June 18, 2014
While the finalized results have yet to be confirmed, the Bharatiya Janata Party (BJP)-led coalition is on course for a record election victory in India. It will be the first time since 1984 that a single party will have gained a majority on its own (more than 272 seats) and, more importantly, the first time since independence in 1947 that India will have a center-right, probusiness political party. What does this mean for India? T. Rowe Price portfolio managers and analysts are carefully monitoring the likely outcome of this historic victory and how India's new Prime Minister, Narendra Modi, will address the current problems of slow growth and high inflation.
A historic victory
In the largest democratic elections in the world, India's BJP is on track to achieve an outright majority (272 seats)1, and, with its close ally the National Democratic Alliance (NDA), around 320-330 seats. The Congress Party's vote collapsed to approximately 50 seats (60-70 seats for the UPA coalition)—well below even the worst poll predictions of 100 seats. The victory was widely predicted, but the size of the victory has exceeded even the most optimistic forecasts. The BJP has never exceeded 200 seats.
The BJP "swept" states like Maharashtra, UP, Bihar, Haryana, Assam, Jharkhand, and Delhi, where it is currently not part of the state government. It is, thus, likely to form state governments (even adjusting for slightly different voting intentions in assembly versus parliamentary elections) in Maharashtra, Haryana, Delhi, and Bihar, where elections are due in the next year. This has a strong bearing on center-state coordination, as nearly 50% of India's population will be in states under the NDA leadership. Overall, with the NDA coalition gaining close to a two-thirds majority, and with no other party crossing 54 seats, it would mean a parliament with no Leader of the Opposition and a weak and fragmented opposition, thus allowing for important reforms to be pushed through.
The next steps
In terms of next steps, several things will be key to watch:
- How quickly does Modi hit the ground running?
- Who will be the finance minister?
- How does the rest of the cabinet look?
The challenges for India are significant
Many of these are not the types of challenges that even legislation can resolve, but rather complex bureaucratic reforms and execution—which will all take time. These include:
- Stalled infrastructure projects; this is not just due to obstruction at the federal level, but also to state-level governments and intervention by courts or social groups.
- Lack of bureaucratic initiative or conflicted regulatory mandates and political intervention in regulatory decisions.
- Stressed balance sheets of key corporates, especially in the infrastructure sector.
- High level of nonperforming assets (NPAs) on bank balance sheets constraining new lending to infrastructure projects.
- Approximately 9% CPI inflation and slumping savings rates. (This is partly the Reserve Bank of India's (RBI) problem, but Prime Minister Modi will need to give the RBI the room and backing to tackle this.)
Prime Minister Modi has outlined a very ambitious agenda, one that, if reasonably implemented, offers good chances of breaking down these problems over time and putting India back on a fast growth track.
Key highlights include:
- Bureaucratic execution - Devolve more power to the states on taxing and spending.
- Labor law reform - This is a very complex and politically charged issue that requires legislative change. An attempt to reform this would be very market positive, but due to its political nature it is not clear how keen Prime Minister Modi will be to press this.
- Pass the Goods and Services Tax and Direct Tax Code; the former is particularly important for making India an internal common market, boosting economic activity and revenues simultaneously.
- Divestment/privatization - Prime Minister Modi will likely continue divestments via minority stakes, though his commitment to outright privatization is less clear. In his home state of Gujarat, he tended to focus on making state enterprises more efficient through management accountability and hard budget constraints—a strategy that can work to a point but requires disciplined commitment.
- Fiscal reforms - The various microreforms should help put India's fiscal consolidation on firmer footing. This year's budget may be less ambitious, but we expect Prime Minister Modi to recommit to a multiyear fiscal consolidation path but at a slower pace. In the near term, the focus will be on realigning spending priorities in a pro-growth direction.
Where could this new pro-growth and business government struggle?
When looking at what could go wrong with this bullish scenario, the main risk comes down to execution. Prime Minister Modi will need a strong team to execute, prioritize, and organize the government. In addition, despite the stellar election result, the new NDA government will have to reach out to other parties as it does not have a strong presence in the Rajya Sabha (Upper House). Equally, do not ignore the reality of the last five years. In May 2009, when the Congress-led UPA won a second term and the equity market hit the upper circuit, the general assessment was that the election outcome was a "game changer." As subsequent economic missteps showed, that was not the case at all. This time, however, there are more expectations that it could be different.
The BJP win is more an equity story than a fixed income story in terms of upside potential. However, India's equity market has performed strongly in the runup to these elections on the expectations of a BJP win. Although, the size of victory could mean that gains could be sustained. At the same time, domestic stocks have risen strongly over the last three months, so in the short term, it would be difficult for stocks to push higher from here. Cyclical sector valuations look particularly expensive, and we see few catalysts for these sectors over the short term. The overall market is trading on approximately 16 times price-to-earnings with the long-term average being 15 times and a ceiling of 18 times. We believe markets can potentially push higher from here, but it is important to monitor improvements in fundamentals to support the premium valuations.
More generally, though, the election results could be an inflection point for India's story. The electorate's strong and high-quality mandate is for development, in our view. This increases the chances that the new government focuses on accelerating growth and slowing inflation. While India's structural story has been very strong, the pace of reforms has been slow in recent years holding back its growth. Reforms that could follow post-elections will improve business sentiment, thereby lifting corporate sector profitability and incentivizing a revival in private investment.
Prime Minister Modi's inherent strength is his administrative management. The main reason for India's idiosyncratic deceleration has been the multiple policy mistakes, some of which have caused decision-making to freeze. Managing inflation, reviving investment (especially infrastructure), scaling back subsidies, and improving the fiscal deficit will be the key focus areas. Sector-wise, manufacturing and agriculture will be important focus areas.
We also expect there to be emphasis on power and tackling corruption. There is the strong likelihood that an environmental minister could be appointed, and we should see infrastructure projects coming through more quickly. There could also be a focus on agriculture via direct investment as opposed to subsidies under the previous regime.
Overall, if we begin to see signs of a macroeconomic recovery, then stocks could trade higher. Local bonds at 8%-9% look attractive on a 12- to 24-month horizon assuming that the fight against inflation makes meaningful progress. In the near term, the main headwind is a new round of rising food prices and the risks of an El Nino shock. There are also some concerns that if Prime Minister Modi succeeds in reviving the investment cycle, we will also see near-term pressure on inflation. The first term of Prime Minister Modi will likely be a struggle, as we have seen with other politicians in Asia, but there are definitely more positive signs for India under a BJP leadership.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are as of June 2, 2014, and may have changed since that time.