“So what about corruption and crony capitalism - which along with the economic slowdown have destroyed his (Manmohan Singh’s) prime-ministership? Singh slipped up because he views issues from the perspective of policy instrumentality rather than from the viewpoint of curbing wrongdoing by others - about which he is surprisingly non-judgmental for someone so fastidious about personal integrity. As he sees it, businessmen's animal spirits should be nurtured; if they get up to tricks… then, as he told a Cabinet colleague, we can't wait to get ideal men from Mars. He has argued publicly that corruption grows along with economic development. In short, better learn to live with corruption - precisely the view that gave a booster shot to the Aam Aadmi Party and made many people turn to non-corrupt Narendra Modi.”

– TN Ninan, Editor of The Business Standard, writing on Manmohan Singh on May 3, 2014 (please note that the text inside brackets is mine.)

India’s strongman Prime Minister Narendra Modi is likely to engineer three critical resets over the next four years, namely: (1) shift India’s savings landscape away from physical assets towards the formal financial system; (2) disrupt the model of crony capitalism; and (3) redefine India’s subsidy mechanism. Whilst in the long run these resets are likely to lower the cost of land, labour and capital, in the immediate term, these changes are likely to limit GDP growth. Hence I can’t see GDP growth in FY16 being significantly higher than what it is in FY15.

In light of the coming policy reset, my view is that it makes sense for investors to shy away from politically-linked companies, rural-demand-reliant B2C companies and lenders that have built loan books collateralised by real estate.

As the new PM rings the changes, new types of companies will emerge as structural winners. My investment strategy would be to focus on well managed private sector financial services companies, chemicals manufacturers and plays from the export centric manufacturing sector.

The three resets

My discussions with the policy ecosystem in Delhi as well as my colleagues’ understanding of the key policy measures announced by the NDA government suggest that the prime minister is seeking to engineer three structural resets: (1) shift India’s savings landscape away from gold & land and towards the formal financial system by enacting legislation which specifically cracks down on black money; (2) disrupt the Indian model of crony capitalism by tightening law enforcement in the seedy borderland where commerce and politics intersects in India; and (3) redefine India’s subsidy system through the direct benefit transfer mechanism.

These resets should help India deal with a problem that has bedeviled it over the past five years – inflation. Inflation in India was low and stable until the UPA’s 10-year rule. Then, under UPA-II inflation roared away towards double digits. Modi’s resets – by attacking subsidies and black money and pushing labour and capital towards the organised economy - should help bring inflation down on a structural basis.

However, the new structure will take some time to become fully operational; hence the three resets look likely to adversely impact GDP growth in FY16. My reading of the economy and my colleagues’ macroeconomic modelling suggests that in FY16 GDP growth will be around 7.5 per cent, similar to that in FY15. The short-term pain in GDP growth will be driven by: (1) alterations in the subsidy regime, which will adversely affect rural/semi-urban consumption and construction activity; (2) crony capitalists’ refusal to begin capex activity, as they see reduced scope for supernormal profits under Modi; and (3) Modi’s attack on black money, leading to a crack in land & real estate prices, which will adversely impact lenders’ balance sheets.

Investment implications

History suggests that the initiation of powerful resets renders redundant the traditional constructs used by investors. This in turn spawns a new generation of winners and losers in the Indian stock market. For instance, 1992-2002 saw the era of the ‘License Raj’ coming to an end and also saw the Sensex’s churn ratio rise to 60 per cent (i.e. 18 of the 30 companies in the Sensex in 1992 were out of the Sensex by 2002).

Whilst in the short term Modi’s resets will adversely impact crony capitalists and rural-demand reliant companies in the cement, auto, electricals, paints, banking and NBFC sectors, the more interesting development will be the emergence of a new generation of structural winners. My belief is that these winners will emerge from the:

  • Financial services sector: At present two-thirds of India’s annual household savings of around $450 billion goes into gold and real estate. As a result banks and the stock market struggle to attract funding and that keeps the cost of capital high for these institutions. If the PM’s attack on black money is even partially successful, the cost of funding will fall for banks (thus making midcap banks with currently modest CASA franchises particularly attractive) and more money will flow into the stock market (thus making well run listed stockbrokers particularly attractive).
  • Agro chemicals sector: As the PM throttles back on the rapid hikes in Minimum Support Prices of foodgrains seen under UPA-II, we are likely to see more farmers shift towards fruit & vegetables, items which are in short supply. This in turn should increase demand for agri chemicals. India has several well run small-midcap companies in this sector which should benefit mightily from this shift.
  • Export centric manufacturing sector: The 80 per cent depreciation of the INR to the RMB over the past five years has made light industrial manufacturing sector in India competitive vis a vis its Chinese counterpart. Now, as the cost of land, labour and capital stabilises in India, my reckoning is that these companies – which manufacture bikes, cars, various auto ancillary items, air compressors, gensets, etc – will go on to build large global franchises.  

Saurabh Mukherjea is CEO - Institutional Equities, at Ambit Capital and the author of “Gurus of Chaos: Modern India’s Money Masters”. 

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