India

Highlights Indian private sector banks have shown a remarkable improvement in their operating efficiency and have largely cleansed their balance sheets. Further, they have plenty of room to grow as they will continue to grab market share from public sector banks. Investors should go long Indian banks and short EM banks. EM equity portfolios should upgrade the Indian bourse from neutral to overweight. Feature Indian bank stocks have been the star performers among emerging markets banks over the past 20 years (Chart 1). They have consistently outperformed the broader Indian markets too, except in 2020 (Chart 2). What led to such a sustained outperformance? And more importantly, are Indian banks still a buy? Chart 1Indian Bank Stocks Have Been The Star Performer Among EM Banks Chart 2Indian Banks: 2020 Underperformance Is Reversing   Changing Landscape Our research indicates that listed Indian banks have displayed remarkable improvement in their operating efficiencies in the past 15 years. Lately, they have also cleansed their balance sheets meaningfully. Before we delve deeper into the drivers of their outperformance and prospects, we need to be aware of the changing structure in the Indian banking sector, and the disconnect it has created between banks’ assets versus banks’ market capitalization. Even though India’s public sector (PSU) banks have been steadily losing their market share to private ones over the past three decades, they still dominate the Indian banking scene with a 60% slice in terms of assets and loans. Private sector banks’ market share is a third of the total, with the rest belonging to foreign banks and smaller local banks. Yet, Indian bank stock indexes are comprised predominantly of private sector banks. For example, they make up 95% of India’s MSCI bank index1 – a share that has risen rapidly over the past decades. India’s bank stock performance, therefore, has been largely a reflection of its private sector banks. Robust Operating Efficiency Chart 3Indian Private Banks Have Shown Remarkable Operating Efficiency... In terms of operational efficiency, Indian private sector banks have shown significant improvement over the past 20 years. Their operating profit-to-assets ratio went up from around 2% in 2000 to 2.8% currently (Chart 3, top panel). On the flip side, PSU banks’ operating profits have dwindled to 1.6% of their assets. The improving performance of private sector banks also boosted India’s bank stock indexes as they continued to have ever larger weights therein. This remarkable divergence between the operating profits of public and private banks has been caused by several factors:  Private sector banks have been more aggressive than PSU banks in terms of the assets they accumulated, as well as in their management of asset-liability mismatch. This has helped them generate significantly higher net interest income relative to their assets (Chart 3, middle panel). Over the past several years, private sector banks have ramped up their loan book (higher-yielding) while trimming their investments portfolio (lower-yielding government paper). The opposite has happened with PSU banks (Chart 4, top panel). As a result, private banks’ interest income relative to their assets has risen more than that of PSU banks. In their loan portfolio, private banks maintained a higher share of term loans relative to working capital loans (Chart 4, bottom panel). Term loans often entail higher yield as they typically lock-in funds for a longer period than do working capital loans. But term loans also need to be funded by longer duration liabilities to avoid asset-liability mismatch. These liabilities are typically term deposits. Since term deposits cost more than demand or savings deposits, it’s important to balance the term liabilities with term assets. Private sector banks have mobilized term deposits in line with their needs to finance their term loans (Chart 5, top panel). PSU banks, on the other hand, have had much more (higher-cost) term deposits compared to their term loans. Chart 4...Supported By Prudent Asset-Liability Management... Chart 5...That Yielded Higher Cost-Adjusted Return On Loans...   This is one of the reasons why the profitability of banks loans for private banks, after adjusting for funding costs, has been superior to that of PSU banks (Chart 5, bottom panel). Private banks have also made a stronger foray into the world of unsecured loans (Chart 6). These are typically credit card loans and personal lines of credit. Since unsecured loans usually earn a higher rate of interest, this strategy has worked in favor of boosting their net interest margins. Finally, private banks have always had significantly more non-interest income (i.e., fee-based income). This has helped improve their operating profits meaningfully (Chart 3, bottom panel). Notably, in terms of employee cost and other operating costs, private sector banks do not do any better than PSU banks. In fact, the operating expenditure as a percentage of assets has always been higher for private banks than for PSU banks (Chart 7). This divergence has mainly been due to a difference in employee compensation expenditure. Chart 6...And An Aggressive Credit Strategy Chart 7Private Banks' High Operating Cost Was More Than Offset By A Higher Operating Income   Put differently, the “operating efficiency” of private sector banks stems from their built-in business model, in which they take slightly more business risks than their PSU counterparts. But in the process, private banks earn significantly more operating income than PSU banks. This more than offsets their relatively higher operating expenditure resulting in higher operating profitability (Chart 3, top panel). Crucially, private sector banks have steadily taken market share from PSU banks in all four types of loans: agricultural, industrial, services, and personal loans (Chart 8). Their loan book is also quite balanced, with no excessive exposures to any type of borrowers (Chart 9). Yet, their presence in the economy is proliferating at a fast clip. It’s no wonder then that their stock prices have commanded a steady premium over their PSU counterparts. They also gradually displaced the latter in India’s stock market indexes. Chart 8Private Banks Are Grabbing Market Shares In All Areas... Chart 9...But They Are Not Over-Exposed To Any One Type Of Loans   The Saga Of NPLs And Provisions The diverging operating profits of public and private sector banks got more accentuated when it came to net profits. The reason is a much higher share of bad loans among PSU banks. This forced PSU banks to make higher loan loss provisions, which weighed on their net profits (Chart 10). One development that aggravated PSU banks’ market share and NPL woes is the rising trend of disintermediation by corporate borrowers. Large industrial sector borrowers have been increasingly relying on corporate bond markets for their financing needs instead of bank credit. Indeed, disintermediation of large industrial loans is the main reason why overall bank credit in India has decelerated so much recently. Excluding this sector, bank credit growth has been quite decent (Chart 11). Chart 10Private Banks' Robust Operating Margins Let Them Make Aggressive NPL Provisions Chart 11PSU Banks Got Disproportionately Hurt By Decelerating Industrial Loans   Chart 12 shows that the amounts raised by corporates via local debt issuance has far outstripped the incremental bank credit to the industrial sector in the past.  One incentive for large firms to issue debt instead of taking on more credit is that corporate bond yields for top borrowers (AAA and AA rated) have been lower than the prime lending rates of banks. With bond markets maturing in India, corporates are increasingly taking advantage of the situation (Chart 13). Chart 12Large Industrial Firms Shunned Bank Credit In Favor Of Debt Issuance... Chart 13...As Financing Cost Via Debt Issuance Became Increasingly More Attractive   This general shift in credit markets caught PSU banks off-guard. Since almost 90% of all industrial loans were from PSU banks at the beginning of the past decade (Chart 8), the disintermediation process hurt them disproportionately compared to private banks. PSU banks are also now stuck with an ever higher share of old, ageing industrial loans in their books. Older loans are more prone to turning into NPLs as compared to fresh, newly issued loans. This is one of the reasons why the NPL ratio has been higher for PSU banks. Private sector banks, on the other hand, have had a relatively higher share of their loan book in personal and services sector loans. These loans have traditionally been much less prone to turning sour. RBI’s data shows that the stressed loans in the personal loans sector have remained around 2% for the past several years while that of industrial loans hovered in double digits (Chart 14). This is another reason why private sector banks faced relatively lower NPL problems over the years.  