What's the outlook for markets and the economy in post-election India?

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Jahangir Aziz: Welcome to Research Recap on J.P. Morgan's Making Sense podcast channel. I'm Jahangir Aziz, Head of Emerging Market Economic Research at J.P. Morgan. Today, I'm joined by Sajjid Chinoy, our Chief India Economist. And we're here to discuss how the election results and the new coalition government could impact economic policy in India. Thanks for being here today, Sajjid.

Sajjid Chinoy: Great to be here, Jahangir. Thank you.

Jahangir Aziz: Before we get started on India, let me give a brief overview of the global backdrop just to set context. So growth, as we know it globally, is stepping down from the surging space in the second half of last year. We also think that in the second half of this year growth is going to be about par. US growth, so to speak, is spilling over and helping other countries, and we see that happening not just in Euro area. We see that happening in Japan. We see that happening, more importantly, in the part of the world you're in, particularly in the manufacturing exporters of EM Asia. They had been a very strong disinflation in the second half of last year. That pace of disinflation has slowed down considerably. But at least it has ticked off a important box for the Fed which seemed quite reluctant even two, three months ago to start the easing cycle to begin cutting. We now have a September cut, [inaudible 00:07:55] in our forecast,  followed by December cut and the four cut in 2024 and 2025. And all of this means that emerging markets will be able to start cutting rates. But having said that, we now have a different problem. And the problem is that we now have to face the uncertainties of the US elections. And if indeed we have a change in government, then it is almost clear that there will also be changes in policies, and particularly changes in US trade policy with the new administration easily increasing tariffs not just on China, but also on the rest of the world. And that could be a significant headwind to emerging market assets. So that sort of is the background. Let's turn to India. India has been hitting the headlines with very strong growth, very strong macroeconomics, inflation pulling down, surging equity markets, bond yields are easing off. And all of these has changed the way in which the global investors look at India.

Jahangir Aziz: So let's start with that. Sajjid.  What really is happening on the growth, inflation, macro economics front that has brought about this change in the minds of investors especially international investors?

Sajjid Chinoy: Thank you Jahangir. You know, as you rightly pointed out, the narrative of India, globally, has changed quite dramatically. Two years ago it was all about the scaring from the pandemic and the large contraction in the pandemic year. And for much of the last year it's been about consistent growth revisions that had been made in one direction. In fact we just recently saw the IMF has increased its GDP forecast for India for '24 '25 from 6.8% to 7%.  But I think the numbers apart, I think what's important to appreciate is what the growth drivers are. And there seem to be at least four different growth drivers that have emerged over the last few years since the pandemic. The first, as we've been discussing frequently is, yes the government made a determined infrastructural push. There was skepticism in the pandemic year about whether the state had both the physical space and the state capacity to do it. And to the government's credit, they plowed through. Central government CapEx is almost doubled. It's gone from 1.7% to GDP to 3.2%. Importantly, however, states have finally joined the CapEx bandwagon. So last year we saw some of the growth surprise because now we've got both center and the state is creating infrastructure. That is kind of driver number one. Driver number two is exactly opposite to China. After 10 years, India is finally seeing a housing cycle. We didn't have much, um, housing momentum over the last decade. Affordability kept increasing under the radar, and then the pandemic triggered that. So we're seeing inventories that used to be 36 months of demand are now down to less than 10 months of demand, and that's kicked off new launches. So, you now have both infrastructure being built and housing construction taking place, and both of these are combining to drive a construction cycle, which has been at the heart of India's growth in recent years. Driver number three has been a clean banking system that's now inclined to lend again. Again, a conversation we've had for much of the last decade is India's quote "twin balance sheet problem" where they have a high non-performing asset and bank balance sheets. High levels of corporate debt. And over the last decade that the leveraging has occurred, [inaudible 00:12:21] is today in India the lowest since 2011. And if you look at the loan officer's survey you'll see that lending standards have eased and banks are very keen to lend again. Last year, for example, credit growth was running at 16% on a nominal GDP of 9.6. So the ratio of credit to nominal GDP was 1.6. The last time we saw this ratio was 2007. So you’ve got banks lending again. And the fourth driver really is, everybody is very focused on China Plus One and how much of that tie India can pick up. But the real revelation has been on the services front. Now, these are not IT services. These are kind of high value added services. There are now 1800 of these captive global capability centers. So, Jahangir, the excitement is the fact that we have got these four relatively uncorrelated growth drivers: an infrastructure push, a natural reversal of the housing cycle, clean bank balance sheets and service exports. And there are tantalizing signs that the power sector may be inflecting as well. So I think that's what's driving some of the excitement around India's growth story.

