India: Keeping score

Source: Indian Express

"The most important economic event of 2014"

When Martin Feldstein, the soft-spoken Harvard economist, sounds ecstatic about something (anything), it's time to pay attention. In his newest piece about the election of Narendra Modi, Feldstein puts the remarkable performance of the Indian stock market in perspective. "India's recent general election could be the most important positive economic event of 2014," he writes.

Investors appear to agree. The benchmark Sensex Index has soared almost 20 percent this year, outperforming both the S&P 500 and the emerging markets index by a wide margin. These gains come in spite of persistent economic challenges, including high inflation, declining industrial production, and troubling fiscal imbalances. To paraphrase the Joker from The Dark Knight... why so optimistic?

Source: Yahoo Finance

"No one better qualified"

India optimists are wagering that Modi, a scrappy pragmatist and the son of a tea seller, can leverage his parliamentary majority to address several longstanding constraints to India's economic potential. Modi's success as Chief Minister of Gujarat has inspired the image of a turnaround artist prepared to roll up his sleeves and finish the job left by his predecessors. Last month, The Economist asserted, "There may be no one better qualified than the forceful Mr. Modi to kick-start the investment cycle."

But, behind the sunshine of optimism illuminating the skies over New Delhi, the storm clouds of economic reality threaten to rain on Modi's parade. Last year, the Indian economy grew only 4.4 percent -- 3 percentage points slower than its emerging markets neighbor, China -- and inflation remained high (see chart below). Savers are shunning bank deposits in favor of gold, putting pressure on both the banking system and India's current account balance. These trends, combined with a worsening business environment, have depressed private investment.

Source: Capital IQ

Window of opportunity

Feldstein is quick to recognize these realities. "The measures needed to stimulate economic growth will take time to implement and to produce results," Feldstein acknowledges. None of the items on Modi's reform agenda are easy. Unlike Japan, India can't warm up with some light fiscal stimulus and monetary easing exercises before getting into the high intensity intervals of structural reform.

Even so, the market seems to have faith that Modi has the muscle and stamina to succeed where so many of his predecessors have failed. The key question for investors is: how much time markets are willing to give the Modi administration before the post-election momentum wears off and valuation multiples compress?

Source: Yahoo Finance

I won't try to time the market by taking a position on current valuation multiples (which admittedly make the market look expensive) and guessing when investor sentiment might change. I see India, like any emerging market, as an opportunity to capitalize on a strong secular growth story over a long time horizon. In other words, I'm more interested in the denominator of valuation multiples.

To that end, I will be following the metrics Feldstein has identified to measure the impact of Modi's reforms. I've compiled some high frequency data around the major reform areas (acknowledging that some, including reducing corruption and expanding privatization, are hard to measure quantitatively) to size up the challenges and provide a foundation for evaluating success.

Education

1. Public spending on education
2. Student-to-teacher ratio

Only 60 percent of the adult population in India can read and write at an elementary level, and the quality of teachers has fallen substantially in aggregate. Public spending on education declined from 11.5 percent of GDP in 2003 to 10.4 percent in 2011. Moreover, the student-teacher ratio stands at 35:1, versus the average of 26:1 among lower-middle income countries.

Infrastructure

1. WEF competitiveness rankings
2. Paved roads
3. New roads

Insufficient infrastructure remains one of the biggest challenges for businesses, and one of the biggest headaches for policymakers. In its latest Global Competitiveness Report, the World Economic Forum identified "inadequate supply of infrastructure" as the single most problematic factor for doing business in India. As of 2011, only 53 percent of the roads in India were paved. New roads are also being added at a slower pace, growing at 2.35 percent in 2011 vs. 3.8 percent between 2004 and 2010.

Source: World Economic Forum

Fiscal consolidation

1. Budget deficit
2. Public debt

Large deficits are absorbing a large portion of India's precious savings. Reducing the budget deficit remains a top priority for Modi, who appears committed to meeting the ambitious targets established by his predecessors. The chart below shows a positive trend, but the challenge remains daunting.

Source: International Monetary Fund

Private Investment

1. Total investment
2. Cost of doing business

India needs private investment in order to deepen its industrial base, enhance the productivity of its workers, and create a foundation for continued prosperity. A surge in investment would confirm the business community's confidence in India's economic prospects. It would also demonstrate the government's progress in streamlining convoluted administrative procedures, eliminating wasteful monopolies, and reforming labor regulations to encourage more hiring.

Also watch the cost of doing business metrics provided by the World Bank. For example, looking at the cost of business startup procedures, one notices India underperforming its peer group, with costs equating to 47.3 percent of gross national income versus 42.4 percent across other lower-middle income countries.

Source: International Monetary Fund

Foreign Direct Investment

1. FDI inflows

Modi made Gujarat a prime destination for foreign direct investment. He will need to overcome enormous legal and institutional barriers to spread the benefits of FDI -- new technologies, industrial expertise, and desperately-needed capital -- across India. During the election, the BJP signaled their intent to liberalize India's complex foreign investment regime. As the chart below shows, there's plenty of room for progress, as FDI represented less than 1.5 percent of GDP in 2012.

Source: World Development Indicators

The next underdog story?

Anyone trying to take a position on the Sensex should remember that Rocky, the ultimate underdog story, played out over 35 years and 6 glorious movies. The important question for value-minded investors is whether Modi can mobilize the right combination of innovative policies, political action, and administrative reforms to address India's longstanding structural issues and revitalize the country's long-term economic prospects. Now that the sugar high has started to dissipate and investors are waiting to see whether the economic data verify their optimism, we should look to the characteristics Feldstein has identified before we either celebrate or deny the success of Narendra Modi.