Rising Political Risk and Negative EM Backdrop to Keep India on the Defensive

The rupee has been the worst performer in Emerging Asia this year. With political risk picking up ahead of elections next year, we think Indian assets will likely remain on the defensive, especially as the global backdrop remains negative for EM.

POLITICAL OUTLOOK

Next general elections will be held in 2019. The ruling Bharatiya Janata Party (BJP)-led National Democratic Alliance (NDA) holds 314 seats in the 545-seat lower house (Lok Sabha). State elections in 2017 and 2018 have seen mixed results for the BJP. Several recent by-elections to the Lok Sabha have gone against the BJP, which does not bode well for next year’s vote.

Prime Minister Nahendra Modi has seen a dip in his popularity. A recent poll by India today shows his popularity has fallen to 49% in July from 53% in January. This compares to an all-time high of 65% in late 2016, just before his controversial decision to demonetize and eliminate the stock of outstanding INR500 and INR1000 bank notes that November. A controversial Goods and Services Tax (GST) that went into effect last July has also weighed on Modi’s popularity.

The opposition Congress Party has broadened its alliances. It recently brought the Bahujan Samaj Party (BSP), the Samajwadi Party (SP), and the Trinamool Congress (TMC) into its United Progressive Alliance (UPA) coalition. One poll suggests that given these new UPA alliances, the UPA could win 41% of the vote next year while Modi’s NDA would win 37%. If the UPA contested the elections with the same allies as it did in 2014, the same poll suggests it would likely win only 31% of the vote.

The new Pakistani government led by Imran Khan is making peace overtures. Foreign Minister Shah Mahmood Qureshi said he is seeking talks with both India and Afghanistan as part of a regional peace initiative. Qureshi added that Indian Prime Minister Narendra Modi has contacted his Pakistani counterpart Imran Khan requesting peace talks be resumed. It remains to be seen whether Modi’s popularity will be helped by a potential thaw in India-Pakistan relations.

The US Treasury added India to its FX monitoring list in its semi-annual FX policy report from April.  The Treasury noted that India has increased its FX purchases and has a “significant” trade surplus with the US. The Treasury also kept China, South Korea, Japan, Germany, and Switzerland on its currency monitoring list. However, it did not name any country to be an actual currency manipulator.

India scores poorly in the World Bank’s Ease of Doing Business rankings (100 out of 190). The best components are protecting minority investors and getting credit and electricity, while the worst are dealing with construction permits and enforcing contracts. However, India does slightly better in Transparency International’s Corruption Perceptions Index (81 out of 180) and tied with Ghana, Morocco, and Turkey.

 

A BRIEF HISTORY LESSON

India was still part of the British Empire when World War II began. During the war, over 2.5 mln Indian soldiers fought for the Allied forces in all the major theaters, with an estimated 87,000 casualties. As the British Empire waned after the war ended, it partitioned the Indian subcontinent and granted independence to the nations of India and Pakistan in 1947.

The Indian National Congress dominated Indian politics for decades after independence. India’s first Prime Minister was Jawaharlal Nehru, who served for 17 consecutive years until his death in 1964. Former Home Minister Lal Bahadur Shastri became India’s second Prime Minister, but only served a little over a year and a half until he died of a heart attack in 1966. The Nehru dynasty continued, as his daughter Indira Gandhi took the mantle of Prime Minister and served for the next eleven years.

In June 1975, a controversial state of emergency was imposed by Gandhi and a compliant president because India’s security was “threatened by internal disturbances.” Many consider this to be one of the darkest periods for post-independence India, as Gandhi jailed many political opponents and censored the press. Some religious organizations were banned, and many historians say this was the closest that India ever came to becoming an autocratic state.

In response to growing protests, the state of emergency was lifted in March 1977 and a general election was held that month. Opposition parties led by the Janata Party banded together and won, as Gandhi badly miscalculated just how much the state of emergency hurt her. Morarji Desai became India’s first Prime Minister that was not from the Congress Party.

