Singapore: The Narendra Modi administration is rebuilding the economy and reviving confidence “brick by brick," says Rana B. Gupta , India equities specialist at Manulife Asset Management. The government’s emphasis on financial inclusion, enhancing productivity and boosting the manufacturing sector will restore the pace of economic growth back to the trend rate, Gupta said in an interview.

Edited excerpts:

The US will hike rates in the future. In this scenario, the traditional response from investors is to sell and run from countries like India and Indonesia, which depend on external funding. But, unlike in 2013, don’t you think the approach has changed now, and investors will stay invested?

Absolutely. The “Fragile Five" has improved definitely in the case of both India and Indonesia. At worse, a spike in US interest rates can cause some temporary dislocation. India has seen an inflow of $20 billion in fixed income, and some of this is not long-term, and may go out and, at worse, cause some temporary disruption. But, taking a medium- to long-term view, there is no reason to worry, and I agree there have been fundamental improvements in many Asian economies, including India—trade deficits are smaller and, therefore, current account deficits (CAD) are smaller, funding needs are lower, foreign reserves are higher, interests rates are higher and the economy looks in a more balanced shape when compared with a year back.

If you look at just India’s GDP (gross domestic product) growth—last year, the consensus estimate was 4.6%, and this year the consensus is expecting 5.5-6.5%. If you just look at incremental growth from 4.5% in FY14 to about 7% in FY17, this will be the highest among all emerging markets. 7% growth may not be the highest because China may still be 7.5%...but the delta of growth is highest in India, and along with other factors—lower CAD and the fact that the currency is much more stable—it will keep medium- to long-term investors interested.

Last week, India surpassed Switzerland to become the ninth biggest stock market, with a market capitalization of $1.58 trillion. Are the markets fairly priced at the current levels? How long do you expect this rally to sustain? Is this the beginning of a big bull run?

The Indian economy was bottoming out well before elections—growth was around 4.5% for about six quarters. Inflation peaked in December 2013 at around 10%. Trade deficit was coming down in the latter half of 2013. Economy was recovering, but not good enough for investments to come in—plus, consumer sentiment and confidence were still quite low. This election gave a decisive verdict and brought back the perception of a strong government—this, in turn, changed the business sentiment and also consumer confidence. Our view is the current government has made slow but steady progress on the economy. The economy has bottomed out and our conviction is further reinforced with the Q1 GDP numbers which put growth at 5.7% already. Our view is that the cyclical downturn has ended, and the upturn has begun, where at the very minimum, we will go back to the trend growth rate, which averages 7.5% over the last 10 years. Even getting back to the trend rate is a fairly significant gap to bridge—we have to go from 4.5% growth to 7.5%, and it can take up to three years. From bottom-up, the stock market will be driven by earnings. When you have that kind of a lift coming from GDP growth, the revenue growth that had been stagnating, will pick up. There are many companies—particularly in cyclical sectors—which have very high fixed costs, and opportunities will play out, and their earnings will improve handsomely. Earnings in the second half of FY15, and in FY16 and FY17, will see significant pick-up. In our view, we are in the beginning of a bull market, rather than a mature bull market.

As earnings pick up, equity market returns should at least be in line with earnings growth. It is also worth highlighting that price-to-earnings (P/E) ratios are currently in line with past averages, and that periods of robust earnings growth have been historically accompanied by P/E re-rating.

In spite of the recent run up in Indian equities, it is just beginning to catch up with regional and global peers. There can be short-term corrections—that is part of the bull market, but next two to three years, the markets will have substantial upside.

Which sectors will lead the way? Where do you see infrastructure stocks?

Here there is an interesting perspective from our side. Every bull market is different in character—if this were to be compared with the 2003-2008 bull market, there are some things to highlight. In terms of similarities, during a bull run, consumer discretionary companies like auto and retail do well—particularly passenger vehicles. Commercial vehicles will also do well. Banks tend to do well with a lag, because as economy improves, we expect slippages to come off in FY6 and, as a result, credit costs to come off in FY17—so bank earnings will pick up and they will do well. In terms of infrastructure, we have a different view—in the last bull market, this sector was all about domestic infrastructure and domestic investment—there was a pick-up in cement, roads, steel, mining, refining and real estate. Will that come back? It might, but it will take a long time. First, there are serious amount of capacities that were created the last time, and people who created it, their balance sheets are not in the best of shape. There are genuine concerns about legal issues, about regulatory uncertainties and it is difficult for any government to sort this out overnight. There are bottlenecks on fuel, on environment—this will take a long time to come back. The industrial part of the story, will come back—for instance, engine players and bearing makers. Focused infrastructure firms like those in railways, roads—they will come back as they do not have a baggage of bad assets from the past.

If you were to list key reforms that investors would want the Modi-led government to carry out in the second 100 days, what would they be?

