Fairfax notes on developments in India

I’m including below select excerpts from the annual letters of Prem Watsa, one of the most distinguished value investors in the world who recently launched a fund dedicated to India “Fairfax India”.

These excerpts provide a concise and insightful view into the key developments in India since the advent of PM Modi in 2014. If you have not been following the India story closely over the last few years, these observations are valuable, and especially so to help you decide in what way & to what extent you would want to participate in the inevitable growth of India.

My highlights are in blue

Excerpts from the March 2016 letter (for FY2015)

“While we are bottom-up investors looking to buy exceptional Indian companies at reasonable prices, since our investment thesis was predicated on the transformational impact on the Indian economy of Prime Minister Modi, we would like to review how things are tracking in India as compared to our initial expectations.

We are not in the large camp of naysayers who are disappointed because they expected miraculous changes and immediate results. We had no such expectations for an economy that was moribund from 67 years of socialism, a literally unnavigable bureaucracy and endemic corruption, but we see significant progress on many important fronts since the new government took office. Here is a list of measures already enacted by this government (our apologies that the list is so long!):

Crack-down on crony capitalism: Corruption in high places has dramatically declined and there is a crack-down on crony capitalism and the patronizing of well-connected industrialists by public sector banks (although they still have to deal with vested interest lending of the past). The tendering process of government departments and public sector companies is being made transparent and decision-making powers are being responsibly delegated.

Implementation of a biometric-based identity program (Aadhaar scheme): The Aadhaar network of biometrics-based identity now covers 970 million people or 75% of the country’s population. Growth in Aadhaar coverage creates a credible base for future direct benefit transfers (DBT) of government subsidies.

Financial inclusion: Almost 200 million new bank accounts have been opened under the Jan Dhan scheme, a program launched by Prime Minister Modi to open zero balance bank accounts for all Indians who did not already have a bank account. 43.2% of these accounts are linked to Aadhaar and they are thus unique. This creates a credible base for expanding the scope of DBT in the future. Only some 32 million of these accounts have zero balances and savings accounts opened under this scheme have aggregate deposits of $4.5 billion. Out of India’s 240 million households, 140 million middle and higher income households have already been mapped through another scheme called the LPG scheme, and the Jan Dhan scheme will likely cover the vast majority of the rest.

Subsidies shifting to DBT: The government has started the process of shifting all subsidy payments to a DBT framework. The liquefied petroleum gas (LPG) subsidy has already completely moved to the DBT framework and this has resulted in a substantial elimination of duplicate and fraudulent subsidy claims. Without DBT, it was suspected that 50% of the subsidies ended up in the hands of middlemen and crooked politicians. The government is doing a pilot program to move the food subsidy to DBT. Recently the government also took a decision to move the kerosene subsidy to the DBT framework. A combination of lower crude prices and deregulation of diesel and petrol prices should cut down the fuel subsidy cost from $9 billion in fiscal 2015 to an estimated $4.5 billion in fiscal 2016.

Improvement in national railway infrastructure: The government is focusing on improving railway infrastructure and proposes to invest $130 billion in this area over the next five years. Projects worth $14.5 billion have already been approved for capacity augmentation. Also, Japan has agreed to modernize 400 railway stations that the government has identified for upgrading with private investment.

Corporate tax: In its budget last year, the government announced its intent, over the next few years, to cut the corporate tax rate to 25% from 30% and to eliminate exemptions, in order to simplify the corporate tax structure and to improve the competitiveness of Indian companies. Recently, the government announced a roadmap for implementation, with the process beginning in this year’s budget. This should improve the ease of doing business.

Financial turnaround of state power distribution companies (DISCOMs): The government has approved a plan to revive the chronically dysfunctional DISCOMs. The DISCOMs’ collective debt is some $65 billion at rates of 14-15% per annum. The government has proposed that the states should take over 75% of DISCOM debt over the next two years and bear 50% of any future DISCOM losses. This proposal should improve the financial health of DISCOMs and, along with other measures to lower costs and improve efficiency, should help achieve the goal of 24⁄7 power supply.

Auction of coal mines: A total of 31 coal mines have been auctioned so far, including 13 mines that are currently non-producing where production should start in the next 12 months. Another 36 mines have been allotted to public sector companies and 130 non-producing mines are expected to be auctioned or allocated over the next year. This could add, over time, 300-350 million tons to the current annual coal production of about 500 million tons.

Other mineral mines are also to be auctioned: The government will henceforth conduct open auctions for all new mining concessions for bauxite, iron ore, limestone and manganese ore. This should boost India’s mining output in the coming years and reduce its dependence on imports. States have identified 108 new and unexplored mineral blocks that can be auctioned in fiscal 2016 and the auction process has commenced.

Higher foreign direct investment (FDI) in insurance, defence and railway infrastructure: The government has increased FDI limits in the insurance, defence and railway sectors. Further, it has allowed composite FDI and foreign portfolio investments (FPI) caps in most sectors, giving companies flexibility in deciding the composition of foreign investment they seek to attract. FDI of $1.8 billion has been announced in the insurance sector due to the increase in FDI limits. India was recently the top ranking destination for FDI, ahead of China and the U.S., with $31 billion of inflows in the first half of 2015.