Jahangir Aziz: I thought you would say that because India won the T20 Cricket World Cup what's this excitement all about.

Sajjid Chinoy: (laughs)

Jahangir Aziz: Uh, what's the specific-

Sajjid Chinoy: That's the icing on the cake. ( laughs).

Jahangir Aziz: Let's just stick to the growth drivers. So you talk about the significant increase in physical infrastructure, I will add to it the digitalization that has taken place which is also a part of the infrastructure. You talked about the massive increase in services sector exports, so to speak. Even though they are onshore firms, these are essential exporting services. But why is it the case that manufacturing exports, which is where the government had been pushing for: Make in India. Make in India was not about services. Make in India was about manufacturing. Why is it that manufacturing exports isn't picking up, number one. Number two, why isn't FDI, particularly manufacturing FDI, also, actually declining in the last ... I would say what? six to eight quarters? So what are your thoughts about that? Is it that the government is pushing on the front that isn't where the world is or that is something that might pick up maybe two, three years down the road?

Sajjid Chinoy: You raise really important points, Jahangir. I think that one lament has been that we haven't seen manufacturing exports pick up nearly as much as we would've liked. We have been writing since 2010 about the importance of exports, and later, I'm gonna link this to the lack of a private investment cycle.  And my sense is that we are getting some part of the China Plus One but we need much more. And you have a better sense of this in New York is that there is a bring a strong global food fight over this because most countries in Asia are competing for what's coming out of China. Mexico is competing for what's coming out of China. And the fact that developed economies are using industrial policy are so liberally also becomes a source of competition to emerging markets. So the government's been trying. There was a couple tax cut in 2019, infrastructure has been built. There is this production-linked incentive scheme. But I guess, at the heart of all this is we've got to continue with reforms that makes manufacturing more competitive in India so we can compete with the Vietnams and the Mexico’s of this world. So I think that clearly needs to be part of the agenda going forward on manufacturing. And related to that on FDI, part of what I think the FDI slowdown is a cross emerging markets because of where global rates are. I would add that even if you dig deeper and look at FDI that goes to emerging markets outside of China, India's share unfortunately has actually fallen. So I think correlated to the earlier point. I think if we get a larger piece of China Plus One that it'd be preceded by stronger FDI.

Jahangir Aziz: So you talked about the fact that India still needs more reforms, right? And we know have a new government in power. The government no longer has single majority. It is a coalition government. When you think about the reforms that the government needs to put in place: A, where, what are those reforms that are missing? And B, Does the fact that the government is a coalition government make a difference?

Sajjid Chinoy: So a lot of the reforms that we traditionally think of on the manufacturing front goes back to factor market reforms to make India more competitive. And a lot of that is actually at the state level. And the hope, really, has to be, as you get this competitive federalism, that states will find it in their own interest to keep plugging away at some of these reforms. At the central level, we have always kind of expected continuity that I think the government will continue pushing on infrastructure and the expectation is that production-related incentive scheme will perhaps deepen or broaden. From my perspective, one crucial part to this whole story is just making labor a more attractive factor of production. One worry has been that India's manufacturing and production has become very capital intensive in the last 20 years. If you look at the ASI data, capital labor ratios have gone up just when India's demographic transition has been in motion. So just when the working population growth rates have been high, you're seeing high capital intensity in manufacturing. You see that in our exports. Gems and jewelry, leather, textiles have all fallen and declined and the share, and the more capitalism exports have picked up. So for me, there's a whole bunch of reforms on how does one make labor a more attractive factor of production? Education, skilling, health on the supply side. On the demand side, the incentives of capital versus labor, labor laws, I think that the list of reforms is long. But given that political capital is not infinite, it'll need to be judiciously used to kind of alleviate some of the binding constraints.