Because of the unstable nature of the coalition, Desai only ruled for about 2 ½ years and resigned in July 1979. His successor Charan Singh was able to form a government with conditional support from Congress, but that was pulled in early 1980 after five months. The Janata Party was dissolved in 1980, but former members eventually formed the Bharatiya Janata Party (BJP).

Fresh elections in 1980 saw Congress win an absolute majority and Indira Gandhi became Prime Minister again. On June 6, 1984, the Indian army carried out a controversial deadly raid on the Golden Temple, a sacred site for the Sikh minority. As a result, Gandhi was assassinated by her Sikh bodyguards on October 31, 1984. The Gandhi dynasty continued as her eldest son Rajiv was immediately sworn in as Prime Minister. He called a general election that year and Congress won in a landslide, claiming 414 of the 533 seats then in the Lok Sabha (lower house).

During Rajiv’s term, a corruption scandal led to the expulsion of former Defense Minister V.P. Singh. Singh went on to form the Janata Dal party and then cobbled together other anti-Congress parties to form the National Front. With the help of the Bharatiya Janata Party (BJP) and other parties, the National Front won the 1989 election and V.P. Singh became Prime Minister.

Due to internal strife, this broad coalition was unstable and did not last long. General elections were eventually called for May 1991, and Rajiv Gandhi was assassinated during the early rounds of voting. No party won a majority and so Congress ruled as a minority government, led by P.V. Narasimha Rao. Faced with an imminent economic collapse, Rao oversaw a radical liberalization of the economy that was led by Finance Minister Manmohan Singh. He became the first Prime Minister outside of the Nehru dynasty to serve a full 5-year term.

This period of stability did not last long. After Rao’s term ended in 1996, India saw four Prime Ministers over the span of three years. After serving two terms lasting 13 days and 13 months, respectively, Atal Bihari Vajpayee served a full third term after the BJP-led National Democratic Alliance (NDA) won the 1999 elections. In doing so, Vajpayee became the first non-Congress leader to serve a full 5-year term. He continued the reforms started under Rao.

Rajiv Gandhi was succeeded as the leader of Congress by his widow Sonia. While she never held elected office, Sonia led Congress into the 2004 elections where it became the largest party in parliament. However, it did not have a majority and had to rule in a coalition called the United Progressive Alliance (UPA). Former Finance Minister Singh became Prime Minister, and was the first Sikh to lead the nation. Of course, Singh continued the reform process that he himself started as Finance Minister. After winning the 2009 elections, Singh’s second term was marred by allegations of corruption.

The 2014 elections saw the BJP win an absolute majority of seats. Indeed, the BJP became the first party since 1984 to win an outright majority with 282 seats, a gain of 166 seats from the 2009 elections. With party alliances giving the NDA 336 seats out of 545, Narendra Modi became Prime Minister and looks likely to serve a full five-year term. Note that Congress experienced one of its worst defeats, winning only 44 seats and 19% of the vote. Rajiv and Sonia Gandhi’s son Rahul currently leads the Congress Party.

 

ECONOMIC OUTLOOK

The economy is robust. GDP growth is forecast by the IMF at 7.3% in FY2018/19 and 7.5% in FY2019/20 vs. 7.1% in FY2017/18. GDP rose 7.7% y/y in Q1, the strongest since Q2 2016 and up from 75 in Q4. Q2 data will be reported August 31, and monthly data suggest further acceleration. As such, we see upside risks to the growth forecasts.

The July 15 report on new GDP methodology by the National Statistical Commission is worth mentioning. In its “Report of the Committee on Real Sector Statistics,” a table shows that if the new GDP methodology is applied, growth was a record 10.1% pace in FY2006/07 instead of 9.6% under the old series. That gives Prime Minister Manmohan Singh of the Congress Party bragging rights to overseeing the best post-reform performance of the economy.