The top panel of Chart 15 shows the gross NPL ratios of both public and private sector banks. The middle panel shows the yearly provisions they made as a share of their total loans. Chart 14Industrial Loans Have A High Propensity To Become NPL; Personal Loans Low Chart 15Private Banks' Copious NPL Provisioning Led To Lower Net NPL Chart 16In Past Decade Private Banks Have Provisioned For Half Of Their Average Loan Book! Evidently, over the years private banks have made nearly as much provisions (as a % of loans) as their PSU counterparts, even though the former has had much less gross NPLs. This is why private banks’ balance sheets are cleaner now, i.e., they have less net NPLs (Chart 15, bottom panel). Notably, these data also indicate that private sector banks have set aside a mammoth INR 5.5 trillion as cumulative provisions over the past ten years. This would be equivalent to 55% of their average gross loans outstanding that existed over a five-year period between 2010 and 2014 (both years inclusive) (Chart 16). Since most of these provisions have since been used up to write-off bad loans, one could estimate that around half of the loans that existed in the early 2010s have since been written off. The same figure for PSU banks would be INR 14 trillion, and about a third of their average loans between 2010 and 2014 have already been provisioned for. These figures are all as of March 2020, i.e., before the pandemic kicked in. This entails that Indian banks’ balance sheets, especially those of private sector banks, were largely clean going into the pandemic. The reported net NPL ratio of 1.5% for private sector banks as of March 2020 is therefore a credible figure. The Pandemic And Its Aftermath Banks’ NPLs will surely rise as the negative ramifications of the prolonged country-wide lockdown becomes clearer in the months ahead. That said, the RBI and banks have taken several prudential measures to minimize the fallout: During the pandemic, the RBI (and later the Supreme Court) had allowed a loan moratorium period from March to August 2020. Borrowers needed not to pay any instalment or interest for loans during that period, and their loans would still not be downgraded to NPLs. What’s more, for loans up to INR 20 million (all small, medium and micro enterprises, and personal loans), the borrowers won’t have to pay the foregone instalments after the moratorium period is over. They won’t have to pay even the incremental interest that will have accrued on their loans as their principal balance stayed higher for six months than if they would have continued making repayments. The federal government has agreed to pay for the incremental interest, which has mitigated the loss of profitability for banks on these loans. Thus, most borrowers are unlikely to face sudden, additional debt servicing burdens after the moratorium period is over. This would help in avoiding more accounts from turning bad. Banks, at the same time, did make separate provisions – whenever instalments or interests remained overdue during the pandemic – as if no moratorium was in place. As such, banks have already taken the hit in their income statements for any slippage in their loan books. Excluding the moratorium-period new NPLs and provisions, private sector banks’ regular stock of provisions stood at 80% of their gross NPLs as of September 2020. For some listed private banks, the figure was well over 100%. For PSU banks, this figure was 70.5% as of last September. Hence, the bottom line is that in the absence of further pandemic and lockdown-related growth slumps, the private sector banks’ NPL profile is quite benign. To assess the future impact on banks’ NPL and capital adequacy, the RBI conducted a stress test in January this year: As per their projections (not forecast), in the worst case scenario where GDP would grow only at 3.8% in the six months from April to September 2021 (against the IMF’s base line projection of 11.5% growth in April 2021 to March 2022), the gross NPL ratio of PSU banks could rise from 9.7% in September 2020 to 17.6% a year later. For private sector banks, it could rise from 4.6% to 8.8%.  In that case, assuming that banks will set aside another 4% of loans as provisions this year (as they did last year), net NPLs for PSU banks will rise from 2.9% to 6.8%, but that of private banks will remain largely unchanged at 1.2%. Since private banks dominate the bank stock index, there will be a muted negative ramification on stock prices, if any, on account of such a pessimistic scenario of a new wave of NPLs.   Investment Conclusions Indian private sector banks have had plenty of tailwinds: high net interest margins and profitability, good asset-liability management, and exposure to good-quality credit. Besides, they have been aggressive in the provisioning of their NPLs. More importantly, going forward, these banks have plenty of room to grow. Their market share is still relatively small, and India’s bank credit to-GDP ratio is also relatively low at 55% of GDP. Including corporate bonds, total borrowings of non-financial, non-government sectors are still not high at 72% of GDP (Chart 11, bottom panel). Post-pandemic, once India’s economy gets back in the groove, these banks are very well placed to exploit the opportunity over a sustained period. This warrants a bullish view on Indian private sector banks: While their valuation remains expensive, they have fallen somewhat compared to the past several years. Given their balance sheets are now much cleaner than they were in the recent past, they offer a better risk-reward profile (Chart 17). A good harvest and lingering domestic demand weakness will keep inflation in check in India. This also means that the RBI is unlikely to raise rates anytime soon. Periods of low inflation and no monetary tightening are beneficial for both banks and borrowers. Indeed, bank stocks usually do well, both in absolute terms and relative to overall markets, whenever inflation is under control (Chart 18). Chart 17Bank Valuations Are Better Than In Recent Years Given Balance Sheets Are Cleaner Chart 18Muted Inflation And Lower Policy Rates Are Supportive Of Bank Stocks   Investors should go long Indian banks and short EM banks. We recommend dedicated EM equity portfolios to use the latest relapse in India’s relative equity performance to upgrade the country's allocation from neutral to overweight (Chart 19). India’s yield curve remains steep with the ten-year swap rate 120 basis points above the policy rate. Indian local currency government bonds offer value relative to both US and EM bonds. The spread of India’s GBI bond index over the same duration of US and EM local currency bonds are 570 and 150 basis points respectively. Investors should stay on with our recommendation to receive ten-year swap rates. Finally, the rupee is likely to stay well bid thanks to a strong balance of payments – which was boosted by copious capital flows (Chart 20). A potential rebound in the US dollar could produce a mild setback in the rupee. However, this currency will outperform the majority of EM exchange rates. Chart 19Upgrade Indian Stocks To Overweight In An EM Portfolio Chart 20A Strong Balance Of Payment Is Supportive Of Indian Rupee   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Box 1 A Note On India’s Agriculture Reforms We published a report on India’s Agricultural reforms on November 19, 2020 where we elaborated on why this law was very important for India’s structural outlook. As we contended therein, it’s a highly politically sensitive issue. Expectedly, it was met with political resistance from a few political parties and a section of farmers. Just to provide some context to the agitations, out of the 500 million agricultural workers in India, only about 50 thousand or so large farmers from a particular region in India are protesting. While these protesters have significant political clout, they can hardly be called representative of all farmers. As to the reason for these protests, the new law will upend the monopoly and vested interests of many large farmers who benefitted from the current system for decades. Even though the reforms will usher in private capital, improving overall farm productivity, they will also introduce competition in procurement and distribution. The latter will certainly hurt many large farmers who practically run the current “mandi” system (designated marketplaces where farmers sell their produce). It’s still uncertain how this will play out. As many as 11 rounds of discussions between the farmers’ representatives and the government failed to sort out the issue. Meanwhile, the Supreme Court intervened and formed a committee to look into the matter over the next six weeks, but the protesting farmers have refused to accept its involvement and forthcoming ruling. The government’s offer to put the act on hold for the next 12-18 months while discussion continues has also been refused by the farmers. The protesters’ sole demand is a complete repeal of the law. Our best guess is, eventually, there will be some modification in the most contentious parts of the new laws, and the roll out will probably be delayed by a year or so. In any case, we will keep you updated. Footnotes 1 The MSCI India Financials index makes up 27% of the broader MSCI India index, and the MSCI India Banks index makes up 20%. The latter is dominated by private sector banks with 19% weights, and figure in only one PSU bank, the State Bank of India (SBI), which has an index weight of 1%. However, SBI’s assets or deposits are still higher than the rest of the index constituents (all private sector banks) combined.

