India economics: The Modi effect

In the first few months of this year there was a clear sense that the Indian economy was bottoming out. In February, in the run-up to the general election, the International Monetary Fund (IMF) estimated that GDP growth would decline to 4.6% for the year ending March - about half the level of three years ago. The fund also noted that India's slowdown was unusual among emerging markets in both its severity and the fact it has coincided with elevated inflation. It seemed that things could not get any worse.

In this context, it is understandable that the hopes of a nation were pinned so resolutely on Nahenrda Modi, delivering the Bharatiya Janata Party (BJP) leader a landslide election victory. The 64-year-old career politician from Gujarat, with his apparent runaway popularity and business-friendly credentials, is seen as the perfect anecdote to an outgoing government that for years had been plagued by apathy and inertia.

However, as the celebrations die down, the real business of getting India back on track has begun. The new administration's opening salvo came last month with the Union Budget. Hastily put together just three months after the election, the budget lacks detail but serves as a statement of intent for Modi's promises of big change and big business.

For private equity specifically, it is hoped that the positive macro-economic impact will not take long to trickle through to the asset class. The industry wants to see an energized government bring down some of the barriers that have hindered investment of late. It is clear what needs to be done; and the improved sentiment will only last provided Modi starts doing it.

A return to confidence

With the election just a few months gone, the government is still enjoying a honeymoon period.

"The Indian capital markets have responded very positively, with the stock market rallying strongly ahead of the elections in anticipation of a BJP victory," says Rajiv Biswas, chief economist for Asia-Pacific at IHS. "The large majority won by the BJP and its allies has further boosted investor sentiment with the anticipation that the new government will be able to make significant reforms to boost growth."

The effect on the markets could actually be seen as early as December, when local elections pointed to a national BJP victory. Opening on the Friday following the Modi's win, however, the benchmark Bombay Stock Exchange Sensex index was up more than 4.5%, the strongest opening for the Indian markets in five years.

The index has since made further gains and is up 24% from the start of the year. Part of the reason for this reaction is that, while it was widely accepted that Modi would emergence from the election victorious, it was uncertain whether he would get the majority needed to push through reforms.

But the BJP alone managed to win 279 of the 543 seats in the Lok Sabha, the lower house of the Indian parliament. This comfortably crosses the half-way mark 272 seats, something that hasn't been achieved since 1984. The BJP-led coalition, meanwhile, took a total of 320 seats. This means the government will not need to solicit partners to get through specific legislation, potentially making compromises that would hinder, or water-down, much-needed reforms.

The impact of the elections on GDP has been less dramatic. According to a Reuters poll of economists conducted last month, growth is expected to speed up significantly this financial year but forecasts have since been trimmed. While GDP growth is still expected to surpass the sub-5% levels seen over the past to year, predictions do not mirror the stock market hype. Economists project expansion of 5.3% for the current financial year, down from calls of 5.5% made during the election period.

In the short terms at least, the public markets boost can help tackle the one the major issues for Indian private equity in recent year: exits.

AVCJ Research data show that private equity exits amounted $5.2 billion last year. While this sum appears high compared to previous years - 2012 and 2011 saw exits of $5 billion and $2.9 billion, respectively - it should be placed against the $24.2 billion that was committed to India-focused vehicles between 2006 and 2008. A lot of capital has yet to make its way out of the system and the fundraising struggles of recent years suggest LPs have lost patience with the market.

"Largely in the past few years exit transactions have been either strategic sales or trade investors coming in," says Archana Hingorani, CEO and executive director with IL&FS. "With the possibility of IPOs on the other hand, the public markets now offer a third alternative."

Since 2009, India has seen 53 private equity-backed IPOs that have raised collective proceeds of $5.8 billion. This compares to $161.4 billion from 679 China IPOs over the same period. The gap narrows in terms of trade sales - $11.5 billion generated in India versus $27 billion in China - but it does not obscure the fact that India's public markets have failed to deliver for PE as they have in China. There is considerable unrealized potential.

However, Vikram Hosangady, head of transactions at KPMG India, notes that more public market valuations can be a double-edged sword. "Most people believe capital market will be more robust in the next two years and that is a positive from exit standpoint," he says. "But on the investment side it is threat. Many promoters will not go the private equity route as they can raise money through the capital markets."

Currency capitulation

Poor public markets liquidity has not been the only issue stifling exits in India, though; the weakening rupee has also contrived to make valuations less appealing from the perspective of US dollar-denominated funds. "So many people came in when it was between INR45-50 on the dollar," Hosangady adds. "Having the rupee stay at over INR60 makes exits less attractive."

At time of writing, the rupee was hovering around INR61 to the dollar, still quite a bit weaker than the sub-INR50 levels reached in 2011, but an improvement on mid-2013 when the currency depreciated sharply, plummeting as low as INR70. This had been due to slowing economic growth and the widening current account deficit, which reached a peak of 4.8% of GDP in the first quarter of the current financial year.

"Since Raguram Rajan, the new governor of the Reserve Bank of India (RBI), took office in September 2013, the rupee has stabilized and gradually appreciated," says HIS's Biswas. "This stabilization has been helped by government measures to reduce the trade deficit as well as renewed portfolio capital inflows into the Indian stock market on hopes that Modi will generate an economic recovery in India."

The man charged with bringing through measures that will drive this recovery is Finance Minister Arun Jaitley who presented the budget last month. More an outline of the government's intentions than a granular policy document, it has nevertheless been received positively by the private equity community.