Jahangir Aziz: And just to add to that, I'm guessing the part of the exports of services that is growing, which are these global capability centers, they aren't really employing unskilled labor. They are going after very highly skilled, white-collared jobs and not enough blue-collared jobs are being created. So if with all of these changes that are taking place, with all of these interests from global investors, within India, the equity market's surging, price of capital still not very restrictive at all in India. With the balance sheets of banks so clean, why is it that there hasn't been a pick-up in private investment? Private investment has been languishing my sense is around 11, 12% of GDP at least since 2010. And we have always gone through these little cycles where private investment picks up and we all get excited saying, "Okay, fine. This time it's different." And this time hasn't been different the last 10, 12 years. So why is it that private corporate investment is just not reacting to all of these changes?

Sajjid Chinoy: I think it's the defining question at the moment, Jahangir, because a lot of the investment we've seen so far has been public investment and given physical constraints and debt sustainability  imperatives down the line, at some point, the public sector has to fall back and when then do fall back, that gap will have to be filled by the private sector. Now the good news is that you breakdown cross fixed capital formation and you take public sector out, you are seeing at least, the household sector which is essentially real estate. So real estate investment is picking up. But the missing piece is what you pointed out, which is corporate investment which has it kind of been flat lined around 12% of GDP. The encouraging news is that the old constraints are not binding anymore and you alluded to them that leverage was an issue over the last decade. That is no longer a constraint. Profitability has been strong, cash levels are high, balance sheets are healthy. So those constraints have gone away. The issue in my mind is that the binding constraint has now morphed into a demand constraint. Now, why do I say this? Because if you look at capacity utilization in the manufacturing, in the RBI, in the OBICUS Survey, it's been range bound at 73 to 75%. It is not decisively broken out of that 75% range, A. B, core inflation is now at a 12-year low. It's down to 3.3%. This is good news for consumers but from a producer's perspective, it tells you there isn't much pricing power at all. Right?

Jahangir Aziz: Mm-hmm.

Sajjid Chinoy: Thirdly, again, profits have been strong because there's been cost relief from falling commodity prices. If I look at top line growth,

Sajjid Chinoy: Sales growth is nominal-

Sajjid Chinoy: ... in terms over the last year, it's been in single digits. So if you're a corporate sitting in India and you are seeing that utilizations that you know 74, 75%. There isn't much pricing power. Top line is 74, 75, top line growth is in single digits and most importantly, the elephant in the room is the overcapacity in China, right? Many countries have been affected by that. If you look at India's bilateral trade deficit with China, last year it was 2.4% of GDP among the highest in the last decade. Imports are very strong. So there's all these Chinese excess capacity and there is no conviction on demand visibility. From my perspective, it's understandable why corporate should be on the sidelines. The implication we need to generate demand visibility both on exports and private consumption.

Jahangir Aziz: So why isn't domestic demand picking up? You look at private consumption growth, right? India has a real growth rate last year was what? 8.1, 8. 2% and you had real consumption growth only of about 4.1, 4.2%. So why is it that private consumption is picking up? I mean you talked about China is competing with India and other countries because of its excess capacity which is pushing out but that's in the external front. Internally, why isn't it that domestic consumption not picking up?