Price pressures remain elevated. CPI rose 4.17% y/y in July, down from 4.92% in June. However, a high base effect was largely behind this drop. WPI inflation also fell to 5.09% y/y from the cycle high of 5.77% y/y in June. High base effects were in effect here too, and so both measures should re-accelerate in August. The RBI’s inflation target is 4% and the target range is 2-6%.

The central bank started the tightening cycle with a 25 bp hike in the repo rate to 6.25% in June. It followed up with a second 25 bp hike to 6.5% this month. Next policy meeting will be held October 5, and much will depend on the external environment then. RBI minutes from the August meeting showed the bank took a neutral stance after hiking. This simply implies that the bank could either cut or hike, not that it is committed to steady rates.

The fiscal outlook bears watching. The consolidated budget deficit was equal to -6.9% of GDP in 2017, and the IMF expects it to narrow slightly to -6.5% of GDP in both 2018 and 2019. However, with elections coming up next year, we expect the Modi government to boost spending in the months ahead. As such, we see upside risks to the deficit forecasts.

The external accounts are deteriorating. The current account deficit was -1.5% of GDP in FY2017/18, and the IMF expects the deficit to widen to -2.3% in FY2018/19 before narrowing to -2.1% in FY2019/20. The trade deficit has widened significantly this year due to surging imports, and so we see upside risks to the current account deficit ahead.

Foreign reserves have resumed their downward trend. Reserves dropped to $404.2 bln in July, the lowest since November and down from the March peak of $424.4 bln. They cover about 8 1/2 months of imports and are equivalent to about 150% of the stock of short-term external debt. India’s Net International Investment Position (NIIP) is currently around -15% of GDP. All told, India’s external vulnerability is relatively low.

 

INVESTMENT OUTLOOK

The rupee is underperforming. In 2017, INR rose 6.5% vs. USD. This was in the middle of the EM pack and compares to the worst EM performers ARS (-14.5%), TRY (-7%), and BRL (-2%) as well as the best ones KRW (+13%), MYR (+11%), and THB (+10%). So far in 2018, INR is -8.5% and is behind only the worst performers ARS (-38%), TRY (-37%), BRL (-17%), RUB (-14.5%), and ZAR (-14%). Our EM FX model shows the rupee to have STRONG fundamentals, and so we expect this underperformance to eventually ebb.

USD/INR recently traded at an all-time high above 70. It has since fallen back below 70 but we see further upside potential. The pair is trading in a wide upward sloping channel on the daily charts dating back to July 2017. The top of that channel currently comes in near 70.50.

Indian equities are outperforming after underperforming slightly last year. In 2017, MSCI India was up 29% vs. 34% for MSCI EM. So far this year, MSCI India is up 8.5% YTD and compares to -9.5% YTD for MSCI EM. Our EM Equity Allocation Model has India at UNDERWEIGHT, and so we expect Indian equities to start underperforming.

Indian bonds are performing OK. The yield on 10-year local currency government bonds is +43 bp YTD. This is in the middle of the EM pack and compares to the best performers China (-25 bp), Poland (-17 bp), and Taiwan (-11 bp) as well as the worst performers Turkey (+956 bp), Argentina (+358 bp), and Brazil (+163 bp). With inflation likely to edge higher and the central bank likely to remain in hawkish mode well into 2019, we think Indian bonds will start to underperform more.

Our own sovereign ratings model shows India’s implied rating steady at BBB/Baa2/BBB. Several quarters ago, India was facing downgrade risks to its BBB-/Baa2/BBB- ratings. Now, we are seeing some modest upgrade potential. Fitch wrote this week that the recent rupee weakness illustrates the country’s sensitivity to shifts in investor sentiment, but added that the impact on its sovereign credit profile is likely to be limited due to relatively strong external finances, especially given its low level of external debt. However, the agency added that rupee depreciation could add to existing pressures on India’s corporate and banking sectors.