Time for real reforms, but low-hanging fruits remain

October 22, 2012

(The views expressed in this column are the author’s own and do not represent those of Reuters)

What seemed to be a lost cause merely three months ago has staged a remarkable comeback: the Indian government’s zeal for reform. After many months of dithering, the ruling Congress party remembered that it had the spine to stand up to fierce opposition from various state governments, finally getting its way on certain measures.

While the investment community would like to see India build on this progress and aim higher with reforms that would have a long-lasting impact on the economy, the government still has some low-hanging fruits to pick, and they present opportunities investors should not neglect.

India’s reform momentum was set by the recent increases in diesel prices and divestments in several state-owned firms. While these do not directly lead to economic growth, they help generate revenues and ease the government’s fiscal burden.

Next came the increase in the foreign-ownership limit on multi-brand retail establishments. By law, implementation rests on each state, and, so far, only nine states and two union territories have indicated approval. While these states make up about 30 percent of the population — a large enough market given India’s sizable population — many foreign retailers may decide to wait on the sidelines until more states buy into the reform.

Foreign ownership on airlines was also raised, to 49 percent, but a still-minority stake may not entice foreigners to invest in this notoriously unprofitable sector without further reforms. In short, it may be too soon to get excited about stocks exposed to these sectors.

The second wave of reforms has begun with the proposal to also lift foreign-ownership limits on insurance and pension products. For the measure on insurance, this is its latest incarnation; it had been proposed and rejected several times in the past. This sector will be worth a more serious look once more concrete actions are taken.

Though the recently approved measures have been welcome, the most they have achieved for now is to lift market sentiment. After all, foreign direct investments account for only around 5 percent of all investments in India. For real underlying potential, investors are well advised to turn to areas that may be easier to tackle but would have a bigger, more immediate impact. These include approvals of mining and industrial projects, which have ground to a halt since the end of 2010. The value of started projects is now below those during the 2008-2009 financial crisis, and investments have been shockingly low, suggesting that bureaucracy is the major stumbling block.

In fact, such approvals do not require legislation. However, a series of bribery exposés on other cases have scared other bureaucrats from green-lighting projects to avoid getting involved in similar accusations. Environmental clearances have also been put on hold. Project approvals are an even lower-hanging fruit than the recent reform measures, since they usually involve little state-government or voting-group opposition. Plans for a single-window clearance, which will allow investors to deal with only one agency instead of the current practice that involves different ministries, are a step in the right direction. We believe the central government is likely to improve the process over the next six to nine months.

Looking at the Indian stock market, it is clear that investors are willing to take exposure to India’s growth potential, but they have crowded to defensive sectors in view of the economic risks. This has led to extreme valuation levels especially in consumer-staple stocks. In many cases, the premium they command versus the Sensex index is currently higher than ever before. Their valuation premiums are at risk of being suddenly deflated should India begin to address its true reform roadblocks.

On the other hand, several mining, materials and construction stocks are trading well below book value. Once our assumption materializes and the government revives project approvals in these areas, the broader market will not necessarily jump. Rather, investors are more likely to significantly shift their holdings towards these more-cyclical companies.

We therefore think investors should have faith that the government will tackle the easier reforms, and position themselves before the rest of the market does.

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