Snowball Effect

Reforms : Is there a seamless story behind the seemingly disconnected and discrete set of reform measures?

It has been three years since the current regime took the reins of governance. For anyone who had expected the Govt. to unleash big-bang reforms in the early part of its term, it has been a disappointment to say the least. Much to the criticism of free market enthusiasts, Govt. has been slow on sensitive, yet significant bold reforms such as  privatization of public sector banks and other non-strategic PSUs besides the revamping  of archaic labour and land rules. These are bold measures, if unleashed, could have catapulted India structurally into a higher growth orbit. But to achieve a similar objective, Govt. seems to have chosen much less disruptive path (politically), yet significant in its long-term compounding effect, by systematically scripting a plot connected by seemingly discrete set of incremental reform measures. Strangely, this plot has an equal potential to propel India’s growth structurally into a higher pedigree.

To understand the plot, it is important to decipher what is behind the dots that connect the discrete measures. If there is any common thread that runs across the incremental reform measures such as DBT(targeted subsidy), RERA(Real Estate regulations), Demonetization, Bankruptcy Code, Linking of Aadhaar with PAN, Curbs on Cash transactions, Benami Act and lastly the glorious GST, it is a coherent strategy that runs seamlessly across to structurally swell the tax base and tax/GDP ratio to significantly higher levels. Early signs of such a swell is already visible on the individual tax front with personal tax kitty surging by over 20%+ annually over last 2+ years. GST would do the same magic in indirect tax numbers over time, though in the short-term, implementation hiccups would drag the numbers briefly. Deeper mining on DeMon data trail coupled with effective execution of benami act on the ground would add to the swell,  both in personal tax and in corporate tax.

Crux of all these coherent reform measures is in compliance (tax). With India placed abysmally low on tax base as well as on tax-GDP ratio (ref below charts), these were critical measures to change the structural landscape of the economy. With expected spurt in tax kitty (widening tax net) in the coming years, it will lead to higher fiscal space over time, which will in-turn lead to structural downward shift in inflation / interest rates and thereby changing the structural capacity of economy for higher growth. As the economy shifts to more formalized (from unorganized) one on these reform measures, household savings are expected to see a dramatic shift from physical to financial assets, which will structurally push the potential  growth further.

Over time, with the widening tax net along-with the changing profile of household savings (from physical to financial), India can break out of the 7%+ growth range to join the elite club of 9%+ growth. Though India has seen such a growth rate cyclically (riding on global growth as in the case of 2004-07 up-cycle), to structurally (hence more sustainable) move into that orbit will be a significant achievement for this administration. In summary, the restrained reforms of this Govt., when they play out over next few years, have the potential to have snowball effect to push economy structurally into a higher growth-orbit. No surprise that both FDI and FPI flows are in a rush. Domestic investors too are in a hurry with the trend of changing profile of household savings gathering momentum!

Shaky shift

Monetary Policy : Was RBI too quick to abandon the accommodative stance in its Feb policy?

Back in Jan, when banks were awash with liquidity, thrown in generously by demonetization impact, debate was not about whether there will be a rate cut or not , but how aggressive it will be. Bond Markets were magnanimously marking up the gilts to new highs, as they started factoring in a sizable slice in the rates by RBI (rates and bond prices are inversely related). Some opportune analysts jumped in the fray to make outrageous forecasts on the 10 year yield (on the downside) to feed on to the media frenzy and thereby getting opportunity to hit headlines. Consensus trade was conspicuously long on bonds. Needless to say, traders were sitting on a sizable MTM (mark-to-market) gains in their bond portfolio. So far so good, so it appeared.

But all hell broke loose on 8^th Feb when RBI, in an unusual move, decided to change its monetary stance from accommodative to neutral citing following fears.

• Hardening profile of international crude prices.
• Volatility in exchange rates on global cues which could impart upside pressures to domestic inflation.
• Aggressive rate hikes by Fed on positive US outlook as reflected in the rising US yield
• Impact of 7^th pay commission on inflation

For the bond markets, that shift was surreal and bizarre, as they were counting on surging liquidity in the banking system for raving rate cuts. Shift in stance was significant as it ruled out rate cuts for the foreseeable period. That was a blow to the markets that were marking-in large cuts in the bond prices. What followed was mayhem in the bond markets, triggering a huge sell-off. Prices slumped and yield surged by over 50bps in few quick sessions.

Three months have passed since RBI took that significant shift in stance. We now have the real data to assess whether RBI/MPC (Monetary Policy Committee) went overboard on its fears. Here is the chart that captures the movement of those indices (since Feb) that RBI/MPC was tracking closely for its assessment. As can be inferred from the chart, none of them played out the way RBI had feared. In fact, all of them have moved in the opposite direction, much more favourably for a dovish stance than a hawkish one.

Though it is too early to draw any major conclusion, on the evidence of data over past three months, it certainly seems that RBI could have waited for more data before deciding on the shift in stance.  With softening crude and soaring Rupee, fears of spike in inflationary pressures have been proved totally unfounded. With additional support coming from slumping US ten year yield on rising risks for Trump’s reflationary trade ( with increasing fears on Trump’s ability to pump-up bipartisan support for fiscal stimulus or tax cuts), RBI/MPC might find it difficult to sustain its hawkish stance, unless these trends reverse.

For long-term debt investors, the current subdued price in the bond markets is a stellar opportunity given the potential upside in returns when the policy stance swings back to accommodative.  At the moment, data-points (ref chart above) are favourably inclined for such a shift, though timing of which is difficult to predict.

 

Happy Value Investing!!