Considered a darling of emerging market investors over the last few years, India recently fell out of favour as its growth engine seemed to stall. GDP growth fell to 5% in 2019 from over 8% a year ago, which despite being an enviable growth rate for most economies, remains below India’s potential.
The shorter-term investment case was beginning to look less clear-cut with the repercussions of defaults in the shadow banking industry creating a drag on consumption growth. With a government whose main efforts were concentrated on staying in power and using geopolitics as a tool for instant fulfilment, the health of the economy appeared to be on its periphery and the central bank was left to do all the heavy lifting. The Reserve Bank of India returned to an official easing stance, but given the slow-moving transmission mechanism, held back by congested bank balance sheets and the fear from the recent defaults, rate cuts had thus far been ineffective at reigniting growth.
The spotlights were firmly on India’s policymakers in the hope they would announce meaningful structural reforms and bring fiscal easing to the table to supplement any monetary policy efforts. Minor announcements such as the rolling back of tax surcharges for foreign portfolio investors, further boosts to the affordable housing schemes and consolidation of public sector banks were all well received but the recent blockbuster announcement of slashing corporate tax rates really forced investors to wake up and recalibrate their view on India.
In September, the government unexpectedly announced a cut in the corporate tax rate to a 25% rate from 35% including surcharges. Further, any newly incorporated domestic company that is making investments in manufacturing will only pay an effective 17% rate. The move was probably overdue when comparing corporate tax rates within Asia, but India is now clearly on a better footing to compete in the global market to attract foreign investments and the stimulative effect could be immense.
Lower taxes will boost companies’ profitability, which in turn could spur capital investment and galvanise business confidence. Increased hiring would certainly not go amiss with unemployment creeping up, and the wealth effects from higher profitability increasing asset valuations may eventually prop up consumer demand. On a wider level, the attractiveness of a 17% tax rate for new manufacturing companies may be able to poach supply-chain activity away from China, especially with their continued trade skirmishes. Considering the fact that India’s FDI in the manufacturing sector as a proportion of GDP stands at 0.6%, whereas China’s when at a similar growth phase in the early 2000s stood at 2.5%, there is plenty of space for catching up.
Additional supply-side reforms were probably not at the top of investors’ wish list, considering it was the demand side that had been ailing, but the magnitude of the cut during a time of weakness can only be seen as very positive. More important is the message that policymakers are sending; they are more than ready to step in with radical reforms when needed.
One of the major headwinds of late was caused by defaults in the shadow banking sector which began in 2018 and led to a period of paralysis across the industry. Credit growth plummeted as banks doubted their asset quality and were not comfortable lending money. With limited access to home, auto and personal loans, consumption slumped and with corporates unable to borrow, investments were put on hold.
Pockets of liquidity are now starting to emerge in the banking sector, particularly among public sector banks, as falling consumption and a decline in credit growth has seen loan-to-deposit ratios steadily decline. The decision to force banks to accurately recognise non-performing loans and the landmark Insolvency and Bankruptcy Code have helped cleanse balance sheets; slippages are now heading back down towards average levels. The banking segment is by no means out of the woods just yet, but with the monetary easing cycle in full swing and a tidying up of the sector, lending conditions look likely to loosen up.
The global synchronised monetary easing has reaffirmed the notion that rates will remain low or negative in advanced economies for the foreseeable future. This will increasingly drive investors towards regions with higher prospective returns. Indeed, foreign investors and multinationals have been swift to seek out opportunities in the Indian market with Foreign Institutional Investors rushing back to the market and FDI already increasing in the region on the back of the policy changes.
With tax cuts reviving corporate animal spirits, emerging signs of a recovery in the banking sector and a government seemingly committed to revitalising growth, the stars are beginning to align for a resumption of the Indian bull market.
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