Highlights India has continued its structural reforms agenda with the agriculture and labor market reforms being the latest development. In the agriculture sector, the government is inviting private capital and ushering in free markets after decades of state intervention. This could turn out to be a game-changer for a sector that employs half of India’s labor force, and yet one that is marred by very low productivity and inefficiency. Taken together, the reforms undertaken in the past few years will boost the nation’s productivity and, hence, potential growth rate. Such changes warrant upgrading Indian stocks to neutral within an EM equity portfolio. Feature Undeterred by the chaos of the pandemic, India unveiled its latest rounds of structural reforms during the lockdown. These dealt with the hitherto untouched areas of agriculture and labor markets and represent the latest tranche of what has been a series of piecemeal, yet significant, structural reforms initiated over the past several years. Taken together, these reforms are set to have far-reaching consequences on the economy and asset markets in the coming years. Crucially, the country’s demographic dividend could also turn out to be more positive than is usually acknowledged. We will elaborate on the significance and likely market impacts of all these developments in several reports in the coming months. Today, we begin with the Modi government’s attempt at agricultural reform – a highly contentious and politically-charged issue in India. Agriculture Has Been India’s Achilles Heel On the face of it, agriculture, and allied activities (i.e., fishing, forestry, and animal husbandry), makes up only 15% of India’s GDP. Yet, the sector employs nearly half of India’s 500 million strong labor force, either directly or indirectly. Surely, to achieve sustainable growth the country needs to see strong productivity gains in its largest employed sector. Yet for decades, the sector has remained mired in inefficiencies, extremely low productivity, and structural bottlenecks. To understand the significance of agriculture reforms, one needs to understand the backdrop: India’s food markets have been highly regulated and are subject to various restrictions on exports, imports and even on domestic purchasing and stocking. Food availability and farm incomes therefore depend on local food production and prices, rather than on global agricultural prices. Local food production, in turn, oscillates with the country’s rainfall pattern; since barely half the arable land has any irrigation facilities (Chart 1). Chart 1In India, It's Still Higher Rainfall = More Food Supply, And Vice Versa Severe land fragmentation has been another feature of India’s farmlands. The rapid growth of its rural population and, unlike China, low rates of migration to urban areas due to lack of labor-intensive large-scale manufacturing, have rendered India’s countryside overpopulated – causing perennial land-fragmentation. As much as 86% of the farmers have a landholding of just 2 hectares or below – and this number has steadily risen over the past several decades (Chart 2). Shrinking size of landholdings have hindered farm-mechanization, hurting agricultural productivity and income growth. With capital expenditures exceeding 35% of GDP over the past decade, India boasts one of the highest capital expenditure paradigms in the world (relative to GDP). Nevertheless, its agriculture sector remains grossly underinvested. If anything, agricultural capex has been declining as a share of both total investment expenditure and GDP. The reason is India’s archaic laws, which have tried to shield farmers from the free markets for decades, and in the process, have discouraged the private sector from investing (Chart 3). Chart 2Number of Small Farmers With Tiny Landholdings Kept Rising; Stymying Farm Productivity Chart 3Capital Investments Completely Eluded India's Agriculture Sector ... All this has choked the productivity of Indian farmlands. At 3.2 tons per hectare, the cereal yield in India  remains much lower than many other comparable developing nations (China: 6.0 tons/hectare; Indonesia: 5.2; Vietnam: 5.4; Brazil: 5.2; Argentina: 5.4; South Africa: 5.6) - as per the World Bank’s Food and Agriculture Organization. Chart 4... Leading To Lower Income, But Higher Inflation Lower agricultural productivity entails lower output and higher food prices. Indeed, despite a very low starting point, real growth in agriculture never matched the rest of the economy. And yet, it displayed much greater inherent inflationary pressures (Chart 4). The authorities’ principal solution to alleviate chronic farmer poverty has been to purchase farm produce at a pre-announced ‘Minimum Support Price’ (MSP) for several crops such as paddy, wheat, oilseeds, cotton, jute, and many types of coarse cereals and lentils. While this approach ensures that farmers get a minimum price for their produce, it also hinders market forces. The reason is that since the government is by far the single largest purchaser, the MSP effectively sets the market price. What’s more, MSPs themselves are rarely free from political considerations. The result is that these administratively set prices often end up directing the course of inflation in India, both in rural and urban areas (Chart 5). This is because with a weight of 43% in the urban consumption basket (52% in the rural basket), food inflation dictates Indian households’ inflation expectations. It also sets wage expectations. Those expectations usually spill over into future inflation via second-round effects (Chart 6). Chart 5Government's Minimum Support Prices Are Often The Architect Of India's Inflation Trajectory ... Chart 6... As Food Prices In India Dictate Non-Food Inflation Also The key reason why reforms have excluded India’s agricultural sector for so long has a lot to do with the country’s political landscape. It is considered too touchy and too big a vote bank to tinker with. The fact that most farmers live at a subsistence level means that they are unable to bear the pain of adjustment even for a short time – which most reforms initially entail. A high illiteracy rate also makes them prone to opposition party propaganda, which often stresses short-term benefits for farmers. Finally, there is always a fear that if tinkering with the status-quo were to result in escalating food inflation, it could seriously damage the incumbent government in the polls. Agricultural reform has thus far been thought of as a suicidal idea for any ruling party. It is in this context that one needs to assess the significance of recent steps. What Do The New Reforms Entail? In a past report back in 2008, we had pointed out that in order to improve Indian agriculture’s structural outlook, the following was needed: Commercialization, which will bring about economies of scale; Food price liberalization, which will free the farmers from selling their produce only at a government-mandated market; Investments in irrigation. Importantly, the three laws1 passed by the Parliament of India in September of this year address the first two issues above: commercialization and price liberalization. The lawmakers materially amended the ‘Essential Commodities Act’ of 1955, a law enacted at the time of food scarcity in the country. The law had given the government power to notify any commodity as ‘essential’, and control its production, distribution and impose a stock limit. As a result, private buyers have had very limited ability to buy or hoard farm produce. Farmers therefore largely sold their produce to government-authorized agents and/or marketplaces (called ‘mandis’).   The new laws will ease the rules on sale, prices and stock limits of farm products. Farmers now can sell their produce directly to private players such as food processors or supermarket chains, at market-determined prices. Farmers can also engage in ‘contract farming’, where they tailor their products as per the needs of a specific buyer, at a pre-determined price. On their part, private buyers can now buy, sell, distribute and hoard the hitherto ‘essential’ commodities without legal prohibitions. This will, in turn, encourage new private capital expenditure in the agricultural sector. As they will now be able to purchase farm produce without limitation, private corporations will have an incentive to provide the latest technologies and farm practices to the farmers. Small farmers will have an incentive to engage in group farming to reap economies of scale. With infusion of new capital, both farm productivity and farmers’ incomes are expected to rise.   Chart 7Reforms Will Usher In Private Capex Helping Farmers Shifting To More Remunerative Crops Tiny landholdings in India are often inadequate to provide a subsistence income via regular food grain cultivation. Farmers therefore have an incentive to move toward more lucrative fruits, vegetables and other commercial crops. However, fruits and vegetables are perishable items and need proper and timely transportation and storage facilities.  In the past, the lack of such facilities prematurely halted the shift away from food grain cultivation to non-food grains (Chart 7). With legal obstacles on buying and hoarding now gone, private companies will be encouraged to step in to provide the requisite infrastructure. This will help boost both farmers’ income and availability of farm produce. To be sure, the Modi administration announced that the current ‘mandi’ system and the procurement of crops by the government at the MSPs will continue. In fact, the government has since announced the new MSPs for the coming winter crops. Farmers therefore will now have a choice about where to sell their produce. This choice will make them free from the control of the middlemen who practically run the government ‘mandis’. This will also help smooth the transition to a more market-based system.  Chart 8Surging Investments in Irrigation Will Help Reduce Dependence on Rainfall Importantly, over the past few years, the authorities have also begun investing in irrigation projects in significant measure. As mentioned above, a lack of proper irrigation has been a major impediment to farm yield. In the coming years that problem is likely to ease somewhat (Chart 8).  More generally, state and central governments have in recent years been allocating ever higher budgets to rural economic generation schemes. This will also help boost rural incomes (Chart 8, bottom panel). Bottom Line:  The new laws will largely remove decades-long barriers that separated Indian farmers and investors from the free market. This will boost productivity and output in the agriculture sector; which, in turn, will lead to lower food prices overall. Since food is by far the single largest expenditure item for most Indian households, lower food prices mean more disposable income for discretionary spending. That is bullish for both the economy and asset markets. In addition, lower food inflation would lead to lower inflation expectations, and eventually lower realized inflation – a significant positive for India.  