Indian stocks look to mirror China's 2017 performance

dubai - Investors hold a tolerance level of about 12 to 18 months for new initiatives to flow into these economies and produce results

Emerging markets are beginning to encounter headwinds. Following positive returns in the year to date, the temptation to take profits surfaces as political concerns grow particularly in the Middle East, South America and Southern Africa. Within the emerging market asset class, Asian equities remain attractive, supported by pro-growth policies and robust economic dynamics resulting from rising domestic and global trade demand. Within Asia, the region's two largest economies, China and India, anchor a keen sense of optimism.

China and India are uniquely positioned. An early year stand-off in the Himalayas and rising Chinese investment into Pakistan have annoyed New Delhi, while India's support for the US' Indo-Pacific initiative has in turn aggravated Beijing. Both countries also share striking similarities, including elevated domestic political capital for Chinese President Xi and Indian Prime Minister Modi.

Such approval suggests that the investor community holds a tolerance level of about 12 to 18 months for new initiatives to flow into these economies and produce results. In early 2016, markets were concerned that elevated debt levels would squeeze liquidity and generate an economic hard landing in China, forcing Beijing to deploy nearly $1 trillion of its foreign exchange reserves to stem capital outflows. When Beijing commenced its 19th Party Congress in late 2017, many of these concerns faded as macro readings and equities rebounded following policy implementation over this period. India now hopes to emulate the relative success of China.

In November 2016, PM Modi's demonetisation announcement came as a major surprise and he used the exercise as a political programme with the aim of weeding out corruption. The scheme received heavy criticism from opposition members, since almost the entire supply of paper money (approximately 86 per cent of the currency in circulation) was deposited into banks. The consequences were only a minimal exposure of fraud but instead a major disruption to business and personal activity.

The goods and services tax (GST) followed just six months later. In a similar way to demonetisation, there was poor follow through and uneven implementation combining to produce additional havoc for a still shaky economy. The combination of a liquidity crunch and inventory destocking weighed on investments, as shown by the 5.7 per cent GDP growth during the quarter ended March 31, 2017, the slowest rate under the administration. Modi's reforms were depicted as having wanton disregard for political opponents by pushing an agenda at the expense of the poor.

Formalising the economy
Despite the disruption, Modi's approval ratings remained high, as supporters displayed a willingness to countenance the inconvenience. Changing consumption behaviours also emerged, with deposit inflows increasingly used to invest in mutual and insurance funds in preference to traditional assets such as gold and real estate. Along with a newly passed bankruptcy law and the ongoing push for identification registration through Aadhaar cards, the efforts to formalise the economy and reduce cash leakages were gaining pace.

This set the stage for the most recent events: the PSU (Public Sector Undertaking) capital injection and the sovereign upgrade by Moody's. When New Delhi announced plans to pump Rs2.1 trillion ($32 billion) into state-owned banks, it came as a surprise both in terms of timing and amount. The objective was  to ignite India's lethargic investment cycle and this would later feed into Moody's decision to upgrade India's credit rating, coming just after the first anniversary of demonetisation.

So, what has changed and why does this matter? The capital injection into public state banks increases the availability of credit to lend which previously had been sidelined, while the sovereign upgrade lowers the cost of funding for financial institutions. More importantly, the new bankruptcy law favours the creditor over the debtor, addressing the structural historical issue which had previously benefited the borrower. The effects are both immediate and positive as distressed assets are used better, while capital expenditure projects have scope to allow for longer integration periods before producing economic returns.

These measures should combine to create a positive backdrop for investors as investment interests become aligned with politicians looking to drive growth and win future elections. While momentum is positive, the investment landscape is not without its faults. PSU banks reflect Modi's political will, while tighter credit standards and lingering bureaucratic red tape keep loan demand hesitant. Defaulting borrowers are also not yet completely banned from bidding for distressed assets in bankruptcy liquidation, creating a moral hazard dilemma.

Addressing such legacy issues would be supportive for medium-term growth prospects, carrying political capital for Modi's administration to address other long-standing burdens such as agriculture and land reform which would benefit the longer-term outlook. While Chinese markets rose as the robust economic environment looked set to underpin earnings this year, questions still linger over liberalisation reforms that address state-owned enterprises and market access to foreigners.

New Delhi has already proposed guidelines to tighten the bidding process and ring-fence investments to qualified investors, which would justify valuation premiums. Investors have already given China's equity markets the benefit of the doubt in 2017 and may well reward India similarly in 2018. That would be a good act to follow.

The writer is fund manager - Asian equities, Union Bancaire Privée. Views expressed are his own and do not reflect the newspaper's policy.