Sajjid Chinoy: So, this is a positive, right? Because I mean at some level, if you look at any length of time, private consumption has to be inextricably linked to household incomes. And if you take a five-year view of GDP growth, it is about you know 4.3, 4.4% which is the compound annual growth rate. And that's roughly where consumption is pegged. So the implication of all this is, if we want consumption to pick up more sustainably, it has to mean that household income growth has to pick up which then comes back to the earlier discussion on quality employment. If we get quality employment and there's a larger share of income that's accruing to households, that's what's gonna drive consumption. Again, the good news here is that one of the constraints that was binding in 2019 was the financial sector had retrenched. And liquidity was a problem to households. But that's not a problem anymore. We're seeing in fact the loan growth to household is very strong. So this comes back to actually boosting the balance sheets of households to drive more sustainable consumption.

Jahangir Aziz: So this might be a good time to bring in a different line of thought, which is that, you and I have been talking about this at least I remember from 2010. That there is a widely held belief that India is a quote-unquote "a closed economy”. And that domestic demand is a big driver of the Indian economy. You and I have been saying that India is far more open than people think it is. Is it the case that we, sort of, misread India? That we think of India as a closed economy, a lot of domestic demand, and so far that's what you've been telling us about the strength of the services export. In fact, its actually a very open economy and that is the external demand that is probably the more dominant driver of investment, more dominant driver of Indian growth.

Sajjid Chinoy: That's absolutely right, Jahangir. We've been writing about this since 2009, 2010. Just think back to the 2003 to 2008 cycle where GDP growth was 8% to 9% and we actually had our first full-fledged private CAPEX cycle where CAPEX was growing at 12% or 13% a year. What was it driving that? It was exports. Exports growing in real terms at 16% a year for almost a decade. And so share of GDP went from 10 to 25. Conversely, it's been the export slow-down over the last decade on the goods front, which you alluded to, which has contributed to the lack of demand and lack of private CAPEX that I pointed to. And if we just step back and, because I know there are concerns, especially with the US election that we're heading to a world of more de-globalization, more economic balkanization, more industrial policy in the West that how will emerging markets grow their exports? But we need to remind ourselves, and I use this with clients, that only 13 "miracle economies" since the Second World War have grown at 7% for 25 years at a stretch. Which is basically what India needs to do. And they had one thing in common, all those 13 economies, they all leveraged strong exports in global demand. Now, in my mind there are opportunities. We're already establishing a dominance in higher value added services, which we need to expand and consolidate. And given that our share of global manufacturing exports is so low, there's a lot of potential here but it needs to be labor-intensive exports that create jobs. But you're exactly right, I think exports will have to be a key enabler of growth going forward.

Jahangir Aziz: But domestic demand will still need to play a big part in it. And I think there was a lot of buzz that this year's budget could actually start pushing income transfers or trying to push household income up and household demand up. So what's your sense of the budget? Is the budget going to be something where we might see things coming out of it which might be supporting not just infrastructure, but also domestic demand?

Sajjid Chinoy: I realize we’re having this discussion before the budget, but I think one needs to be realistic. There's a lot of talk about how the budget can deliver a stimulus. But I think, to step back and remind ourselves, we are on a fiscal consolidation path. When deficit's coming down prima facie that's a drag on growth. And the question is how do you minimize that drag given where we are in the business cycle? The good news is that in the July budget fiscal authorities have got much greater degrees of freedom than they had in February for two reasons. Number one, we kind of over-consolidated last year, so in February the expectation was last year's deficit would be 5.8. It came out at 5.6. And this year's target is 5.1. So last year, we did a 0.8% of GDP consolidation. This year, we'll want to do half a percent, so it's less, number one. Number two, between February and now, two things have happened. The RBI has given a dividend to the government, which is almost 0. 4% of GDP higher. More than twice of what authorities had envisaged. And last year's taxes were actually stronger. So on that higher base, you should expect higher revenues this year, even if you make conservative assumptions on buoyancy. In other words, authorities have about half a percent of GDP that they weren't aware of in February. And how that half a percent is used will be very telling in terms of how authorities are thinking about the current economic situation. Will some of that be saved in the deficit? Could next year be lower than 5.1? Or will there be some tax cuts? Will there be more rural revenue expenditure, which was supposed to grow very modestly? Or will we see even more CAPEX? From our perspective, given the need to boost consumption, the sense would be that a lot of that should be used to boost consumption, because with multipliers, at least the propensity to consume of rural households, is quite high. But let me end with one larger point. The budget will come and go. I think that the demand story needs to be, how do you structurally boost demand of consumption of exports, and that requires some of the measures that we discussed earlier. But I think with the budget, we should just recognize, has more degrees of freedom, so we may end up in a situation where deficits are lower, taxes are cut, expenditure is higher, and borrowing is lower. And you can have all of it, because you have this extra half-percent of GDP to play with.