A Word About Other Reforms Chart 9India Is Cutting Subsidies As Part Of Free Market Reforms What is truly encouraging is that the agriculture reform measures seem to be just part of a broader set of free market reforms that began a few years back. Several other reforms, such as diesel price deregulation, have already taken place. Diesel prices in India are now linked to global prices as subsidies have been withdrawn. In the same vain, subsidies on food and fertilizers are also being reduced, making them more market-driven (Chart 9). In our future reports, we will discuss several other structural reforms being undertaken, as well as their likely impact on the economy. The Cyclical Outlook: A Recovering Economy While the reforms mentioned above will have an economic impact over the long term, India’s intermediate-term growth outlook is also looking up. The country experienced one of the most stringent lockdowns among major economies; and yet there are signs that economic activity is almost back to pre-pandemic levels: Chart 10Economic Activity Is Fast Getting Back To Pre-Pandemic Levels The number of E-way bills issued is a measure of current economic activity. These bills are required for transporting goods – both within the state and between states –  under the Goods & Services Tax collection mechanism. Chart 10 illustrates that goods transportation is back to pre-pandemic levels. Consistently, GST tax collection for October has been the highest since February this year and represents a 10.2% YoY rise from October last year. Unlike most other major economies, the lockdown in India hurt its industrial sectors much more than its services sectors. This is because most manufacturing and construction businesses had to abide by the strict government-mandated lockdown norms, whereas the prevalence of informal businesses within the services sector helped them, to a certain extent, avoid such regulations. The upshot is that, with the economy re-opening, industrial sectors will now see a stronger and prolonged acceleration in the months ahead. Industrial production growth had already turned positive by September. It will get a further boost from pent-up demand for consumer goods– as is evident in accelerating vehicle sales (Chart 10, bottom two panels).   Notably, India’s reported Covid-19 recovery rate (at a very high 93.5%) and mortality rate (at a very low 1.5%) are among the best in the world2 (aside from North Asia). This has greatly eroded popular concern and political support for any further lockdown, even in the event of a second wave. As such, economic activity will likely continue to gather steam.       Investment Conclusions Exchange Rate: Chart 11A Strong Balance Of Payment Is Bullish For Indian Rupee Despite facing its first recession in living memory, the Indian rupee has held up well. This is because of the significant improvement in the country’s balance of payment (BoP) — which is supportive of the currency (Chart 11, top panel). The improvement in the BoP is both due to a current account balance that turned positive recently for the first time in 15 years, as well as consistent capital inflows (Chart 11, bottom panel). Meaningful foreign portfolio inflows have continued to pour in since March this year boosting Indian stocks (Chart 12). Going forward, as the economy re-opens, capital inflows in the form of FDI and external commercial borrowings will also likely resume (Chart 13). This is bullish for the rupee as well. Chart 12India Witnessed A Surge In Foreign Portfolio Inflows Chart 13FDI And External Commercial Borrowings Will Likely Resume As The Economy Re-opens   Fixed-Income Markets: Investors should continue receiving 10-year swap rates in India. Over the next year inflation will moderate as food prices have begun to ease. Given the abundant rainfall last summer, a good harvest is expected (Chart 1 on page 2) – which will further dampen food prices.   Even if RBI raises the policy rate, long term rates are unlikely to spike. In fact, they could fall – if markets perceive the RBI as being too hawkish. The yield curve is also quite steep with the 10-year swap rate 77 basis points above the policy rate (Chart 14). Indeed, Indian local currency bonds offer value relative to both US and EM bonds. The spread of India's GBI bond index over the same duration US and EM local currency bonds are 560 and 130 basis points, respectively (Chart 15). Chart 14Steep Yield Curve In India Offers Value At The Long End Of the Curve ... Chart 15... Especially Compared To EM And US Fixed Income Markets   Equities: Relative to the EM equity benchmark, Indian stocks have recently underperformed; and now offer a good entry point for dedicated EM equity portfolios. In view of the country’s progress in implementing structural reforms, we are cautiously optimistic about its improving longer-term outlook. As such, we recommend upgrading Indian markets to neutral in an EM portfolio (Chart 16). Granted, valuations are expensive, but part of the premium can be attributed to India being one of the few countries implementing reforms. Chart 16Indian Stocks Underperformance Is Late; Upgrade Them To Neutral In An EM Portfolio   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com     Footnotes 1The three laws are: (1) The Farmers' Produce Trade and Commerce (Promotion and Facilitation); (2) The Farmers (Empowerment and Protection) Agreement of Price Assurance and Farm Services; (3) The Essential Commodities (Amendment) Act. 2The recovery rate in US has been 60.5%; in Brazil: 91%; Russia: 75%; Italy: 37%. Mortality rate in US has been 2.2%; in Brazil 2.8%; Russia 1.7%,; Italy 3.8%; Spain 2.7%; and the UK 3.7%. Source: Haver Analytics and Deutsche Bank; Data as of 18th November 2020.

Highlights The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. While dedicated EM equity investors should for now maintain an underweight position in India within an EM equity portfolio, they should consider upgrading this bourse on potential near-term underperformance. Absolute-return investors should consider buying this bourse on a setback in the coming months. Fixed-income investors should continue receiving 10-year swap rates but use any rupee selloff to rotate into cash bonds. Feature Indian share prices have staged a remarkable comeback following the financial carnage in March. However, the outlook for the economy and for corporate profits does not justify the current level of share prices. While this thesis is applicable to most markets around the world, the gap between share prices and economic activity is even larger in India. Chart I-1Loans To Companies Are Muted In India In particular: The credit and liquidity crunch has been more acute in India than in many other EM and DM economies. Bank loan growth has surged in many countries as companies have borrowed to avoid a liquidity crunch due to a plunge in sales. However, in India bank loans to companies been shown little improvement (Chart I-1). This means that enterprises in India have not been able to draw on bank loans – to the same extent as they have done elsewhere – to attenuate a liquidity crunch stemming from revenue contraction. As a result, Indian enterprises have retrenched more in terms of both employment and capital spending, and their rebound has been more muted. As an example, the global manufacturing and non-manufacturing PMIs have risen above the 50 line but the same measures in India remain below the 50 line (Chart I-2). India’s employment index from the Manpower group has fallen to a record low as of early July (Chart I-3). As a result, household nominal income growth – which was slumping before the pandemic – has fallen much further. Chart I-2India Is Lagging In Global Recovery Chart I-3India: Employment Conditions Are Very Poor   Passenger car and commercial vehicle sales have plummeted (Chart I-4). Corporate investment expenditure and production have crashed. Manufacturing output, capital goods production and imports all plummeted in March and April and rebounded only mildly in June (Chart I-5). Chart I-4India: Discretionary Spending Is Slow To Recover... Chart I-5...As Are Production And Investment Table I-1India: Share Of Each Equity Sector In Profits & Market Cap Economic activity will improve gradually but the level of activity will remain below the pandemic level for some time. As a result, corporate profits will be slow to revive. Odds are that it will take more than one and half years before the EPS of listed companies reach their 2019 level. This is especially true for severely hit sectors – financials, industrials, materials, and consumer discretionary stocks – which together account for 44% of listed companies’ profits. The sectors less affected by the pandemic recession – namely, consumer staples, information technology and health care – together account for 30% of corporate profits (Table I-1). A Breakdown In The Monetary Transmission Mechanism Impediments to rapid economic recovery are the modest fiscal stimulus and a breakdown in the monetary transmission mechanism. While India announced a large fiscal stimulus, much of this is made up of loan guarantees. Some measures like central bank purchases of government bonds also do not represent actual fiscal spending. Chart I-6 illustrates that government spending has risen only moderately and it has been offset by the drop in the credit impulse. Provided that the credit impulse will remain weak due to reasons we discuss below, the aggregate stimulus will not be sufficient to produce a robust and rapid recovery. The outlook for the economy and for corporate profits does not justify the current level of share prices. Critically, the monetary policy transmission mechanism was impaired even before the pandemic broke out in India, and the situation has gotten worse since March. Even though the Reserve Bank of India (RBI) has been reducing its policy rate, the prime lending rate has dropped very modestly (Chart I-7). Indian commercial banks which are saddled with non-performing loans (NPLs) have been reluctant to reduce their lending rates. Chart I-6Drag From Credit Impulse Has Offset Fiscal Stimulus Chart I-7India: Very Little Decline In Prime Lending Rate   Even though AAA local currency corporate bond yields have dropped, BBB corporate bond yields remain above 10% (Chart I-8). This compares with 5-year government bond yields of 5%. Critically, in real (inflation-adjusted) terms, borrowing costs remain elevated (Chart I-9). Such elevated real borrowing costs will continue to hinder credit demand. Chart I-8Corporate Bond Yields Remain Elevated Chart I-9Borrowing Costs In Real Terms Are Restrictive   Finally, banks might be reluctant to originate much credit because of the rise in NPLs and the uncertainty over the extension of government guarantees on pandemic-induced NPLs and their own recapitalization programs. Bottom Line: Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. Beyond Mega Caps The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. The MSCI equity index has rallied by 50% since its late March lows and stands only 7% below its pre-pandemic highs in local currency terms. Yet, the MSCI equal-weighted index and small caps are, in local currency terms, still 15% and 16% below their pre-pandemic highs, respectively (Chart I-10). The