Bankruptcy code: India does not have a proper bankruptcy code to deal with the issue of business distress. The multiple laws in this area, coupled with delays in the judicial process, have resulted in inordinate delays in resolving business distress. The government promised a world-class bankruptcy code in last year’s budget, and a draft code has been introduced in Parliament.

Smart cities: The government has unveiled a list of 98 cities in which to promote integrated planning for urban India. Under this scheme, the government intends to improve the quality of urban life and drive economic growth by focusing on the availability of water, electricity, public transport, sanitation, healthcare and education. The central government would provide $15 million annually for five years to each of the named cities and any remaining amount required would be financed by the state governments.

Metro rail (commuter infrastructure): 12 new metro rail projects with a total length of 460 kilometres (km) and a cost of $25 billion are under various stages of approvals and funding arrangements. This is in addition to the 270 km of metro rail already in operation, and 280 km under construction. Projects worth $11 billion exhibit high visibility, since all approvals and funding have been finalized for these projects; the balance should be ready for awards over the next 18 months. Civil contractors, rolling stock suppliers, and transmission and distribution (T&D) equipment manufacturers would be key beneficiaries.

Progress on dedicated freight corridors (DFCs): $12 billion of work on Western and Eastern DFCs commenced in late 2013, and work orders of $3 billion have already been placed. Ongoing work consists of civil, electrical and mechanical jobs for tracks and bridges. With commissioning planned by December 2019, awards of more orders worth at least $3 billion are expected in 2016. Funding for the $6 billion Western corridor has been finalized with the Japanese International Cooperation Agency. Funding for the Eastern corridor has been partially arranged with the World Bank and 90% of land acquisition is complete.

Archaic labour and other laws amended: Legislation to amend the Factories Act, 1948, the Apprentices Act, 1961, and the Labour Laws Act, 1988 have been passed, with the aim of easing bureaucratic interference for manufacturers. The government also intends to further ease labour laws but needs to negotiate and agree changes with labour unions and the opposition parties. Meanwhile it has also given the flexibility to states to amend labour laws to promote industrial growth. States like Rajasthan, Madhya Pradesh and Gujarat have already taken the initiative to amend labour laws and Maharashtra is also likely to change labour laws to encourage manufacturing.

Elimination of obsolete laws: The government has passed legislation repealing 125 statutes. A committee set up by the government to identify obsolete laws has identified 1,741 acts to be repealed. The process of repealing is in progress and the government is seeking views from relevant ministries to eliminate the laws.

Make In India: In September 2014 the government launched the ‘‘Make In India’’ initiative to promote manufacturing in India. With the intent of enhancing workforce skills and generating employment in manufacturing intensive sectors, the program focuses on 25 sectors including automobiles, chemicals, textiles, pharmaceuticals and electronics. The government has liberalized norms for foreign investment in these sectors, with most being open to 100% foreign investment.

Invest India: With dynamic leadership, this national investment promotion and facilitation agency (which is a joint venture among the Government of India, the Federation of Indian Chambers of Commerce and Industry (FICCI) and state governments of India) has been rejuvenated. The agency’s team is made up of successful professionals with prior experience working at major global consulting firms and corporate houses in India, all of whom have post-graduate degrees from prestigious foreign and Indian institutions in disciplines such as engineering, economics and business management. The agency’s mission is ‘‘promoting foreign investments in India in a focused, comprehensive and structured manner while acting as the first reference point to provide quality input and support services to foreign investors.’’

Involvement of states to improve business environment: Given the federal structure of governance, states also need to be involved in improving the business environment. The central government, with assistance from the World Bank, has ranked states on the ease of doing business. As noted above Rajasthan, Madhya Pradesh, Gujarat and Maharashtra have focussed on labour law amendments; as well, Maharashtra has also simplified procedures to start a business.

National agriculture market: The government has proposed to set up an online trading portal where farmers could sell their produce to buyers anywhere in India. It has allocated $30 million over the next three years to cover 585 regulated markets across the country. This should integrate agriculture markets across India and eliminate the requirement of multiple licences and fees. The integrated market should help improve the supply chain, reduce wastage and provide better pricing to farmers.

Populist decisions avoided: The government has avoided taking populist decisions and instead has tried to cut expenditure by eliminating wasteful subsidies, as follows:

  1. It has taken several decisions to reduce the fuel subsidy, and recently announced elimination of the LPG subsidy to households earning more than $15,000 per year.
  2. It has announced modest minimum support price (MSP) increases, which in turn has helped contain food inflation.
  3. It has focused on executing existing projects to decongest severely congested rail networks rather than announcing new trains and projects. It has also raised passenger fares and freight charges to increase rail revenue.
  4. To improve the efficiency and work culture of the bureaucracy, it has launched a biometric-based attendance system that should help cut absenteeism and improve the punctuality of bureaucrats and government officials across the country.