Jahangir Aziz: You can have your cake and eat it too [inaudible 00:31:30].

Sajjid Chinoy: Exactly, exactly.

Jahangir Aziz: So, we are coming to the end of our discussion, so let's turn to the financial markets. We had a surging equity market. Bond yields have been falling, the rupee has been holding well against a much stronger market reaction to the fed not starting its easing cycle. But most of this has been driven by domestic investors. If I look at both folios close in equity markets, for example, it's very positive for the year as a whole. There is some bond flows coming in with India joining J.P. Morgan's global bond index. Corporate investment in the form of FDI is significantly lower today than, let's say, it was in '22. Most of the surge in the outside markets in India has been driven by domestic investors and not so much by foreign investors. And do you think that the changes in the budget or the upcoming RBI policy meeting or the rate cuts in the fed that we envisaged, might actually change that? Or we are surely going to struggle like any other emerging markets, because regardless of what happens in the global financial markets, there is this big, huge uncertainty about November US elections?

Sajjid Chinoy: Great questions. I think on the fixed income side, what we've seen is that debt flows used to be very soft before the index announcement, 300 million dollars a month, very soft. But the good news is that we've seen since November about one and a half billion dollars on average coming in every month. So I think everyone thought that when there's an index announcement, all this money will come in one month in June. But of course, investors are forward-looking and a lot of this was front-run. So we've seen, you know, 10 to 12 billion dollars of debt come in and the expectation is that another 10 to 12 billion dollars will come. So this will be steady stream, reflecting the portfolio rebalancing of fixed income investors. And I think on equity the story is a little bit different. So if you look at India's MSCI a price to one year forward earnings, it's 24, which is kind of an all time high. And then if you, in fact, go below to mid, mid cap and small cap, the valuations are even higher. So I guess the combination of those valuations and the uncertainty that envelops the world, as you pointed to, is perhaps keeping equity investors on the sidelines. And therefore a lot of the buoyancy in the Indian equity markets is coming from a structured rebalancing by households. You know, systematic investment plans, SIPs are now 2.5 billion dollars a month, so it's 30 billion dollars or close coming in consistently very year. And that's what's supported the market and that's what's allowed the market to behave the way it has despite there being foreign interest not being strong. Finally, on FDIs we said, this would be correlated both to a domestic CAPEX cycle but as you've written, hopefully the US rates come down, and a rising tide will lift all boats and, and monetary conditions towards EM will ease, notwithstanding the big event risk that you pointed out, in November.

Jahangir Aziz: Well look, I think we need to wrap up. All good things must come to an end, as they say. So what I hear from you, is that India has made a very strong post-pandemic recovery. That recovery right now has been based on two or three growth drivers. But the conditions are there for these drivers to broaden out. They need attention from the government in terms of both policy support as well as reforms. But the path looks, this could be a very strong decade for India. That's my sense and we as analysts should not get too caught up in numbers and what's exactly happened minute by minute. So, Sajjid, thanks very much for joining us today. This was a great session and I'm sure there is a lot of food for thought for listeners.

Sajjid Chinoy: Thank you very much, Jahangir.

Jahangir Aziz: And thanks to the listeners for joining in another episode of Research Recap. Thanks everyone.

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