Last week, Reserve Bank of India unexpectedly lowered its policy rate for the second time this year. This is the latest push to revive economic growth in the developing nation. Citing a weaker economy, the central bank in Asia’s third-largest economy lowered its policy repo rate by 25 basis points to 7.50%. This surprise move came shortly after the Indian bank made a similar cut in January 2015. “Repo rate” is the level at which the central bank lends to commercial banks. With economic growth as the main reason behind this move, investors should be open to adding Indian holdings to portfolios.
Historic Change in India’s Monetary Policy
Reserve Bank of India Governor, Raghuram Rajan, has been a long advocate of moving to an inflation targeting framework. This is when monetary policy criteria focus on containing inflation, a persistently high measure for India. In doing so, the RBI and Indian Prime Minister Narendra Modi unveiled a historic agreement in early March 2015 that will see the Reserve Bank of India move to a formal inflation-targeting system.
Reasoning behind Rate Cut
The Reserve Bank of India (RBI) stated that the move is designed to slow the pace of fiscal deficit and step up public infrastructure spending.
The RBI has set a 4% inflation target for 2016-17 and for all subsequent years a range within a 2% band. In the case that inflation falls outside the 2%-6% target range for three consecutive quarters, the RBI will explain why, what actions it will take and give an estimated time of normalization. The RBI wanted to quickly offer guidance on how it would go about its new tasks and chose to cut rates due to outside pressure from other central banks around the world taking similar action.
The move indicates that Prime Minister Modi’s business-friendly administration is serious about improving the Indian fiscal position. Modi’s most recent budget discusses delaying its fiscal consolidation targets for a year, until 2018, to allocate government’s extra spending towards infrastructure. To compensate for the extra infrastructure costs, the government will phase out several fuel subsidies and slowly do away with price supports for agricultural goods, both of which have been traditional drivers of inflationary expectations.
A mutual agreement between Modi’s political party and The RBI will bode well for the economy as there will be more money flowing and greater tax revenues come the collection period.
Who Benefits from Rate Cut
Indian Middle Class Consumption
More affordable loans for big ticket items like homes and automobiles will increase consumer sentiment, making these purchases more common. This is especially applicable to India’s growing middle class. India’s global middle class, defined as those earning $10-$100/day, is at around 100 million people, or 10% of its population according to an Ernst & Young report. It is projected that this group will grow steadily, reaching 200 million by 2020. After this, India’s middle-class should accelerate, reaching 475 million people by 2030 and adding more people than the Chinese to the global middle class worldwide after 2027. That’s nearly 5 fold in India’s middle class in the next 15 so years.
Bond prices will gain as rates fall, increasing the value of bond portfolios for corporations and households. The Indian benchmark 10-year bond yield dropped to as low at 7.61%, its lowest level since July 2013, after the rate cut.
The Indian Rupee (INR) has deteriorated about 15% in the last two years against the US Dollar, highlighting the Indian economy’s difficult transition following an extended period of low growth and high inflation. The INR hit a 10 year high against USD in 2013 summer at 67.31INR/USD. Volatility between the pair has stabilized in the last year, setting around the 60 INR/USD range.
The Bombay Stock Exchange index (INDY) hit an all-time record high of 30,010.91 after the rate cut announcement. It was the first time the index has crossed the 30,000 mark. Prime Minister Narendra Modi’s election victory nine months ago resulted in India becoming Asia’s second best performing stock market, after China, over the last 12 months. Despite slowing economic growth, investors pinned hopes on sweeping reforms such as higher capital spending and larger fiscal restraint.
Indian companies benefit from the improved market sentiment as they can issue equity easier. Though Indian equities are trading at an 18x P/E ratio in the MSCI India Index, the second highest in emerging Asia as measured by Thomson Reuters Datastream, higher consumer spending and easier availability of loans will drive growth and profits across the Indian economy.
From a global perspective, the World Bank has indicated that it expects India’s GDP to grow at 6.4% in 2015 and likely to catch up with China in 2016 through 2018.
Manufacturers & Industrial Companies
Indian companies have long complained that borrowing to invest money in India was expensive as rates were too high. To compliment India’s “Make in India” program, designed to transform country into a global manufacturing hub, this rate cut is the jolt that many manufacturing and industrial companies need. Here are two companies who could benefit from India’s economic development
Larsen & Toubro (NSE:LT)
Larsen & Toubro is a major Indian conglomerate that is positioned to take advantage of the Modi’s administration focus in infrastructure. The company does everything from engineering to construction and manufacturing. L &T is one of the top 20 largest nationally listed companies in India.
Generally, the company has reported profit margins in the high single digit range, offering international investors a profitable yet diversified business. With the economic and political push to drive India’s industrial sector, L&T could be the bridge for international investors that want exposure to an emerging economy.
Tata Motors (NYSE: TTM or NSE: TATAMOTORS )
To many Westerners, Tata Motors is best known for acquiring luxury car brands Jaguar and Land Rover from Ford back in the automaker’s dark days of 2008. Tata has vehicles covering all types of transport like cars and utility vehicles, trucks, vans, buses and mini trucks. With the investment friendly government, growing middle class and cheaper loan costs, there will be a boost in the Indian auto market. Since Tata covers every segment, from industrial transport trucks to passenger vehicles, the company will be a beneficiary of this tailwind.
The company’s stock trades in the NYSE, so investors can benefit without the hassles of investing in a foreign stock market. With a P/E of 9.7x, which is amongst the lowest when compared to peers in the industry, Tata Motors is a relatively cheap way to invest in India’s economic resurgence while also being offered the global diversity of having a presence across 175 countries.