As the government works tirelessly to slash red tape, generate massive job creation through a fast-growing economy and attract increased foreign and infrastructure investment, the Governor of the Reserve Bank of India (RBI), Dr. Raghuram Rajan, has been a crusader for a more competitive and efficient banking system in India. The RBI has granted 23 new banking licences in the last two years, has been instrumental in promoting the new bankruptcy code which is now before Parliament and has introduced measures to reform public sector banks. Since Dr. Rajan took office in September 2013, CPI inflation has decreased from 10.5% to 5.6% and the wholesale price index (WPI) has gone from 7.1% to minus 0.7%.

As always with massive change, there are some obstacles. The politically motivated opposition, which controls the upper house of Parliament, has managed to thwart legislation for the implementation of a national GST and for land acquisition reform. The government has not been forceful in pursuing reforms to the public sector banks. Opposition arises from entrenched vested interests (ironically, the desirable reduction of subsidy-funded consumption growth and crony capitalism-driven investment by the ‘‘advantaged’’ corporate houses results in a short-term drag on the economy). But overall, India is in the throes of making monumental transformational changes for the better.”

Excerpts from the March 2017 letter (for FY 2016)

Prime Minister Modi continues to aggressively pursue the implementation of all the reform measures that we wrote about in last year’s letter. Many of these reforms required legislative changes. The government successfully passed the following bills by building a consensus:

  • The constitutional amendment bill to enable the introduction of a single goods and services tax in place of the current myriad number of indirect taxes.
  • The Aadhaar (targeted delivery of financial and other subsidies, benefits and services) act to enable targeted delivery of government subsidies and services using the biometric Aadhaar identity.
  • An insolvency and bankruptcy code to help resolve business stress in a timely manner so that the value of underlying assets can be maximized. This is important given the backdrop of large non-performing assets in the banking system.
  • The real estate regulation and development act to establish a real estate regulator in every state so that the interests of consumers, and in some cases developers too, can be protected. Bargaining power in the sector which hitherto was overwhelmingly in the hands of the developer should now be more balanced.
  • An amendment of the RBI act, introducing a new monetary policy framework. Monetary policy setting has now been entrusted to an independent monetary policy committee (MPC) which has an explicit inflation targeting mandate. The RBI will have a majority on the MPC, ensuring its independence.

India continued to build on the macro-economic stability achieved over the last couple of years with the fiscal deficit, inflation and the current account deficit all projected to fall in fiscal 2017 (FY17).

  • The government continued on its path to fiscal consolidation by committing to reduce the fiscal deficit to 3.5% of GDP in FY17. Data for the first 9 months of the financial year suggests the government is on track to achieve this.
  • Inflation continued to moderate and in FY17 should average less than 5% for the second consecutive year. While this is partly due to the fall in global commodity prices, the government should be given credit for continuing its tight fiscal policy and allowing only modest increases in support prices for farm products.
  • India’s current account deficit has continued its declining trend with the deficit likely to fall below 1% in FY17, the lowest in over a decade. Further, the RBI successfully managed the redemption of high cost foreign currency deposits raised from non-resident Indians during the ‘taper-tantrum’ of late 2013 without creating any volatility in either the currency market or money market.
  • As a consequence of continued macro stability, the Indian rupee, compared to other emerging market currencies, remained relatively stable through the course of 2016 despite bouts of global volatility after the Brexit vote and the U.S. elections. In the last three years, the Indian rupee has outperformed a basket of emerging market currencies by a wide margin.
  • Continued moderation in inflation, which is now well within the target band of 2-6%, allowed the RBI/MPC to cut interest rates by 50 basis points in 2016. Consequently, interest rates across the spectrum fell. The yield on the benchmark 10-year government security fell by 125 basis points through the year while those on the benchmark 3-month treasury bill fell by about 100 basis points.

The government continues to focus on increasing the enrolment in Aadhaar and using it for efficient targeting of government subsidies and programs. As of January 2017, over 1.1 billion people had been issued the biometric Aadhaar identification number, covering over 90% of the adult population. The government’s effort to open bank accounts for those under served by the formal financial system has also continued to yield good results. By the end of January 2017, a total of 270 million bank accounts had been opened. Of these, more than half are linked to the unique Aadhaar number and are thus ready for direct transfer of government subsidies. The government has already shifted the cooking gas subsidy to direct benefit transfer (DBT), whereby the subsidy is directly credited to the intended recipient’s bank account. The government is currently doing a pilot study to shift other subsidies such as those for kerosene, food grains and fertilizers to the DBT mechanism. Aggregate subsidies have already fallen due to the decline in oil prices and deregulation of petrol and diesel prices. After the shift to DBT, subsidies are likely to fall further.

India continued to be the fastest growing large economy in the world. GDP growth improved by 40 bps to 7.3% during the first three quarters of 2016, largely due to improvement in agriculture growth to 2.4% from 0.7% last year. Both industry and services growth was broadly stable at 6.4% and 9.1% respectively. Given the normal monsoon rainfall after two consecutive droughts and salary revisions for government employees, consumption demand showed signs of revival in the second half of the year.