Despite the economic and societal challenges brought about by the COVID-19 pandemic, we believe that the worst is likely behind us and the stage is set for growth in India to make a strong comeback in 2021.² This will likely be driven by the government's long-term policy framework and the Reserve Bank of India's (RBI’s) supportive monetary policies. The growth outlook is further underpinned by benign monetary conditions and low real rates resulting from substantial inward capital flows seeking to participate in India's long-term growth story. An end to the economic disruptions caused by the COVID-19 pandemic in India is now visible: Active cases have consistently declined over the past three months and a large-scale vaccination program commenced in January 2021. 

Indeed, focus should now turn to medium- and long-term growth themes that are receiving further impetus through government policy action during the pandemic and the recently released the 2021 Union Budget. 

Two powerful themes have emerged from the focused policy agenda of the past six years. We believe these will drive India's medium-term growth potential:

1.  Formalisation through a digital economy  
2.  Reinvestment in manufacturing

These two themes should serve as primary tailwinds for the country’s growth potential over the medium term. Both can also feed off each other to create a virtuous cycle that should generate more jobs, improve domestic savings, and enable reinvestment in better infrastructure. Formalisation is driving the growth of a massive digital economy, even as the digital economy is itself simultaneously driving the formalisation process by boosting productivity.

We also believe that manufacturing growth is at an inflexion point and India should continue to benefit from global capital inflows as trade tensions and the diversification of supply chains outside of China seem likely to persist in the medium term. International firms have already committed large investments in India in areas such as electronics manufacturing and the Indian government has turned its policy agenda firmly toward incentivising the localisation of manufacturing. As manufacturing grows, more formal jobs will be created, which we believe will drive income growth and consumption, thereby unleashing another virtuous cycle of growth.

We’ve consistently highlighted that despite the challenges of the COVID-19 pandemic in 2020 and the cyclical slowdown that preceded it, India remains a local, bottom-up story that’s supported by a host of structural reforms already in place to promote formalisation: the JAM⁴ trinity, lower corporate taxes, indirect tax reform, real estate regulations (the Real Estate (Regulation and Development) Act), and the Bankruptcy Act. 

We had also argued that with the fundamental building block of formalisation in place, the Indian government has a unique opportunity to revitalise economic growth through a policy framework we called the three Rs (3R):

1. Recycle: Funding government spending needs through the privatisation of state-owned enterprise (SOE) assets.
2. Rebuild: Aggregating savings by providing tax cuts to the private sector and households; further augment savings by opening various sectors to foreign direct investments (FDI).
3. Reinvest: Providing incentives for manufacturing firms and global capital to reinvest such as savings to substitute imports and increase the country's global market share of exports.

While the Recycle initiatives briefly took a back seat in 2020 amid the disruption posed by the pandemic, the government has consistently moved ahead on the Rebuild and Reinvest policy agendas over the past 18 months, focusing on long-term policies during the pandemic to reduce the corporate tax rate, simplify labour laws, and incentivise localisation of manufacturing, rather than just concentrating on fiscal stimulus.⁵

The latest Union Budget presented on February 1, 2021, prioritised growth over near-term fiscal discipline. It also avoided any sudden tax increases that could have affected investor sentiment. We believe this is the right policy direction, as the fledgling economic recovery needs spending and policy support. Benign global monetary conditions and bottom-up factors favour India, meaning that markets can support more near-term borrowing from the government. 

While some near-term fiscal relaxation has been taken, the medium-term fiscal consolidation path remains intact and consistent. Despite being higher than previous targets, the fiscal deficit is still projected to fall to 6.8% in fiscal year (FY) 2021/2022 from 9.5% in FY2020/2021.⁶ The medium-term fiscal consolidation path has also been defined with a targeted deficit of less than 4.5% over the next five years.⁷

The actual outcome is likely to surprise positively as we find both the nominal GDP growth estimates and tax growth targets conservative given the expected rise in tax collection and high-frequency indicators that we’ve seen over the past few months. 

Crucially, we believe that government spending and policy aims should have a better multiplier effect rather than just providing short-term stimulus, and the multiple policy announcements should strengthen medium-term growth potential and attract foreign capital, particularly when viewed through our 3R framework:

Recycle:

The budget has gone big in this category with an ambitious asset monetisation programme:

• Privatisation of two SOE banks and insurance companies
• Creation of more real estate investment trust-like structures to monetise road highways, power distribution, and rail assets (dedicated freight corridors).
• Monetisation of other core infrastructure assets such as airports, oil and gas pipelines, railway infrastructure, sports stadiums, toll roads, and warehousing. 

Rebuild:

• Extension of special tax benefits for affordable housing to support real estate recovery.
• Provision of approximately US$2.7 billion to recapitalise the SOE banks.⁸
• Plans to create an asset reconstruction company to take over stressed banking sector assets may help accelerate nonperforming asset resolution.
• Raising the FDI limit for insurance companies from 49% to 74% is likely to introduce more capital to India's attractive insurance sector.

Reinvest:

• Capex allocation has seen a healthy growth of 26% in the current year, focusing on areas such as road, rail, defense, and urban housing. There’s an additional allocation to the social policy agenda such as education, healthcare, and public transport networks. At the same time, there’s a reduction in subsidies to fund long-term spending.
• Plans to establish a development finance institution that will provide infrastructure financing with a targeted lending portfolio of around US$68 billion in three years.⁹
• To further incentivise localisation, customs duties on specific auto components, mobile parts, and electrical components have been raised.

A growth agenda driven by successful 3R policies (formalisation, digitisation, and manufacturing) should increase domestic savings. As formal employment and capital formation improve, so should tax collection and capital inflows, giving the government more room to spend, but without leading to higher deficits. These factors should potentially help to reduce the estimated fiscal deficit quicker after reaching its peak of 9.5% of GDP in FY 2021, toward the medium-term goal of 4.5%. 

