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Corporates & Markets Is it India’s time to shine? Peter Kinsella HEAD OF EM ECONOMIC & EM FX RESEARCH peter.kinsella@ commerzbank.com 2016 promises to be an interesting year for investors in India. Declines in inflation imply that the Reserve Bank of India (RBI) will be able to cut interest rates significantly. Consequently, we can expect fixed income assets to perform well over the course of the year. However, political opposition to proposed reforms means that large scale growth improvements above trend are unlikely to manifest. From zero to hero In 2013, India was included among the so called ‘Fragile Five’ countries which were considered especially vulnerable to a potential US rate hiking cycle. At the time, India boasted a significant current account deficit of nearly 5% of GDP which clearly put India at risk of a sudden stop in current account financing in the event that external financing costs increased markedly. Coming into 2016, investors are broadly enthusiastic about the prospects for Indian growth and for asset returns. There are two reasons for this large change in investor sentiment. The first lies with the RBI’s monetary policy and the second lies with political / economic reform. In our view, the hype surrounding the RBI’s monetary policy mix is entirely justified, less so the hype surrounding political / economic reform. Aggressive rate hikes stabilised the rupee The RBI also undertook a series of rate hikes in 2013 which increased the headline repurchase rate by 75 bps to 8%. Higher rates stabilised the rupee (INR) which depreciated by nearly 15% against the USD in the space of one month alone during the summer of 2013. At one point, USD-INR traded above 68.00 but it has failed to trade above these levels since the RBI’s aggressive rate hikes. Although INR weakened modestly over the course of 2015, it is an impressive performance when seen in the context of the losses seen elsewhere in the EM space. This is true not just for commodity producers in EM but even for other commodity importers in the EM space. “India boasted a significant current account deficit of nearly 5% of GDP” Chart 1: C urrent account shows large improvement Current account as a percentage of GDP 4 2 0 -2 -4 -6 2000 2005 2010 2015 Source: Commerzbank Research, Bloomberg Chart 2: C PI well within target range Consumer Price Index (CPI) year-on-year 14 12 10 8 6 4 2 0 Jan 12 Apr 13 Source: Commerzbank Research, Bloomberg Jul 14 RBI’s reforms bearing fruit In 2013, the RBI banned gold imports which accounted for the lion’s share of the current account deficit. The deficit subsequently contracted aggressively. At the time of writing, it prints at 1.1% of GDP, which means that India is clearly less exposed to an aggressive increase in external financing costs. As a commodity importer, India stands to benefit from lower commodity prices and lower energy prices and the recent declines in commodity prices will likely continue to have a positive impact upon Indian balance of payments dynamics over the coming months and quarters. Put simply, the current account is one area which the Indian authorities do not have to worry about in the short term. There is a lesson for many more emerging market countries from the RBI’s actions: structural reforms can bear fruit. Oct 15 The significant declines in commodity prices have already had a large impact upon Indian inflation rates. Headline Consumer Price Index (CPI) levels printed above 11% briefly during 2013 but the most recent data show that CPI prints come in comfortably around the 5% level. This is well below the RBI’s target for of 6% for January 2016 and this gave it the excuse it needed to cut interest rates in late 2015 to 6.75%. We expect that headline CPI rates will continue to decline over the course of 2016 as the lagged effects of lower commodity prices are felt. Indeed, we will not be surprised to see inflation rates below the RBI’s target of 5% by March 2017. The long and the short of this situation is that inflationary developments will give the RBI significant scope to ease policy over the course of 2016 and 2017. We expect that the RBI will take a cautious stance initially with respect to rate cuts because it will be cognisant of the risks which come from the US, where consensus expectations are now for at least two rate hikes from the Fed. From a currency perspective, this implies that the rupee will experience a modest weakening trend over the course of 2016. The prospect of RBI rate cuts has not been ignored by the bond market. Indian bond markets enjoyed an excellent performance in 2015 and we see no reason for this to cease. Traditionally market participants were always wary of Thinking Ahead March 2016 2 getting into long Indian bond positions due to highly volatile inflation prints. What we now see is that inflation illustrates a decreasing profile not just in India but globally. As the prospect of further supply side reforms (more on this below) comes into focus, this implies that Indian fixed income assets should enjoy a decent year. The prospect of Indian bonds becoming available through Euroclear later in 2016 will doubtless add to investor interest. All told, we think there are realistic prospects for further outperformance over the course of 2016. Chart 3: INR one of the ‘best’ performing EM currencies in 2015 Total return of INR vs USD as a percentage 5 0 -5 -10 -15 -20 -25 -30 For the first time in a generation the prospect of an explicitly market-friendly administration in India was a real prospect. Equity markets rallied significantly. The Sensex index alone rallied by nearly 35% during the second half of 2014. Specifically Modi’s reform programme included promises to liberalise the labour market, reform the taxation system and institute land reforms. Any one of these reforms alone would be enough to boost potential GDP growth over the medium term, but all three together imply a sea change in Indian economic performance. However, this is easier said than done. Land reform, in particular, is fraught with difficulty owing to incomplete property records in some areas and a notoriously slow property registration system. Although compulsory purchase orders would allow investors to increase productive capacity in a meaningful way, so far these proposed reforms were stymied by growing political opposition. Bharatiya Janata Party’s (BJP) loss of the Bihar state election is a case in point. The loss prevents Modi from pushing through reforms and consequently we have to acknowledge that the chances of reform implementation are clearly slipping. Indeed of all the ‘big ticket’ proposed reforms none have been meaningfully enacted. Consequently, we maintain a more sanguine view for Indian economic growth than most. We envisage decent growth in the region of 6.5% for 2016, which is significantly below consensus expectations. BRL COP TRY ZAR RUB CLP MYR RON MXN IDR PLN THB HUF KR CZK INR CNY HKD -40 PHP -35 TWD Great Expectations Rarely has an Indian prime minister entered office with such heavy expectations. What differentiates Prime Minister, Modi from previous administrations is that his election gave a clear mandate to effect wholesale reform. Previous administrations were foiled at attempts to reform by vested interests and a lack of political backing. This is why Modi’s election in 2014 was a game changer. Unlike previous administrations, Modi enjoyed widespread political as well as popular support in favour of his reform programme. Source: Commerzbank Research, Bloomberg Chart 4: Sensex gives Modi benefit of the doubt If there is no Value then stretch the Chart to the top of the artboard 32 Sensex index in 000’s, ie the Index currently trades at 26,000 30 28 26 24 22 20 18 Dec 12 Dec 13 Dec 14 Dec 15 Source: Commerzbank Research, Bloomberg 50% Blue Overall – a constructive outlook In our view, there are good reasons to expect a decent economic performance in 2016, albeit that this is largely due to anticipated declines in inflation prints and subsequent RBI rate cuts. Any windfall from political reforms remains distant however. Thinking Ahead March 2016 ITC Zapf Dingbats medium square 3 Disclaimer This document has been created and published by the Corporates & Markets division of Commerzbank AG, Frankfurt/Main or the group companies mentioned in the document (“Commerzbank”). 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