India’s Reform Movement Gains Momentum

India has embarked on a sweeping reform movement under Prime Minister Narendra Modi, which has attracted investors’ attention. Templeton Global Macro CIO Michael Hasenstab recently visited India, and takes a look at some of the reforms he’s most excited about as a global fixed-income investor. He believes India’s future looks bright and that its growth trajectory should remain strong—despite some short-term adjustments.

Earlier this summer we traveled to India—it was a good time to visit. The country has put through some ambitious reforms in recent years under the leadership of Prime Minister Narendra Modi, who took office in May 2014. India’s economy has appeared invigorated under Modi, with annual gross domestic product (GDP) rising from 5.5% in 2013 before he took office to 7.5% in 2015 and 8.0% in 2016.1 That growth rate has been the highest among the world’s largest economies, and it has attracted waves of foreign capital in recent quarters.

However, we are at an important juncture in Modi’s tenure—growth has moderated a bit in 2017 (estimated annual growth is 7.1%2 ) as some reform efforts have generated short-term headwinds. Some market participants have seemed concerned, but the short-term negative effects on growth are often necessary consequences of pursuing the right longer-term solutions.

The key to India’s economic future likely won’t depend on what happens to growth over the next few quarters, but instead on whether Modi can continue to push through the types of long-lasting transformational reforms that India needs, and whether they can meaningfully expand the country’s economic potential. We believe they can.

Already, we’ve seen bankruptcy laws enacted (May 2016) that are intended to help enforce contracts and ultimately encourage more lending activity by bolstering confidence in the financial system. We have also seen a massive revision of the tax code, putting in place goods-and-services taxes (implemented in July 2017) to help remedy the complexities and inefficiencies of the domestic tariff system.

The government also deployed a bold plan to pull money out of the shadow economies and bring it into the formal economy by demonetizing 86% of the currency in circulation (November 2016). These are unprecedented and important structural reforms for India—Modi’s government has been able to push ahead in areas of policy that have languished for decades under prior governments.

From a macroeconomic standpoint, Modi has also instilled much-needed stability. The Reserve Bank of India (RBI) has maintained responsible monetary policy, in our view, while using inflation targeting to break periods of high inflation that could destabilize the economy. Inflation in India has dropped from more than 10% in 2013 to below 2% on a year-over-year basis in 2017.3 On the fiscal side, we think the government has also done its part by maintaining a responsible budget. The current account has also significantly improved from the large deficits of 2013.

Taken together, we believe India’s macro picture looks relatively healthy. However, what’s good for long-term health can sometimes feel like tough medicine in the short-term. A credible central bank may need to maintain higher interest rates and a government may need to spend less to maintain fiscal discipline—these measures can inhibit short-term growth but fortify the longer-term health of the economy.