Will reforms be as decisive as the mandate?

May 19, 2014

In this issue:
» Will anyone tap the on-tap banking licenses?
» IPO craze could return to the markets
» Mortgage giants Fannie and Freddie could be wound up
» The US economic recovery is not supported by the housing market
» ...And more!

The election verdict is crystal clear. The BJP has won a decisive majority. Narendra Modi is all set to occupy the Prime Minister's chair in a few days time. The equity markets have clearly given a big thumbs-up to the verdict. Expectations are high that the new government will be able to revive the economy quickly. Now that the dust has settled regarding the elections, the time has come to examine the most serious economic challenges before the government. After all, this government has been elected to power on the basis of its promise of bringing about a change in India's economy.

We would like to state here that the road ahead for the new government will not be an easy one. We believe that GDP growth will bounce back only if bold and decisive reforms are undertaken. The two most important issues facing the government are taming inflation to allow lower interest rates and creating jobs so that India can reap the benefits of the demographic dividend. Inflation was the source of much of the anger against the UPA government. But bringing it under control will be easier said than done. Much of the inflation in India is driven by the price of food items. To gain control over food inflation, the archaic Agricultural Produce Marketing Committee (APMC) Act will have to be repealed and a strong pan-India supply chain will have to be established. At the same time, care will have to be taken to ensure that farmers receive a remunerative price for their produce. Once inflation is brought under control the RBI will be able to safely lower interest rates.

Next in the terms of importance will be job creation. Laws and regulations that encourage entrepreneurship and increase the ease of doing business is the need of the hour. However this will not be enough. The government will have to give a big push to the manufacturing sector. This sector did not receive adequate attention from the previous government and it has resulted in large scale youth unemployment. It is well known that the manufacturing sector can create far more labour intensive jobs than the service sector. A rebound in manufacturing will create significant employment and will lead more income in the hands of the people. This in turn will lead to higher savings as well as higher consumption. GDP growth is sure to pick-up in such an environment. Lower inflation combined with higher income levels is a globally proven recipe for the success of any economy.

The government, having received a decisive mandate, must now move decisively on reforms. The low hanging fruit of pushing through stalled infrastructure projects will only provide a short term boost to the economy. Measures such as the tax reform (GST and DTC), reducing wasteful subsidies on petroleum products, re-capitalization of PSU banks and disinvestment will have to be taken up on priority. We hope that the new government will live up to the high expectations of the people and bring in the much needed changes to revive the economy.

Do you think that that new government will move decisively on reforms? Let us know in the Equitymaster Club or share your comments below.

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 Chart of the day
When we talk of Foreign Institutional Investors (FIIs), the discussion is restricted to their buying vis-a-vis equities. What usually is not taken into consideration is their impact on the debt market. This is unfair however as the FII activity in the debt market is no pocket change. What more, with the arrival of a stable Government at the centre, the FII activity in the debt markets is only likely to go up in the near future.

As per a leading daily, FII inflows into the debt market had picked up this month on the hopes of a stable Government. Now that the results have put all doubts to rest, we won't be surprised that along with the equity markets, there will be more foreign inflows in the debt market as well. After all, the yield on the 10-year Indian treasury is more than three times that on the US treasury of similar duration. The inflows though are likely to be restricted into bonds of shorter duration as they are far easier to hedge. Longer term instruments are a bit difficult to hedge. Therefore FII exposure to these is likely to increase only when there is more clarity on the fiscal situation and interest rates. And this is likely to come only after the budget that's expected in early July. The monsoon scenario would have also become clearer by then.

Will FII's revive the Debt market too?

Editor's Note: As markets touch lifetime high, do you think it is time to book profits and re-enter the market at a later stage? Or could this be the start of a new bull run that could take Sensex across the 30,000 mark? Get answers to questions like these and many more in Equitymaster's biggest WebSummit ever!

One of the many 'hopes' that corporate India has from the new government is increased presence in the financial sector. Needless to say the entities that were rejected in the initial round of issue of banking licenses this year are at the forefront. That the RBI has promised 'on tap' license issue going forward is something that is encouraging. It means that instead of waiting for a decade, interested entities can apply for a banking license any time. However, does that mean the RBI will be allowing the rejected entities to start banking businesses sooner? We certainly do not think so! As per a blog in Economic Times, the RBI's cautious stance is unlikely to change. And entities that have been rejected in the first round are unlikely to get lucky too soon. The process of issue of banking licenses may certainly get more liberal and transparent over time. But for entities that were hopeful of the license in the lure of cheap funds (deposits), the road ahead will continue to remain bumpy. Hence, investors would do well to not get carried away by the speculation of more licenses in the months ahead.

With an emphatic NDA victory, capital markets seem to have gone into a frenzy. The sell side brigade is coming up with rosy Sensex targets every day. However, it is not just the secondary markets; the euphoria has even gripped primary markets. As per an article in economic times, at least a dozen companies have geared up to launch public offers in the second half of the current financial year. It may be noted that the primary market for equities was in a lull since the last one year. In the last fiscal, only Rs 12 bn were mobilized through IPO markets as companies went into hibernation amidst a morbid state of the economy. However, with the sentiment improving, many companies are planning to tap the markets in order to raise money now.