"He provided a realistic budget that emphasizes good governance," says Sanjay Nayar, CEO and India country head with KKR. "Now it's important to move quickly to revive the economy by boosting economic growth and enforcing fiscal consolidation."

With this in mind, the government has set out some clear and ambitious goals. First, Jaitly has vowed to expand annual GDP growth to 7-9% within three to four years, following two years of sub-5% growth. He is targeting a reduction in the 2014 fiscal deficit of 4.2-4.3% of GDP from 4.5% at the end of 2013. In the two years following that, the deficit is supposed to narrow further to 3.6%.

A raft of modest measures outlined in the budget have gone some way to making these goals seem more achievable by easing regulations, promoting infrastructure and offering a degree of clarification over ongoing offshore taxation issues.

These measures include a substantial increase in the foreign direct investment (FDI) limit - from 26% to 49% - across the defense and insurance sectors; changes leading to the recognition of Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts; and proposals to extend a 15% government rebate on investments in excess of INR250 million in new plants and machinery over a 12-month period so it covers mid-cap as well as larger manufacturers.

Wish fulfilment

However, a number of private equity investors are still agitating for reform in other areas. Ever since the fallout from Vodafone's acquisition of domestic mobile service provider Hutchison Essar in 2007, foreign investors have been calling for clarity on the tax treatment of offshore transactions involving onshore assets. The government has said it will not bring new retrospective litigation against companies, but existing cases could still come under attack.

KKR's Nayar is no exception when he says reducing this uncertainty should be priority. "If this can be done adequately, clarifying the government's stance on taxes will go a long way to boosting investor confidence," he says. "This is also important because India has a pretty low tax-to-GDP level. If the government can figure a way to improve this balance, it will lead to an increase on the revenue side."

Another revenue issue that repeatedly rears its head is the introduction of a goods and services tax (GST), which has been bogged down by years of negotiations between the federal and state governments. A type of value added tax, once introduced, the GST will replace all indirect taxes levied on goods and services at any level of government.

"The implementation of the GST will provide a major boost to Indian industry by removing many of the taxation hurdles across Indian states due to the current complex array of varying state sales taxes," explains IHS' Biswas.

The success of these reforms ultimately rests on the government maintaining sufficient policy momentum to keep its promises. It is a tricky balance of optimism and realism: investors must buy into the positive effects of change while accepting that it might not come as quickly as desired.

"People are impatient about the rate at which change will come and there will be some frustration,' says Mark Kahn, founder of agriculture-focused GP Omnivore Partners. "But we have already suffered from a decade of mismanagement, neglect and a general apathy, so I think what has happened since the election is a rebirth. People at least believe the government is serious about getting the country back on the growth track."

KPMG's Hosangady shares this view. He stress that the appetite has always been there but all political inertia and a lack of support for business has stopped the country from achieving its potential. "When we talk to our clients it is clear India is back in favor now," he says. "The question is whether over the next 12-18 months the Modi government can deliver on most of what it is supposed to. If it does, India could be very different story."

SIDEBAR: Boon time - Smart cities and infrastructure

India has one of the fastest rates of urbanization in the world. According to the most recent census data, Mumbai's population reached 12.5 million in 2011, representing 3.1% increase on 2001. The fastest growing city was Delhi which saw headcount swell by 4.1% to 11 million over the same 10-year period. At current growth rates, the population of each is expected to reach 25 million and 16 million, respectively, by next year. Nationally, India's population is set to expand by 200 million in the next 15 years.

To meet the demands of swelling urban population, the government's Union Budget outlined plans for 100 so-called "smart cities" intended to boost long-term economic growth and global competitiveness over the next 10 years. According to Rajiv Biswas, chief economist for Asia-Pacific at analytics firm IHS, the total investment associated with this development could be far in excess of $1 trillion, with a significant share coming from foreign governments and private sector inflows.

To many, the smart cities strategy represents the first comprehensive effort by an India government to upgrade the country's urban infrastructure. Opportunities to get involved in the provision of electricity, transport and information technology systems for expanding urban centers is likely to be a big draw for investors.

"A number of major international project developers such as Singapore's Ascendas India Development Trust and Dubai's Tecom Investments are already involved in smart cities projects in India," Biswas tells AVCJ. "The potential economic impact from the development of India's smart cities development will act as a significant catalyst for economic growth through a number of drivers, including increased foreign direct investment (FDI), accelerated development of real estate investment trusts (REITs), increased competitiveness and job creation."

Archana Hingorani, CEO and executive director with infrastructure investors IL&FS shares the view that smart cities will be a boon for both the Indian economy and private equity.

"I think the biggest thing will be the pick-up in the economy from an infrastructure standpoint," she says. "Not only will investment into sectors like roads, airports and smart cities create better infrastructure, it will also generate private equity investment opportunities into the core sectors and the ancillary companies - that will be able to demonstrate strong growth and some rewarding exits."

Total FDI entering India across all sectors came to $28 billion in 2013. The accelerated development of smart cities in conjunction with the roll-out of REITs could see a substantial increase in this figure in the medium-term, Biwas argues.

Using AVCJ Research data as a guide, a boost in India infrastructure investment would be most welcome. Last year saw just $326 million transacted across six deals, the lowest in decade. This year has not fared much better with $354 million transacted across three deals. This is just a fraction the 2006-2007 peak when nearly $1.7 billion entered the sector over a two-year period.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Infrastructure
• South Asia
• Expansion
• Buyouts
• Regulation
• India
• Economy
• regulation
• Infrastructure
• Growth capital
• buyout
• KPMG
• KKR
• IL&FS Investment Managers