performance of the overall equity index has been exaggerated by the rally in Reliance Industries’ share price as well as information technology stocks, consumer staples and health care. The 150% surge in Reliance Industries stock price since late March lows is due to company-specific rather than macro factors. This company presently accounts for 15% of the MSCI India index. The monetary policy transmission mechanism was impaired even before the pandemic broke out in India. In addition, info technology, consumer staples and health care (including sales of personal care products and medicine) have benefited due to the pandemic. By contrast, equity sectors leveraged to the business cycle in general and discretionary spending in particular have all underperformed. Importantly, bank share prices have been devasted due to poor economic growth and rising NPLs. India’s mega-cap stocks that have led the rally since March lows are expensive, as anywhere else. Finally, India’s equal-weighted equity index has failed to meaningfully outperform the EM equal-weighted index after underperforming severely in late 2019 and Q1 2020 (Chart I-11). Chart I-10Muted Revival In Broader Equity Universe Chart I-11India Relative To EM: Little Outperformance   Bottom Line: The advance in Indian share prices has been amplified by the rally in large-cap stocks. Meanwhile, the equal-weighted and small-cap indexes have done considerably worse reflecting the downbeat economic conditions. Equity Valuations And Strategy Chart I-12Indian Equity Valuations Are Elevated On A Market-Cap Basis... As discussed earlier, India’s equity market leaders like information technology, consumer staples and health care are already expensive, trading at a trailing P/E ratio of 23, 47 and 33, respectively. The rest of the equity market is not expensive, but its profit outlook is mediocre. As to other valuation metrices, the market seems to be moderately expensive both on an absolute basis and versus the EM equity benchmark: The 12-month forward P/E ratio is 22.5, the highest in the decade (Chart I-12, top panel). Relative to the EM benchmark, on the same measure is trading at 50% premium (Chart I-12, bottom panel). Based on the equal-weighted equity index – i.e. stripping out the effect of large-cap stocks on the index, Indian equities are overvalued in absolute terms (Chart I-13, top panel). On this equal-weighted measure, Indian stocks are currently trading at a 35% premium versus their EM peers (Chart I-13, bottom panel). The cyclically-adjusted P/E ratio is close to the historical mean (Chart I-14, top panel). Chart I-13...And On An Equal-Weighted Basis Chart I-14Cyclically-Adjusted P/E Ratio   However, the CAPE ratio is agnostic to corporate earnings on a cyclical horizon. It assumes corporate profits will revert to their long-term rising trend (Chart I-14, bottom panel). This is not assured in the next six months in our opinion. Hence, a lackluster profits recovery – profits disappointments – is a risk to the performance of India’s bourse in the coming months. Equity Strategy: Weighing pros and cons, we recommend that dedicated EM equity investors maintain an underweight position in India within an EM equity portfolio. However, they should consider upgrading this bourse on potential near-term underperformance. The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Absolute-return investors should consider buying this bourse on a setback in the coming months. Odds are that the index could drop up to 15% in US dollar terms triggered by a potential global risk-off phase and domestic profit disappointments. Currency And Fixed-Income Chart I-15Consumer Inflation Is Not A Problem In India We have been recommending receiving 10-year swap rates in India since April 23 and this recommendation remains intact. As argued above, the economic recovery will be gradual, and the output gap will remain negative for some time. Consequently, wages and inflation will likely surprise on the downside. Even though headline and core inflation rates have recently picked up, this has been due to a rise in food prices, transportation and personal care products (Chart I-15). Hence, there are not genuine inflationary pressures in India and the RBI will be making a mistake if it stops easing due to rises in headline or core CPI readings. Food prices have been rising for a while due to supply shocks. Importantly, the rise in food prices should not be interpreted as genuine inflation. Meanwhile, personal care products include gold jewelry and this CPI sub-component has therefore been rising due to the surge in gold prices (Chart I-15, bottom panel). Finally, transport costs have been on the rise due to supply chain bottlenecks in India as a result of COVID-19 and due to the rise in global oil prices. The broken monetary transmission mechanism means that the RBI will have to cut rates by much more. The fixed-income market is not discounting rate cuts.  There is value in long-term rates in India. The yield curve is very steep – the spread between 10-year and 1-year swap rates is 92 basis points. In addition, 10-year government bond yields are currently yielding 522 basis points above 10-year US Treasurys. We are not particularly concerned about public debt. Central government debt was at 52% of GDP before the recession and total public debt (including both central and state governments) was 80% of GDP. The same ratios are much higher in many other EM and DM economies. Chart I-16India's Stock-To-Bond Ratio Is At A Critical Resistance Finally, the rupee could correct as the US dollar rebounds from oversold levels, but foreign investors should use that setback in India’s exchange rate to rotate from receiving rates to buying 10-year government bonds outright, i.e., taking on currency risk. The RBI has been accumulating foreign exchange reserves, meaning it has been preventing the currency from appreciating. The current account is balanced and the financial/capital account has passed its worse phase. India will continue to attract foreign capital due to its long-term appeal and higher-than-elsewhere interest rates.  Domestic investors should favor bonds over stocks in the near term (Chart I-16). Bottom Line: Continue betting on lower interest rates in India. Fixed income investors should switch from receiving rates to buying 10-year government bonds on a correction in the rupee in the coming months. Dedicated EM local currency bond portfolios should continue overweighting India.     Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes

Highlights The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. While dedicated EM equity investors should for now maintain an underweight position in India within an EM equity portfolio, they should consider upgrading this bourse on potential near-term underperformance. Absolute-return investors should consider buying this bourse on a setback in the coming months. Fixed-income investors should continue receiving 10-year swap rates but use any rupee selloff to rotate into cash bonds. Feature Indian share prices have staged a remarkable comeback following the financial carnage in March. However, the outlook for the economy and for corporate profits does not justify the current level of share prices. While this thesis is applicable to most markets around the world, the gap between share prices and economic activity is even larger in India. Chart I-1Loans To Companies Are Muted In India In particular: The credit and liquidity crunch has been more acute in India than in many other EM and DM economies. Bank loan growth has surged in many countries as companies have borrowed to avoid a liquidity crunch due to a plunge in sales. However, in India bank loans to companies been shown little improvement (Chart I-1). This means that enterprises in India have not been able to draw on bank loans – to the same extent as they have done elsewhere – to attenuate a liquidity crunch stemming from revenue contraction. As a result, Indian enterprises have retrenched more in terms of both employment and capital spending, and their rebound has been more muted. As an example, the global manufacturing and non-manufacturing PMIs have risen above the 50 line but the same measures in India remain below the 50 line (Chart I-2). India’s employment index from the Manpower group has fallen to a record low as of early July (Chart I-3). As a result, household nominal income growth – which was slumping before the pandemic – has fallen much further. Chart I-2India Is Lagging In Global Recovery Chart I-3India: Employment Conditions Are Very Poor   Passenger car and commercial vehicle sales have plummeted (Chart I-4). Corporate investment expenditure and production have crashed. Manufacturing output, capital goods production and imports all plummeted in March and April and rebounded only mildly in June (Chart I-5). Chart I-4India: Discretionary Spending Is Slow To Recover... Chart I-5...As Are Production And Investment Table I-1India: Share Of Each Equity Sector In Profits & Market Cap Economic activity will improve gradually but the level of activity will remain below the pandemic level for some time. As a result, corporate profits will be slow to revive. Odds are that it will take more than one and half years before the EPS of listed companies reach their 2019 level. This is especially true for severely hit sectors – financials, industrials, materials, and consumer discretionary stocks – which together account for 44% of listed companies’ profits. The sectors less affected by the pandemic recession – namely, consumer staples, information technology and health care – together account for 30% of corporate profits (Table I-1). A Breakdown In The Monetary Transmission Mechanism Impediments to rapid economic recovery are the modest fiscal stimulus and a breakdown in the monetary transmission mechanism. While India announced a large fiscal stimulus, much of this is made up of loan guarantees. Some measures like central bank purchases of government bonds also do not represent actual fiscal spending. Chart I-6 illustrates that government spending has risen only moderately and it has been offset by the drop in the credit impulse. Provided that the credit impulse will remain weak due to reasons we discuss below, the aggregate stimulus will not be sufficient to produce a robust and rapid recovery. The outlook for the economy and for corporate profits does not justify the current level of share prices. Critically, the monetary policy transmission mechanism was impaired even before the pandemic broke out in India, and the situation has gotten worse since March. Even though the Reserve Bank of India (RBI) has been reducing its policy rate, the prime lending rate has dropped very modestly (Chart I-7). Indian commercial banks which are saddled with non-performing loans (NPLs) have been reluctant to reduce their lending rates. Chart I-6Drag From Credit Impulse Has Offset Fiscal Stimulus Chart I-7India: Very Little Decline In Prime Lending Rate   Even though AAA local currency corporate bond yields have dropped, BBB corporate bond yields remain above 10% (Chart I-8). This compares with 5-year government bond yields of 5%. Critically, in real (inflation-adjusted) terms, borrowing costs remain elevated (Chart I-9). Such elevated real borrowing costs will continue to hinder credit demand. Chart I-8Corporate Bond Yields Remain Elevated Chart I-9Borrowing Costs In Real Terms Are Restrictive   Finally, banks might be reluctant to originate much credit because of the rise in NPLs and the uncertainty over the extension of government guarantees on pandemic-induced NPLs and their own recapitalization programs. Bottom Line: Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. Beyond Mega Caps The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. The MSCI equity index has rallied by 50% since its late March lows and stands only 7% below its pre-pandemic highs in local currency terms. Yet, the MSCI equal-weighted index and small caps are, in local currency terms, still 15% and 16% below their pre-pandemic highs, respectively (Chart I-10). The performance of the overall equity index has been exaggerated by the rally in Reliance Industries’ share price as well as information technology stocks, consumer staples and health care. The 150% surge in Reliance Industries stock price since late March lows is due to company-specific rather than macro factors. This company presently accounts for 15% of the MSCI India index. The monetary policy transmission mechanism was impaired even before the pandemic broke out in India. In addition, info technology, consumer staples and health care (including sales of personal care products and medicine) have benefited due to the pandemic. By contrast, equity sectors leveraged to the business cycle in general and discretionary spending in particular have all underperformed. Importantly, bank share prices have been devasted due to poor economic growth and rising NPLs. India’s mega-cap stocks that have led the rally since March lows are expensive, as anywhere else. Finally, India’s equal-weighted equity index has failed to meaningfully outperform the EM equal-weighted index after underperforming severely in late 2019 and Q1 2020 (Chart I-11). Chart I-10Muted Revival In Broader Equity Universe Chart I-11India Relative To EM: Little Outperformance   Bottom Line: The advance in Indian share prices has been amplified by the rally in large-cap stocks. Meanwhile, the equal-weighted and small-cap indexes have done considerably worse reflecting the downbeat economic conditions. Equity Valuations And Strategy Chart I-12Indian Equity Valuations Are Elevated On A Market-Cap Basis... As discussed earlier, India’s equity market leaders like information technology, consumer staples and health care are already expensive, trading at a trailing P/E ratio of 23, 47 and 33, respectively. The rest of the equity market is not expensive, but its profit outlook is mediocre. As to other valuation metrices, the market seems to be moderately expensive both on an absolute basis and versus the EM equity benchmark: The 12-month forward P/E ratio is 22.5, the highest in the decade (Chart I-12, top panel). Relative to the EM benchmark, on the same measure is trading at 50% premium (Chart I-12, bottom panel). Based on the equal-weighted equity index – i.e. stripping out the effect of large-cap stocks on the index, Indian equities are overvalued in absolute terms (Chart I-13, top panel). On this equal-weighted measure, Indian stocks are currently trading at a 35% premium versus their EM peers (Chart I-13, bottom panel). The cyclically-adjusted P/E ratio is close to the historical mean (Chart I-14, top panel). Chart I-13...And On An Equal-Weighted Basis Chart I-14Cyclically-Adjusted P/E Ratio   However, the CAPE ratio is agnostic to corporate earnings on a cyclical horizon. It assumes corporate profits will revert to their long-term rising trend (Chart I-14, bottom panel). This is not assured in the next six months in our opinion. Hence, a lackluster profits recovery – profits disappointments – is a risk to the performance of India’s bourse in the coming months. Equity Strategy: Weighing pros and cons, we recommend that dedicated EM equity investors maintain an underweight position in India within an EM equity portfolio. However, they should consider upgrading this bourse on potential near-term underperformance. The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Absolute-return investors should consider buying this bourse on a setback in the coming months. Odds are that the index could drop up to 15% in US dollar terms triggered by a potential global risk-off phase and domestic profit disappointments. Currency And Fixed-Income Chart I-15Consumer Inflation Is Not A Problem In India We have been recommending receiving 10-year swap rates in India since April 23 and this recommendation remains intact. As argued above, the economic recovery will be gradual, and the output gap will remain negative for some time. Consequently, wages and inflation will likely surprise on the downside. Even though headline and core inflation rates have recently picked up, this has been due to a rise in food prices, transportation and personal care products (Chart I-15). Hence, there are not genuine inflationary pressures in India and the RBI will be making a mistake if it stops easing due to rises in headline or core CPI readings. Food prices have been rising for a while due to supply shocks. Importantly, the rise in food prices should not be interpreted as genuine inflation. Meanwhile, personal care products include gold jewelry and this CPI sub-component has therefore been rising due to the surge in gold prices (Chart I-15, bottom panel). Finally, transport costs have been on the rise due to supply chain bottlenecks in India as a result of COVID-19 and due to the rise in global oil prices. The broken monetary transmission mechanism means that the RBI will have to cut rates by much more. The fixed-income market is not discounting rate cuts.  There is value in long-term rates in India. The yield curve is very steep – the spread between 10-year and 1-year swap rates is 92 basis points. In addition, 10-year government bond yields are currently yielding 522 basis points above 10-year US Treasurys. We are not particularly concerned about public debt. Central government debt was at 52% of GDP before the recession and total public debt (including both central and state governments) was 80% of GDP. The same ratios are much higher in many other EM and DM economies. Chart I-16India's Stock-To-Bond Ratio Is At A Critical Resistance Finally, the rupee could correct as the US dollar rebounds from oversold levels, but foreign investors should use that setback in India’s exchange rate to rotate from receiving rates to buying 10-year government bonds outright, i.e., taking on currency risk. The RBI has been accumulating foreign exchange reserves, meaning it has been preventing the currency from appreciating. The current account is balanced and the financial/capital account has passed its worse phase. India will continue to attract foreign capital due to its long-term appeal and higher-than-elsewhere interest rates.  Domestic investors should favor bonds over stocks in the near term (Chart I-16). Bottom Line: Continue betting on lower interest rates in India. Fixed income investors should switch from receiving rates to buying 10-year government bonds on a correction in the rupee in the coming months. Dedicated EM local currency bond portfolios should continue overweighting India.     Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Special Report

Highlights Our net assessment of India is bullish over the long run, but this year is full of risks. Prime Minister Modi will struggle to reboot the economy and maintain social stability in his second term. If unemployment, social unrest, and communal tensions spiral out of control, Modi could lose political capital. A foreign policy blunder with China and Pakistan would also weaken Modi’s strongman image. Losses for Modi and the BJP would weigh on India’s potential growth and earnings outlook. Buy Indian stocks on dips, but monitor risks. Go long Indian pharma and local currency government bonds. Feature The Indo-Chinese conflict on the Himalayan border is unlikely to have a significant impact on global financial markets. A major escalation could cause short-term volatility. But most likely an escalation will have a regional impact and present a buying opportunity for Indian, Chinese, or Pakistani equities. There is a potential problem for India, however, in the combination of internal and external political risks. Prime Minister Narendra Modi faces a threat to his popular support because of the economic shock of the COVID-19 pandemic. Insufficient fiscal stimulus will lead to a faltering recovery. Lingering large-scale unemployment will motivate social unrest. Thus Modi will struggle to ensure economic recovery and law and order in his second term. Our base case is that he has the political capital and enough time on the political clock to stabilize the country and his rule. However, a failure to handle domestic challenges poses a risk to our view. And a foreign policy defeat at the hands of the Chinese would further undermine our view. Over the past two months we have written about the risk of social unrest and political instability in emerging markets due to the global pandemic. In this report we extend that analysis to India. We are strategically bullish on India. But a fundamental loss of control by Modi’s administration would skew the risk to the downside over the near and medium term. India’s Domestic Risks India is neither the worst nor the best off among emerging markets. It ranks right in the middle of our COVID-19 Social Unrest Index, mostly because of the status of the economy (Table 1). Table 1Our COVID-19 Social Unrest Index For Emerging Markets Chart 1India's Economic Pain A Challenge For Modi Given that Chile, Russia, and China rank at the top our list, and yet face challenges to their stability, India’s middling position should not be interpreted optimistically. The economic hit has been massive. Manufacturing and especially services PMIs collapsed in April and May, pulling down the composite index to 7.2 and 14.8 respectively, from 50.6 in March – just a hair above the 50 boom-bust line (Chart 1). The breakdown in manufacturing is one of the worst among India’s emerging market peers (Chart 2). This is a problem for a country that is trying to upgrade its manufacturing sector. The domestic economy was frail even prior to COVID. Growth slowed to 4.2% in 2019 from 6.1% in 2018. Discretionary spending by households, reflected in passenger car sales, and capital expenditure by companies were already extremely weak (Chart 3). Chart 2India's Manufacturing Hit Harder Than Other EMs Chart 3India's Consumers And Businesses In Freefall Exports have slowed since 2018 due to the Chinese slowdown and trade war (Chart 4). COVID-19 dashed the small signs of a rebound in early 2020. India runs a twin deficit and its fiscal position is especially precarious. At 7.4% of GDP in 2019, the general government deficit was among the largest going into the pandemic. Coupled with a high debt-to-GDP ratio, fiscal policy is a risk to India’s long run sustainability and foreign investors’ returns (Chart 5). This