The Indian central bank maintained its official interest rates in early December, saying it needs to see inflation remain at low levels. However, disinflationary pressures are building in India as the economy becomes more efficient and, in our view, it may not be long before rates are cut.
Extremely bullish sentiment
I recently returned from a trip to India where sentiment among ordinary people on the street as well as fund managers and other investment professionals appeared extremely bullish. Although the Indian economy has continued to slow, many are feeling the effects of falling inflation, internet development and rapid government reforms. Individually, these changes appear to be small but cumulatively they are designed to make the economy more efficient. Some of these positives seem to be already reflected in share prices and the market now appears relatively expensive on historic valuation measures. However, in my view, there are still plenty of opportunities for long-term investors, particularly if and when interest rates fall.
Where now for inflation?
So far the Reserve Bank of India has avoided rate cuts. This is due to concerns that inflation might return in the coming months if commodity prices rise. Consumer price inflation hit a low of 5.5% in October [1], which is below the central bank’s target of 6% for January 2016 and well below its 8% target for January 2015. Some commentators say this was mainly as a result of lower oil and commodity prices which might rebound in the coming months as they have fallen rapidly since their peak in June 2014. I believe, however, there is more to the recent disinflationary trends in India than falls in commodity prices.
Systemic inflation being eliminated
Price rises in the services sector, which in my view were a major cause of the systemic inflation in India, have come down in recent months. Both the public and private sectors have worked hard to tackle inefficiency and, as a result, productivity in India has started rising, enabling prices of services to fall.
In particular, the government has been improving the approval process for private and public projects by eliminating unnecessary bureaucracy. It is also introducing biometric identity cards linked to bank accounts which will enable it to transfer benefits directly to recipients, rather than relying on layers of middlemen and losing some of these benefits along the way. One obstacle to this scheme had been the lack of bank accounts among India’s rural population. But thanks to the government initiative introduced at the end of September to change this, more than 80 million people [2] have so far opened bank accounts. A number of states have achieved the target of all households having at least one bank account.
Prices of agricultural produce are also falling. In order to protect farming, the government sets minimum prices for core products such as rice, wheat, maize, oil seeds and cotton. However, in the last few years, an excess amount of these crops have been produced, and the government has reduced their minimum prices in real terms. As a result, farmers have begun to shift towards producing more commercially profitable items such as onions and tomatoes, leading to a more efficient use of agricultural resources. In addition, the rapid rise of e-commerce is reducing prices of clothing and electronic products in particular, further lowering inflationary pressures.
Together these factors can provide a disinflationary tailwind for India, in my view, and a rebound in commodity prices alone should not mean a return to the high levels of inflation that have plagued India in the past.
Meanwhile, lower oil and commodity prices are also helping the government to tackle the budget deficit by reducing subsidies for oil and by enabling it to raise taxes on diesel and petrol. At the same time, lower raw material and energy prices are helping companies to increase profitability. Although many Indian companies are not seeing significant revenue growth, with the exception of consumer durables companies, their earnings are expected to grow strongly over the medium term.
Inflection point?
Indian equities may currently look expensive. However, given lower inflation, persistent and cumulative reform measures and gains in corporate profitability, the economy may be at an inflection point which I think could lead to a GDP growth rate of more than 7.5% in the next couple of years. There are of course risks that may lead to a failure in attaining this. However, I believe falling inflation and lower bond yields will necessitate official interest rates to come down soon. I think the longer the central bank keeps current interest rates unchanged, the deeper it will likely have to cut them. At the current level, I do not think the market has fully priced in the deep cuts in interest rates that I anticipate. So, I believe any weakness in the market should provide a good buying opportunity.
