With most eyes on today’s Brexit referendum and the approaching US presidential election, we figure many investors may have missed the latest news out of India. Two years into Prime Minister Narendra Modi’s administration, and with one of the fastest growing economies in the world, India seems like it’s on an upswing—especially with the latest reform easing foreign investment. However, recent developments at the Reserve Bank of India (RBI) also revealed Indian politicians’ penchant for infighting and prioritizing local interests above all else, often to the country’s detriment. Though investors should be mindful of India’s history of unwelcome political intervention—a common risk with Emerging Markets (EM)—we remain optimistic overall about the country’s current reform progress.
First, the positive: Modi’s administration just introduced new foreign direct investment (FDI) reforms targeting a swath of sectors like defense, civil-aviation and retail. Foreign investors can now own up to 100% of domestic airlines (up from 49%) as well as 100% of defense companies (pending government approval)—a positive given inefficient state-run companies currently dominate the sector. The government also relaxed a rule requiring foreign retailers to buy 30% of their materials from Indian vendors, rolling out a three-year grace period to comply (and an additional five-year period for retailers offering “state-of-the-art” or “cutting-edge” technology[i]). Requirements on the broadcasting and pharmaceutical sectors, among some others, have been liberalized, too.
Now, we understand these changes aren’t huge, sweeping, sexy moves that get splashed across headlines from Toronto to Timbuktu: The “Big Bang” they are not. But these incremental improvements are realistic, and given India’s history of aiming high and then massively undershooting on reform, Modi’s administration deserves credit for managing expectations and making them happen. Besides FDI reforms, Modi has overseen other positive liberalizations too, from a key bankruptcy law to working on a uniform goods and services tax (GST)—changes that help modernize and streamline parts of India’s archaic, byzantine economic system. All are beneficial for Indian stocks over time.
However, India also just experienced a bit of a setback: Its central bank head, Raghuram Rajan, announced last Saturday he will step down when his term expires in September. Since taking over in 2013, Rajan has been a steadying presence for the RBI. He took a hardline stance on inflation and established inflation targeting as the RBI’s framework, addressing India’s chronic issues with stagflation and hyperinflation. Rajan also fiercely advocated for the RBI’s independence, as separating monetary policy from political influence is critical to a central bank’s credibility. His decision to step down doesn’t appear to be driven by a personal choice like retirement (he is young at 53 years old) or incompetence (he is widely praised globally), but due to political pressures. Rajan has his detractors in Modi’s Bharatiya Janata Party (BJP) who have been highly critical for years. Already skeptical because he was appointed by the prior government, opponents portray Rajan as an outsider—not “sufficiently Indian”—who has been stubbornly slow in reducing interest rates, which would help spur economic growth. Rajan has also publicly disagreed with government officials pushing for monetary easing, making him persona non grata with some in the BJP. Facing this lack of support, Rajan announced he won’t seek renewal.
This negative here isn’t so much about losing Rajan’s expertise. The reforms he spearheaded should help the RBI function well under a new leader, and there is no shortage of capable, qualified replacement candidates. Yet the Indian government’s tendency to meddle introduces uncertainty, which markets don’t much like. While it is near-impossible to be completely independent, monetary policy is best when politics are out of the mix. A central bank and executive administration pursue different interests. The former is focused on the money supply and assisting troubled banks when needed—regardless of the current political environment. Politicians, on the other hand, are mostly focused on pleasing their constituents to win votes for the next election. Boosting economic growth through any means possible is a great selling point to voters, even if it sets up problematic issues down the road. If politicians are allowed to influence monetary policy, markets could lose confidence in the central bank’s independence—and there goes its credibility. At this point, it is speculative to say India’s politicians are interfering heavily right now, but it is a factor worth watching and considering.
This bumpy dynamic isn’t uncommon in Emerging Markets, where institutions aren’t as developed or strong as ones in the developed world—one reason pledged reforms often don’t come to fruition. India in particular has a checkered past with pledging big reforms that end up nonexistent or watered down. Historically, the country hasn’t relinquished much control to overseas investors, discouraging foreign capital. Even when national administrations promised change, they faced stiff resistance from state governments protective of their autonomy. Despite the seeming rational appeal, reforms aren’t easy to pass and implement. They choose winners and losers, and local interests understandably don’t want to be on the losing end.
But it’s here that Modi’s administration, Rajan’s departure aside, has still made impressive strides, especially compared to its predecessors: It has made some economic reforms—albeit of the smaller, more incremental variety—a reality. Rather than grandiose but unfulfilled promises, Modi has pragmatically overseen steady, real progress: an overall positive trend for India moving forward.
India has been one of the bright spots in the EM category, with a bustling economy supported by government-driven liberalizations. Though not all is perfect, as the Rajan episode highlights, there is certainly a lot to like for anyone currently investing in Emerging Markets. India’s example reminds investors of how multi-faceted reality can be, especially with EM boasting big growth numbers with bouts of political uncertainty. Though some negatives linger, India’s reality is also better than most outlets seem to appreciate, and we expect that uptrend to continue for the foreseeable future.
[i] Likely an attempt to curry favor with a big tech company headquartered in Cupertino, CA.