marks a major limitation on India’s ability to stimulate aggregate demand. Chart 4Consumer-Led, But Not Immune To Global Shock Chart 5Debt Constraint On Stimulus On the positive side, India’s foreign currency reserves are sufficient, and it is capable of repaying the foreign debt obligations coming due in the near term, according to our Emerging Markets Strategy (Chart 6). Thus while it has less fiscal space than some other emerging markets, it is not as exposed to a foreign funding squeeze. Chart 6AIndia Can Cover Foreign Debt Payments Chart 6BIndia Not Over-Reliant On Foreign Capital How large is India’s stimulus package? The headline-grabbing INR 20 trillion stimulus package – equivalent to 10% of GDP – overstates the direct stimulus to the economy (Table 2). Only about 1.3% of GDP consists of genuinely new on-budget spending. This is much bigger than the 0.5% of GDP fiscal stimulus in 2008-10 but smaller than what other major countries have done in the pandemic thus far (Chart 7). Table 2India’s Fiscal And Monetary Stimulus Amid Coronavirus Crisis Chart 7India’s Stimulus: Larger Than GFC, But Smaller Than Many Peers Modi will likely need to unleash more stimulus, but his response thus far indicates that he recognizes the country’s fiscal constraints and is not throwing everything at the economy all at once. The COVID-19 crisis hit not long after Modi reconsolidated power in parliament. He has the political capital to make tough decisions – he is not forced to stimulate the economy frantically for the sake of general elections.1 Thus the administration is unlikely to take the path of fiscal profligacy. This is positive for the debt outlook, although it is negative for the demand outlook and recovery. Structural reform is a cornerstone of Modi’s stimulus package. Finance minister Nirmala Sitharaman has highlighted changes to land, labor, and law as parts of the stimulus package, as well as more typical measures to stimulate demand. For Modi the COVID-19 crisis and stimulus measures provide an opportunity to get reforms back on track after several initiatives, such as land reform, were put on hold in order to concentrate on the single biggest reform initiative of his first term (the goods and services tax). This reform agenda cannot go too far as Modi will be forced to sacrifice painful reforms for the sake of maintaining stability. But as long as India snaps back from its lockdown period like other economies, its decision to keep a lid on spending will enable it to manage inflation and generate savings and capital investment over the long run. This is what India needs to reform its moribund economy. Modi can also cut red tape and bureaucracy to speed the recovery. Bottom Line: Indian policymakers recognize the constraints of large deficits and debt and have thus far shown a reluctance to deploy massive fiscal stimulus. The upside is that India will avoid crowding out private investment that is essential to maintain its economic rise. The downside is a slower recovery. India Re-Opening, But Pandemic Yet To Peak On the pandemic, the good news is that India is experiencing a relatively low number of COVID-19 cases and deaths compared to Brazil and South Africa (Chart 8). This may be due to the early and stringent lockdown, the relatively small elderly share of the population, or other epidemiological factors. India also lags in terms of testing (Chart 9). Chart 8COVID-19 Still Poses A Risk Chart 9India’s COVID Testing Has Lagged However, any surge would devastate India’s weak health care system. The fact that the economy is reopening without having already experienced a peak in new cases bodes ill. What’s more, India does not appear to be in control of the virus’s spread. By contrast, the number of new cases is still rising in India three months after the nationwide lockdown was first imposed. Indians are vulnerable to the virus as they are more susceptible to die from major diseases than many other countries. India spends notoriously little on health. The health care infrastructure is in no shape to withstand a surge in infections. Reports indicate that even at current low COVID-19 infection rates, hospitals are already turning down patients due to a shortage of beds and ventilators. The implication is that India is not prepared to handle an outbreak that reaches levels seen in say Brazil, South Africa, or Turkey. Given that it is already loosening the lockdown without having witnessed a peak in cases, there is a risk that India has yet to experience the worst of the pandemic. Bottom Line: The pandemic has so far been relatively manageable in India. However, cases are still on the rise and are at risk of surging as the nationwide lockdown is eased. India’s poor health infrastructure puts the nation in a weak situation in handling the virus. Even if the virus itself proves overblown, Prime Minister Modi’s political capital could suffer from the health care crisis. The Risk Of Social Unrest Assuming that India muddles through the pandemic, Modi’s next big challenge is large-scale unemployment. Official unemployment figures – which are not published regularly – understate the impact of the deteriorating economic situation on households, as does our COVID-19 Unrest Index. Our index shows that Indian households, relative to EM peers, are not particularly distressed as measured by a combination of the Gini index of inequality and the “misery index” of unemployment and inflation (see Table 1). However, these are real problems for Indians themselves. Especially unemployment. The massive informal sector makes it hard to measure the real employment situation (Chart 10). Informal workers are the most vulnerable and face the greatest uncertainty. Chart 10India’s Informal Sector Masks Real Unemployment Chart 11Household Income Shock Chart 12Job Rolls Shrink For Traders And Workers Data from April, before reopening, show that nearly half of households saw a drop in income, according to the Centre for Monitoring Indian Economy (CMIE) (Chart 11). But the lifting of lockdowns is starting to bring down unemployment which peaked in May at nearly 25%, with small traders and laborers suffering the brunt of the layoffs (Chart 12). Individuals working in this category, along with farmers, are the most likely to be considered part of the informal sector. The improvement in unemployment also overlooks the decline in labor force participation, which fell to 38.7% in May from 43.2% before the pandemic. Therefore while economic reopening is undoubtedly positive for the labor market, the data do not capture the full extent of the impact of the pandemic and recession on household incomes. Moreover, the labor market may not revert to its pre-pandemic status quickly. Despite record unemployment, construction companies – a cornerstone of the Indian economy – were reporting difficulty in accessing labor in late-April when unemployment was at its peak, weighing on their ability to resume work.2 This is because migrants – which account for 20% of the labor force – are reluctant to return to work as they have been traumatized by the lockdown experience during which restrictions on travel left them stranded far away from their families and hometowns. Even though the restrictions have since been eased, many of the migrant workers are choosing to return home rather than take up work in the construction sector. Moreover, on June 9 the Supreme Court ordered states to transport all stranded migrant workers home within 15 days. The court’s request that federal and state governments ensure they are providing employment to migrants will help reduce unemployment among migrants. However, the unemployment rate is likely to stay high due to transitional unemployment. A lesser challenge comes from the collapse of oil-dependent Persian Gulf economies. Overall, remittances account for 3% of India’s GDP, which is substantial. Many of these workers are now jobless and India is repatriating its citizens that are stranded in the Gulf. An estimated 8.5 million Indians work there, which is small relative to the ~519 million strong domestic labor force. But the return of laborers may have an impact in certain regions. For example, the finance minister of Kerala noted they expect 500,000 Indians to return to his state, which could prove destabilizing. Modi’s biggest challenge is unemployment. Bottom Line: The easing of lockdowns has been positive for the jobs market. However, unemployment will be slow to recover to pre-COVID levels. India will face greater household grievances, threatening social unrest. This is a risk to Modi’s political capital over his second term. Communal Tensions Will Worsen Another risk to Modi’s political capital is the rise of communal tensions. These could potentially mobilize the political opposition against Modi, beginning at the state level. They could also lead to a secular rise in domestic insecurity, which would deter foreign investment. Religious polarization is picking up. India’s COVID lockdown brought a halt to anti-government demonstrations which started in December 2019 in protest of the Citizenship Amendment Act. Prior to the lockdown, many Indians had taken to the streets arguing that this act discriminated against the Muslim minority, violated the country’s foundational secular values, and was unconstitutional. Indian views on the law differ according to religion, with 63.5% of Muslims opposing the Act vs. 32.3% of non-Muslims (Chart 13). Chart 13Muslim Minority Opposes Citizenship Law By granting citizenship to illegal migrants who entered India prior to 2014 from Afghanistan, Bangladesh and Pakistan, and who are Hindu, Sikh, Jain, Parsi, Buddhist, or Christian, Modi’s act used religion as a basis for citizenship, discriminating against the Muslim minority – which makes up almost 15% of India’s population. Although the demonstrations have paused, protesters’ grievances and the Citizenship Law itself remain unresolved. If anything, religious tensions intensified during the lockdown period, as police have been arresting high-profile activists. Right-wing groups have accused the Muslim community of being “super spreaders,” and pro-government media highlighted that regions with large populations of Muslims following the Tablighi Jamaat group have more COVID-19 cases.3 For example, these groups spread rumors that Muslim food vendors were intentionally spitting on fruits to spread the virus. They distributed flags to Hindu food vendors to make them more identifiable. Religious polarization and Modi’s suppression of the Muslim community will continue to be a source of instability throughout Modi’s second term. The prime minister’s stance regarding the minority group will not change. Rather, the weak economy will force Modi to seek success elsewhere, including through sectarian rhetoric to fire up his Hindu nationalist political base. Widespread unemployment will stoke these animosities. Thus religious and ideological tensions are likely to pick up rather than die down, resulting in communal violence and even radicalization and terrorism. This point is especially relevant in Muslim-majority Jammu and Kashmir, which is seeing a spike in communal tensions as well as an escalating