have favored socialist systems with large transfer payments to India’s rural poor.  Because of the poorly developed nature of India’s financial infrastructure, these transfer payments and subsidies have often been in cash or in kind, and have been delivered to local recipients through local middlemen.  In the absence of any central databases about citizens, their identity, and their status, those middlemen have frequently become corrupt agents siphoning off benefits for themselves and rendering the entire welfare system ever more bloated and detrimental to the nation’s economic growth.

Further, many Indians, including more affluent citizens, have held cash as a form of tax evasion.

Understand that we’re talking about a nation of 1.3 billion people in which a quarter are illiterate, 60% are rural, and the majority do not have access to the banking system, and you’ll understand something of what Modi is up against in his vision to make India the world’s next manufacturing powerhouse.

Modi Cheers Markets… and Then Complacency Sets In
Narendra Modi worked wonders for Gujarat during his 12-year tenure as the state’s Chief Minister.  When his Bharatiya Janata Party won a decisive victory in India’s 2014 general elections, markets were thrilled and rallied strongly.  That exuberance faded, as it typically does in such cases, as it became apparent to investors that although he was a transformative leader, he was up against formidable entrenched opposition as well as cultural and bureaucratic inertia.

We believed then, and we continue to believe, that Modi’s election was a watershed moment for India — but that it would take years for him to slowly, steadily guide the country to a better growth path and gradually uproot corruption, streamline the government, and improve the legal, financial, and physical infrastructure of the country.

Cleaning Up the Dirty Cash

Another key moment in Modi’s administration came late last year, when the government made a surprise edict that took more than $200 billion in 500- and 1000-rupee banknotes out of circulation — so-called “demonetisation.”  Hoarders of these notes had a brief window in which they could deposit them or exchange them for new notes — of course, in the process, alerting the government and incurring the long-avoided taxes.  It was a blow against tax evasion and against the black market.

Analysts, especially abroad, at first cheered.  Then they began to criticize it as a heavy-handed measure implemented in a chaotic manner that would end up crimping commerce and damping GDP growth.  The Indian stock market dropped sharply.

The Indian SENSEX Index in U.S. Dollar Terms:  Rallied After Modi’s Election, Fell Back, and Is Now Approaching the Old Highs

Source:  Bloomberg

Smarter Than They Thought

But lo and behold, after that drop, the Indian market has powered ahead.  Some of that move reflects the global rise in optimism that has accompanied the anticipation of a coordinated uptick in economic growth after the last few years’ doldrums.

But in India’s case, there is something else at work.  Analysts misjudged the purpose and efficacy of Modi’s shock move to punish cash hoarders and tax evaders.  When Indians went to the polls in Uttar Pradesh, India’s biggest state, in February, they handed Modi’s party a crushing victory.  Why?  Because ordinary Indian voters understood that the government’s surprise move against the holders of cash was targeting the affluent who were not paying their fair share — and they felt that Modi was on their side.  This victory strengthens Modi’s position in parliament, and will enable further progress on his agenda moving forward.

In short, it turns out that the disruptive financial move was a brilliant piece of politics — catching Modi’s opponents by surprise, strengthening his base, and establishing him as a leader willing to court severe criticism to achieve his goals.

Modi’s Ultimate Goals

It wasn’t Modi who initiated the core reforms that he is implementing.  Those reforms have been underway since 2009, when the government began rolling out “Aadhar,” a single digital identity for all Indian citizens.  But Modi is the first politician with national clout who has made the agenda his mission.  In a nutshell, that agenda is to use digital infrastructure to eliminate corruption in the Indian welfare system and to connect all Indians to the banking system via wireless infrastructure.  That will reduce the government’s burden of fraud and theft from welfare payments and the loss of tax revenue — and will give many millions of ordinary poor and rural Indians access to credit for the first time.

Our takeaway from all the events since the 2014 elections: India is a tough place to be a reformer, with entrenched corrupt interests, Byzantine bureaucracy, and a deep legacy of dysfunction.  Narendra Modi will not achieve it all at once, or quickly — but he is making steady progress and has shown both patient determination and an artful sense of when to strike a dramatic blow.  Especially in the context of a nascent global reflation, we think India has great long-term potential.

Investment implications:  Retail investors can gain exposure to India through a variety of exchange-traded funds, some of which reflect the broad Indian market, and some of which are focused on particular sectors or firm capitalizations.  We recommend broad exposure to the Indian stock market, and counsel investors to take a long-term view.