As a result of successful 3R policies, we’ve already seen a rise in India's share of net exports in areas such as electronics and chemicals. India has also garnered a higher regional share of FDI and foreign portfolio investment flows over the past 12 months.¹¹ This has augmented domestic savings, pushed the current account to surplus, and propelled the country’s foreign exchange reserves to an all-time high.¹² As growth improves in 2021, we expect the current account surplus to moderate due to higher consumer demand; however, we believe that the structural trend of a higher share of foreign flows to India will continue and this should keep external account balances manageable despite higher growth.

Given the favourable structural backdrop, we also see three key cyclical factors turning positive, which augurs well for a V-shaped recovery in growth in FY2021/2022, with real GDP growth projected to reach double digits.

1 Monetary conditions remain benign

Real rates have come down due to higher foreign flows (capital account), supportive central bank policies, and gains in the share of net exports (current account) that are augmenting domestic savings and liquidity. The RBI has supported the recovery with various policy tools—including market interventions—to ensure that both the pricing and credit availability are adequate for growth to recover. This has pushed real rates into negative territory and consumer lending rates to decade-low levels. 

2 The COVID-19 pandemic situation has improved quite sharply

Since peaking in mid-September 2020, active COVID-19 cases have continued their sustained downward trajectory (as of the end of January 2021). India has already started a mega vaccination program with the goal of inoculating 300 million people by the end of July—this includes 30 million healthcare and other frontline workers, and those aged over 50 or with preexisting medical conditions.¹⁴ As of January 30, 2021, 3.7 million people had been vaccinated.¹⁵ In our view, India has enough domestic capacity to produce COVID-19 vaccines. As the vaccination drive picks up pace, we anticipate improvements in more sectors, especially on the services side, which should further boost the recovery.

3 Economic conditions have likely bottomed

We’ve seen both a pickup in high-frequency indicators and an upgrade of GDP estimates for FY2021/2022 at the RBI's recent monetary policy meeting. As the pandemic situation improves, economic activity has normalised faster than expected; over the past few months, high-frequency indicators have surprised positively. We expect this trend to continue, as economic activity completely normalises over the next few quarters.

Given our view that India should experience a sharp growth recovery in 2021 based on cyclical tailwinds supporting the two medium-term growth drivers, we have a positive view of the following sectors:

• Financials
  

Financials should benefit from both a cyclical upturn, such as a growth revival in vehicle sales and housing, as well as longer-term structural trends, including higher spending through the formal channels (e.g., credit cards), and an increasing savings pool in the country. We expect banking asset quality to remain under control since large private banks have raised capital to strengthen their balance sheets. Pandemic-related stress has also been lower than expected and the RBI has actively intervened in the market to prevent systemic issues.

• Materials and industrials

In our view, these sectors directly benefit from economic recovery, increased government spending on infrastructure, and an upturn in real estate through increased demand for cement, building materials, and commercial vehicles.

• Consumer discretionary

As the economy rebounds, this sector should continue to do well with higher sales of discretionary items such as consumer durables, electronics, and automobiles.

• Structural themes

We remain constructive on macro themes such as import substitution plays that benefit from the government's supportive domestic manufacturing (e.g., electronic manufacturing services companies, policies that are supportive of industries associated with the auto sector, and production diversification away from China due to the trade war (specialty chemicals). These companies are present across both the consumer discretionary and materials sectors.

• Consumer stables

Valuation of stocks in this segment has rerated ahead of growth expectations, as the group is expected to benefit from the lockdown. We see better opportunities in more cyclical sectors such as consumer discretionary and financials.

We believe that the worst is behind us and the stage has been set for a strong comeback in 2021. We believe the recovery will be two pronged: Formalisation will continue to boost the digital economy while reinvest policies should lead to a revival in manufacturing. Given favourable structural government policies and cyclical tailwinds that support the two transformative medium-term trends, we believe the medium- to long-term investment outlook for Indian equities remains compelling.

1 Bloomberg, January 7, 2021. 2 National Statistical Office: First Advance Estimates of National Income: The growth in real GDP during 2020/2021 is estimated at -7.7% compared with the 4.2% growth rate in 2019/2020. 3 Manulife Investment Management, as of February 11, 2021. 4 JAM refers to “Jan Dhan Yojana, Aadhaar and Mobile,” which is a government initiative to link Jan Dhan bank accounts, mobile numbers, and Aadhar cards (identity cards). 5 The government reduced the corporate tax rate to 22% from 30% in 2019, consolidated 44 different labour laws into four labour codes, and introduced production-linked incentive schemes in key electronic and pharmaceutical manufacturing segments. 6 “Union Budget,” India Ministry of Finance, February 1, 2021. 7 “Union Budget,” India Ministry of Finance, February 1, 2021. 8 “Union Budget,” India Ministry of Finance, February 1, 2021. 9 “Union Budget,” India Ministry of Finance, February 1, 2021. 10 Fiscal deficit data sourced from RBI, India Ministry of Finance, Kotak Economics Research estimates, as of February 2, 2021; current account data from Bloomberg, as of September 30, 2020. 11 “FDI inflows into India jump by 13% to $57 billion in 2020: UN,” Times of India, January 26, 2021. 12 Bloomberg, as of December 31, 2020. 13 Negative real rates data sourced from RBI and Bloomberg, as of December 31, 2020. Home rates data sourced from SBI, HDFC, Jefferies, as of December 31, 2020. 14 Reuters, January 15, 2021. 15 Our World in Data, as of January 31, 2021. 16 www.covid19india.org, as of February 2, 2021. 17 CSO, Kotak Institutional Equities estimate, January 2021.