struggle over the central government’s authority. Modi’s August 2019 decision to revoke the constitutional autonomy of Jammu and Kashmir also increases security risks. While the Indian government justified the move by the need to stop militancy in Kashmir, it is perceived by many Kashmiri Muslims as an attempt to tighten the government’s grip on the region and suppress their interests. The government’s moves in late 2019, which included a lockdown on the citizens of Kashmir, an internet blackout, and the arrest of local politicians and public figures, will provoke dissent, resistance, separatism, and radicalization. Fresh anti-India protests have already arisen in Indian Kashmir after the killing of nine rebels at the hands of Indian forces. The killings followed intelligence received by the Indian government that some of the rebels either wanted Kashmir to be independent or to merge with Muslim-majority Pakistan. According to a tally by the police, 73 rebels have been killed in Indian-administered Kashmir so far this year. New tensions could arise if India encroaches on Pakistan-administered Kashmir or if Pakistan-backed proxy groups strike out against India’s change of Kashmir’s status. This could lead to a more open-ended military confrontation between India and Pakistan than the tit-for-tat attacks in early 2019. The latter incident could be contained due to a novice government in Pakistan and the approaching general election in India, whereas a new round of hostilities might not so easily be dampened. Tensions with Pakistan are already high – two Pakistani embassy officials were expelled by New Delhi on May 31 due to allegations of spying. An India-Pakistan standoff could easily mingle with Sino-Indian tensions given China’s strengthening alliance with Pakistan. India accuses the People’s Liberation Army of assisting Pakistan on its side of Kashmir. A major escalation with China over Ladakh could entangle Pakistan and widen the conflict. Bottom Line: Religious polarization is picking up amid the lockdown and could explode as containment efforts are eased. India is likely to experience an intensification of unrest from the Muslim minority. In addition to being frustrated by the economy, this group is being politically marginalized, and thus will become more restless and radicalized over time. Will Modi’s Popularity Persist? Modi remains extremely popular, but he has seen his pandemic popularity “bounce” come and go (Chart 14). He is credited for the early and aggressive response to the outbreak, but his approval rating may have trouble in the coming months and years as the economic aftermath unfolds. The positives for Modi are very clear. India’s economic woes this year will be blamed on the shock brought on by the pandemic even though the economy was in bad shape prior to that, washing away any bad memories from the country’s de-monetization and implementation of the new goods and services tax. Another positive for Modi: while states led by his Bharatiya Janata Party (BJP) were previously worse off in terms of unemployment rates, this situation reversed in April and May. Now states led by the opposition Indian National Congress (INC) are suffering the greatest in terms of job losses (Chart 15). In fact, the average unemployment rate for states led by the BJP fell in May. Chart 14Modi’s Popularity High, But COVID Bounce Gone Chart 15Opposition States Bear Brunt Of Unemployment The dichotomy in state unemployment is due to the heavier presence of industry in BJP-led states such as Gujarat, Karnataka, and Haryana. The exodus of migrants from these states reduced the size of the labor force, bringing down unemployment rates. By contrast, unemployment spiked in migrant workers’ home states such as Jharkhand, and Punjab, which are opposition-led. Moreover there’s been little effective political opposition to Modi’s handling of the pandemic. True, as with all federal systems, Modi faces pushback from the state governments, which argue that their funding is drying up. A major source of state funding comes from alcohol sales, fuel, and real estate. The latter two have collapsed amid the recession, while the federal government’s decision to ban alcohol sales during the lockdown weighed on state financing and catalyzed the political clash. Yet Modi has used the occasion to centralize control and make his case for stronger federal government. For instance, he has mandated that only the central government can produce, procure, import, or distribute COVID-combating materials and equipment, from personal protective equipment (PPE) to masks to ventilators, thus clipping states’ powers. From a structural point of view, India needs a stronger central government to pursue economic and strategic objectives. Since the pandemic is a challenge that requires a strong central response, Modi’s centralizing approach continues to receive a tailwind from public support. India has a relatively strong score on our COVID-19 Unrest Index when it comes to governance, especially in terms of voice and accountability and control of corruption. Modi’s centralization of power could weaken governance over time, but it is not an immediate concern for investors since the overriding problem in India is a lack of national coordination.4 Clearly, then, the risk to Modi is that unemployment, unrest, communal tensions, and conflict with Pakistan and China lead to political defeats that deplete his political capital in his second term and make him vulnerable to electoral losses at the state level and ultimately in the general election in 2024. At the moment he has sufficient political capital, but political risks are much higher for him than they were prior to COVID-19. If these risks mount, Indian equities will suffer, as the clear implication is a loss of Modi’s and the BJP’s high level of control over both federal and state governments. This would reduce India’s ability to execute policy. The lack of coherence would shake investors’ faith in India’s ability to accelerate reforms and economic development. Bottom Line: Modi’s popularity enjoyed a solid bounce from the crisis and remains very high. He is concentrating power into the federal government, demonstrating that it is capable of rising to India’s modern challenges. The risk is that governance could suffer as a result of the massive challenges to the economy and social stability in the wake of COVID-19. Investment Takeaways Chart 16Indian Equities Breaking Down Indian equities relative to emerging markets are hovering at the 12-year moving average, a critical technical point. If they break beneath this level then there is further downside. Indian equities have broken down relative to global equities (Chart 16). The breakdown occurred despite the collapse in oil prices, which normally would help Indian stocks since the country’s import bill runs to 5% of GDP (Chart 17). Oil prices will strengthen in the second half of the year as global supply-demand balances tighten on the back of OPEC 2.0 supply restraints. Our Commodity & Energy Strategy expects cartel discipline to persist this year. A spike in oil prices driven by production cuts will penalize Indian stocks relative to EM peers. However, we maintain a bullish outlook on India over the long run and tend to view major selloffs, from today’s levels, as an opportunity to buy on the dip. Major selloffs from today are a buying opportunity. Specifically, we see a buying opportunity in Indian pharmaceutical equities (Chart 18). India is one of China’s top competitors in producing both active pharmaceutical ingredients and finished drugs for the United States. While India’s fiscal stimulus will incentivize foreign companies to move supply chains out of China, the United States’ upcoming rounds of stimulus will offer incentives for companies to move out of China, particularly health care companies. While the US rhetoric will emphasize “Buy American, Hire American” onshoring, economic constraints will still motivate companies to work abroad. It is China that will bear the brunt of US protectionist impulses, not the world as a whole. Therefore India stands to benefit, particularly when it comes to pharma. Chart 17Oil Price Drop Brought Cold Comfort This Time Chart 18Go Long India Pharma Versus EM Pharma We also recommend investors go long Indian local currency bonds relative to emerging markets. These bonds are protected by the fact that foreign ownership and capital outflows are limited, as Ayman Kawtharani of our Emerging Markets Strategy observes (Chart 19). Chart 19Go Long Indian Local Currency Government Bonds Chart 20Rupee Will Trend Sideways From Here Easier monetary policy will weigh on the rupee, but it is already near the floor of the narrowing band in which its been trading against the dollar since 2018 (Chart 20). Thus odds are that the currency will move sideways over the near term. The primary risk to our view is Modi’s political survival. A collapse of Modi’s political capital and momentum – for any reason – would not deliver a new prime minister or ruling party with the same degree of capital and momentum. Rather it would produce either a weak Modi and BJP, or a challenger that will likely lack Modi’s single-party federal majority and state-assembly majority. If unemployment, social unrest, and communal tensions evolve in a way that fundamentally undermines the Modi regime – if Modi and the BJP suffered permanent damage from this year’s crises – then India’s overall economic policy uncertainty would rise on a long-term basis. The market would have to downgrade India’s economic outlook and earnings expectations to adjust. We remain bullish India on a secular basis, however, because there would remain an underlying national consensus on the need to prioritize economic development. That will not change anytime soon, as Modi has demonstrated to the public and the opposition that it is a winning formula.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com   Footnotes 1 Upcoming state elections are a different story, but any stimulus will be local. 2 Pandya, Dhwani “Biggest Job Creator Short of Labor Amid Vast India Unemployment,” Bloomberg, May 6, 2020. 3 Muhammad Saad Khandalvi, leader of Tablighi Jamaat, has been charged with manslaughter after ignoring two notices to put a stop to an event hosted by the group at a mosque in New Delhi which started on March 3. The group claims to have ended the event prematurely upon learning of a national curfew on March 22, arguing that other non-Muslim religious gatherings are not facing the same charges. 4 The risk of centralization is that India’s governance could suffer over time. For example, the Prime Minister’s Citizen Assistance and Relief in Emergency Situations Fund, chaired by Modi, has been criticized for its lack of transparency and for diverting resources from other efforts. Modi created a new fund when an older fund, the Prime Minister’s National Relief Fund, already existed. Political patronage is clearly at work. Modi’s fund enjoys benefits that are unavailable to other relief funds, allowing overseas contributions and corporate donations to count toward the mandatory 2% of profits spent on corporate social responsibility.