In his 15 August speech, and from what we have observed so far, the following are on Modi’s agenda. First, financial inclusion of every family having a bank account—ultimately, this will be used for targeted subsidies through direct benefit transfer. This will reduce overall subsidy burden on the state. Second, he is undertaking productivity enhancing measures and implementing digital infrastructure. Providing sanitation facilities, clear drinking water and power is also high on the agenda. These will take time, but will improve productivity of the masses. He also talked about promoting investments in manufacturing. This is important because there are about $150 billion worth of projects that are stuck at advanced levels for lack of approvals. The current administration is focused on getting such projects moving again, and this can alone add 50 basis points (half a percentage point) to the economy. Modi has also spoken on improving the transportation infrastructure by focusing on rails, roads and building cities around them. That is also a positive. The current government is also big on manufacturing—once you improve and build infrastructure, investments will come in this space. All these put together will restore growth back to the trend levels.

We have seen Modi to be active on foreign policy—the countries that he is meeting, like the recent Japan trip, it is targeted to get more technology and capital—and it is a welcome step.

The current government is also working towards granting more autonomy to the states. In a federal structure, states have to implement most of the policies, and by giving them more autonomy, several chief ministers are focusing on reform-friendly measures, and they are also competing among themselves to build infrastructure to get more investments.

Execution of some of these measures are yet to happen. For India to go back to trend growth rates, in our view, big bang reforms are not required—such steps are only required if you want the country to grow at 8-9%. In the next two to four years, we would expect this government to sort out the coal, power, banks, and in the longer term, say five years, we expect them to sort out the land labour situation.

It also depends on where your starting point is—my starting point is whether 4.5% can go to 7.5%. For this, fiscal deficit has to come down—here, subsidy reduction is needed and he has initiated work on it. Tax collection has to go up—will GST (goods and services tax) be implemented from 2016-17, the answer is yes. Investments had collapsed in the last two years—can manufacturing, investments and jobs come back? The answer is yes, as we should see progress on this in the next one to two years. If you want a higher growth rate than the trend rate, the fuel security of the country is important—whether Coal India Ltd can produce enough coal and the import costs for coal will be important.

So the strategy should be to get the low hanging fruits, implement them first, and then move on the next things. The term “brick-by-brick" is overused, but it best describes this government action in restoring the economy and reviving confidence.

You are bullish on manufacturing—but will Prime Minister Modi’s “Make in India" pitch work? South and South-East Asia are far more competitive for multinational companies (MNCs) to base their manufacturing facilities—they have better infrastructure, good port facilities, supply chains and don’t have regulatory and bureaucratic uncertainties. So why should they relocate to India?

When I say manufacturing exports, we are not bullish on any export where labour is an important part of the component. For instance, we are not betting on apparel, garments or toys, where we think other countries have an edge. We are bullish where there is a bit of value-added engineering export. India has a large supply of skilled labour, whether it is engineering diploma holders or degree holders. This large talent pool will enable India to do well. If an auto maker wants to set up design facilities, or in sectors like power equipment, where there is a large demand and firms would want to be closer to where domestic demand is. If they can also address global demand, it gives them scale, and at the same time, if they can get lower inputs costs, which are the skilled engineers—all these can come together help India’s case. Some of the global auto firms use India as their manufacturing hub even if they have facilities in Thailand—they use India to serve the domestic market and also as an exports hub to Middle-East and Latin America.

Let us also not forget, India provides a large base, and has a large pool of engineers and, in dollar terms, the costs are very reasonable—at the same time, if global scale can be added, the benefits are really huge. Another side of the same coin is import substitution—if you look at many of the MNCs, earlier, because of the rupee appreciation, they would import from the parent and sell the parts in India. As India has grown, the market has achieved a particular size for them to make investments. Secondly, because of the rupee-dollar movement, it is no longer feasible for them to import and sell, as in rupee terms the costs have gone up. They are, therefore, doing localization to cut down on costs.

Should the rupee be kept weak if India wants to succeed in its plans to revive manufacturing?

It should be kept competitive. There is a difference between keeping it weak and competitive. If rupee can be maintained at 60 (to the dollar)—the last 5-6 years, the rupee has depreciated a lot even vis-à-vis other emerging market currencies—so keeping it at a competitive level will help. But more important will be improving infrastructure and improving governance issues—some of the entrepreneurs are hassled with taxation issues, transportation hassles. If there are better roads and the same truck can do many more turns, it helps.

The Reserve Bank of India is likely to hold rates in the September credit policy. What’s your take on the interest rate scenario, given the inflationary situation?

(RBI governor Raghuram) Rajan has clearly shifted the focus from WPI (Wholesale Price Index) to CPI (Consumer Price Index). This is very important because, ultimately, what the consumer faces is the CPI. One of the reasons we saw so much investments in gold was because the real rates were negative. We are looking at 7-7.5% CPI and rates of around 8%—so, real rates start to become positive and should build financial savings. Our view is that interest rates will remain stable for a fairly long period of time. We do not see any upward bias in interest rates because CPI is in the glide path that RBI has mentioned... Every time Rajan speaks, he highlights the target of 6% CPI by January 2016—that is achievable, but given there is so much food component in our CPI, it is not given. Unless he is sure this target can be met, I don’t think Rajan will cut rates. Secondly, although we do not think US interest rate will cause a disruption beyond a certain point in equities, I think one would want to take a step back and see when the first rate hike eventually comes in, and see if there are material outflows from the Indian market. I don’t think any governor would want to be in a position to cut rates and then get caught on the other side, where because of US rate hikes, you begin to see outflows and then you have to hike rates.

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