Guest Comment: Can India Be Unshackled?

My friend, Mehran Nakhjavani of MRB Partners was kind enough to provide a guest comment, Celebrity Yoga, Tear Gas and Reform: Can India be Unshackled?:

India arguably owes its existence as an independent democracy to a charismatic guru who made the rulers of the day squirm with his uncomfortable questions. It took some 50 years of for the movement led by Mahatma Ghandi to topple the British Raj, but the current anti-corruption protest led by guru Ramdev is asking for something far simpler. While Ramdev and his supporters were greeted this past weekend with a display of force worthy of the colonial masters in their day, his essential demand is merely for the rule of law to be applied equally to India’s feckless and bloated public sector, as well as to the private sector that feeds at the trough of privileged access to bureaucrats and their political masters.

That India’s government feels so deeply threatened by simple demands to crack down on corruption speaks volumes. India’s burgeoning middle class has in recent years taken a huge leap forward in its access to higher standards of living and a better quality of life, but along with more income and more information comes less tolerance of the shenanigans of an incestuous and venal ruling class. For as long as the only route to social and economic advancement lay through the door of dealing with or being employed by the government, this middle class was co-opted into the self-serving game. But for the past decade or so, the path to advancement, and the escape from caste and social limits, has come via education, technology and business savvy (all of which are in plentiful supply in India) and fortunes have be made without needing access to government connections.

The disgust over a telecom scandal that has exploded in recent months is by no means the first in Indian history. However, this episode is shaping up to be a social mutiny because of three factors: the emergence of a large middle class as noted, the rapid dissemination of incendiary details of the scandals via social media, and most importantly, the gathering storm over the immediate cyclical prospects of the economy.

The inflation tiger is out of its cage

Indian policymakers are frozen in the face of an inflation tiger that has already escaped its cage. They are pinning all their hopes on the ability of the central bank to choke off price pressures with monetary policy. But they remain absolutely incapable of supporting monetary policy with the requisite fiscal tightening. Watching this slow-motion train wreck, India’s middle class has every right to fear the consequences: a credit squeeze and a further delay in being able to afford a new home, along with less attractive job prospect to match their hard-won educational qualifications.

India’s inflation is the highest among emerging markets, and it can’t blame food prices for its problems: headline inflation currently outstrips food CPI by 1.5%. The mounting inflationary pressure has come despite a cumulative 200 bp of tightening by the Reserve Bank of India (RBI) since March last year which has had a moderating effect on monetary expansion, but which has not prevented a dramatic expansion of credit growth to the private sector. In addition to the CPI, asset inflation is a mounting problem, with major city home prices rising at a compound annual growth rate of 23% since 2007.

There are, of course, very powerful structural forces driving India’s long-term economic growth, including a dynamic and globally competitive service sector, very positive demographic tailwinds and massive pent-up demand for both capital and consumer goods and financial services. The key constraint is its infrastructure, which, in turn, is a reflection of a creaky public sector. To the extent that investment can debottleneck key chokepoints such as transportation and energy, the inefficiency of the state does no more to sprinkle some sand into the gears of economic growth. But the public sector’s inability to balance its books is a long-term challenge.

In the current circumstances, with policy rates and bond yields both ratcheting up as a result of the inflationary surge, the cost of budget deficits of the order of 10% of GDP generates an appreciable crowding-out effect for the private sector. The RBI’s policy tightening is raising the cost of capital for India’s businesses and will continue to act as a drag on their return on equity (ROE).

Despite significant underperformance relative to other EM equities, Indian valuations are still not compelling. Its trailing P/E ratio is still 40% higher than other emerging markets, and this premium is no longer justified by a substantial ROE premium.

Conclusions for investors

Avoid Indian equities. The RBI tightening cycle is in its very early stages and there is as yet little evidence that overheating pressures are waning. Typically, investors will seek to front-run economic indicators, so timing re-entry is by no means straightforward. Three pieces of evidence will need to be in place or imminent before buying equities: real credit growth to the private sector lower than real GDP growth; real policy rates close to potential GDP growth rates; and attractive valuations within the EM equity universe.

Mehran Nakhjavani

MRB Partners

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I thank Mehran for sharing his insights on India with my readers. I invite institutional clients to contact MRP Partners at the contact info above and get additional information on their research and services.