We believe investors have to be cautious in such times. It is typical of companies to raise money when sentiments are good. That's because raising capital is relatively easy in such times. Investors riding high on sentiments latch onto issues without paying much attention to valuations and suffer later as a result. While there is no doubt that if ease of doing business improves under the NDA regime, capital markets will blossom. However, investors have to be careful that they do not fall prey to the euphoria. Any investing decision should be taken after accounting for fundamentals and valuations.

The restructuring of the US residential mortgage market may begin with winding up of two housing giants Fannie Mae and Freddie Mac. These two companies support the US housing market by buying mortgages form the banks and then converting them into securities and then finally selling them to investors. In 2008's housing bust, these companies were bailed out by the US government. As per president Obama's proposal, phasing out Fannie Mae and Freddie Mac would get the government out of the mortgage business and the risk will be transferred to private lenders. However, the bill is being vehemently opposed by Republicans as well as Democrats. There could be many reasons for this. First and foremost, the US housing market is recovering gradually. Lenders now are more cautious than ever and subprime and Alt-A mortgage issuance is very uncommon now. Also being government run entities, they can ease the access to affordable mortgages to the middle class people; which may not be the case if private organizations come in to the picture.

All said and done, even if phasing out of Fannie Mae and Freddie Mac is finally approved, the US government shall look for a suitable alternative as these two entities buy, sell and guarantee about two-thirds of US' housing loans. The involvement of private sector in the housing business can lead to many banks or other private entities buying a stake in Fannie Mae and Freddie Mac. This multiple ownership can increase competition for mortgage loan rates. Also, a consortium of lenders running the mortgage business with an explicit government guarantee could be a safer proposition than theses entities remaining entirely public or private.

Economists are of the view that the US economy is likely to witness faster growth in the second half of the year. However, while they maintain that hiring as well as manufacturing activity is expected to pick-up, the outlook on homes sales remains weak. The housing market in the US continues to remain in a slump. Although mortgage rates have risen a bit, they are still historically quite low. Many reasons have been attributed to this tepid demand for homes. One is that higher student loans are not leaving much room for a couple to buy a home. The other more important reason seems to be that salaries have not really increased, making people cautious of buying homes.

So will house prices rise in the near future? The interest rates are already close to zero so there is not much headroom there to induce Americans to buy homes. The crux here is the job market. Increase in jobs and reduction in unemployment is bound to rub off positively on home prices as well. But there is not much clarity on whether the job scenario in the US has improved. Data with respect to jobless claims has not given any meaningful trend and does not also factor in the percentage of population that has given up looking for work altogether. Hence, we will not be surprised if house prices continue to remain weak in the medium term.

The Indian stock markets continued to trade firm. At the time of writing, the benchmark BSE-Sensex was up by 291 points (+1.2%). Most of the sectoral indices were trading in the green with power and capital goods leading the gainers. However, IT and FMCG stocks were trading in the red. Most of the Asian stock markets were trading weak with China and Japan being the biggest losers. European markets opened the day on a negative note.

 Today's investing mantra
"We don't get paid for activity, just for being right. As to how long we'll wait, we'll wait indefinitely." - Warren Buffett

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2 Responses to "Will reforms be as decisive as the mandate?"

Rajiv Gogate

May 24, 2014

That the reforms will be decisive is not doubted, considering the nature of Mr Modi; to what extent the reforms will yield results as expected by the govt., only time will tell.
Since there is no 2+2=4 type solution to such problems, even the success of the reforms will be debated unendingly.


S S Subramanian

May 19, 2014

The things like petroleum subsidy, agricultural food prices, bureaucracy, taming the inflation, creating jobs etc for which BJP and NAMO have won the mandate are conflicting issues. These can be achieved not by tweaking the system in short run, but by taking up structural reforms at the grass roots. Take agriculture. The best way to increase agricultural production is to mechanise the agriculture so that less number of people depend upon agriculture. So Modi has to repeal the various acts protecting agriculture as Sacred Cows. Many of these laws are under the state list or concurrent list. How Modi will change the laws. To promote new business, the ease of doing business in India should be improved. In Singapore it takes one day to incorporate a company. In India it takes minimum three months. Even after that each state is having different shop and establishment act, labour acts etc. So complying with all these laws is a real nightmare. So most of the people who want to do business do it in an informal way or bribe the government officials. If petroleum subsidy is removed there will be huge increase in inflation. If we want to increase the sale of cars and scottors, the petrol prices and excise duty should be reduced. If the sale of automobile are increased, the import of crude oil will increase and it will increase the inflation and also affect the BOP. The list is endless. So Modi should strive for sustainable growth, instead of consumption based growth, which will be self destructive. Singapore has done it as it is small country with just 40 lacs population and one party government for the last 50 years. I am doubtful whether Modi even with his absolute majority can dot it within 5 years.Best of Luck to NAMO

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